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SYLLABUS-B.Com - Banking and Insurance Semester IV

Module 4.1 Universal Banking

Evolution of Universal Banking, Commercial Banking Vs. Development

Banking

Sources and Uses of finds

Universal Banking as a Mix of Commercial and Development Banking

Asset-Liability Mismatch Possibilities

Risks in Project Lending

Short term nature of funding resources

Universal Banking in the open economy context

Off Balance sheet items and services that the development wing of

the universal banks provides The entry of commercial banks into the securities business

Consumer finance, Retail Banking, Principles of Retail Lending, Case

studies

Merchant Banking, Non banking investments and activities of banks

Universal banking and the future of small business lending

Case studies-Universal Banking abroad-applicability of universal

banking in open market-oriented emerging economies-advantages

and disadvantages; supervisory issues and regulatory concerns

The debate over universal banking in India; Recent trends in

universal banking in India.

Challenges of Universal banking in the Indian context

International Banking

Mergers & Acquisitions

Syndication of Loans

Prudential lending Norms

Non-Banking Finance Companies-RBI guidelines

Venture Capital, Money Laundering

RBI Act 1934

Bibliography

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S.No. Chapter Page

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Universal Banking

i. Evolution

ii. Universal BANKINGV/S Narrow Banking

Challenges in Banking Sector

i. Basel Committee

ii. The New Growth Avenue

iii. Consolidation

iv. Future Outlook

v. Corporate Governance

Indian Financial System

Commercial Banking Vs Development Banking

Development Banks

Development Financial Institutions

Asset Liability Management (ALM)

i. What is ALM

ii. Scope of ALM and Role of ALCO

iii. Risk Management

iv. Tools of ALM and their mechanisms

v. Relevance of ALM to printing of Currency Notes

Risks in Project Lendingi. Credit Policy and Bank Lending

ii. Bankers Credit Report, Specimen of a CR

iii. Credit Control

Short Term Nature of Funding

i. Consumer Finance

ii. Need of Emphasis for Retail Banking

Universal Banking: The Road Ahead

The Challenges of Universal Banking in the Indian context

and Universal Banking abroad

The Debate over Universal Banking in India

i. Thoughts on Universal Banking

ii. Advantages and Disadvantages

iii. ICICI-ICICI Bank Merger

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The Entry of Commercial Banks into the Securities Market

Money Laundering

i. Essential Elements and Legal Setup

ii. Role of Banks With Regard To Money Laundering

iii. Know Your Customer (KYC)

Computers and Banking

i. Banking Services through Information Technology

ii. Bank Automation

Customer Relationship Management(CRM)

Full Service Banking Relationship Managers are a New Breed

of Banker

Loan Syndication

i. Loan Syndication Domestic

ii. Loan Syndication External

Mergers, Amalgamations and Takeovers

Merchant Banking

International Banking

International Financial Market

Major Financial Instruments

Multilateral Financial Institutions

International Equity Markets

Universal Banking Abroad

i. Islamic Banking

ii. US Banking

iii. European Banking

Non-Banking Financial Companies (NBFCs)

Financial and banking Sector Reforms Money and

Government Securities Markets

Venture Capital

Banking Reforms of Narasimham Committeei. Income Recognition

ii. Asset Classification

The Reserve Bank of India (RBI) Act, 1934

Conclusion

Bibliography

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UNIVERSAL BANKING

A shift from brick and mortar banking to click and mouse banking, a banking

company turning into a financial departmental stores, rendering services comparable

to that of a cafeteria according to the tastes and needs of a customer

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- c.m.lakshmanan

EVOLUTION:

The fabric of financial institutions is closely linked to the economic stature of acountry. For many years, banks have been concentrating on their traditional

functions of acceptance of deposits from the public and investing them in selected

number of restricted securities. Lack of infrastructure, economic, financial and the

mindset of the financial system were the deterrent factors in developing economies

like India, not to switch over to broad based activities. It requires better knowledge

management, globally acceptable standards banking practices, sound credit appraisal

mechanisms, development of customer centric skills.

Unlike the erstwhile banking fraternity, with more and more players entering into

banking activities competition is becoming severe. Customers expectation for

innovative products, rationalization of service charges, competitive pricing and

simplified procedures for documentation are having a telling impact on the earning

spread. Banks no longer offer plain vanilla products. It has become imperative for

them to explore new innovative products to retain, if not increase their market

share. The banks should shed their thoughts, that they no longer are financiers of

working capital finance; they are expected to extend term loan facilities also. This

rationale for undertaking the activities of development financial institutions has been

a long felt need. This would facilitate the concept of single window, serving like a

cafeteria, paving way for the birth of Universal Banking.

UNIVERSAL BANKING V/S NARROW BANKING

The concept of narrow banking was widely discussed in the late 1980s and

early 1990s in the United States following the failure of large number of insured

institutions in the savings and loan crisis. In India it came to discussion after thesubmission of the report by the Committee on capital Account Convertibility

(Tarapore Committee). The concept has been suggested as a solution to the problem

of high Non Performing Assets and related matters. The Committee proposed that

incremental resources of these narrow banks should be restricted only to

investments in government securities.

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The Narrow Bank in its narrow sense, may be defined as the one which

places its funds only in short-term, risk free assets or alternatively it is one whose

demand deposits are matched by safe and liquid assets. Due to this pattern of

deployment of funds, these banks are expected to remove the problems of bank

failure and the consequent risk and loss to depositors. However, this systemrestrains Banks from going into more risky business or advances, which may

increase their profitability as these Banks do have enough potential to withstand any

short term crisis also. To overcome this problem, it was suggested that the Banks

should go in for Universal Banking.

As against narrow banking, Universal Banking means the removal of

distinction between the activities which the financial institutions (like IDBI, IFCI in

India) and Banks undertake and allowing these financial institutions to undertake any

activity of banking or development financing or activity associated with that, subject

to compliance of statutory and other requirements as prescribed by the Central Bank

(i.e. Reserve Bank of India). This will help bring harmony in the role of Financial

Institutions/Banks, offer world class efficient services under one roof, compete with

international banks due to size and reap cost benefits arising from economies of

scale.

CHALLENGES IN BANKING SECTOR

After the nationalization of Banks, increasing adoption of technology, continuous

mergers in the banking, modernizing backroom operation in the banks and

competition pave the path of growth of Indian banking. By the mid-1990, the near

monopoly of public sector banks faced the competition by the more customer-

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focused private sector entrants. This competition forced older and nationalized banks

to revitalize their operations.

Year 1992 was the golden period of Indian Banking system due to the scam-tainted

stock market. Large proportion of household saving moved into the banking system,

which recorded an annual growth of 20 percent in deposit.

But along with the continuous growth and modernization, there are several

challenges confronting the banking sector. The main challenges facing the banking

sector is the deployment of funds in quality assets and the management of revenues

and costs. The problem of NPA (non- performing assets), overall credit recovery

system still exist. There is a continuous reforms and modernization is in process. Anumber of recommendations of two Narasimham committees have been

implemented.

Foreign Banks are focusing on corporate and on the middle class consumer

and providing them better service. Nationalized Banks are also attempting to get on

the path of automation. Strong Banks will acquire the weaker banks. The member of

foreign banks operating in India has increased significantly and their share of total

assets has also increased. In the year 2001 estimated foreign bank account for 14.7

percent of the total net profit of commercial banking sector in India.

The Reserve Bank of Indias recently released report on Trend and Progress of

Banking (2003-04) once again highlights the major issues in Indian banking in the

light of increasing global competition. The financial sector reforms have to go hand in

hand with the overall economic reform process.

To achieve this, a number of suggestions have been put forward from time to time.

Since the banks have been exposed to competition at home and also at global level,

Indian banks are taking steps under the overall regulatory and supervisory

framework of the RBI. Due to new practices, greater accountability and market

discipline among the participants, the Indian financial system is now moving closer

to global standards. Accordingly, an elaborate roadmap has been drawn to move the

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Indian banks closer to Basel II norms. No doubt, there are some problems in this

respect.

