bn101 foundation course in banking i

Foundation Course in Banking – I 1

FDN-BN101

Foundation Course in Banking – I


Table of Contents

1 Evolution of Banking ________________________________________________ 6

1.1 What is Banking? ________________________________________________ 6

1.2 History of Banking _______________________________________________ 7

1.3 Definition of Banking _____________________________________________ 10

1.4 Services Offered by Banks _________________________________________ 12

1.5 Trends in Banking Services ________________________________________ 15

1.6 Classification of Banking Systems ___________________________________ 15

1.6.1 Central Banking System _______________________________________________ 16

1.6.2 Central Bank Structure in the US _______________________________________ 21

1.6.3 Bank of International Settlements _______________________________________ 22

1.6.4 Commercial Banking System __________________________________________ 23

1.6.5 Line of Business for a Commercial Bank _________________________________ 25

2 Introduction to Retail Banking _________________________________________ 29

2.1 Types of Deposit Accounts _________________________________________ 30

2.2 Demand Deposits ________________________________________________ 30

2.2.1 Savings Account _____________________________________________________ 30

2.2.2 NOW Account _______________________________________________________ 30

2.2.3 Money Market Account ________________________________________________ 32

2.2.4 Current Account ______________________________________________________ 32

2.3 Term Deposits __________________________________________________ 33

2.3.1 Certificate of Deposits _________________________________________________ 33

2.4 Retirement accounts _____________________________________________ 34


2.5 Insurance on Deposits ____________________________________________ 34

2.6 Withholding Tax _________________________________________________ 35

2.7 Retail Payments _________________________________________________ 36

2.7.1 Transactions in checking accounts ______________________________________ 38

2.7.2 Check ______________________________________________________________ 39

2.7.3 Physical Check Clearing Mechanism ____________________________________ 41

2.8 Private Banking or Wealth Management ______________________________ 48

2.8.1 Products in Wealth Management _______________________________________ 54

2.9 Card System ____________________________________________________ 56

2.9.1 Evolution of Cards ____________________________________________________ 56

2.9.2 Types of Cards _______________________________________________________ 57

2.9.2.1 Credit Card _________________________________________________________ 57

2.9.2.2 Charge Cards _______________________________________________________ 58

2.9.2.3 Debit Cards _________________________________________________________ 59

2.9.2.4 ATM Cards _________________________________________________________ 59

2.9.2.5 Credit card cum ATM Cards ___________________________________________ 59

2.9.2.6 Debit card cum ATM Cards ____________________________________________ 60

2.9.2.7 Travel Currency card cum ATM Cards __________________________________ 61

2.9.2.8 Gift Cards ___________________________________________________________ 61

2.9.2.9 Petro Cards ________________________________________________________ 62

2.9.2.10 Corporate Cards ____________________________________________________ 62

2.9.2.11 Other Private Prepaid cards __________________________________________ 64

2.9.2.12 Non-Financial Cards _________________________________________________ 64

2.10 The Participants in the Card Business ________________________________ 66

2.11 Business Models- Private Label and White Label Cards __________________ 67


3 Commercial Banking ________________________________________________ 68

3.1 Fund Based facilities _____________________________________________ 69

3.1.1 Lines of Credit _______________________________________________________ 70

3.1.2 Revolving Loans _____________________________________________________ 71

3.1.3 Term Loans _________________________________________________________ 72

3.1.4 Syndicated Loans/Club Loans __________________________________________ 73

3.1.5 Trade Finance _______________________________________________________ 74

3.1.6 Export-Import Finance ________________________________________________ 74

3.1.7 Factoring ____________________________________________________________ 76

3.1.8 Leasing _____________________________________________________________ 77

3.1.9 Bill Discounting ______________________________________________________ 77

3.2 Structuring of Loans ______________________________________________ 80

3.2.1 Fixed Rate Vs. Floating Rate ___________________________________________ 80

3.2.2 Types of Repayment __________________________________________________ 81

3.3 Concept of Default _______________________________________________ 83

3.4 Non-Fund Based Facilities _________________________________________ 84

3.4.1 Letter of Credit or Documentary Credit __________________________________ 84

3.4.2 Uniform Customs and Procedures for Documentary Credits (UCC) __________ 89

3.4.3 Types of LCs ________________________________________________________ 90

3.4.4 Guarantee ___________________________________________________________ 96

3.5 Other Non-Fund Based Products/Services____________________________100

3.6 Cash Management Services _______________________________________100

3.6.1 Collection Services ______________________________________________102

3.6.2 Payment Services _______________________________________________103

3.6.3 Benefits of CMS _________________________________________________105


3.7 Trade Finance___________________________________________________106

3.7.1 Role of Banks ___________________________________________________106

3.7.2 Services related to Import __________________________________________108

3.7.3 Services related to Export ________________________________________110

3.8 Lending Process________________________________________________111

3.8.1 Stages in a Lending Process _____________________________________113

4 Financial Statements of Banks________________________________________116

4.1 Balance Sheet _________________________________________________116

4.1.1 Assets _______________________________________________________120

4.1.2 Liabilities _____________________________________________________123

4.2 Income Statement (Report of Income)______________________________ 128

4.2.1 Interest Income ________________________________________________132

4.2.2 Interest Expenses ______________________________________________132

4.2.3 Net Interest Income ____________________________________________132

4.2.4 Loan-loss Expenses ____________________________________________133

4.2.5 Non-Interest Income____________________________________________133

4.2.6 Net Income ___________________________________________________133

4.2.7 Appropriation of Profit ___________________________________________133

4.3 Financial Reporting _____________________________________________134


In this chapter, the reader will learn about the process of evolution of banking and its

contribution to growth of world commerce. The chapter will provide the rationale for banking and

its supervision. A brief mention has been made of the high level segmentation of banking, which

will be explored further in the next chapters. The chapter ends with the description of typical

financial statements of a bank and the description of terms in a financial statement.

1 Evolution of Banking

1.1 What is banking?

Traditionally, banking is defined as the process of accepting deposits from surplus units in the

economic system (lenders) with the objective of lending these funds to the deficit units in the

economic system (borrowers).

A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and

Greece, which loaned at high rates of interest the gold and silver deposited for safekeeping.

Private banking existed by 600 B.C. and was considerably developed by the Greeks, Romans,

and Byzantines. Medieval banking was dominated by the Jews and Levantines because of the

strictures of the Christian Church against interest and because many other occupations were

largely closed to Jews. The forerunners of modern banks were frequently chartered for a

specific purpose, e.g., the Bank of Venice (1171) and the Bank of England (1694), in connection

with loans to the government; the Bank of Amsterdam (1609), to receive deposits of gold and

silver.

Banking developed rapidly throughout the 18th and 19th centuries, accompanying the

expansion of industry and trade, with each nation evolving the distinctive forms peculiar to its

economic and social life. Over a period of time banking has undergone lot of changes and now

banking is not restricted to only taking deposits and lending. Although deposit taking and


lending still remains the core banking activity, now banking includes services like wealth

management services for ultra-rich high net worth individuals, housing finance, mergers and

acquisitions advisory services, leasing, trade finance, automobile finance, education finance,

and the list goes on.

The following section describes how banking has developed over all these years since its

inception.

1.2 History of Banking

Banking is one of the most important services in financial sector. It also provides fuel for

economic growth of a country. It offers safety and liquidity for the investors, both on short and

long-term basis, offering a comparatively fair comparatively fair return for them. Banks are the

principal source of credit for dealers, households, small businesses like retail traders and large

business houses. Efficiency of a bank depends on its ability to satisfy its investors by offering

comparatively a better interest rate to depositors and at the same time offering credit to their

borrowers comparatively at cheaper interest rates. With a narrow interest rate spread

(difference between borrowing and lending rate), they should make profit also. Looking into the

present profile of a bank, it has grown up phenomenally offering large number of products other

than the traditional functions of accepting deposits and lending funds. It is worth analyzing the

historic background of evolution of banking services.

When and how did the banks appear? Linguistics (the science of language) and etymology (the

study of origin of words) suggest an interesting story about the origin of banking. Both the old

French word ‗banque‘ and the Italian word ‗banca’ were used centuries ago to mean a ‗bench‘

or ‗money changers table‘. This describes quite well what historians have observed concerning


the first bankers who lived more than 2000 years ago. They were money changers seated

usually at a table or in a small shop in the commercial district aiding travelers who came to town

by exchanging foreign coins for local money or discounting commercial notes1 for a fee in order

to supply merchants with working capital.

During early stages, European Banks were only for safe keeping of valuables like gold, and

silver as people had the fear of loss of their assets due to theft, expropriation by government or

war. Merchants who collected their payments in the form of gold and silver in other countries

deposited their collections in the nearest bank instead of carrying such assets and exposing

themselves to the risk of piracy or storms in the sea.

During the reigns of King Henry VIII and Charles I in England, government‘s efforts to seize gold

and silver from the public made them deposit their stock of gold and silver with goldsmith shops

who in turn issued paper tokens or certificates indicating details of gold and or silver deposited

with them. This certificate began to circulate as money because it was more convenient and

less risky for them to carry this certificate. These goldsmiths also offered the service of valuing

the gold and silver and issuing a ‗valuation certificate‘. Most customers brought gold, silver or

ornaments to these goldsmiths and got it examined to find out whether they were genuine or

fake. Even today certain ‗approved valuers‘ provide this service.

The early bankers might have used their own capital for funding such activities but it was not

long before the idea of attracting deposits and securing temporary loans from wealthy

customers became an important source of bank funding. Loans were then made available to

1 Short-term unsecured promissory notes acknowledging a loan/obligation of one party against

the other.


shippers, landowners and merchants at lowest interest of 6% per annum and as high as 48%

per month for riskier ventures. Most banks in early stages were of Greek origin.

Gradually, the banking industry spread outward from the classical civilization of Greek and

Rome into northern and western parts of Europe. Banking industry encountered religious

protests during the Middle Ages primarily because the loan given to the poor was at higher

interest rate. However, in Europe, when the Middle Ages drew to a close and the Renaissance

started, bulk of deposits and loans were from wealthy customers and the religious opposition

died down slowly.

Between the 15th and 17th centuries, due to the development of navigation facilities, new trade

routes and cross country trade activities, nucleus of world commerce gradually shifted from

Mediterranean region towards Europe and British Islands where banking became a primary

leading industry.

Industrial revolution took place during the same period, which demanded a well-developed

financial system. When production activities expanded at a mass scale, it required an equal

quantum of expansion of global trade to absorb the output produced and new methods of trade

payments and credit availability. Banks that had the competency and capacity to manage the

needs, grew faster. Some of the institutions that had the fastest growth during this period were

Medici Bank in Italy and Hochstetler Bank in Germany.

When colonies were established in North and South America, banking practices were revised

and new practices were introduced. In the beginning of 19th Century, however, the state

governments in US began chartering banking companies. Many of them were simply


extensions of other commercial enterprises in which banking services were largely secondary to

merchant‘s sales. Developments of large professionally managed banking firms were centered

in few commercial centers especially in New York. During Civil War, the federal government

became a major force in US banking. Congress established office of the Comptroller of

Currency (OCC) in 1864 for the purpose of chartering national banks. This divided banks‘

regulatory system with both federal government and the states playing key roles in the control

and supervision of banking activities, which continues even today.

Barclays Bank also has a long history. It was founded by John Freame and Thomas Gould in

1690 under the name of Goldsmith Bankers. The bank was renamed as Barclays by Freame's

son-in-law, James Barclay, in 1736.

1.3 Banking Definition

The word Bank has been used differently in different geographies. The regulator in the

respective countries defines the scope of the functions and services the banks can offer.

There are specific regulations related to the banking, which will be discussed later.

As per English Common Law, a banker is defined as a person who carries on the business of

Banking, which is specified as

Conducting current account for the customers

Paying cheques drawn on him, and

Collecting cheques for his/her customers

In United States any institution accepting deposits subject to withdrawal on demand such as

drawing a cheque or by making an electronic withdrawal and making loans of commercial or

business nature is defined as a ‘bank’. Several financial service companies and leading bank

holding companies filed application for ‗non-bank banks’ because they could establish these

service units freely across state lines and also have an access to federal deposit insurance.


In 1987 Congress put a halt to further non-bank bank expansion by subjecting the parent

companies of non-bank banks to the same regulatory restrictions that traditional banking

organizations are subjected to. Moreover, Congress defined bank as ‗a corporation that is a

member of the Federal Deposit Insurance Corporation‘. By this law a bank‘s identity depends

on which government agency insures its deposits.

Banks in the US are also classified as Depository Institutions whereas other non-banking

financial institutions are referred to as non-depository

Depository Institutions

These institutions play an important role in the development of the financial markets. These

institutions play an important role in channelizing the savings in the economy. Depository

institutions mainly include:

Commercial Banks

Savings and Loan Associations

Credit Unions

Commercial Banks: These are depository institutions which are in the business of deposit

taking and lending. They provide a range of products and services for individuals as well as

businesses.

Savings and Loan Associations: These institutions provide savings account facilities and are

also into mortgage lending. Many of them provide a range of services similar to a commercial

bank.


Credit Unions: These are not-for-profit financial cooperatives that offer personal loans and

other consumer banking services

Commercial banks, savings and loan associations and credit unions together hold a large share

of the nations‘ money stock in the form of various types of deposits and help in their transfer to

effect payments. They also lend these funds directly to individuals and businesses for a variety

of purposes and also lend them indirectly through investment in financial instruments.

Non-Depository Institutions

These institutions perform a variety of functions other than banking. The following are the

common types of non-depository institutions:

Finance Companies

Mutual Funds

Security Firms – Investment bankers, brokers and dealers

Pension Funds

Insurance Companies

1.4 Services Offered by Banks

The services offered by commercial banks can be broadly classified into four viz. (1) Payment

System (2) Financial Intermediation and (3) Financial services (4) Ancillary Services.

The Payment system is the backbone of the entire money flow in an economy .The payment

system, in the olden days was basically through negotiable instruments like cheque, bill of

exchange, Demand Draft and Telegraphic/Wire Transfers.


With evolution of technology, payment processes have changed drastically. Newer payment

systems also have evolved with the advent of technology.2

Financial Intermediation:

This is one of the oldest functions of the Bank. Accepting deposits from customers and then

lending these funds to borrowers is the core of Financial Intermediation. This continues to be

the mainstay of the Bank even in this century and will continue as long as the banking system

exists.

Financial Services:

Over a period, customer requirements have changed and newer services have evolved. These

services include investment banking, foreign exchange business, wealth management, and

investment banking.

These services generate income for the commercial bank in the form of commissions etc. which

is termed as Non-Fund income in accounting parlance. The services under this umbrella has

also been growing at a very fast pace.

Ancillary Services:

Banks have been looked upon with trust by the common man and this resulted in offering of

many ancillary services which form a very minuscule of the services offered by the banks.

Typical services include safe custody of articles with the bank and safe deposit lockers.

Ancillary service related to payments would be cheque pick up facility, cash payment at the

doorstep referred to as door step banking.

2 The same will be dealt in detail in subsequent sections


Traditional services offered by banks

Carrying out currency exchanges

Discounting commercial notes and making business loans

Offering savings deposits

Safe keeping valuables

Supporting government activities with credit by purchasing government bonds

Offering checking accounts and demand deposits

Offering trust services, managing financial affairs, and property of individuals and

business forms for a fee

New services offered by banks

Granting consumer loans

Financial Advisory Services

Credit and debit cards

Cash management

Equipment leasing

Venture capital loans

Insurance services

Retirement plans

Security brokerage and investment services

Mutual funds and annuities

Investment banking and merchant banking services


Looking into the additional services that are extended by a bank today, it is evident that

beginning with a safe custodian for gold and silver, banking has moved into an era of offering all

types of financial services under one unit. Service menu of banks is constantly growing, leading

to a trend of ‗banking revolution‘. These rapid changes may leave banks of the next generation

almost unrecognizable from those of today.

1.5 Trends in Banking Services

While tracing the evolution of banking services one cannot lose sight of the following trends:

Proliferation of new services and innovation of new customer friendly products

Rising competition

Deregulation of banking and financial markets

Raising operational costs

Invasion of information technology – electronic funds transfer – data transfers

Consolidation of banking industry – mergers and acquisitions

Globalization of financial services

Transparency in banking operations

Capital adequacy to withstand credit and operational risks.

1.6 Classification of Banking Systems

Banking systems have evolved to meet the requirements that arose at different points of time in

various economies and also the regulatory intervention that followed.


Banking can be broadly classified as:

1.6.1 Central Banking System

Central Banking system is a non-commercial banking system which consists of a national

supervisory framework for regulation of banking and controlling money supply in the economy.

The role of the central bank is totally different from that of a commercial bank. The central bank

does not interact with the public directly except with the Bank. The central bank is often referred

to as the Banker‘s Bank.

The need for a central bank is felt only when there is a banking system in place. Most central

banks evolved in order to take care of actual or potential problems in the banking system.

Central banking was initially practiced with the help of a large number of informal norms,

conventions and self-imposed codes of conduct. These were later formalized into theory and

institutionalized into laws that apply to today‘s central banking institutions. The first central bank,

the Sveriges Riksbank, was established in Sweden in 1668; and the second was the Bank of

England (BoE), set up in 1694 under a Royal Charter. Most of the bigger European central

Banking

Central Banking

Commercial Banking


banks were established in the nineteenth century, while the German Bundesbank and the U.S.

Federal Reserve System in the twentieth century. Early central banks were established primarily

to finance commerce, foster growth of the financial system and to bring about uniformity in

issuance of currency notes.

