BANKING BEAT COUNCIL ‘12 BANK OPERATIONS

Prepared By

Ghada taha sara saeed

TOPIC NO 1 BANK OPERATIONS

COURSE CONTENT

Importance of banking

How banks operate

Functions of banks

Types of bank according to

Ownership, function , scope

Departments within the banks

Credit department

Loan policy

Lending process

Credit analysis

External operations department

Letter of credit

Letter of guarantee

Risk management department

Types of risks

The importance of banking

Banks are essential for each country’s economy, since no growth can be achieved

unless savings are efficiently channeled into investment. They are a primary

source of funds for both individuals and businesses In this respect, the lack of a

full-fledged banking system has often been identified as a major weakness of any

economy.

What is a Bank?

Banks are privately-owned institutions that, generally, accept deposits and make

loans. Deposits are money people leave in an institution with the understanding

that they can get it back at any time or at an agreed-upon future time. A loan is

money let out to a borrower to be generally paid back with interest. This action of

taking deposits and making loans is called financial intermediation. A bank's

business, however, does not end there.

How Banks Create Money

Banks can't lend out all the deposits they collect, or they wouldn't have funds to

pay out to depositors. Therefore, they keep primary and secondary reserves.

Primary reserves are cash, deposits due from other banks, and the reserves

required by the CBE. Secondary reserves are securities banks purchase, which

may be sold to meet short-term cash needs. These securities are usually

government bonds .the central bank of Egypt sets requirements for the

percentage of deposits a bank must keep on reserve, either at the central bank or

in its own vault. Any money a bank has on hand after it meets its reserve

requirement is its excess reserves.

It's the excess reserves that create money. This is how it works (using a

theoretical 10% reserve requirement): You deposit $500 in Your Bank. your Bank

keeps $100 of it to meet its reserve requirement, but lends $400 to Ms. Smith.

She uses the money to buy Toyota car. The Toyota Company deposits $400 in its

account at Their Bank. their Bank keeps $80 of it on reserve, but can lend out the

other $320 as its own excess reserves. When that money is lent out, it becomes a

deposit in a third institution, and the cycle continues. Thus, in this example, your

original $500 becomes $1,220 on deposit in three different institutions. This

phenomenon is called the multiplier effect. The size of the multiplier depends on

the amount of money banks must keep on reserve.

The central bank can contract or expand the money supply by raising or lowering

banks' reserve requirements. Banks themselves can contract the money supply by

increasing their own reserves to guard against loan losses or to meet sudden cash

demands. A sharp increase in bank reserves, for any reason, can create a "credit

crunch" by reducing the amount of money a bank has to lend.

How Banks Make Money

While public policymakers have long recognized the importance of banking to

economic development, banks are privately-owned, for-profit institutions. Banks

are generally owned by stockholders; the stockholders' stake in the bank forms

most of its equity capital, a bank's ultimate buffer against losses. At the end of the

year, a bank pays some or all of its profits to its shareholders in the form of

dividends. The bank may retain some of its profits to add to its capital.

Stockholders may also choose to reinvest their dividends in the bank.

Banks earn money in three ways:

They make money from what they call the spread, or the difference

between the interest rate they pay for deposits and the interest rate they

receive on the loans they make.

They earn interest on the securities they hold.

They earn fees for customer services, such as checking accounts, financial

counseling, loan servicing and the sales of other financial products (e.g.,

insurance and mutual funds).

Why I have to deal with bank ?

Small savers face costs of

Searching;

Contacting;

Negotiating;

Trying to diversify;

Monitoring;

Enforcement etc

Given the large number of savings and deposit by banks, related transaction costs are either falling or constant , lets clarify the importance of banks by defining its functions :

1- Reduce transaction costs Banks reduce costs through several other ways including :provision of convenient places of business ,standardized products and less costly expertise through the use of tested procedures and routines. This besides the regulation and supervision of banks by regulatory and supervisory bodies to ensure conformity with acceptable codes of behavior frees customers from the burden of collecting information and monitoring banks. 2-Delegate monitoring Contracts are necessarily incomplete, so Borrowers need to be monitored to ensure maximum probability that loaned funds will be repaid. Lending contracts are incomplete in that the value in large part is determined by the behavior of the borrower after the issuance of the loan. Depositors delegate banks to monitor the behavior of borrowers. 3. provide liquidity Borrowers and lenders have different liquidity preferences so,

banks pool funds together ,banks rely on the law of averages to be able to offer liquidity to their customers. The existence of banks can be derived from the bank’s balance sheet.