Indian banks have smaller asset bases and volume of operations in

comparison with international standards. No bank is big enough to rank among the

top 100 banks of the world. The operations of the Indian banks are mostly in the

domestic sector. Some of them have a few foreign branches but they are not

exposed to significant lending or investments in the overseas market. Indian banks

are not major banks of world class stature. There is also huge cost involved for

putting in place proper automation system needed to switch over to the Basel II

model.

Public sector banks in the past have adapted themselves to international

practices such as computerization, asset liability management and Basel I norms.

Under the circumstances it should not be difficult for banks to adopt the Basel II

norms as it provides opportunity to Indian banks to raise their standard of banking

practices as per international standards. The Basel Accord is something that has to

be adopted if Indian Banks are interested in becoming global players. Initially RBI

had taken a view that the standards will apply only to a few select banks depending

on the strength of the institutions. But now the RBI has taken a view that the

standards will apply to all the banks. Accordingly, a taskforce has been formed to

examine the related issues. The report has pointed out that as much as two-thirds of

the recent growth in credit has been on account of retail loans. That means corporate

borrowing is yet to pick up significantly in spite of rise in investment demand.

Another important aspect of the report is its analysis of the cooperative

banks. They are facing a deep crisis with the rising NPAs and the financial position of

one third of these banks is not satisfactory. Cooperative banks need restructuring if

they are to survive in the competitive environment. They have to turn to modern

technologies for better performance. The new private and foreign banks have thrown

open many challenges for the Urban Cooperative Banks (UCBs). They have to

strategically alter their business models in terms of marketing and dealing with

customers at the lowest cost. They should not be slow in providing round the clock

service to the customers.

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The major challenge before the cooperative banks is technology. Some

cooperative banks are facing challenges created by a few badly managed banks.

These banks have to use technology for value addition and cost reduction, for easing

the work of the bank staff and to attract customers. Finally, for maintaining orderly

growth, UCBs have to be more professional in their approach in order to face newrealities.

The Changing Landscape of Banking Sector

Under Universal Banking, banks would handle (a) Working Capital (b) Long term

Capital (Term Loans) meant for industrial development. The ongoing reforms

process, growing use of technology, increased competition and product innovation

has all put the banking sector on a high growth trajectory. However significant

challenge lie ahead for the banks in the country as they gear unto embrace

international standards and best practices in line with BASEL II norms.

A Word about Basel Committee

Founded in 1974, the Basel Committee is made up of central banking officials from

leading industrial nations including the U.S., Canada, France, Germany, Italy, Japan

and the U.K.

The committee does not have enforcement powers, instead, it recommends broad

standards, guidelines and best practices that central bank in member nations can

use the foundation for their own policies or statutes. Basel committee addresses the

need for better risk management practices, transparency, audit, and secrecy as third

party contractors are used to support e-banking services, but has also increased

banks exposure to financial and legal risks.

The banking sector in India has undergone remarkable changes since the economic

reforms were initiated in 1991-92. The period has been marked by a slew of reforms

in the sector, which provided the much-needed impetus for the growth of the sector

as a whole. Some of the major initiatives during this period deregulation of interest

rates, adoption of prudential norms in terms of capital adequacy, asset classification

and provisioning, lowering of reserve requirements in terms of Statutory Liquidity

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Ratio (SLR) and Cash reserve ratio (CRR), dilution of government equity holding in

Public Sector Banks (PSBs), opening of the sector to private participation, permission

to foreign banks to expand their operations through subsidiaries, introduction of

Universal Banking, greater emphasis on risk management by allowing banks to

participate in instruments such as interest rate swaps, cross country forwardcontracts, liquidity adjustment facility, liberalization of FDI norms in banks, and the

introduction of Real Time Gross Settlement (RTGS), among others. These measures

along with Reserve Bank of India (RBI) efforts to adopt international Banking

standards and best practices as prescribed in the Basel Accords have no doubt

helped the domestic banking industry enter a new era. Further it has pushed banks

to put greater emphasis on risk management and corporate governance areas that

were until now ignored.

Growing Competition

The opening of the banking sector to private as well as foreign banks has been a

major milestone in the history of the industry in the country. As a result of the

deregulation of the sector, a host of new generation private banks have entered the

scene. This along with the permission to foreign banks to expand their operations in

the country through subsidiaries has galvanized the domestic banking sector,

dominated so far by the hitherto slow and lethargic public sector banks. Increased

competitive pressure is forcing public sector banks to wake up from their deep

slumber and adapt to the changing business environment so as to remain

competitive. On the positive side, PSBs have begun responding to the challenge well;

although many of them are yet to gear up to meet the challenges of the deregulatory

era.

The entry of new generation private sector and foreign banks is rewriting the rules of

banking in the country. Today, there is a greater emphasis on customer

convenience, which is the key to success. Technology has emerged as a key enabler

to achieve this objective, and is now an integral component of any bank strategy. Itis helping new generation banks overcome the disadvantage of late entry by allowing

them to achieve greater market penetration without having a brick-and-mortar

structure, which is time consuming and expensive. The proliferation of ATMs of both

private and foreign banks in the towns and cities of India prove that. A majority of

these banks are now widening and running their operations almost branchless, using

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technology platforms like ATMs, Internet banking, etc. Also, technology is helping

banks in bringing down their operational costs, which is allowing them to stay

competitive even as competition is heating up.

Universal Banking The New Growth Avenue

Another notable change that has taken place in the banking environment of the

country is the introduction of Universal Banking, which refers to cross-selling of

financial products and enables a bank to act as a one-stop financial supermarket. It

is also helping transform the financial institutions in the country that were facing

bleak prospects as their traditional sources of lending dried up and became virtually

non-existent. Further, it is attracting existing banks. Today, many banks have

begun to migrate to the universal Banking model, which has opened up new avenues

of growth for them. Several banks are now foraying into areas such as credit cards,

insurance, DEMAT services, mortgage financing, investment banking, securitization,

mutual funds, insurance, etc. , thereby offering different services to their customers

under one roof. This is also fueling the growth of these banks.

Consolidation The Inevitable

As the competition increases, it will make consolidation in the sector inevitable. With

the highly fragmented nature of the sector, it is not unlikely that many banks

especially PSBs will find some of their branches unproductive and unsustainable. The

greater cost competitiveness of private banks will also force PSBs with inefficient

operations and high costs to either close those branches of merge with other banks

to bring down the costs. Signs of consolidation have already begun to emerge. The

high profile merger of Times Bank with HDFC Bank five years ago marked the arrival

of Mergers and Acquisitions (M&A) in the banking sector in the country. A couple ofrecent mergers clearly send a signal that consolidation is inevitable. The merger

between ICICI Bank and Bank of Madura, Nedungadi Banks merger with Punjab

National Bank, and more recently, the merger of the beleaguered Global Trust Bank

with the government-owned Oriental Bank of Commerce vindicate the argument.

Industry experts opine that there may be many more mergers on the cards. The

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Union Finance Minister has also hinted that he is favourable to mergers between

banks, especially government-owned ones. He was recently quoted saying,

Consolidation alone will give banks the muscle, size and scale to act local and seek

new markets, new classes of borrowers. This gives enough indication as to what

lies in store for the banks, particularly the PSBs, as far as consolidation is concerned.Further as banks in India look forward to expanding their presence outside the

country and have a global reach they will be competing with global behemoths like

the Citigroup, HSBC Bank, etc. in terms of strong balance sheet, and economies of

scale and size. To acquire these capabilities Indian banks will have to look beyond

organic growth. State-owned banks like State Bank of India and Bank of Baroda,

and private sector players like ICICI Bank have already made their intentions of

going global clear.