After the First World War, the role of central banks became even more important. Their role of

supervising the business of private commercial banks was extended and lender-of-the-last-

resort function3 to stabilize the banking system during financial panics was strengthened. The

First World War also led to the central banks‘ increasing involvement in extending credit to their

governments. In order to handle their new role as brokers for government debt, central banks

were allowed to trade government paper in the open market and were entitled to develop open

market policy instruments for fine-tuning of interest rates and for credit and money supply

expansion. This gave rise to more discretionary powers to central banks to conduct their

operations. Since 1933 in the US and shortly after the Second World War in Germany, central

banks were empowered to change minimum reserve requirements, which constituted an

important direct tool of monetary policy.

Central banks have evolved in accordance with the specific requirements of the economies in

which they are situated and in response to the kind of demands made on them. The genesis of

central banking is different between developed and developing countries. As a result, the role of

central banks in developing countries of today is typically different from that of the developed

country central banks when they were developing. In industrial countries this purpose centered

on the need to have a lender-of-the-last-resort, in developing countries such as India, central

3 Central banks act as lender of last resort for banks/financial institutions that do not have any

other means of borrowing left and whose failure would adversely affect the economy


banks came into existence when banking was underdeveloped. In fact, the central banks were

instrumental in influencing the spread of commercial bank networks in developing countries.

Regulatory Evolution

The origin of banking regulation in a broad sense or the primitive form of banking regulation can

be traced back to the end of the Middle Age right after the emergence of banking industry. But

systematic and extensive banking regulation originated only in the mid-nineteenth century when

government involvement in the national economy began to grow. Before that, banks were not

regulated or little regulated, a situation often referred to as free banking or laissez faire banking.

Late Medieval Period

The late medieval (late 13th century) experience of Aragon demonstrates vividly the genesis of

banking regulation as a response to moral hazard following government guarantees. In some

city states such as Barcelona, Valencia, and Tortosa, the economy was booming and the

government had relatively abundant fiscal resources. Understanding well the importance of

bank stability to the society, the kings of these cities offered guarantees to bank deposits.

Government insurance caused moral hazards: irresponsibility, speculation, and lack of foresight

on the part of some early bankers led to fraudulent bank failures during the last third of the

thirteenth century. In response to fraudulent bankruptcies, the legislatures in Barcelona and

Lerida passed the first laws governing banking in Catalonia in 1300 and 1301, respectively. The

law in Barcelona provided stringent rules to punish those bankers who went bankrupt: they

should be publicly denounced, not only in the streets of Barcelona but also in all the towns

where they had done business. They could not open any exchange or bank thereafter, and

would be imprisoned and kept on bread and water until they paid off all their creditors. The

government also strengthened regulation of bank accounting system and enhanced the


creditor‘s rights. The banker was declared responsible for all entries made for his/her clients,

and no one, not even the king, could postpone settlement of credit beyond the set time. In

Lerida, the king decreed that money changers were responsible to their creditors and that their

goods could be confiscated in cases of default.

To curb problem of moral hazard as a result of deposit guarantee, the government required

banks to submit a deposit as guarantee: no one would be allowed to open a bank in Catalonia

without first depositing 1000 silver marks in Barcelona and Lerida and 300 marks in all other

towns and cities in Catalonia. Only after the deposit was paid could the money changer place

the tapestry bearing the shield of the city on his/her table, indicating that his/her office was

guaranteed. Those who did not pay the fee had to leave the wooden top of their tables bare,

without tapestries or other cloths, as a warning to their clients. This is in nature similar to the

deposit reserve or capital adequacy requirement in contemporary banking practice, which no

doubt can contribute to banking stability.

Early Nineteenth Century

As the government‘s involvement in the national economy began to increase, the role of

governments to intervene in the economic affairs as well as the fiscal and financial capacity of

governments increased. The power of taxation and monetary policy equipped the governments

in respective economies with ever increasing financial resources. At the same time,

governments were subject to the pressure of public opinions and therefore became concerned

with social welfare. In this role, governments used to bail out failing banks in order to provide a

social safety net. The bailout of the Chilean Mortgage Bank is one of the earliest examples of

government bailouts in the 19th century.


During the same period, the concept of laissez faire was made popular by Adam Smith.

Laissez-faire is a French phrase meaning "let do, let go, let pass." It came to be used as a

synonym for free market economics during the early and mid-19th century. It is generally

understood to be a doctrine opposing economic interventionism by the state beyond that which

is perceived to be necessary to maintain peace and property rights.

―Laissez faire banking‖ or ―free banking‖ refers to the institutions of banking with no or little

government regulation. Under this regime, there is no government control of the quantity of

exchange media, no state-sponsored central bank, no legal barriers to the entry, branching, or

exit of commercial banks, no government restriction on interest rates or bank asset and liability

portfolios, and no government deposit guarantee.

Furthermore, the government doesn‘t have motivation and sufficient financial resources to

ensure solvency of any bank. Contrary to what people might have imagined, ―free banking ―was

not a synonym for banking panic. Individual banks did fail occasionally in the ―free banking‖ era,

but there did not seem to be major banking panics and crises. Some banks did fail, but usually it

was not because of bankers‘ fraudulence or recklessness. One important reason for bank failure

in that period was that banks succumbed to political authority by extending loans in an

inappropriate way. For example, some banks with international business in Britain lent money to

British aristocracy under political pressure without daring to ask for collateral. Some British

aristocrats simply defaulted on loans to escape the liability.

The Scottish experience of free banking in the 18th and 19th centuries presents a classic

example of how market discipline can stabilize the banking system. In the absence of

government regulation, market generates effective mechanism in disciplining bankers‘ behavior.

Virtually all bank owners carried unlimited liabilities: all but three of Scotland‘s banks operated


with unlimited liability during the free banking era. This contributed to banking stability by

removing risk-taking tendency on the part of bank owners. Bankers made very careful decisions

and risk management to avoid financial risk contagion. To protect itself from any spillover effects

from other banks‘ difficulties, each bank attempted to establish a distinct brand-name identity

and reputation, and held as little of other banks‘ liabilities as possible.

Late Nineteenth and Twentieth Century

Over a period of time, different economies depending upon their stage of development and the

specific constraints, formulated and developed national regulatory systems. At the same time,

financial liberalization was also becoming popular. To strengthen bank regulation and

supervision following financial liberalization often requires the government to choose alternative

regulation instruments and methods to monitor banks. Unfortunately, in reality, many countries

didn‘t establish complementary banking regulations, and as a result suffered from financial

turmoil in the wake of financial liberalization. Prominent among these were the Savings and

Loans Associations Crisis in US, Chilean and Mexican Crisis, etc.

1.6.2 Central Bank Structure in US

The central bank of US is known as the Federal Reserve .Generally one country has only one

central bank. However US have a very unique structure as there is a state level Fed as is

depicted below. The Banks are regulated at Federal and State level depending upon the

banking organization‘s charter type and organizational structure


1.6.3 Bank of International Settlements

Globalization posed new threats and challenges in terms of cross border transaction.

A financial crisis no longer happened in silos .This led to a need for the central bank of one

country to interact with other countries and bring a common platform for interaction and a

meeting point for the various issues.

This need crystallized in the form of Bank of International Settlements (BIS) on 17 May 1930.

This was set up to foster international monetary and financial cooperation and serves as a bank

for central banks. Currently 56 central banks of various countries are members of the BIS.

BIS is popularly known by the Basel Norms. Basel happens to be the Headquarters of BIS. All

the international norms of BIS are referred to as Basel Norms worldwide.

When banking systems in a number of industrial countries weakened in the late 1980s, pressure

developed for harmonizing bank regulation among industrial countries, at least for large

internationally-active banks in these countries. The harmonization was intended both to

enhance safety by reducing the likelihood of individual failures that could spread the adverse

effects across national boundaries and to provide for a more level playing field, so that banks in

different countries would not benefit from any competitive advantages due to subsidies from


their governments, such as lower capital ratios in an environment of explicit or implicit deposit

insurance or other government support. In large measure, the call for such transnational

regulation reflects both the limited market discipline on banks in most countries because of the

existence of actual or conjectural government guarantees and the greater difficulty in monitoring

banks in non-home jurisdictions by both private stakeholders and government regulators.

This resulted in a capital measurement system commonly referred to as the Basel Capital

Accord. This system provided for the implementation of a credit risk measurement framework

with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been

progressively introduced not only in member countries but also in virtually all other countries

with active international banks. In June 1999, the Committee issued a proposal for a New

Capital Adequacy Framework (Basel II) to replace the 1988 Accord. Following extensive

interaction with banks and industry groups, the revised framework was issued in June 2004.

1.6.4 Commercial Banking System

Commercial banking system consists of a network of banks which provide a variety of banking

services to the individuals and the businesses in the economy. The commercial banking

systems may be of two types:

Commercial Banking System

Unit Banking

Branch Banking


Unit Banking System

Unit banking involves provision of banking services by a bank in a limited local area.

Sometimes, unit banks are also permitted to have branches in a limited area. The unit banks are

connected through correspondent bank system which provides for the transfer of funds between

unit banks. The advantage of unit banking is that it facilitates mobilization of deposits and their

deployment for needs of the local community where the bank is located.

Unit banking gave way to branch banking system due to the following reasons:

Economic interdependence among various states

Infrastructure development

Growth of big business firms

Mobility of population

Increasing emphasis on convenience

Branch Banking System

In Branch banking system the bank has a head office which controls and directs the branches

located in multiple locations. The branches may be located in the same city, same state, across

states, or even across countries. The head office as well as the branches is under the control of

the same board.

Branch banking offers the following advantages:

Facilitates the allocation of savings to their most efficient use across the nation

irrespective of their origin i.e. savings may originate at different locations and may be

deployed at different locations.


Diversifies of risk as risks are spread over an entire range of commercial assets

Leads to uniform structure of interest rates

Facilitates the penetration of best banking services to the far flung areas of the nation

A major drawback of the branch banking system is that there is excessive centralization and

branches have to look up to the head office for many issues. Further, in branch banking the

personnel may also get relocated to various branches during their employment with the bank

and if they are from a different area or state, they may not be aware of the special problems

faced by the locals/natives of that area/state.

1.6.5 Line of Business for a Commercial Bank

The banks may offer different services for different customers across geographies based on the

customer need as well as the geography specific regulations.

The Basel Norms categorized Lines of Business (LOB) into eight classes:

Srl. No. Line of business Srl. No. Line of business

1. Corporate finance 2. Payment and settlement

3. Trading and sale 4. Agency services

5. Retail banking 6. Asset management

7. Commercial banking 8. Retail brokerage

Certain Multinational banks may have all of the above LOBs whereas certain banks may

concentrate only on one or a few LOBs.


Corporate Finance

The activities clubbed under this LOB are Mergers and acquisition, underwriting, privatizations,

securitization, research, debt (government and high yield), equity, syndication, IPO, secondary

private placement.

This activity is also known as investment banking /merchant banking activity.

Payment and Settlement

The activities clubbed under this are payments and collections, fund transfer, clearing and

settlement activity.

Trading and Sale

The level two functions under this will be sale, marketing proprietary positions and treasury

functions related to Fixed Income, equity, foreign exchange, commodities, credit ,funding ,own

position securities, lending and repos, brokerage and prime brokerage

Agency Services

They are further sub-classified as Custody Operations, Corporate Agency and Corporate Trust

Services.

Escrow, Depository, securities lending (to customers) and corporate actions are covered in

Custody Operations.

Issuer and Paying Agents role is categorized under Corporate Agency.

Corporate Trust Services include inheritance and other trustee services.


Retail Banking

Retail banking refers to the mobilization of deposits from individuals and providing loans to

individuals and small businesses. Retail banking is characterized by large volume of small value

transactions. They are sub categorized under retail banking.

The Private Banking services offered by the banks are also categorized under this line of

Business. The services covered hereunder include private lending and deposits, banking

services, trust and estates and investment advice.

Interestingly the Basel norms classify the Card services under retail banking. The entire gamut

of card like merchant/corporate and commercial cards, private label cards and retail cards are

covered under this service.

Asset Management

Asset management services include both discretionary and non-discretionary fund

management.

In the US, mutual fund investment is much bigger than commercial bank deposits in terms of the

relation to GDP.

Commercial Banking

A number of activities are clubbed under commercial banking activity.

This activity is age old and traditional commercial banking comes under this.

The services offered are

Project Finance

Real Estate Finance

Export Finance

Trade Finance

Factoring


Leasing

Lending

Guarantees

Bills of Exchange


In this chapter, readers will be introduced to the retail banking products, including private

Banking and Retail Payment Systems. The suite of retails banking products includes Retail

Liability product that encompasses various types of deposit accounts. The Asset Portfolio is

not specifically discussed here as there is a separate module on Retail Assets.

The Retail Payment systems have seen burgeoning volumes in the past few years and the

latest electronic payment systems like ACH has been dealt in depth .The Private Banking

topic discusses the various services. The Card section gives a short overview of the Credit

card product and services.

2 Introduction to Retail Banking

Retail Banking is one of the biggest shock absorbers in the banking system. If one were to

closely study the Banking sector, one would observe that retail bank failures seldom happen.

The reason for proliferation of retail banking is twofold. The principle of spreading the eggs in

multiple baskets is the core philosophy of retail. The probability of all multiple loans failing

together at the same time is less than a big loan failing occasionally.

On the retail liability side, the retail portfolio generates low cost deposits which mean chasing

current and savings accounts.

The credit card business is also a lending business, in addition to fees generated by way of

annual maintenance charges and other service charges.

Private banking business is also similar to retail banking, except for the ticket size


2.1 Types of Deposit Accounts

A deposit account is an account at a bank that allows money to be held on behalf of the account

holder. The account holder retains rights to their deposit.

Deposit accounts are of classified into two broad types:

Demand Deposits

Term Deposits

2.2 Demand Deposits

Demand Deposits by definition are deposits that can be withdrawn by customers on demand,

while Term deposits are deposits that can be withdrawn after a specified period of time. Term

deposits are also known as fixed deposit. The term fixed refers to the term of the deposit which

is fixed in nature

2.2.1 Savings Account

Savings account is the most popular type of demand deposit. Savings Account provides deposit

services to individuals. Banks pay a nominal interest rate (3-4% pa) on this account. The

savings account can be with a cheque facility or without a cheque facility. Depending on

whether it is with or without cheque facility, the minimum balance that is to be maintained in the

account varies. There are restrictions on the number of withdrawals from this account.

2.2.2 NOW Account


The Negotiable Order of Withdrawal(NOW) is a deposit account that pays interest on which

cheques may be written and is a product unique to the US .They are structured to comply with

Regulation Q (one of the several regulations related to banking in US).As per this regulation

interest payment is prohibited on checking accounts. Checking accounts are those accounts

where the customer can draw a cheque from that specific account.

NOW accounts are interest-bearing, and cheques may be written on them, but legally they are

not interest-bearing checking accounts.

NOW accounts are interest-bearing transaction account that combines the payable on demand

feature of cheques and investment feature of savings accounts. A NOW account is functionally

an interest paying checking account. The NOW account began in Massachusetts in 1974 when

mutual savings banks offered interest bearing transaction accounts (NOW accounts) to compete

with commercial banks. These accounts, which paid a rate of interest equivalent to that of

passbook accounts, were authorized nationwide for all depository institutions by the 1980

Monetary Control Act.

The NOW account is similar to a savings account globally.

Super NOWs (SNOW)

These deposits offer flexible money market interest rates but accessible via cheque or

preauthorized draft to pay for the goods and services.

In 1986 interest rate restrictions on NOWs were relaxed. So, there is no longer any distinction

between NOWs and SNOWs. SNOWs were eligible for federal deposit insurance and subject to

reserve requirements.

To sum up, savings deposits have following characteristics:


They do not have fixed maturity.

Deposits can be set up periodically to cover over-withdrawals (drawing in excess of the

balance available).

They provide transaction funds by means of limited cheque-writing privileges

2.2.3 Money Market Account

These accounts are known as MMA or MMDA accounts. A money market account (MMA) is a

deposit account offered by a bank, which has a relatively high rate of interest and typically

requires a higher minimum balance to earn interest or avoid monthly fees. The resulting

investment strategy is therefore similar to, and meant to compete with, a money market fund

offered by a brokerage, which is considered almost as safe as savings.

In the US, an MMA is a deposit account that is considered a savings account for some

purposes, but upon which cheques can typically be written, subject to certain restrictions. Like a

Negotiable Order of Withdrawal account, it is structured to comply with Regulation Q, which

forbids paying interest on checking accounts. Thus money market deposit accounts are

accounts that bear interest and on which cheques can be written. However, due to various

restrictions, they are not legally checking accounts and thus do not run afoul of Regulation Q.

Since the account is not considered a transaction account, it is subject to regulations on savings

accounts: only six withdrawal transactions to third parties are permitted per month, only three of

which may be paid by cheques. Banks are required to discourage customers from exceeding

these limits, either by imposing high fees on customers who do so, or by closing their accounts.

Banks are free to impose additional restrictions (for instance: some banks limit their customers

to six total transactions). ATM transactions may or may not be counted.

2.2.4 Current Account


This can be opened in a way similar to the savings account. There is no restriction on the

number of withdrawals from this account but the bank also does not pay any interest on the

balance maintained in this account.

This account is known as a transaction account in the US. As per Regulation Q, Transaction

account means a deposit or account from which the depositor or account holder is permitted to

make transfers or withdrawals by negotiable or transferable instrument, payment order of

withdrawal, telephone transfer, or other similar device for the purpose of making payments or

transfers to third persons or others or from which the depositor may make third party payments

at an automated teller machine ( ATM ) or a remote service unit, or other electronic device,

including by debit card, but the term does not include savings deposits or accounts described in

paragraph (d)(2) of this section even though such accounts permit third party transfers

2.3 Term Deposits

Term deposits, in contrast to demand deposits, are placed by customers with the depository

institutions for a fixed period of time and under normal circumstances cannot be withdrawn

before the maturity.