Liabilities side: banks accept deposits and in turn provide transaction services.

Asset side: banks issue loans, thereby providing liquidity. As Small-business borrowers find bank lending important because due to small size and relative opacity, funding through public markets is virtual impossible. Banks build relationships with customers that give them valuable information about their operations. Enhanced bank-customer relationships help small businesses access funding because the bank has got special knowledge about the firm. 4-Payment system Banks administer payment systems which are core to an economy. Through payment system:

o banks execute customers’ payment instructions by transferring funds between their accounts.

o customers receive payments and pay for the goods and services by cheques, credit or debit cards or orders

o funds to flow between individuals, retail business and wholesale markets quickly and safely.

o Currently, we have to pay electricity, phone buying mobile phone bills, send money via atm, paying employee salaries using bank services.These services very easy and gives a sense of security and comfort to those who use it.

4- Risk transformation With risk transformation borrowers’ promises are converted into a single promise by the bank itself. Depositors who hold the institutions’ liabilities must be able to regard them as absolutely safe. Banks’ loans inevitably bear some risk. Banks’ ability to transform these risky assets into riskless liabilities depends on several factors :

they control risk by incorporating an allowance for probable losses

they spread risk to guard against the probability that loans to some customers or categories of customers will lead to unusually heavy losses.

they ensure that their own capital is adequate to absorb any losses they may incur through a failure to control risk properly

Different types of banks : Banks can be divided according to

According to function: Retail banks Retail banks are banking in which banking institutions execute transactions directly with consumers, rather than corporations or other banks. Services offered include: savings and transactional accounts, mortgages, personal loans, debit cards, credit cards, and so forth.

Investment Bank

A financial intermediary that performs a variety of services. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients.

Function

o Commercial banks o Investment banks o Retail banks o Specialized banks o Central banks

Ownership

o Private banks

o Public banks

Scope

o National banks

o International

banks

o Multinational

banks

Types of banks

Investment banking isn't one specific service or function. It is an umbrella term for a range of activities: underwriting, selling, and trading securities (stocks and bonds); providing financial advisory services, such as mergers and acquisition advice; and managing assets. Investment banks offer these services to companies, governments, non-profit institutions, and individuals.

Specialized banks : are those banks which are specialized in serving a certain sector in

the economy as industry, agriculture & soon , examples of specialized banks :

Industrial Banks / Development Banks Industrial / Development banks collect cash by issuing shares & debentures and providing long-term loans to industries. The main objective of these banks is to provide long-term loans for expansion and modernization of industries.

Land Mortgage / Land Development Banks Land Mortgage or Land Development banks are also known as Agricultural Banks because these are formed to finance agricultural sector. They also help in land development.

Development Banks Business often requires medium and long-term capital for purchase of machinery and equipment, for using latest technology, or for expansion and modernization. Such financial assistance is provided by Development Banks.

Central Bank A bank which is entrusted with the functions of guiding and regulating the banking system of a country is known as its Central bank. Such a bank does not deal with the general public. It acts essentially as Government’s banker; maintain deposit accounts of all other banks and advances money to other banks, when needed. The Central Bank provides guidance to other banks whenever they face any problem. It is therefore known as the banker’s bank. The Central Bank maintains record of Government revenue and expenditure under various heads.

It also advises the Government on monetary and credit policies and decides on the interest rates for bank deposits and bank loans. In addition, foreign exchange rates are also determined by the central bank. Another important function of the Central Bank is the issuance of currency notes, regulating their circulation in the country by different methods. No other bank than the Central Bank can issue currency . (this is only a brief note about the central bank as it will be explained in more detail later)

Commercial Banks Commercial Banks are banking institutions that primarily handle banking needs for large and small businesses but it also accept deposits and grant short-term loans and advances to their customers. In addition to giving short-term loans, commercial banks also give medium-term and long-term loan to business enterprises. Now-a-days some of the commercial banks are also providing housing loan on a long-term basis to individuals. So commercial banks provide a wide range of service whether to business or individuals , ex : Accepting Deposits , checks, loans, paying bills ….etc.

According to ownership Public Sector Banks: These are banks where majority stock is held by the Government so the government conducts most of the banking operations.