Improved financial health

The ongoing reforms process has seen several major positive changes for the Indian

banking sector. Deregulation has enabled banks in India to improve their financial

health in terms of capital adequacy, asset quality, profitability, and provisioning

(read: Non Performing Assets). Many of the PSU Banks have shown improved

Capital Adequacy Ratio (CAR) for the fiscal 2002-03 as against the previous fiscal.

Further, the progress made on the NPA front too is encouraging, though it needs to

be further improved. For instance, only eight PSBs have shown NPAs of more than

5% for the fiscal 2003, as compared to 15% in the previous fiscal. According to

Standard & Poors, key structural reforms have improved the asset quality,

profitability and capital adequacy ratio of banks, besides increasing transparency and

efficiency in the system. This is an encouraging sign as the Indian banking industry

has for long been suffering the chronic problem of NPAs. However, the Securitization

Act that came into vogue two years ago is helping banks clean their balance sheets.

However, as the banks have pointed out the Act suffers from certain loopholes and,

therefore, needs fine-tuning.

Basel II challenges

As the process of integration of the Indian economy with the global economy gains

momentum it will pose significant challenges to the banking sector in India as a

whole. A major challenge it faces is the implementation of Basel II norms. The Basel

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II norms relate to the new comprehensive framework for global capital standards laid

down by the Basel Committee on banking supervision. RBI has asked Indian banks to

gear up to migrate to the new guidelines by the end of December 2004. RBI

announced that India should examine the options available under Basel II and draw

a road map by the end of 2004 so that they are ready for the migration to Basel II,and review the progress made thereof at quarterly intervals. The Basel II norms will

be implemented from 2006. However, banks are concerned that unless some

loopholes are plugged it will be difficult to implement the norms in their entirety.

According to a survey finding by Federation of Indian Chambers of Commerce and

Industry (FICCI), the low level of computerization, the absence of robust internal

credit rating mechanism and a strong Management Information System (MIS) and

lack of training and education among employees are the prime reasons why Indian

Banks are reluctant to shift to the Basel II norms by 2006. A total of 87%

respondents felt that the provision for capital changes to address operational risks

will put pressure on capital adequacy requirements and will also adversely affect the

credit flow to the industry, as banks will become more averse to risk. However,

overall, as the survey finding reveal, banks feel that internal rating-based Basel II

norms will make Indian banks more resilient to risk and help them face competition

better.

Future Outlook

While moving ahead the banks in India face challenges on the following fronts:

Financial Performance: Banks in the recent past have enjoyed strong earnings

growth from treasury operations. As their exposure to capital market is limited, and

spreads are shrinking with the competition heating up, this will have a significant

impact on their profitability. Also as more and more banks get listed on the stock

exchanges, their performances will be closely watched by the markets, and they

could be exposed to severe punishment in terms of stock price if their financial

performance does not meet market expectations.

Technology: As technology emerges as the key enabler in terms of customer

convenience, retention and services, banks with strong IT capabilities will have an

edge over competition. Technology will also facilitate better capability in terms of

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managing large volume of transactions and improving and maintaining cost

competitiveness.

Risk Management: With increasing pace of globalization and easy flow of money

across the globe, banks in the country will be exposed to several new kinds of risk,prominently country risk, besides the traditions risks like credit risk, and operational

risk. In this backdrop, banks will be required to strengthen their risk management

and surveillance systems and improve their credit assessment and risk management

skills.

International Best Practices: If the banks in the country have to compete with

international banks, they will have to gear up to embrace international best practices

and standards in terms of operating, reporting and disclosure norms.

Corporate Governance:

With growing emphasis on the part of listed companies worldwide on creating

shareholder wealth; domestic banks, which are seeing a dilution in government

ownership, will come under intense pressure to be more transparent in their

operations, and improve disclosure and reporting practices. Hence these banks will

have to gear up to meet the stock market demands, and improve their corporate

governance practices.

Increased integration with the global economy and the fast changing banking

environment in the country along with the reform process will be an overwhelming

challenge for the banking sector. Factors such as cost competitiveness, giving

emphasis on acquiring and leveraging technology capabilities to deliver services,

strong balance sheet, better risk management skills, and, perhaps a global presence

will hold key to the success of banks in the future.

Questions:

1. What is meant by Universal Banking?

2. Comment on the evolution of Universal Banking?

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3. Make a comparative study of Universal banking Vs Narrow Banking?

4. What is current scenario on consolidation of banking?

5. What are the recommendations of Basel II reforms, and Indias status in this

regard?

6. What is risk management?7. How important is corporate governance from the point of view of financial

institution and the shareholders?

INDIAN FINANCIAL SYSTEM

Indian Financial System is broadly classified into two groups:

1. Organized sector

2. Unorganized sector

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The financial system is also divided into users of financial services and providers.

Financial institutions sell their services to households, business and government who

are the users of financial services. The providers of financial services are:

1. Central bank

2. Banks

3. Financial institutions

4. Money and Capital markets

5. Informal financial enterprises

The organized financial system comprises the following subsystems:

1. The banking system

2. The co-operative system3. Development banking system

a. Public sector

b. Private sector

1. Money markets

2. Financial companies/institutions

The unorganized financial system comprises of moneylenders, indigenous bankers,lending pawn brokers, landlords, traders, etc. There are also a host of financial

companies, investment companies, chit funds, etc. in the unorganized sector. These

are not regulated by the Central Bank or the government in a systematic manner.

CO-OPERATIVE SECTOR

The co-operative banking sector has been developed in the country to the

supplement the village moneylender. The co-operative banking sector in India is

divided into 4 components

1. State Co-operative Banks

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2. Central Co-operative Banks

3. Primary Agriculture Credit Societies

4. Land Development Banks

5. Urban Co-operative Banks

6. Primary Agricultural Development Banks7. Primary Land Development Banks

8. State Land Development banks

DEVELOPMENT BANKS

Development Banks are those financial institutions that provide long-term capital for

industries and agriculture namely :

1. Industrial Finance Corporation of India (IFCI)2. Industrial Development Bank of India (IDBI)

3. Industrial Credit and Investment Corporation of India (ICICI)

4. Industrial Investment Bank of India (IIBI)

5. Small Industries Development Bank of India (SIDBI)

6. SCICI Ltd.

7. National Bank for Agriculture and Rural Development (NABARD)

8. Export Import Bank of India

9. National Housing Bank

MONEY MARKET

The money market is the market in which short-term funds are borrowed and lend.

The leading money market institutions are :

1. Discount and Finance House of India Limited (DFHI)

2. Securities Trading Corporation of India (STCI)

FINANCIAL COMPANIES

Financial companies are those companies who mobilize and channel savings into

investment. They are only partly controlled by the Reserve Bank and partly by the

Registrar of Companies under the Companies Act.

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Over the years, the structure of financial institutions in India has developed and

become broad based. Today, there are more than 4,58,782 institutions channelizing

credit into the various areas of the economy.

INDIAN BANKING SYSTEM

Banking in India has its origin as early as the Vedicperiod. It is believed that the

transition from money lending to banking must have occurred even before Manu, the

great Hindu Jurist, who has devoted a section of his work to deposits and advances

and laid down rules relating to rates of interest. During the Mogul period, the

indigenous bankers played a very important role in lending money and financing

foreign trade and commerce. During the days of the East India Company, it was the

turn of the agency houses to carry on the banking business. The General Bank of

India was the first Joint Stock Bank to be established in the year 1786. The others

that followed were the Bank of Hindustan and the Bengal Bank. The Bank of

Hindustan is reported to have continued till 1906 while the other two failed in the

meantime. In the first half of the 19th century the East India Company established

three banks; the Bank of Bengal in 1809, the Bank of Bombay in 1840 and the Bank

of Madras in 1843. These three banks also known as Presidency Banks, were

independent units and functioned well. These three banks were amalgamated in

1920 and a new bank, the Imperial Bank of India was established on 27th January

1921. With the passing of the State Bank of India Act in 1955 the undertaking of the

Imperial Bank of India was taken over by the newly constituted State Bank of India.