They earn a fixed rate of interest. The interest computation has various permutation

combinations in terms of simple interest and compound interest.

2.3.1 Certificate of Deposits

In US the Term Deposits are known as Certificate of Deposits (CD).In other geographies the

Certificate of Deposit have a totally different connotation.

The basic attributes of the CD

Tenor (The period for which the CD is in effect): there are restrictions as per the local

regulations in terms of the minimum tenor and the maximum tenor


Interest compounding (there are three methods of interest computation viz. Simple,

Compound and discounted)

The minimum and maximum amount of subscription

Auto renewal facility (in case this service is availed the CD will be automatically renewed

for the same tenor as the original CD)

Premature withdrawal (certain CDs may not have the facility to withdraw before maturity

period, while in certain cases they may be withdrawn before maturity on payment of

certain service charges as well as sacrificing partially the interest portion)

2.4 Retirement accounts

Retirement accounts are another category of accounts with the banks. They are basically long-

term deposits with a twin advantage viz. Tax Benefits and long-term savings with withdrawal

restrictions.

Even though these accounts are collective instruments for employer‘s they are also available to

individuals, especially the self-employed.

The two popular products are the 401K accounts and the Individual Retirement Accounts

(IRA).Within these products there is a further bifurcation as traditional and Roth accounts.

However, retirement accounts are not FDIC insured

2.5 Insurance on Deposits

One of the most outstanding features of the deposits with banking institutions worldwide is the

concept of insurance on deposits similarly to the life insurance.

Deposits are insured with an insurance firm on payment of the insurance premium by the bank

to the insuring agency. However, the entire deposits are not insured. There are limits per


customer per bank restrictions. In the event of a bank failure, the insurance firm will pay the

deposit amount to the customer directly.

In the US, Federal Deposit Insurance Corporation (FDIC) is the entity which insures the Bank

deposits. It is an independent agency under the Federal Government created in 1933 in

response to the thousands of bank failures which happened in-between 1920 and early 30s.

The maximum amount of deposit insured per person per bank is $2, 50,000.

The banks have to pay a premium to FDIC at periodic rests as decided by FDIC.

2.6 Withholding Tax

Taxation of deposits is also another aspect to be looked into especially in case of interest

earning deposits.

The local regulations define the entity from which the tax can be withheld, the amount to be

withheld as well as the minimum threshold to be withheld.

In case of the US, for Interest paid on deposits, there is no withholding tax for US residents.US

except for salary. However US residents will have to produce the necessary Tax Identification

Number.

For Non-residents, withholding taxes are applicable on interest paid on deposits

A minimum rate of tax may be deducted at source from savings interest payments. In the United

Kingdom, tax is withheld at source unless the saver submits an R85 form (if a domestic non-tax

payer) or a R105 form (if a non-resident) to claim exemption. In the Republic of Ireland, the tax

is known as Deposit Interest Retention Tax or "DIRT".

The commutation of withholding tax is complicated as it can vary form the type of entity to whom

the Interest paid. In certain geographies the withholding taxes will have to be deducted on the

interest accrued rather than interest paid.


2.7 Retail Payments

The transaction facilitates the transfer of money amongst individuals, corporates and merchants

via paper and electronic instruments. These instruments mitigate risk of carrying cash and also

ensure that money can be sent/ received across distant locations.

The retail payment system is the backbone to facilitate these transfers. The instruments used

are traditional paper based instruments (Cheques/Check) and electronic transfers (ECS, Credit

Transfers, Debit Transfers).

Payment system facilitates settlement of financial transactions. Retail payment system is used

by individuals for paying their bills and receiving funds into their bank accounts.

Retail payments usually involve transactions between consumers and businesses. Although

there is no definitive division between retail and wholesale payments, retail payment systems

generally have higher transaction volumes and lower average dollar values than wholesale

payments systems. This section provides background information on payments typically

classified as retail payments. Consumers generally use retail payments in one of the following

ways:

Purchase of Goods and Services—Payment at the time the goods or services are

purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending

machines), and remote purchases (e.g., Internet and telephone purchases). A variety of

payment instruments may be used, including cash, cheque, credit, or debit cards.

Bill Payment—Payment for previously acquired or contracted goods and services;

payment may be recurring or non-recurring. Recurring bill payments include items such as


utility, telephone, and mortgage/rent bills. Nonrecurring bills include items such as medical

bills.

P2P Payments—Payments from one consumer to another: The vast majority of

consumer-to-consumer payments are conducted with cheques and cash, with some

transactions conducted using electronic P2P payment systems. For example, PayPal,

Yahoo Direct, C2IT, etc. are some of the popular P2P payment systems.

Cash Withdrawals and Advances—Use of retail payment instruments to obtain cash

from merchants or automated teller machines (ATMs): For example, consumers can use a

credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash from

an existing demand deposit or transaction account. Consumers can also use personal

identification number (PIN)-based debit cards to withdraw cash at an ATM or receive cash-

back at some point-of-sale (POS) locations.

The checking accounts can have debit and credit transaction in an account. A debit transaction

is one where the customer account is debited .E.g. of debit transactions include bank charges,

cash withdrawals etc.

In a credit transaction the account of the customer is credited to that account. Examples are

Interest credit, Dividend credit, salary credits etc.


2.7.1 Transactions in checking accounts

The debit and credit transactions in checking accounts are further classified into

Cash

Transfer

Clearing

Cash Transaction includes deposit or withdrawal of cash into the operating account. There are

multiple channels through which cash can be withdrawn or deposited.

The most common channel is the ATM channel followed by Branch teller. In US there are

service charges for withdrawal of cash from Non ATM Channels.

Cash can be withdrawn by self as well as third parties. Large cash withdrawals need to be

reported to the regulator across the countries as it is one of the primary routes of money

laundering.

A transfer transaction refers to the transaction from one account of the bank to another account

in the same bank. For e.g., Mr. A and his spouse Mrs. A have separate accounts in Bank B. Mr.

A wants to give some money to his spouse and requests his bank for the same. In this scenario

the bank affects a transfer to the debit of Mr. A and Credit of Mrs. A. This is an example of a

customer induced transaction.

A bank induced transaction on the other hand indicates an internal transaction originated by the

bank. An example would be the interest paid on a NOW account or a CD.

In addition, loans and repayments are made via these bank accounts which necessitate the

availability of a mechanism to transfer funds across accounts. In case of the loan repayment


from the checking account to the loan account within the same bank would be through a

process of standing instructions and not necessarily through physical cheque

A clearing transaction is a transaction between banks affected through a common third party

called a clearing house /clearing corporation.

This clearing activity is undertaken using the cheque mechanism.

2.7.2 Check/Cheque

Check is similar to a bill of exchange. A bill of exchange is a kind of promissory note without

interest and is a written order by one person (drawer, maker, or payer) to pay another (payee) a

specific sum on a specific date sometime in the future. The bank making the payment is known

as the drawee bank or the paying bank.

A check is a negotiable instrument and there are specific laws in specific geographies on the

term and nature of the law across geographies. These laws may be called the negotiable

Instruments Act/Bill of Exchange Act etc.

The anatomy of the check is as follows:

Payer/Drawer

Payee

Drawee Bank


Depending on the type of mechanism to handle the check the local regulator can define the

dimensions of the check, the type of ink to be used for printing the font size as well as the

positioning of the various attributes of the check like account number, routing number etc.

Check payment system is a debit transfer system. The check payment system does not function

through a single channel. When a payee receives a check, he or she deposits it in a bank. That

bank then has a number of choices available to collect the check:

It is possible that the payer and payee do business with the same bank. In that case,

balances are transferred on the books of that bank, and there are no inter-bank

transactions. This is known as an ―on-us‖ transaction, in which there is no delay in

settlement. Further, processing costs are lower.

The bank of first deposit may decide to present the check directly to the bank on which

the check is drawn. This occurs in situations where two banks are in close proximity and

have a lot of bilateral transactions. This is known as a ―direct send.‖

The bank of first deposit may present the check to a local clearing house, an

arrangement whereby a number of banks agree to meet for the purpose of presenting

checks to each other and settling the net differences at the end of an agreed-upon period.

The bank of first deposit may avail itself of the services of another bank—a

correspondent bank—to collect the check on its behalf.


2.7.3 Physical Check Clearing Mechanism

The technological evolution also has brought about drastic changes in which the checks have

been cleared. Currently there are a number of ways a check can be cleared. They are

Traditional clearing process

Check Truncation (known as the Check21 in US)

Automated Clearing House(ACH)

Traditional Clearing Process

Scenario: Mr. John receives his salary check from Wal-Mart, his employer. Mr. John has his

account with Wells Fargo while Wal-Mart‘s banker is Citi Bank. The salary check will be drawn

on Citibank and is referred to as the paying banker. Mr. John‘s bank is referred to as the

Collecting Bank. It is also assumed that the branches of the bank are situated in Washington

DC.

The diagram below depicts the typical inter-bank check clearing and settlement process through

a Central Bank or Clearinghouse. The steps are as follows:

Step 1: Mr. John will deposit his check with Wells Fargo Washington Branch

Step2: Wells Fargo, after authenticating the check, accepts the check for payment. At the end

of the day, the bank accumulates the checks received from its various customers sorts them

into three categories viz. checks drawn on Wells Fargo Washington Branch, checks drawn on

other branches of Wells Fargo and checks drawn on other banks. Checks drawn on other banks

will be sent to the service branch of financial institution for collection whereas checks drawn on

Wells Fargo will be processed at the branch itself.

Step 3: The Service branch of Wells Fargo will collect the checks form the various branches

across Washington and send them to the clearinghouse.


Step 4: At the clearinghouse, the checks are exchanged. Wells Fargo will hand over all the

checks they have collected drawn upon the other members of the clearinghouse, and collect all

the check drawn on the bank. Thus the check will go back to the Citibank.

Step 5, 6 and 7: The Citibank will cross check the balances of Wal-Mart account and other

particulars of the check. In case the check is found in order and there are sufficient balances

then In case sufficient funds are not there in the Wal-Mart‘s account in Citibank, the check is

returned ,the check will physically traverse back all the way through the same route all the way

back to the John‘s bank i.e. Wells Fargo

Check Clearing and Settlement

The physical check movement is called the clearing process. This is followed by the settlement

process. The clearing house will then have to debit /credit the overall amount across banks for

the checks processed.

1

2

3 4

5

2

6

7

Wal-Mart

(Payer)

John

(Payee)

Wells Fargo

Clearing

House

Citi Bank


In the days of non-automation the payment process was fully manual. The settlement process

was followed the MICR process. The Magnetic Ink Character Recognition (MICR) automated

the sorting of checks bank and branch wise as well as well as arriving at the clearing figure.

Check Truncation

In a traditional clearing mechanism the physical check has to move from the payee bank to the

drawee bank which has the related risk associated with it. With the advent of technology the

process has been improved to move the image of the check instead of the physical check itself.

In the example above the Wal-Mart check deposited by John will continue to remain with Wells

Fargo and only the image of the check will flow to Citibank for the purpose of processing .The

remaining processes will remain the same as the traditional clearing process.

Automated clearing House (ACH) System

The Automated Clearing House (ACH) Services product suite provides financial institutions with

efficient, low-cost batched payment services that enable an electronic exchange of debit and

credit transactions through the Automated Clearing House (ACH) network. The suite includes a

wide range of easy-to-use services that conveniently and seamlessly integrate with all Federal

Reserve Financial Services and offer a variety of access and connectivity options. This is an

electronic batch-processing electronic payment system for small- value payments.

Unlike the large-value payment systems (Fed wire4 and CHIPS5), which process only credit

transfers, the ACH system processes both credit and debit transfer payments. Financial

institutions participate in the ACH system as either originating depository financial institutions

4 A wholesale wire transfer system operated by the Federal Reserve System. Primarily it is used for

transferring reserve account balance of depository institutions, high value domestic payments, inter-bank transfers, third party transfers and high value inter-corporate payments. 5 This is a private electronic funds transfer system operated by large private banks in New York for international movements of funds. Financial transactions like foreign/domestic trade services, international loans, syndicated loans, foreign exchange sales/purchases, etc. are done through CHIPS. Domestic EFT (Electronic Funds Transfer) payments are also done through CHIPS.


(ODFI) or receiving depository financial institutions (RDFI) or both. Originators and receivers are

customers. The originator prepares a file of transfers, delivers it to the ODFI, and the ODFI

delivers the data to the ACH operator, who then transmits the information to the RDFI, who

either credits or debits the account of the receiver depending on the nature of the transaction.

There are different types of transactions that can be processed in the ACH system. The

transaction type is referred to as Standard Entry Codes (SEC).The type of processing depends

upon the SEC.

• Some common Standard Entry Class (SEC) Codes:

• ARC Accounts Receivable Entry. A consumer check converted to a one-

time ACH debit. [

• CCD Corporate Cash Disbursement. Primarily used for business-to-

business transactions.

• POP Point-of-Purchase. A check presented in-person to a merchant for

purchase is presented as an ACH entry instead of a physical check.

• POS Point-of-Sale. A debit at an electronic terminal initiated by use of a

plastic card. An example is using your debit card to purchase gas.

• PPD Prearranged Payment and Deposits. Used to credit or debit a

consumer account. Popularly used for payroll direct deposits and

preauthorized bill payments.

• RCK Represented Check Entries. A physical check that was presented

but returned because of insufficient funds may be represented as an ACH

entry

• TEL Telephone Initiated-Entry. Verbal authorization by telephone to issue

an ACH entry such as checks by phone. (TEL code allowed for inbound


telephone orders only. NACHA disallows the use of this code for

outbound telephone solicitations.)

• WEB Web Initiated-Entry. Electronic authorization through the Internet to

create an ACH entry.

• XCK Destroyed Check Entry. A physical check that was destroyed

because of a disaster can be presented as an ACH entry

• BOC- back office conversion

The three most popular SEC cods related to the merchant transaction are POP, ARC and BOC.

The comparison of all the three Sec Codes is given below.

For e.g. Smith walks into Carrefour Store and buys goods worth USD1000/.He can tender a

check for the payment across the counter .This can be treated as a POP transaction

Peter pays his Mobile bill through a check. The mobile service provider can use ARC code and

process the same as an ACH Transaction.


POP ARC BOC

How it Works Checks converted at a cash

register, voided and returned to

customer

Checks mailed to pay a bill

or deposited into payment

drop box

Checks presented at store or

manned bill payment location;

converted later in the "back

office"

Notification Receiver notified of conversion

via voided check and signed

receipt; must be provided opt-out

option

Receiver notified of

conversion via notice/biller

insert prior to each

payment; must be

provided opt-out option

Receiver notified of

conversion via sign at

checkout/receipt message;

must be provided opt-out

option

Source

Document

No copy required; check returned

to customer at register

Reproducible, legible

image, microfilm, or copy

of check front required

Reproducible, legible image,

microfilm, or copy of check

front required

Retention Consumer retains voided check

as long as desired

ODFI retains copy of

source document for two

years from settlement date

Originator retains copy of

source document for two

years from settlement date

Eligibility Checks > $25,000 or containing auxiliary on-us field are ineligible for conversion

Authorization Authorization receipt signed

during purchase

Mailed or deposited check

considered authorization;

notification by Originator

required prior to payment

Check presentment

considered authorization;

notification by Originator

required by posted

sign/similar receipt

Presentments Three presentments allowed

‗


The process flow for Smith’s POP Transaction is depicted below:

The process flow for Peter’s ARC Transaction is depicted


The process flow for a BOC Transaction is depicted below:

In ACH also there is the concept of check return due to paucity of funds similar to the traditional

check clearing process. Regulation E-Electronic Fund Transfer Act defines the various rules

and regulations pertaining to ACH

2.8 Private Banking or Wealth Management

Wealth management is defined as a comprehensive service to optimize, protect and manage

the financial well-being of an individual, family or corporation. Its basic definition covers advice

on loans, investments and insurance to give a broad picture of how individuals should best

deploy their financial resources. A broader picture may include tax advice, estate planning,

business planning, and other financial needs. Inheritance services is also becoming part and

parcel of the private banking Services.

Wealth management means taking care of the needs of clients, their families and their

businesses as part of a long-term, consultative relationship. It‘s best conceptualized as a

platform where a number of different sets of services and products are provided. It‘s a full-


service model, which can offer advice on investment management, estate planning, retirement,

taxation, asset protection, cash flow, and debt management.

Wealth Management is the next step in financial planning. It challenges advisors, especially

those with high-net-worth clients, to bring together all aspects of a client's financial life into a

single plan-from investment advice to estate planning to long-term-care insurance. The

components, and the methods of approaching them, vary as widely as the number of

practitioners who are moving into this area.

As any professional financial planner, the wealth manager's focus is the client. His efforts are

devoted to assisting clients achieve life goals through the proper management of their financial

resources. While the money manager may not necessarily have background information about

his client, the wealth manager will know all of this, as well as the client's goals and fears. The

practice of the wealth manager is holistic and individually customized. It is holistic because there

is very little about the client's global fiscal life that is not important information.

Wealth management is a broader term than Investment management.

Investment management is the science of choosing investments — such as stocks, bonds and

derivatives — and combining them in a way that respects a client‘s specific risk-to-reward

needs. It is also frequently called ―money management‖ or ―asset management.‖ On the other

hand, the Wealth Management process is founded on the values of the client first. What is

important to the clients? What goals do they have and how do they want to accomplish them?

What is their timeline for implementing these values and accomplishing these goals? Answering

these questions will establish the foundation upon which the wealth manager and client work

together.


Wealth management is an ongoing process. It involves keeping track of the needs of the clients

and their changing definition of success. Constant attention should be paid to the portfolio and

performance of investment should be monitored.

