Overview of Banking

Prof. Ganga S (TIMSR)

Guess What

Guess What

Guess What

Indian Financial System

Financial Intermediaries InvestmentsSavings

OrganisedUnorganised

Types of Financial Intermediaries

Types of Financial Intermediaries

• Banks

• Investment companies,

• Domestic Financial Institutions

• Mutual Funds

• Insurance Companies

• Non Banking Finance Companies

• Pension Funds

Activities Financial Intermediaries

Banks DFIs Insurance NBFC

Accepting Deposits Accepting Deposits Selling risk protection services

Accepting Deposits

Fund based and Non Fund based lending

Fund based and Non Fund based lending (Long term)

Investment Lease and Hire purchase

Transaction Banking services

Merchant Banking & Advisory

Investment Banking & Advisory

Advisory & Syndication

Advisory & Syndication

Authorised Dealer

Banking Sector

Journey So far

• Phase 1 :Early phase from 1786 to 1969 of Indian Banks

• Phase 2 :Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.

• New phase of Indian Banking System with the advent of Indian Financial & Banking Sector Reforms after 1991.

Journey So far -1786 to 1969 • 1786- General Bank of India• The East India Co. established three banks – Bank of

Bengal (1809), The Bank of Bombay (1840) and Bank of Madras (1843)– Merged as Imperial Bank of India in 1921

• State Bank of India Act, 1955• 1959: Nationalisation of SBI subsidiaries

• Reserve Bank started functioning in the Private Sector in the year 1935 (by the passing of the Reserve Bank of India Act, 1935)– RBI was nationalised in the year 1949 as Central Bank of

Country

• 1949- Banking Regulation Act

Journey So far -Nationalisation • Objectives:

– Class Banking to Mass Banking– Reach out to unbanked areas – Growth in deposit mobilisation, credit disbursals

– loan portfolio to sectors identified as “priority sectors”.

• 1969- Nationalization of 14 major banks • 1971- Credit guarantee corporation• 1975- Creation of Regional Rural Bank• 1980- Nationalization of 6 more commercial

banks

Narasimha Committee• Progressive reduction in pre-emptive reserves (CRR

and SLR)• Liberalisation of branch expansion policy• Introduction of Prudential norms – Capital Adequacy,

Asset Classification, Provisioning, Income Recognition• Decrease in the emphasis laid on directed credit• Phasing out concessional rate of interest to priority

sector

Narasimha Committee • Deregulation in the entry norms for private and foreign

banks• Reduction of government stake in banks to 33 percent• Greater emphasis on asset-liability management• Setting up of Asset Reconstruction Funds to takeover

NPAs• Consolidation of banking industry by merging strong

banks

Liberalisation (1991)• Lowered Entry Barriers• Deregulating the Interest Rates• Lowered Regulations

– Technological Revolution, – Better customer service,– Automated teller machines, – plastic money, telebanking,

– Electronic Funds Transfer, Anywhere banking

Liberalisation-Challenges

• Competition levels- PSB• Profitability with optimal risk return matrix• Non Performing Assets , Income recognition

standards• Greater transparancy norms

• Capital Adequacy norms• Off Balance Sheet items

Liberalisation-Challenges

• Role of CIBIL• Areas of Risks

• Credit Risk• Operations Risk• Interest Rate Risk• Liquidity Risk• Currency Risk

Performance Review - Scheduled Commercial Bank

Bank Credit (growth rate-%)

May 2007 May 2008

Non food credit 26.4 24.1

Agriculture and allied activities 32.2 19.3

SME 26.4 26.9

Personal loans 23.9 15.9

Services 26.1 31.3

• Interest income growth 26.2% as compared to 40%• Provisioning increased resulting in reduced PAT growth

– SBI,ICICI Bank, Canara Bank,Central Bank of India

• Improvement in Capital adequacy ratio- more than 11%• Banking sector yields 6.7%

Banking Sectors

• Corporate Banking

• Retail Banking

• International Banking

• Rural Banking

Banking Sector

• Financial services and products for large corporate house– Working Capital

• Foreign curreny loans

– Term loans– CMS– Take over finance– Derivatives– Corporate Deposits– Advisory services– Buyer’s credit/Supplier’s credit– External Commercial borrowings– Internet based banking

• Sales Model- Focus relationship manager

• Service Model- Focused service desks in Branches

• Monitoring- Focused Credit Managers

Corporate Banking(large corporates)

• SME classification based on networth or turnover• Corporate Linked business structure• Financial services and products for SME