The Reserve Bank which is the Central Bank was created in 1935 by passing Reserve

Bank of India Act 1934. In the wake of the SwadeshiMovement, a number of banks

with Indian management were established in the country namely, Punjab National

Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda

Ltd, the Central Bank of India Ltd. On July 19, 1969, 14 major banks of the country

were nationalized and in 15th April 1980 six more commercial private sector banks

were also taken over by the government. Today the commercial banking system in

India may be distinguished into:

1. Public Sector Banks

a. State Bank of India and its associate banks called the State Bank group

b. 20 nationalized banks

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c. Regional Rural Banks mainly sponsored by Public Sector Banks

2. Private Sector Banks

a. Old generation private banks

b. New generation private banks

c. Foreign banks in India

d. Scheduled Co-operative Banks

e. Non-scheduled Banks

COMMERCIAL BANKING VS DEVELOPMENT BANKING

Commercial Banks

Commercial banks are profit making institutions. A commercial bank accepts money

from those who have to save and disburse loans to those who need them. Out of

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such transactions the commercial bank makes profit. Examples of commercial banks

are, Allahabad Bank, Bank of Baroda, Bank of India, Canara Bank. Dena Bank,

Indian Bank, Indian Overseas Bank, Oriental Bank of Commerce, Punjab National

Bank, State Bank of India and its subsidiaries, Union Bank of India, United Bank,

United Commercial Bank, Vijaya Bank etc.

Functions of Commercial Banks (CB)

There are three types of functions of CB.

1. Primary Functions

These functions includes accepting of different deposits (current deposits, savings

deposits, fixed deposits etc), giving loans (short term loans and medium term loans).

2. Secondary and Subsidiary Functions

These functions include

(i) Agency services rendered by the commercial banks such as making payment

of insurance, payment, rent, school fees, salary collection, pension, dividend etc.

(ii) Saving and purchasing of security and shares, collection of bills, cheques,

demand draft etc.

(iii) Undertaking and executing the trust, agreements and wills etc.

(iv) Carrying transactions as an agent to government to local authority.

3. General Utility Services :

Providing safe deposit vaults or locker to the customer for keeping

their valuable and maintaining in the safe custody of bank, documents,

security papers, shares, wills and sealed packets on behalf ofcustomers

Securing of travelers confidential status report about the customers

on the basis of balance in their accounts, the mode and frequency of

repayments.

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Some banks maintain foreign exchange department dealing with foreign exchange.

(Banks carry on and transact every kind of guarantee in connection with business on

behalf of its constituents).

The commercial bank also serves as correspondence and underwriters for the issueof shares and debentures of public limited company. Thus, commercial banks play

an important role in the conduct of trade industry and commerce.

The description of above functions is as follows:

Commercial banks act as intermediaries between those who have surplus money and

those who need it. To receive deposits and advance loans are thus the two main

functions of all commercial banks. In short, they borrow to lend. They borrow in the

form of deposits and lend in the form of advances. Besides, there are other

incidental functions which have developed according to the needs of society. We

discuss all of them below:-

1. Accepting Deposits Banks attract the idle savings of people in the form of

deposits. These deposits may be of any of the following types:

Demand Deposits, also known as current accounts.

These are repayable on demand without any notice. Usually no interest is

paid on them because the banks cannot utilize short-term deposits and must

keep almost cent per cent reserve against them. On the other hand, a little

commission is charged for the service rendered. Occasionally, a small interest is

paid to the people who keep large balances.

Fixed Deposits or Time depositsThese deposits can be withdrawn only after the expiry of the period for which

these deposits are made. Higher interests are paid on them, the rate rising with

the length of the period.

Savings Bank Deposits

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These deposits stand midway between current and fixed deposit accounts. The

rate of interest is less than that on fixed deposits.

2. Granting Loans

After collecting money, a bank invests it or lends it out. Money is lent to

businessmen and traders usually for short periods only. This is so because the bank

must keep itself ready to meet the demand of the depositors who have deposited

money for short periods. Money is advanced by the banks in any one of the following

ways:

By allowing overdraft:

Customers are given the right to over-draw their accounts. In other words they can

get more than they have deposited, but they have to pay interest on the extra

amount which has to be repaid within a short period. The amount of permissible

overdraft varies with the financial position of the borrowers.

By creating a Deposit

Cash credit is another way of lending by the banks. When a person is in need of a

loan from a bank, he has to satisfy the banker about his ability to repay, the

soundness of his venture and his honesty of purpose. After that the banker may

require a tangible security, or it may be satisfied with the borrowers personal

security. Usually such security is accepted as can be easily disposed of in the

market, e.g. government securities or shares of approved concerns. Then details

about time, rate of interest are settled and the loan is advanced.

After the period for which the money has been borrowed is over, the borrower

returns the amount with interest to the bank. Banks make their profits thus by givingloans.

Discounting Bills

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The discounting of bills is another way of lending money. The banks purchase these

bills through bill brokers and discount companies or discount them directly for the

merchants. These bills provide a very liquid asset (i.e. an asset which can be easily

converted into cash). The banks immediately disburse funds for the bill after

discounting discount and wait for the bill to mature when they get back their fullvalue.

3. Remitting funds: Banks remit funds for their customers through bank drafts

to anywhere they have branches or agencies. This is the cheapest means of

remitting funds. Funds can also be remitted to foreign countries.

4. Miscellaneous Functions: Besides these main functions, the banks perform

several other functions as given under:

Safe Custody:

Ornaments and valuable documents can be kept in safe deposit with a bank, in

its strong room fitted with lockers, on payment of a small sum per year. Thus,

risk of theft is avoided.

Agency Functions:

The bank works as an agent of their constituents. They receive payments on their

behalf. They collect rents, dividends on shares, etc. They pay insurance premium

and make other payments as instructed by their depositors. They accept bills of

exchange on behalf of their customers. They pass bill of lading or railway receipts

to the purchases of goods when they pay for them. This amount is passed on the

suppliers of goods.

References: They give references about the financial position of their customers.When required they supply this information confidentially. This is done when their

customers want to establish business connections with some new firms within or

outside the country.

Letters of credit:

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In order to help the travelers the banks issue letters of credit. A man who is

going abroad takes with him a letter of credit from his bank. It is mentioned

there that he can be paid sums up to a certain limit. He shows this letter to banks

in other countries which make the payment to him and debit the bank which has

issued the letter of credit.

UTILITY OF BANKS

An efficient banking system is absolutely necessary for a country. If it is to

prosper economically, the services that an efficient banking system can render a

country cannot be exaggerated. Undeveloped banking system is not only an

index of economic backwardness of a country, it is also an important cause of it.

The banking system can be useful in the following ways in addition to what has

been mentioned above in the functions of banks:

1. The banks create instruments of credit which serve very convenient

substitutes for money. This means a great saving.

2. The banks increase the mobility of capital. They bring the borrowers and the

lenders together. They collect money from those who cannot use it and give it

to those who can. They thus help the movement of funds from place to place

and from person to person in a very convenient and inexpensive manner.

3. They encourage the habit of thrift. One of the requisite conditions of saving is

that there should be channels of investment. So long as money is kept in

ones pocket, the chances are that it will be spent and not saved. But if it is

put in the bank, it is out of sight and to be out of sight is to be out of mind.

The chances are that it will remain in the bank.

4. By encouraging savings, the banks bring about accumulation of large

amounts of capital in the country from small individual savings. In this way,

they add to the productivity of the resources of the country and contribute to

the general prosperity and welfare.