A wealth manager examines a client‘s financial situation and then suggests a combination of

banking and investment services that best address his unique wealth management issues.

These include:

• Current lifestyle needs. The income a client needs for living, the needs of their children and

short- or long-term goals.

• Legacy goals: To who does the clients want to entrust his/her money and how much control

doe he/she want to bestow on potential heirs?

• Philanthropic pursuits. The charities a client would like to support as well as when and how

he wishes to gift his/her money or assets (a decision that determines any tax benefits to the

client).

• Income tax considerations. The timing of stock or bonds purchases and sales might affect

total tax liability, or the form in which money is gifted to others, triggers taxes due.


Constructing a Financial Plan

There are three basic steps in establishing and maintaining any sound financial plan:

Determining client’s needs or customer profiling

First step is to set the financial goals before one starts working towards them. Everyone

who has aspirations for the future—such as buying a house or saving for a child's

education—needs a detailed plan to make those dreams a reality. Effective financial

planning is a process that first requires the answers to several important questions from

the client:

What is the client saving money for (i.e. car, house, college education,

retirement, etc.) and how much does he want to save?

What is the client‘s timeline for achieving these goals?

What are the client‘s investment preferences?

Does the client consider himself/herself a conservative or an aggressive

investor?

Building the plan

Next step is the need to choose overall investment strategy and the specific investment

vehicles that will help best to achieve client‘s goals. A variety of investment types—

including stocks and bonds, life insurance and annuities—all have a place in the overall

plan. It's important to understand these options and how they can help to achieve

success. Before selecting the best mix of investments for client‘s portfolio, the bank will

seek an answer from the client to several factors so as to develop an overall investment

strategy:


The length of time the client plans to invest the funds.

The availability of emergency cash.

The preferred risk level for investment choices.

The client and the bank‘s past experience investing in different financial options.

The client‘s current income tax rate.

Ongoing management

All successful financial portfolios require constant attention and monitoring—as goals and needs

evolve, so too should the investment mix.

Changing role of wealth manager

Wealth management is becoming an extremely important part of financial services. Wealth

management requires a more comprehensive relationship with a customer. Therefore, the

relationship involves more trust and requires the wealth manager to be more intimately involved

with customers' overall facts, financial circumstances and risk profile. It will require spending

more time with each customer and their broader needs, whether those needs are for mutual

funds, life insurance, annuities, asset management or long-term care. More importantly, the

future will be about retirement income; creating appropriate personalized "draw-down"

strategies for people who will need to live off those assets for 25 or 30 years.

Advice given by wealth manager cannot be static--it needs to be dynamic because individuals'

circumstances change over time.

Because of the rapidly changing nature of the financial markets, most wealth management

accounts are managed on a ―discretionary‖ basis. This means that the wealth management firm


makes specific buy and sell decisions on behalf of clients (according to their risk-to-reward

needs), while frequently informing them of portfolio decisions and performance updates. The

investment manager has a fiduciary responsibility to manage clients‘ assets prudently and

according to established goals and guidelines. This fiduciary role is a legal duty to make

portfolio decisions in the clients‘ best interests.

On the other hand, in case of a ‗non-discretionary‘ investment authority given to the wealth

manager, his/her option to acquire, manage, and dispose off the assets on behalf of the client is

limited. There are controls imposed on what actions the wealth manager can or cannot take

without prior approval of the client. Typically in the non-discretionary relationship, the wealth

manager acts according to an investment strategy that is agreed upon by the wealth manager

and the client. However, the wealth manager may not have the authority to purchase or dispose

of any assets, or implement major investment decisions, without the prior review and approval

of the client.

Importance of KYC in Private Banking

Supervisors around the world are increasingly recognizing the importance of ensuring that their

banks have adequate controls and procedures in place so that they know the customers with

whom they are dealing. ―Know Your Customer‖ (KYC) policies are most closely associated with

the fight against money laundering. Especially as Wealth Management deals with large value

transactions, KYC is more critical in this business.

Certain key elements should be included by banks in the design of KYC programmes. Such

essential elements should start from the banks‘ risk management and control procedures and

should include (1) customer acceptance policy, (2) customer identification, (3) on-going


monitoring of high risk accounts and (4) risk management. Banks should not only establish the

identity of their customers, but should also monitor account activity to determine those

transactions that do not conform with the normal or expected transactions for that customer or

type of account. KYC should be a core feature of banks‘ risk management and control

procedures, and be complemented by regular compliance reviews and internal audit. The

intensity of KYC programmes beyond these essential elements should be tailored to the degree

of risk.

All well run private banking operations have written "Know Your Customer" policies and

procedures that require banking organizations to obtain identification and basic background

information on their clients, describe the clients' source of wealth and lines of business, request

references, handle referrals, and identify red flags and suspicious transactions.

2.8.1 Products in Wealth Management

The basis of Private banking is the diversification of asset classes. There are a number of asset

classes which is available to the investors. They are also called as products

The main products being offered to the wealth clients by the private banking group are:

• Portfolio Management Services (PMS)

• Mutual Funds Investment

• Insurance Products

• Equity

• Fixed Income instruments

• Artworks

• Commodities

• Real Estate


• Private Equity

Portfolio Management Services (PMS): PMS is one of the popular products offered to wealth

management clients. The bank provides advisory services to the client to better manage the

portfolio of the client. The service may be ‗discretionary‘ or ‗non-discretionary‘.

Mutual Fund Investment: The bank advises the client about investment in mutual funds. Mutual

fund is a mechanism for pooling the resources by issuing units to the investors and investing

funds in securities in accordance with objectives as disclosed in offer document.

Insurance Products: This is an important financial planning product used by wealth managers.

They offer various insurance policies to their clients to adequately cover the risks faced by the

clients.

Equity: This is the most important asset class from the point of view of yield enhancement.

Wealth managers usually advise their clients to remain invested in this asset class for a long-

term.

Fixed Income instruments: These are the bonds/debentures issued by corporate or by

government. These are debt instruments and help the client in earning interest periodically over

the life of the bond and getting back the principal at the time of maturity.

Artworks: This is an emerging asset class. Art Advisory is also being most sought after.

Commodities: This has become a new asset class in the last few years. Historically the volatility

of the commodities has been less than the volatility of the equity. In commodities like precious

metals like Gold there has been a negative co relation during certain period and has become a

popular asset class.


Real Estate: This has become a new asset class in the last few years. Banks have either setup

specific desk for the same or tied up with reputed Real Estate advisory and execution firms.

The exposure to Real estate can either directly by buying the real estate or through the indirect

route. In an indirect route, internationally there are funds like real estate mutual funds known as

REITS.

Private equity:

Private Equity is an emerging asset class even for the Private Banking clients. They give an

opportunity to earn higher return at higher risk.

2.9 Card System

In the retail banking landscape, the biggest volumes of transactions are perhaps managed by

the Card system.

2.9.1 Evolution of Cards

The Card industry has grown phenomenally in the last two decades and has become a strong

substitute for cash. This is often referred to as plastic money. However there are certain

countries which have a huge parallel economy where even today a large chunk of financial

transactions happen in cash. This is because a card transaction leaves back sufficient financial

trail which will enable traceability of the fund flow.

The Diners club and American express where the two early birds in this financial space. The

same was launched in 1950s. The credit of issuing the first credit card goes to Diner‘s club .The

same was introduced in 1951.

The backbone of the Card processing is the settlement mechanism. In the early days this

process was a pure manual one. The burgeoning volumes as well as the technology evolution

had brought drastic changes to the processing environment.


The diverse business needs have moved the card industry form the Credit and Debit Cards to

other segments like Petro Cards, Frequent Flyer Cards, Integrated Transport system cards

where in a customer using a single card can purchase a metro/railway ticket as well as bus

tickets. This model is prevalent in Singapore.

Business innovation has no boundaries. Even though it is too early to comment on the technical

details, the ambitious UID project of the Government of India may culminate into a Smart Card.

The Kisan credit Card introduced in India is a very innovative manner to support the Framers

and enable straight through processing.

However carrying multiple cards leads to inconvenience and days are not far off when a single

card will be able to cater to multiple services similar to a mobile phone has now converged

other electronic devices like a music player, video and camera.

2.9.2 Type of Cards

Cards can be classified based on various categories like Business Usage, Issuer, Technology

used etc. There can be overlaps between these classifications.

2.9.2.1 Credit Card

This is one of the oldest types of cards issued since 1950‘s.In a credit card the card holder

enjoys a credit limit which needs to be repaid in a billing cycle.

There can be preset limits on the card beyond which the outstanding cannot increase.

There are cards which are issued to certain category of customers where there is no preset

credit limit.

In terms of popularity Credit cards are the most popular.


The new trend in Credit card segment is the co-branded cards. For e.g., Jet Airways has tied up

with Master Card to issue a Jet airways Card wherein JP Miles can be earned on spending on

this card. Yatra launched a Co-branded VISA card.

VISA also has launched theme cards like Women‘s card/Students card etc.

Credit Cards can be further classified into various levels based on the credit score and the

spending patterns. The lowest card is the standard, followed by Gold and the highest category

is Platinum. In addition to the limits differences in the card, the facilities provided in the card as

well as the charges on the card may vary.

2.9.2.2 Charge Cards

Very often one will come across the terms Credit card/Charge cards. Both these words are used

interchangeably by the world at large.

There are conspicuous differences between a credit card and a charge card.

A charge card requires the card holder to repay the balance in full at the end of each billing

cycle. A credit card on the other hand allows the card holder to have a revolving balance that

one can pay off over a period of time.

Some cards do not have a preset credit limit giving one a limitless amount of credit.

Unlike a credit card one needs a strong credit score to get the same while it is not true of the

credit card.

There are certain restrictions on the transaction that can be undertaken on charge cards.

American Express and Diners Club Charge cards are the most popular.

American Express charge cards are again classified to cater to the different strata of the society

and the Platinum charge card is the most sought after .The Platinum charge card is also a

status symbol among the elite


2.9.2.3 Debit Cards

Debit Cards are of recent origin. This card evolved after the technology evolution where in the

settlement was electronic. In this card the customer can spend up to the amount which is

available in the account of the customer. These cards are typically linked to the operative

account of the customer and validation of the balances happens prior to the spending on the

card.

These cards are free of credit risk (to a certain extent) from the perspective of the issuer as the

issuer does not carry the default risk at all. The element of risk may be there when a merchant

transaction is affected without checking the balances in the card. To overcome this certain

Issuers have come out with a variant of the Debit Card which can be 100 percent online. For

E.g. VISA Electron

2.9.2.4 ATM Cards

ATM cards where used solely for the purpose of cash withdrawals only. In the initial stages the

ATM card could be used only in the network of the Card issuer itself. I.e. if X bank issues an

ATM Card the Card could have been used only in the network of that bank and nowhere else.

This reduces the utility value of the card and the customer had to carry a separate card for ATM

and a separate card for Debit Card.

Even today one may come across this type of card in certain technologically under developed

country.

2.9.2.5 Credit card cum ATM Cards

Modern day credit cards offered by institutions also has the facility for the customers to withdraw

cash and separate cash limits are set on the credit card for the same. This will take care of

emergency cash requirements of the customer.


However cash withdrawal on credit cards entail service charges over and above the normal

transactions.

2.9.2.6 Debit card cum ATM Cards

The ATM cards can also cater to the customer‘s need of using it as a Debit Card as well.

Unlike a Credit Cum ATM Card, the overall limit be it Cash withdrawal or using the card as a

debit card is restricted to the balance in the operative account to which the card is linked .In

certain countries/issuers also call the debit card as Check card as it is as good as check(in the

Indian context cheque)

However based on the issuer there can be overdrawing to a certain extent.

For example VISA has two types of cards. One is the normal VISA Debit Card and the VISA

Electron. VISA electron cards cannot be overdrawn as the balances are checked online. Some

merchant establishments may not accept Electron Cards

Another major development in this segment is the interoperability and using the cards on a

common platform. In the modern days typically a customer who has a debit cum ATM card

issued by an Issuer say VISA can use this card for withdrawal of the cash from any bank‘s ATM

which is also a member of VISA. In the past if the Debit Cum ATM card was issued by Bank A,

the customer had to necessarily go to the A Bank‘s ATM only for cash withdrawal while other

merchant transaction could be done with any VISA affiliated merchant.

VISA is only an example there are other issuers like MASTER. There are other shared payment

networks .For e.g. in India we have a network called BANCS which caters to those ATM

network for Banks which are not part of the VISA and MASTER. (Earlier there was a network

called Swadhan)

The biggest advantage of using the Debit cum ATM cards of Global issuers like VISA and

MASTER is the same card can be used to withdraw cash not only in the local currency but also


in foreign currency when the customer travels abroad. For e.g., the customer is an Indian and

he/she has a VISA card issued by a bank in India. The customer travels to Riyadh and sees an

ATM of a Saudi Arabian Bank with VISA logo on the ATM. The customer can walk into the ATM

and do a cash withdrawal in SAR(Saudi Arabian Riyals).(The exchange rate and the services

charges are the hidden cost in such a transaction which needs to be worked out vis-à-vis

carrying a travel currency card).

2.9.2.7 Travel Currency card cum ATM Cards

This is a new type of cards. They are cards preloaded with a specific amount. It can be issued in

multiple currencies. The same card can be used as an ATM Cards.

VISA and Master issue these types of cards.

In the Indian context, the difference between Debit cum ATM card and Travel Currency

Card are as follows:

The exchange rate is locked in at the time of purchase and not across the period

of spending

If one is travelling to multiple countries, one may have to carry multiple travel

currency cards which become a bit cumbersome.

This card strictly cannot be used in India

The travel currency card becomes handy to those people who do not have a debit card .Other

facility in this card is that the top up is available. Unused amount on these cards can be

surrendered, if the unutilized amount is above a threshold level.

2.9.2.8 Gift Cards

The concept of Gifting has undergone a sea change in modern times. Gift vouchers are being

replaced with Gift Cards universally.


In terms of technical comparison between Gift Card and Travel currency cards is that both of

them are pre-paid cards. In case of the former the same cannot be topped up once the limit is

exhausted while in case of the latter the same can be topped up.

2.9.2.9 Petro Cards

There are different variances of the Petro Cards.

The Petro Cards in India are standalone cards and are pre-paid cards. Both BPCL and HPCL

have come out with the Petro cards. However BPCL is most popular petro card. The attraction

towards this card is the loyalty bonus and other discounts.

The second variant of a petro card is the Co-Branded Credit Card similar to the co-branded

credit cards of Airlines. For e.g. in Canada there is Citi Petro Points Master Card.

The third variant of a Petro Card is linking the petro card to the Credit card. One such company

which issues such a card is Petro Canada. The petro card of that company can be linked to the

credit card for a consolidated view of the same

2.9.2.10 Corporate Cards

All the major card issuers have launched the cards for business houses.

The businesses have been classified into

Small Business.

Mid-size

Large companies

Government and Public Sector

Unfortunately the definition of the first three business classification varies from issuer to issuer.

For e.g. Master Card defines a Mid-size/Medium Size business with revenue between USD 10

Mio and USD 1 Bio, while VISA‘s definition is revenue between USD 25 Mio and USD 500 Mio.


The business cards can be issued either to employees or to the organization. Certain cards can

be assigned to specific departments within an organization. In case of individual, these cards

are generally issued to the senior management for their travel and entertainment expenses

incurred.

The basic purpose of issuing such cards is for the purpose of control and convenience.

Control from the perspective of spending limits, type of spending. The convenience factor is

from the repayment of the spending in an effective and efficient manner.

It also enables corporations to monitor the type of spending as well as patterns of spending.

The corporate are wooed by the card issuers with a number of features on the card as well as

other add on features.

The facility to the corporate is innumerous. They have different types of cards .The business

card need not necessarily be a credit card. It can also be a debit card.

VISA has the following type of Business cards for small business

VISA Business Credit Card

VISA Business Debit Card

VISA Business Line of credit

VISA Signature Business Card

VISA Gift Card

VISA Incentive Card

For medium and large corporate the cards can be basically classified on the spend types viz.

Corporate Travel Card, Corporate Purchasing Card, Corporate Fleet card. There are integrated

cards which can take care of all the four functions.

The differentiator for the business cards is the frills and additional resources etc. provided by the

issuer.


In case of growing economy to exercise better control and monitoring the business card

segment is poised for growth in the days to come.

2.9.2.11 Other Private Prepaid cards

The concept of prepaid cards are picking up in developing countries. In India the most popular

pre-paid cards which are of multipurpose is ItzCash. It can be used to transact on mobile as well

as the internet. These cards can be used for making utility payments as well.

However the challenge in the private players compared to Master and Visa is the acceptability

of these cards.

2.9.2.12 Non-Financial Cards

The second segment of the cards which has sudden spurt in the recent times is the Non-

financial type of cards.

The typical types of cards are

Frequent Flier cards issued by Airlines

These cards are used for tracking the frequent flier miles accrued. These cards cannot be

used for undertaking financial transactions.

Basically these cards are used for awarding mileage points based on different business

logic.

There are grading in these cards as well. For e.g. Jet airways have JP Blue, Blue Plus,

Silver, Gold and Platinum. Most of the big travel companies do offer such cards.

Airlines have gone beyond mileage points only for source airlines. There is Airline code

sharing arrangements wherein if one flies a partner airline, the passenger is available for

Mileage points. For e.g. If one is a Jet Airways Frequent flier and flies Malaysia airlines, the


mileage points can be earned on the flights of Malaysia airlines. Flying: Over and above

code sharing with other partner airlines, they also tie up with other partners such as hotels.

The frequent flier cards are different from the co-branded credit cards issued and one must

not confuse the same with the Frequent flier cards.

Co-branded cards .as already mentioned above are typically credit cards issued jointly

which gives special facilities to the card holders.