– Working Capital– Term loans– CMS– Derivatives– Corporate Deposits– Advisory services

• Private equity

– Buyer’s credit/Supplier’s credit– External Commercial borrowings– Internet based banking

• Sales Model- Outsourced to DMAs/DSAs (for small exposures)– Focused relationship manager

• Monitoring Model- Call centre for small exposures and asset relationship manager for large exposures

Corporate Banking(SMEs)

• Customer profile- farmers, Village Level aggregators, co-operative societies, wholesale markets, mandies

• Corporate SME linked to Agri sector

• Micro finance loans

• Corporate Linked business structure

• Financial services and products for SME– Working Capital and overdraft– Commodity based financing– Term loans

• Sales Model- Outsourced to DMAs/DSAs (for small exposures)

– Focused relationship manager

• Monitoring Model- Call centre for small exposures and asset relationship manager for large exposures

Rural Banking

• Target countries- UK, Russia Singapore, Bahrain, Hong Kong, Sri Lanka, Dubai, United States etc

• Target customers- Non Resident Indians, Advisory services such as loan syndication, fund based non fund based loans etc to Indian companies setting new venture overseas

• Transaction banking such as internet banking, deposits etc

• Private equity funding

• Sales Model- Focused relationship manager

• Monitoring Model- Focused Credit managers and relationship managers both in Indian branches and overseas branches

International Banking

Risk Management

Basel II• 26th June 1974 a German Bank, Bankhaus Herstatt, with total assets of

around US $800 million, was ordered by the West German authorities to close its doors after suffering foreign exchange and other losses which were eventually put at over $ 450 million, bringing to the fore “Herstatt risk” or “settlement risk” in the forex transactions.

• 1975 a standing committee of Bank supervisors, “Committee on Banking Regulations and Supervisory Practices” (now known as Basel Committee on Banking Supervision)

Basel II• The G 10 supervisors joined, in resulting in the historic Basel Capital Accord

agreement of July 1988 viz International Convergence of Capital Measurement and Capital Standards” which unified capital adequacy among their banks.

• The ability of a bank to absorb unexpected shocks and losses rests on its capital base. Basel II norms are centered on sustained economic development over the long haul and include

1. promotion of safety and soundness in the financial system

2. the enhancement of competitive equality

3. the constitution of a more comprehensive approach to address risk

Basel II

Existing Accord1)Focus on single Risk measure

2)One size fits all

3)Broad brush structure

New Accord1)More emphasis on Banks own internal methodology, supervisory review and market discipline

2)Flexibility, menu of approaches, incentive for better Risk Mgmt.

3)More Risk Sensitivity

Basel II• The new risk sensitive approach seeks to strengthen the safety and

soundness of the industry by focusing on:

Risk based capital (Pillar 1)- assessment of minimum capital requirement for banks

Risk based supervision (pillar 2)- supervision to review banks capital adequacy and internal assessment process

Risk disclosure to enforce market discipline (Pillar 3)- use of market discipline for greater transparency and disclosure and encouraging best international practices.

First pillar- Minimum Capital Requirement

• Minimum capital requirement of 12 percent of risk assets

• Calculation is based on credit, market and operational risk.

• Capital Adequacy? It is cushion against unexpected losses Total Capital =(Tier I+Tier II+Tier III) Tier I Capital: Tier I capital is the core capital and provides the most permanent

and readily available support to a bank against unexpected losses, the Tier II consists elements that are less readily available.

Principles of sound lending

Application of Funds

Principles of sound lending• Principle of liquidity• Principle of safety and security• Principle of profitability• Principle of purpose• Principle of diversification of Risks• Principle of Social Responsibility

Credit Risk • Key principles:

– Evaluation– Pricing – Monitoring

• Macro Level credit risk management- Capital Adequacy Ratio– CAR= C/RWA where in C= Capital, RWA= Risk Weighted Assets

• Synergy Banking Services Ltd has an asset based of Rs 1000 crores out of which 60% carry 50% percent risk weight, 30 percent carry 20% percent risk weight and the remaining zero percent risk weight. Compute the CAR of SBSL if it has a capital of Rs150 crore. Comment on the credit risk position of the company

Credit Risk

Capital Adequacy= Capital/Risk Weight of Assets

= 150

--------------------------------------- = 41%

(600*0.5+300*0.2+100*0)

Credit Risk

• Credit Risk Model– Expert systems,

• Capital structure• Capacity• Collateral• Cycle/Economic conditions• Character

– Rating systems, and credit scoring system

Credit Risk

• Credit rating/scoring– Determine the loss probability of default and the

recovery rate (as opposed to repayment) – It allocates a potential or existing borrower into either

a good group (higher rating) or a bad (lower rating) based on a score and a cut off point.