Questions

1. What is a commercial Bank and what are their functions?

2. What are the general utility functions of commercial banks?

3. What role does commercial bank play in the development of an economy?

4. What is meant by funding and non-funding facility of commercial banks?

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5. Write notes on:

6. (a) Letter of credit

7. (b) Bill discounting business

8. (c) Types of advances

DEVELOPMENT BANKS

After the independence of India from the yoke of British rule, one of the primary

visions of the then Prime Minister Pt. Jawaharlal Nehru was to industrialize the

nation and also to make India a self-reliant one. The policies pursued by him,

were to encourage state participation in infusing funds into the economy. The

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investment by the private entrepreneurs had no place and infact, totally

discouraged. Consequent result is bureaucratic regime, mired in the rigmarole of

unimaginable rules. Growth as envisioned was a distant dream.

The birth of International bank for Reconstruction and Development toreconstruct the liberated underdeveloped economies was the first phase of

development. Protectionism coupled with excessive control over foreign

interference had resulted in lop-sided development all around.

Origin and Nature

Development Financial Institutions (DFIs) or development banks provide long

term credit for projects. The rapid industrialization of continental Europe in the

19th century has been facilitated with the emergence of DFIs. Many of these

institutions were sponsored by national governments and international

organizations. The Netherlands set up an institution in 1822; and in France

institutions such as Credit Froncier and Credit Mobiliser were created during

1848-1852. In Asia, the Industrial Bank of Japan founded in 1902 assisted not

only in the development of the domestic capital markets, but also obtained equity

for the industrial firms in Japan.

To resolve the dearth of long term funds and the perceived socially unjustified

risk aversion of creditors specialized financial institutions were set up in India:

Industrial Finance Corporation in 1948 followed by the setting up of State

Financial Corporations (SFCs) at the state level under the State Finance

Corporation Act, 1951; Industrial Credit and Investment Corporation (ICICI) in

1955; and Industrial Development Bank of India (IDBI) as the apex bank 1964.

There are investment institutions which mobilize resources and provide mediumto long term investment. These are Unit Trust of India (1964) and LIC and GIC

and its subsidiaries; and specialized institutions like the Technology and

Information Company of India Ltd (TDICI) and Tourism Finance Corporation of

India (TFCI) and Small Industries Development Bank of India (SIDBI) to serve in

their specified areas. These institutions played an important role in acquiring and

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disseminating skills necessary to assess investment projects and borrowers

creditworthiness.

Sources of Term Loans

The sources of funds of financial institutions were Reserve Bank of India,

multilateral and bilateral agencies and issue bonds. Reserve bank made available

funds at concessional rates for long-term financing from its Long Term

Operations (LTO) funds. The funds from multilateral and bilateral agencies to FIs

were guaranteed by the Government and carried low coupon rates. Finally the

bonds issued by FIs qualified for SLR investment by banks thus ensuring a

captive market.

Financial institutions also raise term money borrowings, CDs, term deposits and

inter-corporate deposits. An umbrella limit for the financial institutions has been

prescribed by RBI. FIs make available term loans of 5 to 7 years and even

exceeding 10 years. They also make available foreign exchange loans out of

funds made available by foreign agencies to meet the foreign exchange

component of project.

DEVELOPMENT FINANCIAL INSTITUTIONS

Industrial Development Bank of India (IDBI)

The Industrial Development Bank of India (IDBI) which was established in 1964

under an Act of Parliament is the principal financial institution for providing credit

and other facilities for development of industry, coordinating working of

institutions engaged in financing, promoting or developing industrial units andassisting development of such institutions. IDBI has been providing financial

assistance to large and medium industrial units.

Industrial Credit and Investment Corporation of India (ICICI)

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ICICI was established in 1955 as a public limited company to encourage and

assist industrial units in the country. It provides term loans in Indian and foreign

currencies, underwrites issues of shares and debentures, makes direct

subscription to the issues and guarantees payment for credit made by others.

Industrial Finance Corporation of India (IFCI)

IFCI was set up under a statute in 1948 but has been converted into public

limited company to give flexibility to its operations. IFCI provides to industrial

units project finance, financial services and promotional services. Under its

project finance, financial assistance is available to units in the corporate and co-

operative sectors for new units, expansion, diversification and modernization

programme in the form of rupee loans and foreign currency loans, underwriting

and direct subscription to shares, debentures, guarantees for deferred payments

and foreign currency loans.

State Financial Corporations (SFCs)

At the state level, State Financial Corporations have been set up under State

Finance Corporations Act 1951. Along with the all India financial institutions they

form an integral part of the development financing institutions in the country.

There are 18 IFCs in the country. They provide financial assistance to small and

medium enterprises by term loans, direct subscription to equity/debentures,

discounting of bill of exchange and guarantees. SFCs also provide equity type

assistance under the special capital and seed capital schemes to entrepreneurs

having viable projects but lacking adequate funds of their own.

Small Industries Development Bank of India (SIDBI)

SIDBI has been established in 1989 to function as an apex bank for tiny and

small scale industries. It functions as the principal financial institution for

promotion, financing and development of industrial concerns in small scale sector

and will also coordinate functions of institutions engaged in promotion, financing

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and developing industrial concerns in this sector. From 1993 SIDBI is extending

direct assistance to small scale units on a selective basis. SIDBI will also

participate with selected commercial banks financing small scale projects so that

working capital will be fully tied up in the case of jointly financed projects.

Equipment Finance targeted at well run existing units will be extended to take upmodernization and technology up gradation. Procedures have been simplified in

the matted of refinancing limit.

Shipping Credit and Investment Company of India (SCICI)

The SCICI was set up in 1987 by ICICI for the development of shipping, fishing

and related industries and financing projects on the strength of their financial

viability after careful elaboration of the project

t. The primary function of SCICI is to act as a channel for providing development

finance to shipping, deep sea fishing and related industries which inter alia

include road and air transportation, agriculture, feed mill, hatchery, fish

processing, on-shore and off-shore oil survey, exploration and production, food

processing and associated infrastructure facilities.

SCICI provides financial assistance to enterprises in rupee loans, foreign currency

loans, guarantees and underwriting of public and private issues and offer for sale

of securities. There was a significant overlap in the business activities of SCICI

with ICICI. SCICI was mainly promoted by ICICI and it is its largest shareholder.

With a view to consolidate their activities as size is a significant factor in both

lending and resource raising SCICI was merged with ICICI effective April 1, 1996.

The merger of the two entities was based on economic logic of strong capital

base and optimization of operational efficiencies. The merger of both the

institutions will result in an increase in market share and reap the benefits of

economies of scale. The merger is also expected to provide synergy in operationsand resource mobilization and improve asset quality.

Industrial Investment Bank of India

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IIBI was formed on 27.3.1997 under the Companies Act as a development

financial institution by reconstructing the erstwhile Industrial Reconstruction Bank

of India with adequate operational flexibility and functional autonomy. The entire

assets and liabilities of IRBI were transferred to IIBI.

Tourist Financial Corporation of India Ltd. (TFCI)

TFCI was sponsored by IFCI which commenced operations in 1989 to sanction

project loans, lease assistance and direct subscription to shares. Apart from the

conventional tourism projects in the accommodation and hospitality segments,

assistance sanctioned by TFCI has enabled non-conventional tourism projects like

amusement parks, car rental services and air taxi passenger facilities.

National Bank for Agriculture & Rural Development (NABARD)

NABARD is a apex credit institution set up on July 12, 1982 under the National

Bank for Agricultural and Rural Development Act 1981 (Act 61 of 1981). It was

established by merging the Agricultural Credit Department and the Rural Planning

and Credit Cell of the RBI and Agricultural Refinance & Development Corporation

(ARDC.)

Objectives:

Supporting and promoting agriculture and rural development

Providing credit for the promotion of agriculture, small scale industries,

handicrafts and other rural areas

Promoting integrated rural development and securing prosperity of rural

areas

Functions:

1. Credit Functions:

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NABARD provides all kinds of productive and investment credit through the banking

system to agriculture, small scale industries, village and cottage industries,

handicrafts and other economic activities. It provides short term, medium term and

long term finance to eligible institutions namely state co-operative banks, regional

rural banks state land development banks (excluding short term), commercial banks(only long term) and other financial institutions approved by the RBI. NABARD has

prescribed lower rates of interest on the refinance provided by it and the rates

payable by the ultimate borrowers.