The new concept in the travel industry is the credit card point conversion programs. This is

applicable to non-co-branded cards as well.

To illustrate, if a Citibank Platinum Card holder has 10000 reward points the same can be

exchanged for JP Miles with jet airways. The conversion ratio varies from type of card. In

case of a Platinum card 1 point on a credit card can be exchanged for 2.5 JP Miles

Loyalty cards issued by Hotels

This card is very similar to the frequent flier programs. The facilities offered on this card vary

from hotel to hotel.

Some of the most popular programs are of

Starwood Preferred Guest

Marriot Rewards

Hilton Honors

Hyatt Gold Passport

Similar to the code sharing arrangement of the airlines, the hotel programs also have a chain of

hotels under their umbrella

Fuel Management Cards

In Canada the most popular Fuel management card is the Super Pass TM is the most popular

petro cards issued by PETRO CANADA. The business logic is a Hybrid between Individual

cards and corporate cards. The cards can be issued to drivers etc. for refueling etc.


Lot of innovation has been built into this card in terms of control like which fuel station can be

used for refuel, time of refuel etc.

2.10 The Participants in the Card Business

The card industry has a number of participants in the processing. The role of each participant

needs to be understood clearly before delving into the Card Dynamics.

The major participants in this market can be classified as follows:

Srl No Participant

Name

Participant Role

1. Global

Technology

Companies

Visa, Master and Discover examples of such companies. These

companies per se do not issue cards, extend credit or set rate and

fees for consumers

2. Card Issuers An Institution which issues the card is referred to as the card issuers.

Generally Banks are the issuer. It is the issuer that extends credit

and sets rates and fees for consumers.

In case of

3. Acquirer An organization that collects (acquires) credit

authorization requests from Card Accepters and provides guarantees

of payment. The acquirer can also be a financial institution

4. Issuer Cum

Acquirer

American Express cards and Discover are examples of Issuer cum

Acquirer

5. Merchant or

acceptor

an individual, organization, or corporation that

accepts credit cards as payment for merchandise or services

6. Card Holder Last but not the least the most Important participant in the Card

business


7. Independent

Sales

Organization

(ISO)

A third-party company that provides services to merchants on behalf

of the acquiring bank. These services include merchant accounts,

funds processing, and account activity reporting.

2.11 Business Models- Private Label and White Label Cards

In addition to various classifications on end use of the card, cards can also be classified as

private label cards and whit label cards. This classification is over and above the normal cards

(there is no default name for the normal cards).

Private label cards can be used only at the merchants own network. The BPCL petro card for

example is a private label card as the Petro card cannot be used anywhere.

White Label Card on the other hand is launched by a merchant in association with the issuer

and the VISA/Master card. However it will not hold the name of the issuer. The same can be

used freely like a normal credit card. For e.g. Reliance Capital can tie up with State Bank of

India for a white label Visa Card. When such a card is issued, it will carry only the name of

Reliance Capital and the name of State Bank of India will not feature anywhere on the card


This chapter discusses the Commercial Banking Business, by covering the fee and non-fee

based products in the business. Cash Management and Trade Finance are introduced to the

readers. The Lending Process is also discussed at a high level.

3 Commercial Banking

Wholesale banking is also known as business-to-business banking. It refers to the transactions

between banks and large customer like corporates and government involving large sums of

money. It also includes the transactions between banks.

Project Finance

Real Estate Finance

Lending

Trade Finance

Export Finance

Factoring

Leasing

Guarantees

Bills of Exchange

The aim of Wholesale Banking is to meet requirements of corporate clients by offering a full

range of banking products and services. It is not always necessary that the wholesale banking

customers have only the need to manage the asset side of their balance sheet. They may have

short-term investable surpluses and other service requirement like foreign exchange

management as well.


From the Bank‘s balance sheet perspective, the whole sale banking products are classified into

two Viz. Funded Income and Non Fund Income or Fee Based income. Bank lending continues

to be the mainstay of the banks and generates Funded Income.

3.1 Fund based facilities

Banking is defined as the ―accepting, for the purpose of lending or investment of deposits of

money from the public, repayable on demand or otherwise and withdrawable by checks, draft,

and order or otherwise."

The very definition of banking stresses the importance of lending function, when it defines

banking as 'Borrowing for the purpose of lending'. Hence the basic objective of bank is pre-

supposed to be lending.

Banks need to deploy funds borrowed from the public to be able to pay the contracted returns to

the depositors. The most important source of deployment of funds and earning revenue is

interest through lending. Banks act as intermediaries between the depositors and borrowers.

When a bank agrees to lend money to a borrower, either against a tangible security or without a

security, against a borrower‘s promise to repay the amount at a future date, with interest for the

amount used for the period, is a form of fund based lending.

Most of the commercial credit products are in the form of loans. Loan is a comprehensive term

used to refer to the various types of short, medium and long-term credit facilities made available

by banks. Loan is a contractual agreement between the borrower and the lender of the funds

which states the underlying terms and conditions such as loan amount, repayment period, rate

of interest, penal provisions for breach of the contract, etc.


The fund Based lending may be via any or a combination of the following products:

Lines of Credit

Revolving Loans

Term Loans

Syndicated Loans/Club Loans

Trade Finance

Export-Import Finance

Factoring

Leasing

Bills Discounting

Banks set limits for each of these product types. This limit determines the maximum amount that

the borrower can borrow under the given product. The actual borrowing can therefore be

different from the limit. The actual borrowing amount is called the ‗drawing‘ or ‗drawdown‘ or

‗utilization‘ under the product.

3.1.1 Lines of Credit

A Line of Credit allows a company to borrow up to a pre-fixed amount called the credit limit for

short-term business requirements. This allows borrowers to obtain a number of loans without re-

applying each time as long as the total of borrowed funds does not exceed the credit limit. The

bank usually charges some amount of fee as well as interest on such borrowings. A Line of

Credit can be secured or unsecured. If secured, the customer is required to offer some collateral

security to cover up the borrowing. In case, the customer fails to repay, the bank may take

charge of the collateral. The collateral is usually "short-term" assets, such as receivables and/or

inventory.


It can also be by way of an overdraft where a 'credit limit' up to the amount to be lent is set in

the current account. It may be a ‗Cash Credit Account', where the bank lends against the

security of stocks6 or receivables7 up to a certain limit in a form of checkable account8 allowing

multiple withdrawals and deposits as per his/her business needs. The interest is payable only

on the utilized amount.

A company generally requires funds for the day to day activities which is called the working

capital in the accounting parlance. The working capital basically would be to meet the short-term

needs of liquidity of the organization. Lines of credit are typically set up for that purpose.

The duration of a line of credit is generally one year and the line of credit needs to be renewed

every year.

3.1.2 Revolving Loans

A Revolving Credit is firm commitment by the bank to lend up to a certain amount .Revolving

credit is similar to the line of credit except for the fact that the duration of the line of credit is

longer ,generally up to five years. The duration of a commitment to lend against a revolving loan

is therefore longer than a Line of Credit. This commitment is subject to a loan agreement

containing mutually agreeable terms and conditions. Revolving credits are to be paid in full at

maturity, and the revolving credit line can be re-used again for a fresh borrowing, if required. A

fee generally is charged for a Revolving Credit commitment. This is a monthly charge from

0.25% to 0.50% per annum on the average daily-unused portion of the committed amount.

6 Inventory of raw materials, semi-finished goods or finished goods.

7 Money owed to the company by the customers who purchased the goods on credit. 8 A bank account on which a check may be drawn.


3.1.3 Term Loans

Terms loans are normally given for financing the long-term assets such as buildings, equipment,

leasehold improvements, etc. Term loans are unlike Lines of Credit or Revolving Credit as its

repayment does not allow the borrower an automatic right to re-borrow the unused credit limit

(unused credit limit = Limit for Term Loan – Drawing under the term loan). The interest rate can

be either fixed or floating. If it is fixed, it remains constant for a certain time period after which

re-fixing is done. For example, if the repayment period is 15 years and re-fixing is to be done

after every three years, the interest rates will remain fixed for a period of 3 years and after every

3 years, the interest rate for the next three year period is determined and fixed. In case of

floating rate loans, the interest rate is linked to a benchmark and the rate of interest on the loan

keeps changing depending on the changes in the benchmark interest rate

The term loan can be of two types:

Short-term loan

Long-term loan

Short-term loan as the name suggests is given for a shorter period and the purpose of such a

loan is to meet the short-term requirements of the borrower. It differs from a line of credit in that

it is taken for a specific purpose and a fixed amount of money is usually borrowed for a given

time period.

Long-term loans on the other hand, are loans which are taken for a longer period of time, say

5-10 years and usually the purpose is acquire some fixed asset or expansion of the existing

facilities, etc. Interest is payable periodically (say at the end of each quarter). Principal


repayment can occur at the end of the term loan (bullet repayment) or periodically during the

tenor of the term loan

3.1.4 Syndicated Loans/Club Loans

A syndicated loan/club loan is an arrangement between two or more banks to provide a term

loan (either short-term or long-term) to the borrower using common loan documentation. This

arrangement is usually opted for when the amount required by the borrower is huge and

exceeds the exposure limits of a single bank. The lead manager/banker of the syndicate is

given a mandate by the borrower, which details out the commercial as well as legal terms of

credit.

In a syndicated loan, all the lenders have a common position relative to the borrower. Each

lender lends only the amount it has agreed to. If any bank in the syndicate fails to fulfill its

obligation, the other banks are not legally bound to make up the difference. In the event of

default, banks may also take legal action against the borrower either independently or jointly as

specified in the contract.


3.1.5 Trade Finance

Trade Finance is a very generic term which represents the purpose for which the lending is

done. It can have a mix and match of the various products like lines of credit, revolving credit

etc. This jargon is used to distinguish between personal and consumer loans disbursed to

individual.

3.1.6 Export-Import Finance

Financing of exports and imports of goods and services is an important activity of wholesale

banking. The dynamics of Export-Import Finance is similar to trade finance, the core difference

being the trade finance refers to domestic trade finance, though many a times the Trade


Finance is used interchangeably with Export Import Finance. These loans are normally provided

by the commercial banks or by the designated trade promotion bank in the country, either

directly or indirectly. For example, in India, Export Import finance is provided by EXIM Bank of

India. In US, it‘s the Export Import Bank of the USA. The services provided include loan

guarantees9 to help U.S. exporters obtain working capital loans to finance the raw materials

used in preparing the goods to be exported, export credit insurance to cover risks of the default

of a buyer in providing a payment, and medium-term and long-term financing for international

buyers.

An exporter may bag an order for a manufacture of goods which may have what is called a

production life cycle. The production life cycle has the following payments involved:

• Procurement of Raw materials

• Wages and salaries

• Establishment Expenses

• Inventory Holding

• Semi-Finished Goods

• Credit period for Buyers

There is a need for the exporter to finance these various components. Export finance can be

classified into Pre-shipment and Post Shipment Finance.

Pre-shipment finance as the name indicates is the lending to the exporter to the activities prior

to shipping of the goods. Once the goods are shipped then the nature of lending gets converted

to Post Shipment.

9 A guarantee that in the event of default by the borrower, the guaranteeing bank will repay the

loan.


If the exporter has availed pre-shipment finance, the same has to be liquidated by post-

shipment finance only, under normal circumstances. Under extraordinary circumstances, like

cancellation of the export order the same can be liquidated by other means.

The post shipment finance is generally disbursed by liquidating Pre- Shipment Finance. In case

an exporter has not availed any Pre-Shipment Finance a fresh Post shipment finance can be

disbursed.

3.1.7 Factoring

This is also known as account receivables financing. Account receivables represent the funds

which are owed by the customers of a company to the company. Usually, every company has a

credit policy according to which a credit period is allowed to the customers buying on credit. The

customers are expected to make the payment on or before the end of the credit period. As a

result, some of the company‘s funds remain tied up as ‗money to be received from customers‘

or accounts receivables.

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,

invoices) to a third party (called a factor, generally a bank or a banking subsidiary) at a discount

in exchange for immediate money with which to finance continued business. Factoring differs

from a bank loan in three main ways. First, the emphasis is on the value of the receivables

(essentially a financial asset), not the firm‘s credit worthiness. Secondly, factoring is not a loan –

it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties

whereas factoring involves three.

The three parties directly involved are: the one who sells the receivable, the debtor, and the

factor. The receivable is essentially a financial asset associated with the debtor‘s liability to pay

money owed to the seller (usually for work performed or goods sold). The seller then sells one

or more of its invoices (the receivables) at a discount to the third party, the specialized financial


organization (aka the factor), to obtain cash. The sale of the receivables essentially transfers

ownership of the receivables to the factor, indicating the factor obtains all of the rights and risks

associated with the receivables.

3.1.8 Leasing

Leasing and hire purchase is another avenue for organization to raise funds for its day to day

operations. Generally leasing is related to equipments which has a short to medium life. For e.g.

a company into building metro rail may have the necessity of heavy duty crane. Once the work

is done they may or may not need the crane in the same location. Moreover they need not block

the big amounts in buying cranes. They can lease out the crane from any specialist

organization. This is an example of an operational lease.

In a financial lease, the lease period is almost equal to the life of the asset. In this, it is one

asset to one person at a time. Generally the banks may not do leasing activity directly instead

does it through a separate subsidiary.

A typical example of big ticket leasing is the leasing of aircraft by the manufacturing companies

to the various airlines.

In addition to the savings on capital expenditure, the lease rental paid is treated as revenue

expenditure.

3.1.9 Bill Discounting

A trade transaction, involving sale of goods, is always supported by an invoice which is drawn

by the seller on the buyer. This buyer can be the end user or the reseller/distributor/retailer

.There is a number of documents in addition to the invoice which the seller has to submit along

with the invoice. The number of documents can vary especially in International Trade. One of


the important documents in addition to the invoice is the bill of exchange, which is a must for

both domestic and international trade.

It is an unconditional order in writing, addressed by one person to another, signed by the person

giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or

determinable future time a sum certain in money to or to the order of a specified person, or to

bearer of the bill of exchange.

Parties in a bill of exchange

Drawer: The person who gives the order to pay is called the drawer.

Drawee: The person thereby required to pay is called the drawee.

Payee: The person to whom the money is payable is called the payee.

Endorsee: The person to whom a bill is transferred by endorsement is called the endorsee.

Bearer: The holder (need not be the rightful holder) of a negotiable instrument

Holder: The generic term holder includes any person in possession of a bill who holds it either

as payee, endorsee or bearer.

A Bill of Exchange can be payable either at sight or after a given pre-specified period (called

usance period) A bill of exchange is payable on demand if it is expressed so in the instrument or

as per the time period expressed in the instrument In calculating the maturity of bills payable at

a future time, three days, called days of grace, must be added to the nominal due date of the

bill. For instance, if a bill payable one month after sight is accepted on January 1, it is payable

on February 4, and not on February 1 as its tenor indicates. A bill of exchange is transferable


i.e. the holder of a bill of exchange (the holder receives the money on a pre-specified date from

a counterparty) can transfer the bill of exchange by endorsement10 to a new holder.

In bill discounting, the bank purchases the bill from its client before the bill is due for payment

(the customer endorses the bill in favor of the bank, and the bank becomes the holder of the

bill). The bank credits the amount to the client‘s account after deducting a charge called the

discount charge. The discount charge basically represents the interest on the amount given to

the client from the date of purchase of the bill till the due date of the bill.

Bill discounting may be done by the bank on a ‗with recourse‘ basis or a ‗without recourse‘

basis. If it is done on ‗with recourse‘ basis, it implies that the bank can approach the client and

ask for payment if the counterparty fails to make payment on the due date. If it is done on

‗without recourse‘ basis, it implies that the bank cannot approach the client in case of non-

payment on the due date.

Sample Bill of Exchange

10

The legal transfer of title of a document by signature, usually, but not necessarily, on the

reverse.


First of Exchange (Second Unpaid) and Second of Exchange (First Unpaid)

In practice, it is not uncommon that two drafts are drawn on the drawee bank in a letter of credit

(L/C) to ensure that at least one draft reaches the drawee when they are dispatched separately.

3.2 Structuring of Loans

Loans can be structured in a variety of ways depending upon the need of the borrower and the

lender. The structuring is done with respect to the interest rate payable and the repayment

arrangement.

3.2.1 Fixed Rate vs. Floating Rate

Loans can be fixed rate loan or floating rate loans depending upon the interest rate payable on

the loans. In case of fixed rate loans, the interest rate is fixed at the time of loan origination and

remains constant during the life of the loan. Such loans are preferred by the borrowers when the

interest rates in the economy are expected to move up.

In case of floating rate loans, the interest rate on the loan is linked to some benchmark like

LIBOR11 (London Inter-bank Offer Rate). E.g. the interest rate can be expressed as LIBOR +

1%. For example, a ten year loan can be priced at LIBOR + 1%, payable six monthly and fixed

six monthly. In this example, the interest rate for the first six months is determined by the value

of LIBOR + 1% at the time of disbursing the loan. The determination of the interest rate for the

next six months is done at the end of the first six months. Depending upon how the LIBOR

11

This is the interest rate at which banks can borrow funds, in marketable size, from other banks

in the London interbank market.


changes, the interest rate on the loan will also change. Such loans are preferred by the

borrowers when the interest rates are expected go down. This is graphically represented below:

LIBOR + 1% LIBOR + 1% LIBOR + 1%

On Disbursal

LIBOR = 2.23%

Interest Rate =

3.23%

LIBOR + 1% LIBOR + 1%

On Disbursal

LIBOR = 2.23%

Interest Rate =

3.23%

6 Months After

disbursal

Current Time

Current Time

LIBOR not known LIBOR not known

LIBOR not knownLibor ‗Fixing‘ at

3.07%

Interest Rate for

next 6 months =

4.07%

After Six Months

3.2.2 Types of Repayment

Loans can have different types of repayment arrangements also depending upon the

requirements of the borrower. The common types of repayment arrangements are as follows:

Equal Periodic Installments

Stepped Up Installments

Bullet Repayment

Deferred Repayment


Equal Periodic Installments

This is the most common type of repayment option usually offered by banks and other financial

institutions to their borrowers. In this type of repayment arrangement, the borrower is required to

repay an equal amount at periodic intervals (which may be monthly, quarterly, semi-annually or

annually) to the bank. This payment from the borrower goes towards meeting the payment of

interest as well as the amortization of the principal outstanding.