Private Sectors Banks: bank owned by individual or small group ,a bank that is owned by a single person or a limited number of private stockholders, bank for wealthy clients, meaning that it provides banking facilities to high net worth individuals.

According to scope International banking Banking transactions crossing national ,Boundaries so this financial institutions allow foreign clients---both companies and individuals---to use their services. As these banks are beneficial for the Companies seeking to conduct business in different countries set up accounts with international banks to facilitate international transactions.

Multinational banks Are banks that mange its operations & deliver its services in at least two countries, for ex : Citibank open its offices in more than 90 countries around the world.

Bank departments

Credit department department in a bank that evaluates the financial condition of credit applicants and maintains a log of loan payments on currently outstanding loans. Credit information is gathered on a confidential basis and stored for future reference. The credit department also responds to requests by other lenders for credit information on a particular borrower. Note: In the past, credit departments have been responsible for handling mostly clerical tasks and identifying obvious trends in companies' financial performance. Today, credit analysts need to be responsible for more than a basic knowledge of financial statement analysis. They should understand a prospective borrower's operation, be knowledgeable about specific industries, and be able to determine whether projected financial performance is realistic. An analyst should also be able to identify appropriate loan structures and provide suggestions on implementing terms and conditions, loan covenants, and loan monitoring. The credit department should be an independent part of the credit approval process. Senior managers should stress that loan officers bear the ultimate responsibility for loan approval. The role of the credit department is to analyze a credit request thoroughly and suggest how to improve the loan structure so that it is an acceptable risk. However, it is the responsibility of the loan committee or others with loan approval …

Establishing a written loan policy : Establishing a written loan policy is an important technique to make sure that the bank loans meet its regulatory standards as such policy gives the loan officers & management specific guidelines in making loan decisions & in shaping the overall loan portfolio, as the bank loan portfolio should reflect what its loan policy says , such policy may contain these elements : 1. A goal for the entire loan portfolio ( characteristics of good loan portfolio in terms of types , maturities, size, & quality of loans) . 2. Operating procedures for soliciting , evaluating & making decisions on customer loan applications. 3. The required documentation that’s required with each loan application & what must be kept in the lender’s files ( financial statement , security agreements …. Etc) . 4. Line of authority defining who is responsible for maintaining & reviewing the institutions’ credit files. 5. Guidelines for taking , evaluating , & perfecting loan collateral. 6. Procedures for setting loan rates & fees & schedules for loan repayment. 7. Identifying limits for the total loan outstanding ( the maximum ratio of total loans to total assets allowed). 8. Putting procedures for detecting & working out loan problem situations ( ex: loan failure).

Steps of the lending process: 1. Finding loan customers

Identifying loan customers can be performed by two ways whether by a direct request from a customer to fill out a loan application or business loan requests which arise from contacts the loan officers & sales representatives develop, ex:( call center, advertisement) as lending game is becoming a sales position , sometimes the loan officer call on the same company for months before the customer agree to fill a loan application & this is due the strong competition between the banks in the market to attract customers.

2. Evaluating customer’s character & sincerity of purpose Once a customer decides to request a loan so he will be forwarded to an interview with the loan officer in order to give the customer an opportunity to explain his or her credit needs at the same time this interview gives the officer an opportunity to understand customer’s character & sincerity of purpose , As the interviewer should be an experienced person in order to be able to understand the customer well .

3. Evaluating customer’s credit record This step involves gathering information about the customers to evaluate his credit record as this step can be executed by two ways : a) loan officer may contact other creditors (banks) who had previously loaned money to this customer to evaluate customer’s commitment to the loan , whether the customer was fully adhered to previous loan agreement . b) The loan officer can understand the customer well through reviewing the customer’s history from the CBE (note: CBE has records for all the customers who were engaged in a loan agreement.

4. Evaluating customer’s financial condition The customer is asked to submit crucial documents in order to evaluate the loan request as these documents may include previous financial statement or expected financial statements , the credit analysis division conduct a thorough financial analysis in order to determine whether the customer has sufficient cash flow , his business is profitable or not & the a brief summary & recommendation is submitted to loan committee for approval .

5. Assessing loan collateral & sign loan agreement Once the loan committee approves the customer request then the credit committee or loan officer have to check other property or asset to be pledged,

then when both of loan officer & credit committee are satisfied so the loan agreement is prepared & signed by all parties of agreement.