2. Development Functions:

NABARD co-ordinates the operations of rural agencies, develops expertise to deal

with agricultural and rural problems, assist the RBI and other institutions in rural

development efforts and acts as an agent to the government and the RBI in relevant

areas. It provides facilities for training and research and assists governments to

enable them to contribute to the share capital of eligible institutions. Development

and dissemination of technology, employment oriented production technology, area

planning for rural industrialization.

3. Regulatory Functions:

The Banking Regulations Act 1949 empowers NABARD to undertake inspection of

regional rural banks, and co-operative banks (other than primary co-operative

banks). If any such bank seeks permission of the RBI for opening of branches, etc.,

it will have to get recommendations from NABARD.

Resources of NABARD

The resources are contributed by the government of India and the RBI. Besides

getting funds from the National Rural Credit (Long term operations) Fund andNational Rural Credit (Stabilization) Fund, and Rural Infrastructure Development

Fund, NABARD is authorized to raise funds by issue of bonds and debentures

guaranteed by the central government and borrowings from other sources.

Participation in thrust areas:

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Integrated Rural Development Programme (IRDP)

IRDP is a scheme devised by Government of India for generating self-employment

opportunities in the rural sector and for development of rural areas. Extending cheapcredit facilities to selected group, poverty alleviation programme and steps taken in

this regard. It includes

Service area plan, backward and forward linkage and infrastructural

support. Bridging income gap and lifting family above poverty line

Optimum utilization of available resources, facilitating provision for

infrastructural project, diversifying the IRDP by encouraging secondary

and tertiary sectors.

Other schemes are,

(a) Swaranjayanthi Gram Swarozgar Yojana (SGSY) Scheme focusing

to help rural poor, women and disabled children.

(b) Development of Women and children in Rural areas by promoting

group activities

(c) Training cum production centre for women by providing

vocational/entrepreneurship training centers

(d) Self-help group by organizing voluntary agencies for poor people in

rural areas

(e)providing refinance for project taken under National Watershed

Development Programme and National Mission of Wasteland

development.

Other activities are briefly given below:

Schemes for Monitoring Evaluation and Research activities-aimed at getting

feedback on performance and initiate proper remedial steps

Vikas Volunteer Vahini Programme-organizing farmers club, creating awareness

among weaker sections of the technology

External Aid Project-implementing projects aided by World Bank, OPEC Fund and

monitoring performance and submitting report to aid agencies

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Human Resources Development providing training to staff of other credit

institutions in credit disbursal through training institutions attached to NABARD,

organizing seminars/programmes on Non-farm Centre Business Development,

inspection of banks etc.,

National Housing Bank (NHB)

NHB was set up in July 1988 as an apex level housing finance institution in India. It

is a wholly owned subsidiary of RBI. The primary objectives are to promote housing

and arrange for refinance housing loans under its refinance schemes of scheduled

commercial banks, housing finance companies, and co-operative housing finance

societies.

Questions:

1. Trace the origin of development of banks?

2. What were the objectives of Development Banks?

3. How do you differentiate the functions of a commercial bank and a

development bank?

4. What are the different types of Development financial institutions?

5. Write a note on NABARD?

6. What are sources of funds for NABARD?

7. What are IRDP and other activities of NABARD?

ASSET LIABILITY MANAGEMENT

Paul S. Nadler said If there is any area of banking that has undergone

drastic change, it is the whole subject of asset/liability management.

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ALM management is an integral part of the planning process of commercial banks.

Asset Liability Management focuses on the maturity balance sheet of asset and

liability transactions on a daily basis. Proper infrastructure and management

Information System is in place for achieving the objectives of ALM. The main focus is

to ascertain the net profit derived from every transaction that has been put throughin banks. Income is a very sensitive issue and leakage is not tolerated.

Mismatches between assets and liabilities of banks expose them to various types of

risks. The experience of the South-East-Asian Crises showed the dangers posed by

compromising asset-liability management principles and allowing the

disproportionate accumulation of mismatches both on and off the balance sheets,

leading to illiquidity and even insolvency. Risk management is a continuous process

of planning, organizing and controlling the assets and liabilities, volumes, maturities,

rates and yields. With the growing complexity of operations in financial markets,

banks would have to rapidly equip themselves with a variety of knowledge-intensive

skills and appropriate technology.

To help manage this fragile transitional phase, the Reserve Bank has provided asset-

liability managers with guidelines that serve as benchmarks for an integrated risk

management system. Asset-Liability Management (ALM) guidelines were issued to

banks in April 1999 for managing liquidity and market risks. In October 1999, the

ALM guidelines were included in a broad framework of guidelines for risk

management systems in banks to cover the management of credit, market and

operational risks. These guidelines would help to prepare the bank management to

meet the challenges posed by the changing context of regulation and supervision.

Banks are encouraged to evolve risk rating systems and internal control mechanisms

based on value-at-risk and duration measures. The primary responsibilities of

prescribing risk parameters and establishing effective control systems are vested

directly in the boards of directors of the banks.

For example the balance sheet of any bank contains asset and liability transactions

of differing maturities. Deposits of any kind are liability for a bank and loans and

advances constitute assets of a bank. These deposits and assets are classified

currency-wise and maturity-wise, so as to ensure that short term deposits are not

used for long term advances and long term deposits are not used for short term

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purposes. Lest it would result in mismatch of asset and liability. There should not as

far as possible gap between the maturity period of asset and liability. If any exists at

any point of time remedial measures must be initiated then and there before

problem strikes.

ASSETS-LIABILITY MANAGEMENT IN BANKS

(ALM)

In India, the assets- liability- management is of recent origin. The Reserve

Bank of India issued guidelines on February 10, 1999, for implementation of ALM. It

has been implemented with effect from April 01, 1999.

What is ALM?

Assets liability management is a comprehensive and dynamic framework for

measuring, monitoring and managing the market risk of a bank. It is the

management of structure of balance sheet (liability and assets) in such a way that

the net earning from interest is minimized within the risk-preference (present and

future) of the institutions.

Traditionally, banks and insurance companies used accrual accounting for

essentially all their assets and liabilities. They would take on liabilities, such as

deposits, life insurance policies or annuities. They would invest the proceeds from

these liabilities in assets such as loans, bonds or real estate. All assets and liabilities

were held at book value. Doing so disguised possible risks arising from how the

assets and liabilities were structured.

Increasingly, managers of financial firms focused on asset-liability risk. The

problem was not that the value of assets might fall or that the value of liabilities

might rise. It was that capital might be depleted by narrowing of the difference

between assets and liabilitiesthat the values of assets and liabilities might fail to

move in tandem. Asset-liability risk is a leveraged form of risk. The capital of most

financial institutions is small relative to the firm's assets or liabilities, so smallpercentage changes in assets or liabilities can translate into large percentage

changes in capital.

Scope of ALM:

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The assets- liability- management functions extend to liquidity risk

management, management of market risk, trading risk management, funding and

capital planning and growth projection.

Residual maturity:

Residual maturity is the time period which a particular asset or liability will

still take to mature i.e. become due for payment (once at a time, say in case of a

term deposit or in installments, say in case of term loan).

Maturity buckets:

Maturity buckets are different time intervals (8 for the time being, 1-14 days,

15-28 days, 29-90 days, 91-180 days, 181-365 days, 1-3 years, 3-5 years and

above 5 years), in which the value of a particular asset or liability is placed

depending upon its residual maturity.

Mismatch position:

When in a particular maturity bucket, the amount of maturing liabilities or

assets does not match, such position is called o mismatch position, which creates

liquidity surplus or liquidity crunch position and depending upon the interest rate

movement, such situation may turn out to be risky for the bank.