Disbursal Details

Amount Disbursed/ Lent/ Principal

= 100

Interest Rate = 5% fixed

Duration or Tenor of loan = 24

months

1st Month

Case: Equal Periodic Instalments

Payment =

4.39

comprising

Repayment

of Principal =

3.97

Payment of

Interest =

Payment =

4.39

comprising

Repayment

of Principal =

3.99

Payment of

Interest =

24 Months

Payment =

4.39

comprising

Repayment

of Principal =

4.37

Payment of

Interest =

0.02

2nd

Month

Other

Payments

from month 3

to month 23

As can be seen from this structure, the payments stay constant at 4.39 per month. However, as

time progresses, the share of principal repayment in 4.39 increases.

Stepped Up Installments

In this type of repayment arrangement, the installments payable on the loan are gradually

stepped up or increased. To begin with the amount of installment is less; however, with time the

amount keeps on increasing either by a constant amount or by a constant percentage. This type

of repayment arrangement is preferred by borrowers who expect an increase in their income

over a period of time.

Bullet Repayment


In this type of repayment arrangement, most of the repayment is made on the maturity of the

loan (known as balloon or bullet installment)

Deferred Repayment

In this type of repayment arrangement, the repayment starts only after a given period of time

after disbursement. For example, the repayment may start only six months after disbursement

and then continue for the entire life of the loan. The deferred repayment can be further

structured as equated periodic repayment, or stepped up repayment or even a bullet repayment

arrangement.

3.3 Concept of Default

All loans carry a credit risk. Credit risk may be defined as the chance of counterparty or

borrower failing to fulfill its contractual obligations. When the borrower fails to repay the loan in a

timely manner or does not repay at all, a default is said to have occurred. Default may be a

willful default (when the borrower intentionally does not repay the loan) or a compulsive default

(when some factors, internal or external to the business lead to a default). Since default may

take place on every potential credit, every credit decision requires an assessment of credit risk

or probability of default.


3.4 Non-Fund Based Facilities

The Non fund Based may take the following forms:

3.4.1 Letter of Credit or Documentary Credit

Pandian and Company is a small Garment Manufacturer operating from Tirupur, a hamlet

near Coimbatore in Tamil Nadu India. John Smith is a Garment Dealer in Antwerp in

Belgium.

Both of them do not know each other but would like to undertake trade across the border. In

such a situation they would need an intermediary like a bank who can assure Pandian and

Co that once the goods are dispatched the payment will be made.

More than one bank may be involved in this transaction. Pandian and Company will only

trust a bank which he may know as his/her knowledge of the financial sector. His faith will be

more on State bank of India compared to the Antwerp Diamond Bank, which is the bank of

John Smith.

This is facilitated by what is called a Letter of Credit (LC). Importer and the overseas seller

while finalizing the commercial contract decide the terms of payment. Since the overseas

seller is not fully aware about the financial capacity of the importer, he insists a bank must

undertake the payment obligation on behalf of the buyer and payment should be made

available to him immediately on dispatch of goods from his/her country.

There are a number of Jargons associated with LC which needs to be understood before

understanding the process.

Applicant of LC-Importer in this case John Smith

Beneficiary of LC-Exporter –Pandian and co

Importer‘s Bank-Antwerp Diamond Bank-Issuing Bank

Exporter‘s Bank-State Bank of India-advising/confirming bank


L/C Definition

Letter of credit is one of the mechanisms for the settlement of payment. There are two other

mechanism viz. Advance Payment and collection. In the former the entire payment for the

consignment is made in advance after which the consignment is dispatched while in the latter

the goods are sent and the payment is sent by the exporter either on receipt of the goods or

after a specific periods

Processing of establishing a Letter of Credit / Documentary Credit

STAGE I

On the basis of this agreement importer (Applicant) requests his/her bank (Issuing Bank) for

undertaking the payment obligation on his/her behalf in favor of the overseas seller

(beneficiary).

To comply with the payment terms prescribed in the commercial contract for

establishing a documentary credit in favor of the overseas seller, importer

submits an application to his/her banker.

Issuing Bank, after checking the credit status of their importer customer,

establishes the documentary credit in favor of the overseas seller (beneficiary)

and forwards the documentary credit to its Correspondent Bank (Advising Bank)

in the Seller's country, with a request to advise the documentary credit to the

Beneficiary with their authentication.

Correspondent bank12 receives the documentary credit from the Issuing bank

and advises the credit to the beneficiary.

12

Bank that accepts deposits of, and performs services for, another bank (called a

respondent bank); in most cases, the two banks are in different cities


There are two possibilities at this stage:

In case the issuing bank‘s financial status is not acceptable to the overseas seller who is the

beneficiary in the documentary credit, he may request the importer for establishing a

documentary credit, which should be through a bank in the seller‘s country. Importer requests

Issuing Bank to make suitable arrangements with a bank in the overseas seller's country for

payment to the overseas seller on submission of prescribed documents. In such cases, the

Issuing Bank requests a bank in the overseas seller‘s country or in any third country with whom

they have prior arrangement, for undertaking the payment obligation on their behalf for this

transaction. This bank may agree for this arrangement subject to their relationship/arrangement

with the Issuing Bank. If they agree for paying the beneficiary they are known as confirming

bank.

Thus, overseas seller is holding an instrument known as documentary credit by which his/her

payment risk on the importer is secured. Issuing bank by extending this product to the importer

facilitates the importer for conveniently managing his/her imports.

The letter of credit stipulates a number of documents to be submitted and various other

conditions which needs to be strictly adhered to .A sample LC is appended


Establishing Documentary Credit

STAGE II

Step 1: The beneficiary after shipping the goods presents the prescribed documents for

payment to the confirming bank

Step 2: On receipt of the documents, the Confirming Bank scrutinizes the documents thoroughly

and if the documents are drawn in order without any discrepancy makes payment to the

exporter/beneficiary of the LC.

Step 3: Confirming bank dispatches the documents to the Issuing bank.

Step 4: Issuing bank on receipt of documents from the confirming bank, scrutinizes the

documents and reimburses the confirming bank and debits the importer.

Step 5: Issuing Bank sends the documents to the importer for collection of payment

Step 6: Importer makes the payment to the issuing bank


Negotiation of Documents under Confirmed Credit

Thus, documentary credit is one of the prominent instruments, which helps the importer to

import the consignment from the overseas seller even though he does not know the seller.

Under wholesale banking this is one of the products, which is aggressively marketed by

commercial banks under import finance.

3.4.2 Uniform Customs and Procedures for Documentary Credits (UCC)

In cross border trade there are a number of complications and each country may take to their

advantage. In order to facilitate the cross border trade there is an international body called the

International Chamber of Commerce (ICC) which is a body of member countries.

They undertake various self-regulating rules which govern the member countries.

One such publication is the UCPDC or the UCC .This has undergone revisions at periodic

interval with the changing business environment

The current one in vogue is the UCC 600 which is the sixth version More than 150 countries

have agreed to issue and operate the documentary credit transactions under this set of

guidelines.

This is a very easy to understand standard and has 39 Articles.


3.4.3 Types of LCs

There are various types of letters of credit available such as:

Revocable

Irrevocable

Confirmed

Back-to-back

Standby

Revolving

Revocable

A revocable LC can be amended or cancelled at any time by the importer without the consent of

the exporter. This option is not often used, as there is little protection for the exporter. By default

all LCs are irrevocable, unless otherwise stated.

Irrevocable

An irrevocable LC once issued can only be changed or cancelled with the consent of all the

parties. The seller must merely comply with the terms and conditions of the LC in order to

receive payment.

Confirmed LC

A confirmed LC is one which has an additional confirmation from some other bank in addition to

the issuing bank. The confirming bank takes on an obligation to pay even if the issuing bank

defaults.


Back-to-Back LC

The original letter of credit is used as security by the exporter to open another credit in favor of

the exporter's own supplier. The bank issuing the original L/C may not necessarily be the

issuing bank of the second L/C.

Standby Credit

Similar to a normal letter of credit, however this differs in that it is a default instrument, whereas

a normal L/C is a payment instrument. A standby credit is only called upon in the event of the

applicant‘s failure to perform.

Standby letter of credit is very similar in nature to a bank guarantee. Standby credits were first

developed by banks in United States after World War II and enable domestic banks to compete

with foreign banks in international business transactions. It is an alternate to guarantee bonds

because of legal restrictions on banks from issuing guarantees. Japanese banks also issue

Standby credits for similar reasons.

Standby credit differs from traditional letter of credit. In a traditional credit the beneficiary is

entitled for payment once he is able to submit the documents prescribed in the credit within the

stipulated time. In Standby credits the beneficiary is eligible for payment from the issuing bank

when the applicant fails to perform his/her obligation.

A Letter of Credit is a simple payment mechanism. Rather than a buyer promising to pay seller,

a buyer / account party (applicant) has an issuer promise to pay a seller / beneficiary: payment

is expected to occur through the issuer. In contrast, the 'standby' letter of credit is merely a


backup. The beneficiary makes proper demand upon the issuer only if the account party

(applicant) fails to pay or perform."

In short, standby credit is a document which:

a) The Issuer, usually a bank

b) At the request of its customer, applicant

c) Agrees that the beneficiary will be paid


d) Before the credit's expiry

e) Upon the beneficiary's presentment of

i. Its demand for payment and

ii. Any documents evidencing the applicant's non-performance or default

This gives the applicant an opportunity to specify the documents that are to be presented by the

beneficiary for claiming payment. In most of the cases it will be a certificate of default of

payment by the importer / applicant on due date.

This is one of the most convenient facilities preferred by the importer client and also the

overseas seller. Under this arrangement, importer client can get the consignment directly from

the overseas seller. Bank undertakes to pay the overseas seller only in case of default by the

importer. Less number of documents is called for in this transaction.

Step 1: Goods are dispatched to the buyer [importer] directly by the seller /exporter,

Step 2: Buyer/importer fails to make the payment on due date to the seller/exporter,

Step 3: On default by the buyer, the seller/exporter presents the prescribed documents for

payment to his/her [exporter‘s] bank

Step 4: On receipt of the documents, the exporter‘s Bank scrutinizes the documents thoroughly

and if the documents are drawn in order without any discrepancy makes payment to the

exporter/beneficiary of the Standby LC.


Step 5: Exporter‘s bank dispatches the documents to the Issuing bank.

Step 6: Issuing bank on receipt of documents from the exporter‘s bank, scrutinizes the

documents and reimburses the exporter‘s bank. If the documents are in order and other terms

and conditions of the Standby LC are complied with.

Step 7: Issuing Bank presents the documents to the Buyer/Importer for collection of payment

against the same.

Step 8: Importer makes the payment to the issuing bank

Revolving LC

This type of LC allows for the L/C to be automatically reinstated under certain circumstances. It

is normally used where shipments of the same goods are made to the same importer.

In a Revolving Credit the amount of drawing is re-instated and made available to the beneficiary

again unto the agreed period of time on notification of payment by the applicant or merely on

submission of documents. The maximum value and period up to which the Credit can be

revolved is specified in the Revolving Credit. The re-instatement clause and the maximum

amount of utilization under the credit are incorporated in Revolving credit.

If the importer wants to import a specified material from the overseas seller for a specified

period at regular intervals, this type of credits are useful. To illustrate, an importer customer has

placed an order for importing certain raw materials from Japan and the contract for import is for

one year on monthly basis. Every month importer imports material worth of USD 250,000. His


annual consumption is USD 3,000,000. Overseas seller insists for entering into one-year

contract and also wants the transaction to be covered under letter of credit.

Importer‘s bank establishes a letter of credit for USD 250,000 for a validity period of 12 months.

At the same time, it is also specified in the credit that this credit will be available on monthly

basis, twelve times during the validity period and the total utilization under this credit should not

exceed USD 3,000,000.

Under this arrangement, the importer is able to receive continuous supply of raw materials for

the contracted period of one year. Instead of opening documentary credit for each transaction

every month, one single credit opened at the commencement of the contract remains valid till

one year. Importer saves time for opening documentary credit for 12 times. Every time when

the credit is reinstated, bank charges reinstatement charges instead of Credit opening charges.

Deferred Payment Credits

When the importer client wants to import capital goods for a project and overseas seller has

agreed for payment under deferred terms such as, 10% advance payment, 80% after 12 months

from date of shipment and the remaining 10% after one year of successful commissioning of the

equipment, the bank which offers documentary credit facility to their client, establishes a credit

undertaking their payment obligation on deferred basis. Payment is not made in one

installment; it is deferred to three stages, in the above example. This product is offered to the

clients who have large value of equipment imports.


Acceptance Credits

Under this product, credit issuing bank‘s liability comes into force only after acceptance of drafts

drawn on them. The payment has to be made by the issuing bank on the due date, typically

three months ahead. An Acceptance credit stipulates that bill of exchange or draft to be drawn

as one of the documents and it is to be drawn on the credit-issuing bank. Credit issuing bank

on receipt of the documents at their counters under their credit, examines the documents and if

in order accepts the bill of exchange and communicates the due date on which they are to

reimburse the sellers bank.

3.4.4 Guarantee

Bank guarantee (BG) is guarantee given by a bank for a business. Thus a bank guarantee

implies a promise by the bank to repay the outstanding amount of an individual or a business if

that individual/business fails to repay his/her debt. BGs are generally used as collaterals by

corporates. When any business wants to enter into a financial transaction with counterparty, the

counterparty may insist that a bank guarantee is put in place. Bank guarantees may be issued

for domestic as well as foreign business purposes.

This is a document issued by the bank on behalf and at the request of a customer to third party for

fulfillment of terms of contract as agreed between them.


Sample Bank Guarantee

Date

Issuing Bank’s Name & Address

Re: (Counterparty's Name)

Dear Sir/Madam

This letter will serve as your notification that (Bank name) will irrevocably honor and guarantee

payment of any check(s) written by (Customer's name) up to the amount of (Amount Guarantee) and

drawn on Account Number (Customer's account number).

This guarantee is for the purpose ____________________. This guarantee shall remain irrevocable

throughout the event, and no stop payment will be issued.

Sincerely,

___________________________________________

Bank Officer's Signature and Title

Types of Guarantees

Different types of bank guarantees issued by a bank are as follows:

Tender Guarantee

This is usually issued for an amount equal to between 1 and 2 percent of the contract value. It

gives the beneficiary compensation for additional costs if the party submitting the tender does

not take up the contract and it must be awarded to another party.


Performance Guarantee

Normally issued for an amount equal to between 5 and 10 percent of the contact value, this

guarantee assures payment to the beneficiary in the event that the contractor fails to fulfill

contract obligations.

Advance Payment Guarantee

This enables the beneficiary to get a refund of advance payments made in the event of default

by the contractor. It is issued for the full amount of the advance payment, but may contain

reduction clauses, which enable a reduction in the maximum amount upon evidence of

progressive performance.

Retention Money Guarantee

Most major projects call for stage payments as work progresses. Often the beneficiary retains a

percentage of the payment (retention money) from the contractor, as cover for any hidden

defects in the completed work. A retention money guarantee allows for immediate release of

retention money to the contractor.

Facility Guarantee

This is normally not trade related. Its purpose is to provide security to another bank to advance

money to an individual or company. It is often used when a company does not have any credit

record and wishes to expand offshore.


Maintenance Guarantee

This ensures that the contactor does not abandon the contract after completion of the

construction phase, but continues to honor any maintenance obligations as per the original

agreement.

Customs Guarantee

Contractors often need to import equipment temporarily to carry out a contract. Import duty

would normally be payable, but the customs authorities will grant exemption if the contractor

undertakes to re-export the equipment on completion of the contract. The contractor then has to

provide the customs authority with this guarantee, which prevents the contractor from selling the

goods in the domestic country, instead of re-exporting them.

Shipping Guarantee

This enables the buyer to obtain release of the goods from the carrier, despite the bill of lading13

being lost or delayed.

When the importer wants to take delivery of the consignment under a bill of lading or any

transport documents he has to produce the original transport document to the transport agency.

13 A document which is issued by the transportation carrier to the shipper acknowledging that

they have received the shipment of goods and that they have been placed on board a particular

vessel which is bound for a particular destination and states the terms in which these goods

received are to be carried. Separate bills of lading are issued for the inland or domestic portion

of the transportation and the ocean or air transportation, or a through bill of lading can be

obtained covering all modes of transporting goods to their destination.


At times the consignment might have landed in his/her country before the documents are

received through the banking system. Shipping company will not deliver the consignment

unless the importer consignee produces original transport document. To avoid delay in clearing

the goods from the shipping company without producing original transport document which is

the original bill of lading importer requests his/her bank to issue a guarantee on his/her behalf in

favor of the shipping company. Under this guarantee, the bank indemnifies the shipping

company for any loss that may be incurred by the shipping company in releasing the

consignment to the consignee (importer) without submission of original documents.

3.5 Other Non-Fund Based Products/Services

The non-fund fee based services are also known as transaction banking services offered by

banks include:

Cash Management Services

Trade Finance

Treasury Products

3.6 Cash Management Services

Cash is an asset with unique features. On one hand, it is an idle asset as it does not generate

any returns if left alone. On the other hand, keeping too little cash may cause liquidity problems

for any organization.