Credit Risk

What is Loan review, administration and management (LRM)

Credit RiskBasel II proposes three principle options:

• Standardised approach – Under this approach preferential risk weights in the range of 0%, 20%, 50%

100% and 150% are assigned for different categories of assets on the basis of external ratings by approved rating agencies. Claims past due over 90 days require a risk weight of 150%.

• Internal rating based (IRB). – Under this approach, banks, which comply with certain requirements, would be

allowed to internally assess and derive the risk weights, which are then used to compute capital requirements. The risk weights are derived as a continuous function of Probability of Default (PD), LGD (loss given default) and EAD (exposure at default). The migrations in ratings in different rating grades are tracked over a period of 5 to 7 years to arrived at a representative PD.

• Securities Frame work

Operational Risk

Operational Risk

• Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

• Internal fraud, External fraud, Employment practices & workplace safety, Clients, products & business practices, Damage to physical assets, Business disruption & system failures, Execution, delivery & process management‹ Includes legal risk.

• ‹Excludes reputational and business/strategic risk.

Operational RiskCase Study:

A man draws a cheque for Rs 50 and inadvertently leaves blanks before the amount both in words and in figures. The cheque is fraudulently raised by the payee. With how much can the bank debit the customer?

Operational Risk

Three approaches have been proposed for the measurement of operational risks under Basel II

Basic Indicator approach- It utilizes one indicatory of operational risk for a bank’s total activity. Bank needs to keep 15% of its Gross Revenues in reserves to cover all it loans out

Standardized approach: It specifies different indicators for different business lines such as 12%, 15% and 18%

Advanced measurement- It requires the banks to utilize their internal loss data in the estimation of the required capital.

Market Risk

Market RiskFramework: managing liquidity, interest rate, foreign exchange,

equity and commodity price risk.

RBI guidelines on market risk in June 2004• Computing capital charge for interest rate related

instruments• Equities• Foreign exchange risk (including gold and precious metals)

Trading Book• Securities included under the “Held for Trading”Category• Securities included under the “Available for Sale” category• “Open Gold” position limits• “Open foreign exchange position limits”

Market Risk

Minimum capital requirement is expressed in terms of:• Specific Risk

– Investment in government securities, claims on banks, investment in mortgage backed securities, securitised paper

• General Market Risk– General market changes

• Standaridised method• Internal Management Model method

Liquidity risk

Liquidity risk management

• Capital Reserves and surplus: Over 5 years• Demand Deposits current and savings bank account: These may be

classified into volatile and core portions. While the volatile portion is placed in o1-14 days the cored portion may be placed in over 1-3 year bucket

• Term deposits: Respective maturity date• Certificates of deposits, borrowings and bonds:Respective maturity

buckets. • Other liabilities(Bills payable)Core component shown under 1-3

years, balance may be placed in 1-14 days• Interoffice adjustment:Net credit balance 1-14 days• Provision other than for loan loss and depreciation in

investment:respective buckets• Export finance-availed: Respective maturity date• Export finance-unavailed:1-14 days

Liquidity risk management

• Cash:1-14 days• Balances with RBI: Excess balance over CRR/SLR in 1-14 days. • Balance in CRR/SLR: respective maturity period• Balances with other banks: Current account, Non withdrawable portion on

account of stipulation of minimum balances may be show under 1-3 years and remaining balances may be shown under 1-14 days

• Money at call: Respective maturity bucket• Investments (net of provisions) Approved securities: Respective maturity

bucket• Corporate debentures, bonds, CDs, CPS etc:Respective maturity bucket• NPA to be classified under 3-5 years bucket• Share/units of mutual: Over 5 years bucket• Investment in subsidiaries: Over 5 years• Securities in trading book1-14 days, 15-28 days 29-90 days

Liquidity risk management

• Advances (performing) Bills purchased and discounted: Respective maturity bucket

• CC, overdraft, demand loan: Based on the past data, the buckets to be determined

• Term loans: Respective maturity bucket• NPA: Over 3-5 years• Fixed Assets: Over 5 years• Contingent liability: Lines of credit committed from

institutions 1-14 days• Unavailed CC/overdraft etc: Empirical data

Currency Risk

Currency Risk

• Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk.

• The banks are required to adopt value at risk approach to measure the risk associated with forward exposures.

• Thus the open positions limits together with the gap limits form the risk management approach to forex operations.