The mismatches for cash flows for 1-14 days and 15-28 days buckets are to

be kept to the minimum (not to exceed 20% each of cash outflows for those

buckets).

Role of ALCO:

Asset Liability Committee is the topmost committee to oversee the

implementation of ALM systems to be headed by CMD or ED. ALCO would considerproduct pricing for deposits and advances, the desired maturity profile of the

incremental assets and liability, in addition to monitoring the risk level of the Bank.

It will have to articulate the current interest rates view of the Bank and base its

decisions for future business strategy on this view.

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Benefits of ALM:

It is a tool that enables Banks managements to take business decisions in a

more informed framework with an eye on the risks that Banks are exposed to. It is

an integrated approach to financial management, requiring simultaneous decisionsabout the types of amounts of financial assets and liabilities both mix and volume

with the complexities of the financial markets in which the institution operates.

RISK MANAGEMENT

Reserve Bank of India issued guidelines on risk management in banks on October

20th 1999 which broadly cover management of credit, market and operational risk in

the banking sector. Banks are also to adopt proper systems to measure, monitor and

control operational risk that is emerging in the wake of phenomenal increase in the

volume of financial transactions.

The highlights are:

1. Banks to set up a comprehensive risk rating system for counter parties.

2. Banks are to fix a definite time frame for moving over to value-at-risk (VaR).

3. From March 2001 banks with international presents have to develop

methodologies for estimating and maintaining economic capital.

4. Banks should evaluate portfolio quality on an ongoing basis instead of near

balance sheet.

5. Investment proposals to be subjected to same credit risk analysis as in case

of loan proposals.

6. Investment proposals to be included in the total risk evaluation.

7. For off-balance sheet exposure, the current and potential credit exposure to

be measured by daily measure.

8. Activities of ALCO (Assets- Liability Committee) and Credit Policy Committee

should be integrated.

9. For managing liquidity risk, Banks should place limits on inter bankborrowings which include call-funding, purchased-funds, core deposits to core

assets, off Balance Sheet commitments, Swapped funds etc.

10.Banks have to provide a contingency plan to meet adverse swings in the

liquidity conditions.

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Tools of Asset Liability Management (ALM) and their Mechanisms

SWAPS

Swap literally means exchange and thus simply stated swap is nothing butexchange of liabilities between two parties. A swap is a financial transaction in which

two counterparties agree to exchange streams of payment over time.

Swaps are a common and popular product in derivative markets. An interest rate

swaps does not involve exchange of principal either at the beginning or at the end of

the agreed period, but does involve periodic exchange of streams of interest

payments, of differing character in accordance with predetermined terms, on a

notional agreed principal.

A Currency Swap is a financial transaction whereby two counterparties agree to

exchange specific amounts of two different currencies at the outset and periodic

repayments overtime in accordance with predetermined terms.

Swap as a derivative product, is a significant development in the financial markets of

the world. This helps the borrowers in capital market to fund their requirements in a

variety of ways. They can thereafter, as and when required under the circumstances,

change the interest rate or currency exposure from the basic terms of the initial

funding. Thus this product helps in not only raising money at a competitive price but

also allows them to change their asset/liability profile as per their needs which might

change in future.

Uses of Swaps:

They can raise finance at a cheaper cost

They can obtain high yield assets

The swaps are used by them to hedge against interest rate exposure

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They use it as a tool for ALM (Asset-Liability Management), particularly in

short term

Swaps have been used to raise resources abroad, which may otherwise be not

allowed by the authorities

Swaps are used for arbitraging in different markets

More venturesome trade (speculate) in swaps.

OPTIONS

Options are derivative products used for hedging the risks arising on account of

wither interest rates or exchange rates. These products are generally, in the form of

agreements and both the counterparties to the contract have certain rights as well as

obligations under the said contracts. It is always good to have a right but noobligation.

Illustration:Let us consider an exchange forward contract entered into by an

exporter @ USD 1= Rs.49.9000, value date July 31. The possibility of exchange

rates on July 31 could be as under:

I) USD 1=Rs.49.9000

The exporter neither gains nor loses by booking a forward contract @ USD 1=

49.9000

Or

II) USD 1= 49.9800

Had the exporter not booked a forward contract @ USD1=49.9000, he would be

better off by selling on spot rate getting 8 paise per USD higher. But by booking a

forward contract he surrenders the upside gain.

Or

III) USD 1= Rs.49.8000

Had the exporter not booked the forward contract @ USD 1=49.9000, he would be

worse off by selling USD on spot rate and getting 10 paise per USD less. But by

booking a forward contract he ensures that the downside risk has been covered.

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Options are contracts which give the buyers right but no obligation to buy or sell the

underlying at the agreed rate, on or before an agreed rate.

If we continue with the illustration and the exporter had instead of entering into a

forward contract, bought an option, he would have a right to sell USD 1=Rs.49.9000but no obligation. If spot exchange rate on July 31, were USD 1= Rs. 49.8000 he will

exercise his right to sell USD @ USD 1= 49.9000 under the option contract but if the

spot exchange rate on July 31 were USD 1=49.9800, he will not exercise his right to

sell USD @ USD 1= 49.9000 under the option contract, rather forego his right and

sell USD @ USD 1 = 49.9800 in the spot market and take advantage of the

movement of exchange rate in his favour.

In the light of the above, we can define an Option Contract a contract under which

the buyer has a right but not an obligation, to buy or sell a specific quantity of a

given asset at a specified price at or before a particular date in future. To acquire

this right, the buyer pays a premium to the seller (as also called the option writer). If

the buyer chooses to exercise his right to buy or sell an asset the seller has the

obligation to deliver or take delivery of the underlying asset. The potential loss to an

option seller is unlimited and to the buyer it is limited to the premium amount.

Currency Option Terminology

Call Option: The right to buy specified amount of one currency against another

currency is known as call option.

Put Option: The right to sell specified amount of one currency against another

currency is known as put option.

Buyer: The person who buys the right to buy or sell specified amount of one

currency against another currency.

Seller (Writer): The person who sells the right to buy or sell specified amount ofone currency against another currency.

Premium: The amount paid by the buyer of an option to the seller (writer of the

option), is called premium.

Strike Price: This represents predetermined price at which the option can be

exercised.

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Exercise Date: For delivery of foreign exchange the buyer of the option must notify

the seller about his decision for taking or giving delivery and this is known as

exercising the option. The date on which the option can be exercised is called

exercise date.

Expiration Date: The last up to which the option can be exercised.American Style: An option which can be exercised at any time between the initial

deal date and the expiry date.

European Style: An option which can be exercised only on the expiry date.

ITM: If by exercising option, the buyer has an advantage, the option is called In the

Money. If the option has intrinsic value, it is called In the Money.

ATM: If by exercising option, the buyer has neither advantage nor disadvantage, the

option is called At the Money. If the option has no intrinsic value i.e., the strike

price is equal to the underlying spot or future rate, it is called At the Money.

OTM: If by exercising option, the buyer has a disadvantage, the option is called Out

of the Money. If the option has extrinsic value it is called Out of the Money.

Intrinsic Value: The difference between current exchange rate and the strike price

is called Intrinsic Value.

Extrinsic Value: The total premium amount less intrinsic value is called Extrinsic

Value or time value or volatility value.

What are Futures?

A currency futures contract is an agreement to buy or sell at future exchange a

standard quantity of a foreign currency at a future date at the price agreed to

between the parties to the contract. Although the contracts are traded between two

parties, however, for clearing purposes clearing house of future exchange is the

counterparty to each contract. This system thus eliminates credit risk on the

counterparty to a large extent.

The future exchange also looks after the work relating to margin accounts,reconciliation of payments and supervision of delivery process. Deals are effected

through Future Commission Merchant who is regulated by the relevant law in the

country. Like in USA, they are governed by Commodity Exchange Act and are

governed by Commodity Futures Trading Commission.