Banks would like to hold less idle cash for the same reason. However, holding too little cash

may result into:


Deposit runs by individuals, if they feel that it does not have enough cash for

withdrawals.

Liquidity problems and increased borrowing costs.

Similarly, business organizations need to manage the cash properly for the same reasons.

Cash in the context of banking does not mean physical cash, it means the cash equivalent

which is the checking or the operative accounts of the customers

Business organizations have receivables from and payables to various counterparties which are

spread out far and wide geographically. Managing outstation collections and payments can be

very time consuming and expensive.

Given this, the fundamental goal of cash management is to forecast the cash flow needs

accurately and to arrange for the various sources of cash at minimum cost. Banks provide a

wide range of cash management services to their customers to put them in a position of control

as far as their cash needs are concerned.

Due to the extensive networking and MIS requirements, many banks may not be in a position to

offer the cash management services. However, those who offer will definitely enjoy competitive

advantage over others. It creates a ‗win-win‘ situation for both the bank as well the customer.

Customers are more satisfied as their receivables are collected speedily into their accounts.

Banks get access to ‗float‘ funds. ‗Float‘ is defined as the funds in the process of collection.

Float arises as there is time gap between the moment a check is written and the moment the

funds get credited into customer‘s account. If a bank can monitor the float funds on a continuous

basis, these can be deployed profitably by the bank‘s treasury. In the competitive environment


in which the banks are operating these days, this additional return can significantly affect the

bottom line of the bank.

Banks offer a wide range of cash management services (CMS) to their customers. The cash

management services offered by banks can be divided into two set of services. These are:

Collection Services

Payment Services

As a result of developments in information technology and MIS, banks can provide these

services very efficiently. These services help in providing liquidity to the client and at the same

time lower the cost of funds to the banks. CMS helps in speeding up the collection process and

reducing the collection time for the clients as well as help in making payments across various

locations with ease.

3.6.1 Collection Services

One of the important banking activities is that of collection and payment of checks. Corporates

route their funds transfer for the purpose of payment for business transactions via banks. This is

so because the various parties to a business transaction for a corporate may be spread

geographically and need not be in the same location. Through the CMS offering, the buyers of

the customer products may deposit their checks payable to the customer at the various

branches of the bank across diverse locations. If the bank does not have a branch at any

location, it usually has a tie up with other banks which have branches in such locations. These

banks are called as Correspondent banks and they help in collecting and realizing the checks

from the buyer on behalf of the main bank.


The common collection services are:

Check Collection Services: This service uses the extensive network of a bank either

on a standalone basis or via a tie up with other banks (correspondents) to help corporate

collect funds from their outstation cheques.

Overdraft: This facility is provided by banks to their business customers whereby even if

adequate funds are not available in the account of the customer, the incoming checks

are still cleared by the bank.

Lock-box service: In this service, the bank provides collection boxes at various

locations in the city where the checks favoring the customer are collected. The box is

operated by the bank and the bank gets the contents of the box removed several times

during the day and deposits the checks into customer‘s account.

Tax-collection services: Under this facility banks accept payment of income taxes,

sales tax, customs duty, etc. from their customers.

3.6.2 Payment Services

Payment services are a counterpart of collection services. Payment refers to the means by

which financial transactions are settled/paid. The common payment services include:

Electronic Funds Transfer (EFT): This service facilitates online transfer of funds

between accounts.


Electronic Bill Payment and Presentation (EBPP): EBPP enables the customers to

pay their bills and send invoices electronically.

Payroll services: Banks provide payroll processing facilities to the small business

clients which help in reducing the fixed costs of maintaining a payroll processing

department by the business.

Collection as well as payment services require an efficient payment system. An efficient

payment system accelerates the flow of liquidity in the economy.

The payment system can be of divided into two types:

Retail Payment System

Wholesale Payment System

Retail Payment System - This is used by individuals for paying their bills and receiving funds

into their bank accounts.

Retail payment system in the United States makes extensive use of paper checks. About 50

billion checks are processed every year. However, credit card and ATM transactions are also

becoming popular.

Wholesale Payment System – This is used by businesses and governments for handling large

value domestic and international transactions.


Clearing of payment instructions/ checks occurs through the check clearing/ ACH clearing

mechanism described earlier (already discussed)

3.6.3 Benefits of CMS

1. Faster Realization of receivable: This is the biggest benefit of the availing the CMS

facility by customers.

2. Reduction in Interest Costs: The collection services provided by banks result in receipt

of funds by the customers into their account with the banks in very short period of time.

This means reduced interest costs for the customer. In addition, the banks might provide

funds to their customers a little later than they receive funds from the check clearing.

This provides banks with zero-interest money, which brings down the average interest

cost for the bank.

3. Increased Liquidity: Since funds get collected quickly, it results into enhanced liquidity

for the customer.

4. Ease in Reconciliation: Customers can obtain detailed information about the

instruments like checks, demand drafts, etc. collected by their bank. This results into

ease in reconciliation of their books with the bank‘s books.

5. Better Customer Service: Since CMS offers so many benefits to the customer, it

translates into more satisfied customers and hence a larger customer base.


3.7 Trade Finance

Global markets have opened up and trade and financial services are moving freely from one

country to other and banking services are becoming more responsive to such rapid changes.

Inputs and accessories can be sourced from country A, assembling and manufacturing can be

done in country B, Seller may be in Country C and the ultimate user or the consignee can be in

country D and the financing institution can be in Country E. This has become possible today

since borders are not the barriers for movement of goods or finance or manpower from one

country to another country

3.7.1 Role of Banks

Banks are offering variety of products under wholesale banking to their clients, starting from

assisting their client financially for importing accessories or raw materials from any country and

funding their working capital requirements for their manufacturing activities and extending credit

against their receivables. Under wholesale banking, banks are also offering risk management

solutions to corporate clients to mitigate credit risk protection against the default of the buyer,

political risk cover for the country exposure and currency risk management against the currency

exposure.

For example, if a client wants to expand his/her production capacity and enlarge his/her client‘s

list to different countries he may require following financial solutions from the bank:

For expansion of production / manufacturing capacity the client may like to avail loan

facilities to import / buy capital equipments and thus to meet modernization expenses.

Credit facilities can be of medium or long-term duration and can be either in home currency


or in foreign currency. The bankers locally or through their correspondent banks abroad can

arrange foreign currency loans at competitive international interest rates.

For importing equipments or accessories, a bank can establish letter of credit or standby

credit or guarantees or bankers acceptance facility in favor of the overseas suppliers.

For working capital expenses to meet any export obligations, banks can sanction export

credit facilities either by themselves or through any of the global credit agencies like EXIM

Bank.

Once manufacturing activities are over and sales start, banks can discount their clients‘

receivables by offering receivable management solutions.

Credit risk insurance is offered by insurance agencies to protect the default risk of the

buyers. Instead of involving two agencies ,one for allowing credit and another agency

offering insurance for managing credit risk, the bank can offer a wholesale product like

factoring or forfeiting whereby bank can allow credit facilities against the receivables and

also offer credit protection i.e., insurance against the default of the overseas buyer.

Besides, banks can offer buyers credit to the overseas buyers.

Ultimately, the clients are able to reduce the cost of funding by availing the cheapest trade

finance from their banks and also able to manage the attendant risks by opting for appropriate

risk management instruments.

Over and above the various products offered under Trade Finance Products

Import Financing

Documentary Collection

Letter of credits

Bankers Acceptance facility


Standby Credits [Discussed earlier in section 3.1]

Guarantees

3.7.2 Services related to Import


This is a product where the bank acts as a conduit between the importer and the seller, by

handling the transport and related documents and releasing the documents to the importer on

the availability of funds/ promises to pay the funds on a specified date.

The process for documentary collection is graphically represented below:

Step 1: Overseas seller submits the documents to the remitting bank.

Step 2: Remitting bank forwards all the documents to the collecting bank.

Step 3: Documents are presented to the buyer or the importer of goods.

Step 4: Importer makes the payment to the collecting bank when the bank presents the

documents. The importer will then receive the documents, which will entitle him to collect


his/her imported goods from the transport agency. The transport documents are quasi

negotiable instruments. E.g. of Transport documents include Airway Bill (AWB), Bill of Lading

(BOL).The importer is not entitled to the goods unless the payment has been made to the bank

in case of Document against Payment (DAP) bills. In case of Usance Bill drawn by the exporter

the goods will be released on the basis of accepting the bill and not necessarily the payment.

Step 5: Collecting bank transfers the payment received from the importer to the remitting bank.

Step 6: The Remitting Bank, when it receives the payment from the importer, transfers the

amount collected to the overseas seller [who submitted the documents for collection]

Bank, which offers this collection product to its importer client, does not undertake any

responsibility for payment. Bank acts as an agent for collection. Importer has an opportunity of

verifying the documents and ensures that he makes payment only after the consignment has

landed in his/her country. Bank acts as an intermediary and helps the importer to receive

documents and the exporter to receive the payment.

Establishing Documentary Credits

Establishing letter of credit on behalf of the importer is one of the fee -based businesses a bank

undertakes. Under this arrangement, the importer‘s bank undertakes the payment obligation on

behalf of the importer to the overseas seller on certain conditions. Conditions are always

related to presentation of prescribed documents. When the overseas seller is not fully aware

about the financial status of the importer, importer‘s bank gives undertakes the payment

obligation of the import subject to submission of prescribed documents by the overseas seller.

This has been covered in the fee-based products offered by the bank


Bankers‘ acceptance facility

Under import financing, bank approves a line of credit to the importer. Under this arrangement

the bank is prepared to accept the bill of exchange drawn by the overseas seller on them on

account of their importer. When the overseas seller supplies the materials to the importer, he

also agrees for this arrangement by which importer‘s bank pays the overseas seller on the due

date.

Shipment Guarantees

Under wholesale banking, bank sanctions this shipping guarantee facility to the importer as one

of their services. (already discussed above)

3.7.3 Services related to Export

The services offered to exporters are a mix and match of Lending and Non lending activities as

mentioned below:

To receive the authenticated documentary credit through his/her bank from the overseas

buyer – Advising of documentary credits.

To get the credit confirmed thereby securing a payment undertaking from the confirming

bank on behalf of the overseas buyers bank, (i.e., Issuing Bank) - Confirming of

documentary credits

Arranging to transfer the documentary credit, which was received in favor of his/her sub-

supplier enabling him to procure the inputs from his/her vendor – Handling transferable

credits

Allowing working capital facilities assisting the exporter with credit facilities enabling the

exporter to execute his/her export orders in time - Pre-shipment finance


Arranging to collect the payment from the overseas buyer through collection mechanism –


Extending receivable financing against the export documents tendered by the exporter on

the overseas buyer – Receivable Financing

Extending credit facilities to the overseas buyer – Buyers Credits.

Extending credit to overseas financial institutions for the purpose of on lending to their

clients – Line of Credit.

Providing credit protection (credit insurance) in case if the buyer defaults to pay the

exporter. International Factoring / Forfaiting.

Lending Process

The process of lending begins even before a loan is made. It is required that the loan

officer/credit manager ensures that the loan is in agreement with the loan policy of the bank.

Since it is not feasible by the board to oversee each and every loan proposal that is received by

the bank and take a credit decision, usually all banks have a written loan policy. Loan policy

sets out standards for exposure limits for industry/company/individuals, credit quality of the

borrowers, lending rates, acceptable risk level, etc. The loan policy of a bank comprises of the

following components:

a. Loan Objectives

b. Volume and Mix of Loans

c. Loan evaluation procedures

d. Loan Sanction

e. Loan Administration

f. Lending Rates


Loan Objectives – This will set out the various purposes for which loans can be given by a

bank. This will also specify if there are any regulatory guidelines with respect to certain

objectives.

Volume and Mix of Loans – This will specify the targeted composition of the loan portfolio in

terms of industry exposure, region exposure, size of loans, etc. This in turn will depend on

factors like size of the bank, credit requirements in the region, and the expertise available with

the bank. This also sets out the risk exposure which the bank can take across industries,

borrower types, countries etc.

Loan Evaluation Procedures – The policy document also specifies the loan evaluation

procedure to be followed by the bank. Usually, it sets out the various types of analysis like

industry analysis, financial analysis of the company, management appraisal, etc. that should be

undertaken while making the credit decision.

Loan Sanction – This part of the loan policy document specifies the sanctioning powers of the

credit officers i.e. how much amount of loan can be sanctioned by which level of credit manager

in the bank.

Loan Administration – Loan administration comes into picture once the loan has been

sanctioned and continues till the loan is repaid. Loan policy should specify the loan

administration procedures like documentation, monitoring, follow-up, etc.

Lending Rates – As mentioned earlier, bank, like any other commercial enterprise has the

profit motive. To ensure that lending results into profits for the bank, it is required that


appropriate rate of interest is charged by the bank for loans of different types. The lending rate

should also reflect the risk inherent in the loan. The lending rates are dynamic and the loan

policy will provide the process for identifying the right lending rates.

3.7.4 Stages in a lending process

The various stages in the lending process are as follows:

Credit Appraisal

Sanctioning and Structuring, the Loan Agreement

Post-sanction Verification and Disbursal

Credit Administration and Monitoring

Credit Appraisal

The decision to sanction or reject the proposal has to be based on a careful analysis of various

facts and data presented by the borrower concerning him and the proposal as assessed by the

relationship manager. Such an objective and in-depth study of the information and data should

convince the sanctioning authority that the money lent to the borrower for the desired purpose

will be safe and it will be repaid with interest over the desired period, if the assumptions and

terms and conditions on which it is sanctioned, are fulfilled. Such an in-depth study is called

the pre-sanction credit appraisal. It helps the approver to sanction the proposal

Credit appraisal focuses on:

a. Borrower/Management Appraisal

b. Technical Appraisal of the project

c. Market Appraisal determining the viability of the project


d. Financial Appraisal determining the viability of the cash flows to meet the loan

repayment requirements.

Sanctioning and Structuring the Loan Agreement

If the credit appraisal is satisfactory and bank decides to grant a loan to the borrower, the loan

agreement is structured. Loan agreements usually have the following elements:

a. Type of credit facility (fund based/non-fund based)

b. Term of the loan

c. Method and timing of repayment

d. Interest rates and fees to be paid by the borrower

e. Collateral14 required

f. Covenants which restrict the borrower from certain actions15 during the period

of the loan

Post-sanction Verification and Disbursal

If the terms and conditions of the loan agreement are acceptable to the borrower, usually a

post-sanction verification is done to ensure that the funds will be deployed for the stated

purpose only. This may require site visits and discussion with the management of the company.

If the post-sanction verification is also positive, the bank issues a disbursal letter which entitles

the borrower to take the loan amount from the bank.

14

Some asset like real estate, etc. provided as a security for a loan taken from a financial

institution.

15 For example, the loan agreement may require that the borrower should maintain debt up to a

specified limit.


Credit Administration and Monitoring

Credit Administration is a critical element in maintaining the safety and soundness of a bank.

The role of credit administration commences soon after the sanction of the credit facilities by the

sanctioning committee/authority. The extent of the activities, given the wide range of

responsibilities, and its organizational structure, may vary with the size and sophistication of the

bank and may be specifically defined by each bank. These would normally be independent of

the credit origination and approval processes. This will normally include communication of the

sanction to the client/ borrower at the unit level, execution of relevant documentation, security

creation and perfection, and disbursement and thereafter ensuring on-going compliance of the

terms of credit, including keeping a watch over any events which may trigger default.


This chapter discusses the financial statements of banks and looks at the two main reports

which provide information about the bank‘s activities – the ‗Balance Sheet‘ and the ‗Profit and

Loss statement.‘

4 Financial Statements of Banks

Like any other business organization, the two important financial statements of a bank are:

Balance Sheet , and

Income Statement

However, given that banks offer different type of services than other commercial organizations,

their financial statements differ from the typical financial statements of other business

organizations. Let us understand what these differences are and what do the various items

appearing in the financial statements of a bank mean.

4.1 Balance Sheet

Banks balance sheet or ‗Report of Condition‘ lists the assets, liabilities and equity capital

(owner‘s funds) held by or invested in the bank on any given date. Balance sheet is prepared

on a particular date – usually the last date of a month or quarter or year. Balance sheet

captures the financial data of an institution at one point in time. It is useful to compare data for

several accounting periods by which we can assess the trends in the banks‘ financial condition.


In a bank‘s balance sheet, Asset side consists of four kinds of assets. They are:

a. Cash at vault and deposits held with other depository institutions – (C)

b. Investments in interest earning government securities (S)

c. Loans and lease finances allowed to customers (L)

d. Miscellaneous Assets (M)

Likewise, Liability side of a bank‘s balance sheet has the following components:

a. Deposits made by various customers (D)

b. Borrowings of funds by the bank – non-deposit borrowings from money and capital

markets (NDB)

c. Other liabilities, like acceptances made by the bank on behalf of their customers

liabilities (OL)

d. Equity Capital representing long-term funds that the owners have contributed to the bank

(EC)

Therefore, contents of a bank‘s balance sheet can be written as below:

C + S + L + M = D + NDB + OL + EC

In short, the assets in a bank‘s balance sheet are ‗accumulated uses of funds’ and liabilities

are ‗accumulated sources of funds’. Assets are made to generate income for their

stockholders, pay interest to the depositors and compensate the employees for their labor and

skills. On the other hand, liabilities provide the needed capital and sources for acquiring the

assets.


Investors, depositors and regulators are concerned about the real position of the bank. The

balance sheet of a bank should disclose the required relevant information transparently.