6. Monitoring compliance with loan agreement & other customer service needs The new agreement must be monitored continuously to ensure the terms of the loan are being followed & all required payment of principle & interest are being made as promised , as for large commercial credit the loan officer will visit the customer’s business periodically to check on the firm’s progress & see what other services the customer may need

5 C’s of Credit Analysis Key to Credit Regardless of where you seek funding - from a bank, a local development corporation or a relative - a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The "Five C's" are the basic components of credit analysis. They are described here to help you understand what the lender looks for.

The 5C's Capacity to repay is the most critical of the five factors, it is the primary source of repayment - cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal or commercial- is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment. Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

Collateral, or guarantees, are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan. Conditions :describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business, to assess industry & economic conditions most lenders maintain file of information, magazine article & research report on the industry represented by by their major borrowing customers Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of your references and the background and experience levels of your employees will also be reviewed.

External operations department

Letter of credit The letter of credit is a written commitment issued by a bank (called the source) at the request of the buyer (applicant or order) in favor of the seller (beneficiary), and is committed to the bank by which to fulfill within the limits specified amount during a certain period when presented seller documents item identical to the instructions accreditation requirements, and the Bank's commitment to fulfill in cash or accept a bill of exchange. The letter of credit is used to finance foreign trade, which represents in our time frame, which is accepted by the other parties in entering the field of international

trade in order to preserve the interest of these parties are all exporters and importers.

For the source, have a guarantee - by letter of credit - that will get the value of the goods which have been contracted for export, and that immediately after the shipment of the goods and documents to the bank, who have let him think that the receipt of accreditation.

For the importer, it also ensures that the light of the adoption of the bank will not pay the contractor the value of the goods imported only with the documents of goods shipped an update to the conditions contained in the letter of credit open to him.

And participate in the documentary credit four parties are: First, the buyer: it is the request to open the credit, and credit is in the form of contract between him and the light bank credit, and includes all the points requested by the importer Second: World Light Accreditation: is the bank which offers the buyer's request to open the credit, where the study of demand, and in the case of approval and the approval of the buyer on the terms of the bank, who opens credit and sends it either to the beneficiary directly in the case of dependence simplex, or one of its correspondents in the country seller in the case of post second bank in the process of the documentary credit. Third , Beneficiary: a source who is on the implementation of accreditation requirements in the period of validity, and in the event that the notification based enhanced from the correspondent bank in his country, the book reported to serve as a new contract between him and the correspondent bank, and under this contract receives the beneficiary price of the goods if the documents according to the accreditation requirements. Fourth, the correspondent bank: the Bank shall inform the beneficiary that the text of the letter of credit given to him by the issuing bank for approval intervene in cases where more than one bank in the implementation process of the documentary credit, as is often, and this adds the correspondent bank.

Why use a Letter of Credit? • The need for a letter of credit is a consideration in the course of negotiations between the buyer and seller • When the important matter of method of payment is being discussed. Payment can be made in several • different ways: by the buyer remitting cash with his order; by open account whereby the buyer remits payment • at an agreed time after receiving the goods; or by documentary collection through a bank in which case the • buyer pays the collecting bank for account of the seller in exchange for shipping documents which would • Include, in most cases, the document of title to the goods. In the aforementioned methods of payment, the • Seller relies entirely on the willingness and ability of the buyer to effect payment. • When the seller has doubts about the credit-worthiness of the buyer and wishes to ensure prompt payment, • The seller can insist that the sales contract provides for payment by irrevocable letter of credit. Furthermore, if • the bank issuing the letter of credit (issuing bank) is unknown to the seller or if the seller is shipping to a • foreign country and is uncertain of the issuing bank’s ability to honor its obligation, the seller can, with the • approval of the issuing bank, request its own bank — or a bank of international repute • to assume the risk of the issuing bank by confirming the letter of credit. •

Step-by-step process: • Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.

• Buyer applies to his bank for a letter of credit in favor of the seller. • Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary). • Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary). • Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company. • Seller presents the required documents to the advising or confirming bank to be processed for payment. • Advising or confirming bank examines the document for compliance with the terms and conditions of the letter of credit. • If the documents are correct, the advising or confirming bank will claim the funds by: o Debiting the account of the issuing bank. o Waiting until the issuing bank remits, after receiving the documents. o Reimburse on another bank as required in the credit. Advising or confirming bank will forward the documents to the issuing bank. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account. • Issuing bank then forwards the documents to the buyer.