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Chapter: Business Science - Banking Financial Services Management - Mergers, Diversification and Performance Evaluation

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Mergers, Diversification and Performance Evaluation

1 Mergers 2 Recent trends in Merger 3 Diversification of banks into securities market 4 Underwriting 1 Underwriting Process 5 Mutual funds 5.1 Types of mutual funds 6 Insurance Business 7 Performance analysis of banks 8 Ratio analysis 9 CAMELS

MERGERS, DIVERSIFICATION AND PERFORMANCE EVALUATION

 

1 Mergers

2 Recent trends in Merger

3 Diversification of banks into securities market

4 Underwriting

1 Underwriting Process

5 Mutual funds

5.1 Types of mutual funds

6 Insurance Business

7 Performance analysis of banks

8 Ratio analysis

9 CAMELS

 

1 MERGERS

 

Voluntary amalgamation of two firms on roughly equal terms into one new legal entity. Mergers are effected by exchange of the pre-merger stock (shares) for the stock of the new firm. Owners of each pre-merger firm continue as owners, and the resources of the merging entities are pooled for the benefit of the new entity. If the merged entities were competitors, the merger is called horizontal integration, if they were supplier or customer of one another, it is called vertical integration.

 

 

2 RECENT TRENDS OF MERGERS IN BANKS

    Earnings pressure increasing

 

    Regulartory scrutiny on the rise

 

    Attractiveness of federal deposit insurance corporation

 

    Valuation stabilising

 

    Investor groups looking for bank transactions

 

 

3 Diversification of banks

 

A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.

 

Benefits of diversification

    Lower cost of capital

 

    Economic gain

 

    Increases managerial efficiency

 

    Increase in market power

 

    Reduce earnings volatility

 

3.1Securities market/capital market

 

According to khan it is a market for a long term funds.it focus is on financing of fixed investments in contrast to money market which is the institutional source of working capital finance.

    NSE

 

    BSE

 

    SEBI

 

Regulators

   Department of economic affair(DEA)

 

   Department of company affair(DCA)

 

   RBI

 

   SEBI

 

TYPES OF SECURITIES MARKET

    Primary market/new issue market

 

 Secondary market/ Stock exchange Functions of SE

 

Trading procedure in stock exchanges

 

    Finding a broker

 

provide information

 

Supply investment literature

 

Availability of competent representatives

    Opening a n account with broker

 

    Placing the order

 

    Mkt order

 

 

    Limit order

 

    Stop loss order

 

    Stop order

 

    Cancel order/immediate order

 

    Discretionary order

 

    Open order

 

    Fixed price order

 

Other order

     Day order

 

    Good till cancelled (gtc)

 

    Not held order

 

    Participate but do not initiate(PNI)

 

    All or none order(AON)

 

    Fill or kill order(FOK)

 

 Immediate or cancel order(IOC) Making the contract

 

Preparing contract note Settlement of transactions

    Ready delivery contracts

 

    for ward delivery contracts

 

Other order

     Day order

 

    Good till cancelled (gtc)

 

    Not held order

 

    Participate but do not initiate(PNI)

 

    All or none order(AON)

 

    Fill or kill order(FOK)

 

 Immediate or cancel order(IOC) Making the contract

 

Preparing contract note

 

Settlement of transactions

    Ready delivery contracts

 

    for ward delivery contracts

 

4 Underwriting

 

MEANING

 

 Underwriting is an agreement entered into before the shares are brought before the public that in the events of the public not taking up the whole of them the underwriter will take an allotment of such part of the shares as the public has not applied for .

    TYPES OF UNDERWRITERS

 

 

Property & casually underwriters

 

Liability underwriters

 

Group Underwriters

 

 

 

 

Classification of Risk in Underwriting

   Preferred Risks

 

   Standard Lives

 

   Sub-standard Lives

 

   Declined Lives

 

4.1 Process of underwriting

   Application

 

   Medical Examinations

 

   Inspection Reports

 

   Medical Information Bureau

 

   Underwriting in the Field

 

 

5 MUTUAL FUND

 

ü A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal.

 

 

 The money thus collected is then invested in capital market instruments such as shares, debentures and other securities.

 

 The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them.

 

Mutual Fund Operation Flow Chart


 

Advantages of Mutual Funds


 

Disadvantages of mutual fund

 

    No control over costs: The investor pays investment management fees as long as he remains with the fund, even while the value of his investments are declining. He also pays for funds distribution charges which he would not incur in direct investments.