To have more clear view on the key items appearing in a bank‘s balance sheet, please refer the

following hypothetical balance sheet of a bank:

Balance sheet of ABC Bank in the USA

(Report of Conditions) as on 31st December 2010. (Amount in ‗000 USD)

Assets (accumulated use of funds)

Cash and deposits due from bank

Cash 10,500 10,500

Investment securities (Liquid portion)

Interest bearing bank balances 1,500

Federal Funds sold 14,500

Investment securities (Income generating portion)

US Treasury and agencies securities 14,200

Municipal securities 14,100

Other securities 4,500 48,800

Loans

Consumer 5,565

Real Estate 46,500

Commercial 10,560


Agriculture 38,500

Financial Institutions 5,600

Total 106,725

Less: Reserve for loan losses 2,450

Unearned income reserves 154 104,121

Miscellaneous Assets (building, equipments etc.)

Building and other fixed assets 5,450

Customers liability on acceptances 1,240

Other assets 3,650 10,340

Total Assets 173,761

Liabilities (accumulated source of funds)

Deposits

Demand Deposits 25,620

NOWs (Negotiable Order of Withdrawals accounts) 10,740

Money Market Deposit accounts 20,155

Savings Accounts 6,345

Time deposits

Under $100,000 22,230

Over $ 100,000 50,660 135,750

Non deposit borrowings

Fed funds purchased 12,150


Other borrowings 5,340 17,490

Other liabilities

Bankers acceptance outstanding 1,240

other liabilities 3,500

Subordinated notes and debentures 2,220 6,960

Equity Capital

Stock 8,250

Surplus 2,120

Retained Earnings 1,120

Capital Reserve 2,071 13,561

Total liabilities 173,761

4.1.1 Assets

Cash assets

The first asset item listed in the banks‘ balance sheet is cash and deposits due from banks.

This includes cash in bank‘s vault, deposit with Federal Reserve (which is often known as

primary reserves), any deposits the bank has placed with other correspondent banks (for

clearing purposes and also to compensate the other bank for providing currency and coin

services) and cash items in the process of collection (mainly uncollected checks). This means

that these cash assets are the banks‘ first line of defense against withdrawal of deposits and

first source of funds when a customer comes in with an unexpected loan request which the bank


has to meet. Generally, banks strive to keep the size of this account as minimum as possible,

because idle cash balances earn no interest income or little income for the bank. Bank

management should always attempt to minimize its holdings in these assets. In the above

balance sheet, cash holdings are USD10, 500,000 and it is 7.73% of the total deposits.

Investment securities (Liquid Portion)

Interest bearing bank balances (USD1, 500, 000), such as short-term certificates of deposits16

at other banks and federal funds sold17 (USD 14,500,000) are highly liquid, earning assets.

They are generally used as part of the bank‘s liquidity management program. Most of the

smaller banks have more federal funds sold than federal funds purchased18, indicating relatively

high liquidity. In the above balance sheet both these items are highly liquid and earn a certain

amount of return which will help the bank for enhancing their profitability and also manage their

short term liquidity.

Investment securities (Income-Generating Portion)

Bonds19, notes20 and other securities held by the bank primarily for their expected rate of return

or yield are known as investment securities. Frequently these are divided into taxable securities

and tax-exempt securities. Taxable securities are mainly US government bonds and notes,

securities issued by various federal agencies (such as The Federal National Mortgage

16 It is a promissory note issued by a bank entitling the holder to receive back the money deposited with

interest. Withdrawal before the maturity date attracts a penalty.

17 These are the loan of excess reserves held at the Federal Reserve by one bank to another. These typically

are overnight loans although longer-term loans can be made

18 These are the borrowings of excess reserves held at the Federal Reserve by one bank from another.

19 A security which entitled the holder to receive periodical interest payment and get back the principal

amount at the time of maturity. The maturity period is typically more than one year.

20 This is similar to a bond with the difference that the maturity period is not more than 3 years.


Association, known as Fannie Mae) and corporate bonds and notes. Tax-exempt securities

consist primarily of state and local government (municipal) bonds. The latter generate interest

income that is exempted from federal income taxes.

Loans

In most of the bank‘s balance sheets, Loan component generally account for more than 60% of

the total assets. Bank‘s Loan folio consists of Consumer Credits, Real Estate loans,

Commercial loans, Agricultural loans and the credit extended by banks to other financial

institutions. In Table -1, referred above, USD10, 672, 5000 represents gross loans owed to the

bank forming part of 61.4% of the total assets. . However loan losses are deducted from the

gross loan figure.

Unearned income (unearned discount) USD 154,000 represents amount of income that has

been deducted from a loan but has not yet been recognized as income on the income statement

because it is to be distributed over the life of the loan. For example, consider a loan for a period

of five years which is payable in five annual installments including interest The interest to be

received on the loan will be considered as unearned income at the time the loan is disbursed.

Every year when the installment is received the interest so earned will be deducted from the

unearned income and the balance will be carried forward.

The amount USD2,450,000 reported as ‗reserve for losses‘ reflects an estimate by the bank

management of probable ‗charge-off‘ for uncollectible /unrecoverable loans and leases on the

date of balance sheet. Although the regulatory authorities have prescribed the norms in the

estimation process, ultimately the bank management decides the final valuation of the reserve


account. Actual loan losses are deducted from reserve account and any recovery made from

uncollectible loans will be added back to reserve account.

Under the current norms recommended by BASEL committee, any scheduled loan or interest

dues not repaid and becomes past due for more than 90 days, is to be classified as F Loans.

Once the loan is classified as Non-Performing Loan, the Bank is not allowed to record any

further interest from this loan until a cash payment is actually received in.

Other assets

Premises, fixed assets, equipments and capitalized leases represent an important though

relatively small portion of the assets. Most of the capitalized leases for banks involve sale-and-

leaseback arrangements in which the bank ‘sells‘ the property and leases21 it back from the

buyer. Terms are structured to allow the bank to maintain control over the property. These

arrangements are done primarily to generate cash. Capitalized leases are recorded under

assets rather than under leases, as if the bank still owns the property.

4.1.2 Liabilities

Deposits

Deposits are the principal liability for any bank. It represents the financial claims held by

households, business houses and governments against the bank. Deposits are the main

sources of funds for the bank. In the event of a bank‘s liquidation, depositors are to be paid

their claims first from the sale proceeds of assets. Depositors have the first priority in

21

This is a contractual agreement, which transfers the right to use the asset from the owner

(known as the Lessor) to the user (known as the Lessee) in return for periodical payment (Lease

Rental).


settlement of claims. Other creditors and stock holders receive their claim from the remaining

proceeds of the assets sold.

Deposits are of five major types:

a. Non-interest bearing demand deposits or regular checking accounts: These

accounts generally permit unlimited check writing. But under Federal law passed in

1933, they cannot pay any explicit interest rate. Many banks offer to pay postage costs

and other ‗free‘ services that yield the demand deposit customer an implicit rate of return

on these deposits.

b. Savings deposits: These deposits generally bear the lowest rate of interest offered to

depositors by a bank but may be of any denomination. Banks may impose minimum

size requirements and permit the customer to withdraw at their will.

c. NOW accounts – Negotiable Order of Withdrawal accounts: These can be held only

by individuals and non-profit institutions and bear interest and permit checks to be

written against each account in order to pay to third parties.

d. MMDAs – Money Market Deposit Accounts: Under this scheme, bank can offer

competitive interest rate to the depositors depending on their short-term requirements

and liquidity position. This scheme offers limited check writing privileges. Minimum

maturity and denomination are not prescribed under federal law; however, depository

institutions reserve their right to require seven days‘ notice before any withdrawal being

made.

e. Time deposits: Time deposits can be broken up into: i) deposits under USD 100,000

and ii) deposits above USD 100,000. Time deposits have a fixed maturity date on

which they are payable with a stipulated interest date. A Time Deposit may have any


denomination. Deposits above USD 100,000 are large interest payable negotiable

CDs22, mostly collected from the banks‘ high net worth customers at a competitive

interest rate. These categories of deposits are mostly negotiable if issued in a

negotiable form in a well-established secondary market.

Bulks of bank deposits are held by household individuals and business firms. However,

governments (local, state and federal) also hold substantial deposit accounts known as

public fund deposits. Any time a local school authority sells bonds to construct a new

building; proceeds of this sale of bonds will flow into its deposit account with a local

bank. Similarly, when US Treasury collects taxes or sells securities to raise funds, the

proceeds normally flow initially into public deposits accounts that the Treasury has

established with banks across United States.

Looking into balance sheets of most banks, it can be observed that they heavily depend

on their deposit folio, which is usually 70-80% of their liabilities. In Table 1 that we

analyze, it can be noted that deposits constitute 78.12% of total liabilities.

22

CDs with a minimum face value of $100,000 and which can be sold in the secondary market at

any time before maturity.


Borrowing from Non deposit sources

While deposits represent the largest portion of banks sources of funds, banks also have

freedom to raise funds through miscellaneous liability accounts. This can be by Federal funds

purchased and securities sold under agreement to repurchase. Borrowings can also be from

money market and transfer of funds from one institution to other financial institutions is instant

through wire transfers.

Finally, other liabilities account serves as a catch-all for miscellaneous amounts owned by the

bank such as deferred tax liability and obligation to pay off the investors who are holding

bankers acceptances23.

Capital Account

Capital account on a banks‘ balance sheet represents the owners‘ share of the business. This

is also known as ‗stock holders‘ interest. Any new bank that wants to enter into a banking

service starts with a minimum capital and it then borrows funds from the public to meet its

operational demands. In the balance sheet under study, we can observe that the equity capital

is USD 8.2 mn and it is 4.74 percent of the total assets.

Equity Reserves, Surplus and Capital Reserves are also included with Equity to arrive at the

Capital Account in a banks‘ balance sheet. Usually, retained earnings (undivided profits) that

represent accumulated net income left over each year after payment of dividend forms the

largest part in capital account. .

23

An order by a customer to its bank to make a certain payment at some future date, which is

accepted by the bank.


In some of the banks‘ capital account, we can observe subordinated notes and debentures.

In the balance sheet under Table 1, it is shown as USD 2.220 mn. These are debt securities

with long-term maturities carrying a claim on the bank‘s assets and income that comes after the

claims of its depositors (subordinated to). It is a debt instrument floated by the banks and the

holders‘ claim on the bank resources has a lower priority vis-à-vis deposits.

Expansion of ‗Off-Balance Sheet‘

Banks have converted many of their customers‘ services in recent years into fee-generating

transactions that are not recorded on their balance sheets. They are known as contingent

liabilities. Some of the examples of these off-balance sheet items are:

1. Standby Credit Agreements, in which a bank pledges to guarantee repaying of a

customer‘s loan borrowed from a third party.

2. Interest rate swaps, in which a bank promises to exchange interest payments on

debt securities with another party.

3. Financial futures and option interest-rate contracts, in which a bank agrees to

deliver or to take delivery of securities from another party at a guaranteed price.

4. Loan commitments, in which a bank pledges to lend up to a certain amount of

funds until the commitment matures.

5. Foreign exchange rate contracts, in which a bank agrees to deliver or accept

delivery of foreign currencies on a future date at a pre determined exchange rate.

Even though these transactions are shown as ‗off-balance-sheet‘ items, often they expose the

bank to added risks. For example, the standby credit which guarantees the loan repayment by


the bank‘s client will result in a risk exposure for the bank, if the guarantee is invoked due to

default of the bank‘s client.

4.2 Income statement (Report of Income)

Income statement of a bank indicates the amount of revenue received and expenses incurred

over a specific period of time. The period can be on quarterly or half yearly or annual basis.

Since Assets on the balance sheet account for the majority of revenue and liabilities generates

banks expenses, Income statement has a close correlation with the balance sheet.

Principal source of banks‘ revenue is dependent on the interest on their loans and securities.

Other than these two items, rental income on assets and fee based income earned on their

other financial services are forming significant portion of the income side of the statement.

Likewise, under expenses side, interest paid on their deposits and borrowings is the major

source of expenses. Apart from this, expenses include salaries, benefits paid to staff, and

maintenance expenses on fixed assets

In short, Net Income = Total revenue items (-) Total expenses items.

Banks can increase their net income by using any of or all the following options:

Increase the average yield on each asset

Redistribute their earning assets towards those assets with higher average yields

Reduce the interest expenses by going for low cost deposits or non-deposits.

Shift preference towards less costly deposits and other borrowings

Reducing the employees or increasing the efficiency of the staff


Reducing the loan losses by having an improved monitoring and efficient appraisal

system

Improving tax management to reduce tax liabilities

Bank management may not have absolute control on all the above options. Specifically interest

payable depends on demand and supply of funds in the market operations. If the bank quotes

rate of interest lower than the prevailing market rate, further deposit accretions may suffer.

Income statement of a bank will have the following major items:

Income statement for the period of …(Report of Income)

Financial Inflows Financial outflows

Loan income Deposit costs

Security income Non deposit borrowing costs

Income from cash assets Salaries and wages expenses

Miscellaneous income Miscellaneous expenses

Tax expenses

Actual bank income statements usually have more details because each item shown above has

different components. For example, loan income includes income from mortgage loans,

consumer loans and other lending activities.

For the purpose of reviewing the details of an income statement, we give below a hypothetical

Income statement of a bank.


Income Statement of ABC Bank in the USA

For the period ending December 2010

Revenue and expenses Amount

In million

Interest Income

Interest and fees on loans 1,080

Interest on investment securities 376

Taxable securities revenue 240

Tax exempt securities revenue 37

Other Interest Income --

Total interest income 1,733

Interest expenses

Interest cost on deposits 613

Interest on short-term debts 181

Interest on long-term debts 150

Total interest expenses 944

Net interest income 789

Provisions for loan possible

losses

355

Net interest income after

provision for loan losses

434

Non interest income

Service charges on customers 49


accounts

Trust department income 26

Other operating income 99

Total non-interest income 174

Non interest expenses

Wages and salaries and other

personal expenses

230

Non occupancy and equipment

expenses

44

Other operating expenses 35

Total non-interest expenses 309

Net non interest income (135)

Income or loss before taxation 299

Provision for income tax 49

Net income or loss after

taxes

250

Average number of common shares of stock outstanding (actual) 50,000,000

Income / loss per share of common stock (actual $5


4.2.1 Interest Income

Interest Income generated by a bank accounts for most of the bank‘s revenue. In the above

statement we can observe that around 70 percent of the interest income is earned from loans.

Interest income on investments follows the loan revenue. The relative importance of these

different items fluctuates from year to year depending on the shift in interest rates, demand for

loans. When the interest income is compared with non-interest revenue sources (fee based

income) it is changing rapidly since fee based business is growing faster.

4.2.2 Interest expenses

Above table shows that total interest expenses is almost 74 percent of the total expenses. If the

bank is not in a position to manage their liquidity position efficiently, they have to raise short-

term loans from the market at the market rates which may be costlier at times. Interest

expenses for borrowing depends on the demand and supply in the money market also.

4.2.3 Net Interest Income

Most of the banks arrive at the net interest income by deducting interest expenses from interest

income. This is also known as ‘net interest margin’ (NIM). It totally depends on the cost of

funds and the interest received on the loans. It is one of the key indicators of a bank‘s

profitability. When the interest margin falls, bank stockholders will usually experience a

weakening in the bank‘s bottom line and perhaps on the dividends they receive on each share

they hold.


4.2.4 Loan-loss expenses

In case of loans that are not recoverable, bank has to make a provision from their current

income. It is known as ‗provision for possible loan losses‘. It is a non-cash expense, created in

the books of accounts to reduce the current income to the extent of the expected loss on bad

loans. When any bad loans that were previously written off is recovered, the recoveries reduce

the outstanding in the loan-loss account.

4.2.5 Non-interest income

Income earned from sources other than loans and securities are called non interest income.

Fees earned from offering trust services, service charges recovered on deposit accounts are

classified under this group. Recently when the banks are expanding their services in selling

insurance, issuing guarantees and standby credits, arranging syndicated loans their non-interest

income is increasing sharply. Since interest margins are under pressure, banks are presently

concentrating on these services to increase their non-interest income.

4.2.6 Net income

Net income is arrived at by deducting interest expenses and non-interest expenses from interest

income and non-interest income. This will be the income earned before taxation. Federal and

State incomes taxes are applied to this income figure to arrive at the banks net after tax income

or loss.

4.2.7 Appropriation of profit

The net income after taxes is usually divided into two categories by the board of directors.

Some of the funds may be distributed to the stockholders in the form of cash dividends and the

other portion will be transferred to ‗retained profit‘ in order to broaden the bank‘s capital base.


4.3 Financial Reporting

The formats and time periods for reporting of the Balance sheet and profit and loss statements

are defined by the Central bank under whose jurisdiction the Bank is operating.

In addition to the regulatory reporting, if the Bank is a joint stock company, it also has to adhere

to the reporting standards as defined by the entity under which it is listed.

For e.g. If a Bank is listed in NASDAQ or NYSE , the financial reporting has to happen as per

the format defined by SEC and as per the accounting standard of US ,even if the Bank is

operating outside US. Hence the Bank will have a financial report as per the US GAAP

(Generally Accepted Accounting Principles).

For balance sheet and income statement, one of the important financial reporting standards that

has evolved over time relates to segment-wise reporting. In the absence of segment wise

reporting, the financial results can be misleading. Many a times Treasury Income overshadows

the commercial banking income and does not depict a true picture of each line of business

performance

Over a period of time, each country has come out with its own GAAP, leading to duplication of

financial reporting and reconciliation. All GAAPs are now converging into what is known as the

IFRS (International Financial Reporting Standard.)

Following are the formats in which US Banks have to report their financial statements to the

Federal Reserve:

– FR2644 effective 1st July 2009 weekly statement of Assets and Liabilities

– FR Y 6 Annual Report of Holding Companies

– FR Y 9 C Consolidated Financial Statements for Bank Holding Companies.