Interest Rate Risk

Interest Rate Risk Management• Interest rate risk is the risk where changes in market interest rates

might adversely affect a bank’s financial condition. • The immediate impact of changes in interest is on bank’s earnings

(i.e reported profits) by changing its Net Interest Income (NII). • A long term impact of changing interest rates is on bank’s market

value of equity (MVE) or Net worth as the economic value of bank’s assets , liabilities and off balances sheet positions get affected due to variation in market interest rates.

• The interest rate risk in the present context is measured through tradition gap analysis method due to challenges of proper MIS.

Interest Rate Risk ManagementAn asset or liability is normally classified as rate sensitive if

Within the time interval under consideration, there is a cash flow The interest rate resets/reprices contractually during the interval The RBI changes the interest rates in case where interest rates are administered It is contractually prepayable or withdrawable before the stated maturities.

The gaps may be identified in the following time buckets:1-28 days

29 days and upto 3 months

Over 3 months and upto 6 months (savings account, balance with RBI)

Over 6 months and upto 1 year

Over 1 year and upto 3 years

Over 3 years and upto 5 years (sub standard assets)

Over 5 years (loss assets)

Non sensitive (eg Capital reserves, cash)

Interest Rate Risk ManagementAn asset or liability is normally classified as rate sensitive if

Within the time interval under consideration, there is a cash flow The interest rate resets/reprices contractually during the interval The RBI changes the interest rates in case where interest rates are administered It is contractually prepayable or withdrawable before the stated maturities.

The gaps may be identified in the following time buckets:1-28 days

29 days and upto 3 months

Over 3 months and upto 6 months (savings account, balance with RBI)

Over 6 months and upto 1 year

Over 1 year and upto 3 years

Over 3 years and upto 5 years (sub standard assets)

Over 5 years (loss assets)

Non sensitive (eg Capital reserves, cash)

Interest Rate Risk ManagementAn asset or liability is normally classified as rate sensitive if

Within the time interval under consideration, there is a cash flow The interest rate resets/reprices contractually during the interval The RBI changes the interest rates in case where interest rates are administered It is contractually prepayable or withdrawable before the stated maturities.

The gaps may be identified in the following time buckets:1-28 days

29 days and upto 3 months

Over 3 months and upto 6 months (savings account, balance with RBI)

Over 6 months and upto 1 year

Over 1 year and upto 3 years

Over 3 years and upto 5 years (sub standard assets)

Over 5 years (loss assets)

Non sensitive (eg Capital reserves, cash)

Interest Rate Risk Management• The gap is the difference between rate sensitive assets (RSA) and

rate sensitive liabilities (RSL) for each time bucket. • The positive gap indicates that it has more RSAs than RSLs where

as negative gap indicates that it has more RSLs. • The gap reports indicate whether the institution is in a position to

benefit from rising interest rates by having a positive gap or vice versa.

• Each bank should set up prudential limits on individual gaps with the approval of the Board or Committee.

Non Performing Asset

Non Performing Asset• Traditional approach of recovery

– Recovery Cell• One Time Settlement• Sale of Assets

– Board for Industrial financial Reconstruction (BIFR) under SICA

– Litigations:• Consumer courts• Debt Recovery Tribunals• High Court• Supreme court

Non Performing Asset• Reforms in recovery mechanism since 2002

– Corporate Debt Restructuring Schemes• Exposures more than Rs 10 crores

– Securitisation of Financial Assets and Enforcement of Security Interest Act, 2002 (SRFAESI Act).

• Strengthens creditors' security enforcement rights; • Secured creditors holding more than three-fourths of the outstanding amount

have been permitted to enforce security interest without reference to the court. Litigations:

• Specialised vehicles to focus on Non Performing Loans – Asset Reconstruction Companies

Asset Reconstruction Companies• Asset Reconstruction Company India Limited with an equity of Rs

10 crores was first ARC company• Securitisation deals worth Rs 1,100 crore in the first half of this

fiscal, of which retail loans account for about Rs 400 crore. This consists of mainly mortgage loans.

• Vehicle loans form a small portfolio of about Rs 20-30 crore. Retail loans are likely to touch about Rs 600-700 crore this year.

• Company has deals with over 60 banks

Asset Reconstruction Companies

– Pegasus

– Dhir & Dhir International Private Ltd

– International Asset Reconstruction Company

– Ace (promoted by IFCI)

– Kotak Mahindra Division

– Reliance ARC

– ARSEC (promoted by UTI)

– Pridhvi Asset Reconstruction and securitisation company