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Exchanges

The order of the customer, to either buy or sell a futures contract, is executed by

Future Commission Merchant on an exchange or Commodity Market. The main

functions of the exchange are:

1. Provide and maintain a physical market place (called floor) where future

contracts can be bought and sold by members of exchange.

2. Supervise and enforce, ethical and financial standards applicable to the future

trading conducted on the exchange,

3. Promote the business interest of the members. Exchangers are generally

membership organizations.

Clearing House

Every future exchange has a clearing house attached to it. The job of clearing house

is to:

1. Receive daily report from the members of the exchange containing details of

all future trades,

2. Matching the shorts against longs and reconcile the same,

3. Computing and collecting/paying daily margin calls to the members.

Financial futures are liquid and transparent tools for hedging currency and interest

rate exposure. Foreign exchange futures are very popular although they are not as

flexible as forward contracts in respect of amount of contract and value date

(maturity date).

Financial Futures

A futures contract is firm obligation to give or take delivery of a commodity ofspecific quantity or quality at a specified date at an agreed price.

The seller is called the short and the buyer, the long. Further the law requires that

all the futures contracts be bought and sold on designated contract markets.

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There are basically two types of futures in the market and these are differentiated on

the basis of underlying. If the underlying is a commodity, these are known as

commodity futures and if the underlying is a financial instrument these are known

as financial futures.

Most actively traded futures are the following:

Treasury Bills, euro dollars, crude oil, S&P 500, Corn, Soyabeans, Gold, Copper,

Wheat, Currencies (DEM,YEN,CHF) are some of the most actively traded futures on

various future exchanges.

In financial futures, interest rates and exchange rates are being increasingly used as

hedging techniques. The futures trading were first started in 1972 and it soon caught

the fancy of the operators in the market. International Monetary market (IMM) in

United States was the first market to trade financial futures. However, since then

similar markets have been established in almost all the important financial centers

like London,

New York, Tokyo, Paris, Frankfurt, Singapore etc. Some of the major exchanges

where various types of futures are traded are as follows:

London International Financial Futures exchange (LIFFE)

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange (CME)

Commodity Exchange (COMEX)

New York Mercantile Exchange (NYMEX)

Le March a Terme des Instruments Financiers, France (MATIF)

Tokyo Securities Exchange (TSE)

Osaka Securities Exchange (OSE)

Singapore Monetary Exchange (SIMEX)

Kuala Lumpur Commodity Exchange, Malaysia

Deutsche Terminborse, Germany

The main reason for such a phenomenal growth of financial futures market is the

volatility of exchange rates and interest rates. In financial futures market, unlike

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cash markets, physical delivery is not required and thus there are pricing markets

only.

A future exchange is an independent body like stock exchange, which provides a

place with infrastructural facilities where members can meet and trade amongthemselves. The same body also frames rules and regulations which govern the

transactions in the futures market.

To benefit in these uncertain times, read between the lines

* * * * * * * * * * *

Questions:

1. What is meant by asset liability management?

2. How does mismatch of asset-liability occur and what are the consequences?

3. Critically analyze the possibilities of mismatch of ALM in Universal Banking?

4. What is short term, medium term, and long term lending?

5. What are the various purposes of the above three types of loans?

6. Why was it considered necessary that commercial banks must switch over to

universal banking?

7. What would be the consequences for development banks if commercial banks

take over to universal banking?

8. Give examples of the merger of development bank and commercial banks?

9. What measures must be in place to prevent ALM mismatch that may be

possible when banks function as a universal bank?

Relevance of ALM to printing of Currency notes

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How does the Reserve Bank of India decide about the requirement of

currency notes?

Under Section 22 of the Reserve Bank of India Act, the Reserve Bank of India has

got the sole right of printing currency notes. It can print and issue currency notes ofdifferent denominations from the rupee notes ten-thousand rupee notes. The

Reserve Bank maintains a separate issue department to look after currency issue.

This department maintains reserve against currency notes. At present the assets of

the issue department consists of a minimum of gold and foreign securities to the

extent of Rs 200 crores (of which gold should be of value of Rs 115 crores and the

balance in rupee securities). The present system is known as the minimum reserve

system of note issue. Although issue of currency notes is the monopoly of the

Reserve Bank of India, it becomes a must when the government meets its surplus

expenditure (so-called deficit financing) by resorting to issue of currency notes.

DEVALUATION

By devaluation of a countrys currency unit is meant the decrease in the external

value of a unit of that currency expressed in terms of gold, SDR or foreign currency

by government edict. A fall in the gold, SDR or foreign currency value of the

currency unit amounts to an increase in the number of units of that currency per

ounce of gold, per SDR or per unit of foreign currency. A country may reduce the

foreign exchange value of her currency unit for more than one reason, e.g., to create

surplus in her international balance of payments. In short, devaluation means an act

of officially reducing the external value of the currency unit of the country in whose

relationship the country has devalued her currency. For example, when the pound-

sterling was devalued on September 20, 1949 in terms of the US dollar, the old

sterling-dollar exchange rate of 1 = US $ 4.03 was altered to the new exchange

parity of 1 = US $ 2.80. Consequently, the dollar price of the pound-sterling had

depreciated by about 30%.

Generally, a country devalues her currency in order to correct the persisting deficit in

her international balance of payments. When a country is faced with the chronic

deficit in her balance of payments which cannot be removed through other methods

at the pre-devaluation foreign exchange rate, e.g., through deflation or export

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subsidies, she devalues her currency. The desired effects of devaluation follow from

the fact that while the external value of currency is reduced there is no change

immediately in the internal value of currency. In other words, the purchasing power

of the currency in terms of domestic goods and services remain unaltered, i.e., the

prices of goods and services in the country do not rise following the devaluation ofthe currency. Devaluation restores the balance of payments equilibrium primarily

through an improvement in the domestic versus the international cost-price ratio.

MEANING OF DEFICIT AND SURPLUS IN THE BALANCE OF PAYMENTS

If the BOP is a double-entry accounting record, then apart from errors and

omissions, it must always balance. Obviously, the terms deficit or surplus cannot

then refer to the entire BOP but must indicate imbalance on a subset of accounts

included in the BOP. The imbalance must be interpreted in some sense as an

economic disequilibrium.

RISKS IN PROJECT LENDING

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The word project has wider meaning. It refers to investment in several areas of

economic development, including agriculture, education, transport and industry.

An entrepreneur conceives the idea of setting up an industrial project after proper

assessment which indicates that there is demand for the products/services and theprofit margin will be attractive. After identification of the project, the entrepreneur

does some preparatory work, such as arranging for some foreign collaboration, if

necessary, and preparation of project report by engaging a consultant. The stage is

now ripe for approaching commercial banks/financial institutions for support.

Banks/financial institutions go for detailed appraisal of the project studying the

following aspects of the project:

(a)Market

(a) Management

(b) Technical

(c) Financial

(d) Economic

(e) Political

Banks and financial institutions must remember that a project is one whole and it

has to be appraised as such. A few deficiencies in one area may be more than made

up by stronger points in other areas. Projects brought up by new entrepreneurs, who

are inexperienced, are bound to have some drawback/deficiencies. The object of a

good appraisal is to improve and revamp the project with the co-operation of the

promoters till it passes all tests.

CREDIT POLICY AND BANK LENDING

Safety of a loan is directly related to the basis on which The decision to lend is taken,

The type and amount of credit

Terms and conditions on which advance will be made available.

Therefore a banker adopts a two-pronged approach to ensure safety. They are

Pre-sanction appraisal to determine the bank ability of each loan proposal

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Post-sanction control to ensure proper documentation, follow-up and

supervision

Tailoring a credit appraisal exercise to suit a pre-conceived decision on a credit

demand is fraught with risks. A pre-sanction appraisal need not justify the creditdemand of a customer. It has to be an objective exercise no matter how well known

the customer is.

Pre-sanction appraisal is concerned with

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