 

    No tailor-made portfolios: The very high net-worth individuals or large corporate investors may find this to be a constraint as they will not be able to build their own portfolio of shares, bonds and other securities.

 

    Managing a portfolio of funds: Availability of a large number of funds can actually mean too much choice for the investor. So, he may again need advice on how to select a fund to achieve his objectives.

 

    Delay in redemption: It takes 3-6 days for redemption of the units and the money to flow back into the investor‘s account.

 

5.1 TYPES OF MUTUAL FUNDS

 

On the basis of Structure

 

Open ended Schemes

 

Closed ended Schemes.

 

OPEN ENDED SCHEMES

 

    Open ended Schemes are schemes which offers unit for sale without specifying any duration for redemption.

 

    They sell and repurchase schemes on a continuous basis.

 

    The main feature of such kind of scheme is liquidity

 

CLOSED ENDED SCHEMES

    These are the schemes in which redemption period is specified.

 

    Once the units are sold by mutual funds, then any transaction takes place in secondary market only i.e stock exchange.

 

    Price is determined by forces of market.

 

On the basis of growth objective

 

GROWTH FUND

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds havecomparatively high risks

INCOME FUNDS

 

Funds that invest in medium to long-term debt instruments issued by private companies, banks, financial institutions, governments and other entities belonging to various sectors (like infrastructure companies etc.) are known as Debt / Income Funds

 

BALANCED FUND

 

These funds provide both growth and regular income as these schemes invest in debt and equity.The NAV of these schemes is less volatile as compared pure equity funds.

 

MONEY MARKET FUNDS

 

Money market / liquid funds invest in short-term (maturing within one year) interest bearing debt instruments. These securities are highly liquid and provide safety of investment, thus making money market / liquid funds the safest investment option when compared with other mutual fund types.

 

On the basis of Special Schemes

 

INDUSTRY SPECIFIC SCHEMES

 

Industry Specific Schemes invest only in the industries specified in the offer document. The investment of these funds is limited to specific industries like Infotech, FMCG, Pharmaceuticals etc

 

INDEX SCHEMES

 

In this schemes, the funds collected by mutual funds are invested in shares forming the Stock Exchange Index.

 

Example- Nifty Index Scheme of UTI Mutual Fund and Sensex Index Scheme of Tata Mutual Fund.

 

SECTORAL SCHEMES

 

Sectoral funds are those mutual funds which invest in a particular sector of the market, e.g. banking, information technology etc. Sector funds are riskier than equity diversified funds since they invest in shares belonging to a particular sector which gives them fewer diversification opportunities

 

OTHER SCHEMES

   Gilt Security Schemes

 

   Funds of Funds

 

   Domestic Funds

 

 

   Tax Saving Schemes.

 

   Insurance business

 

 

6 INSURANCE BUSINESS

 

Meaning

 

―The undertaking by one person to another person against loss or liability for loss in respect of a certain risk or peril to which the object of the insurance may be exposed, or to pay a sum of money or other thing of value upon the happening of a certain event and includes life insurance‖.

 

Characteristics of insurance

     Risk sharing

 

     Risk assessment

 

     Co-operation

 

     Payment at the time of contingency

 

     Larger the number, better the care

 

     Significance of insurance

 

     Protection against risk of loss

 

     Distribution of risk

 

     Specialization of labours

 

     Formation of capital

 

     Advance of loans

 

     Trading and foreign operations.

 

 

7 Performance analysis of banks BASEL norms

 

     These rule written by the bank of international settlements committee of banking supervision (BCBS)

 

     How to assess risks, and how much capital to set aside for banks in keeping with their risk profile.

 

o  tier one capital + tier two capital

 

Ø   CAR=        risk weighted assets

Objectives

     To strength soundness and stability of banking system

 

     To protect depositors and promote the stability and efficiency of financial systems around the world.

 

Basel I Norms

 

Ø   Maintain minimum capital adequacy requirement.

Basel II Norms

 

Ø   banking laws and regulation.

 

Risk based capital(pillar I)

       The first pillar sets out minimum capital requirement.

 

     Measurement and risk.

 

     Measure operational risk and market risk.

 

     2.Risk based supervision

 

     To help better management technique.

 

     Assess overall capital adequacy.

 

     Supervisor evaluate capital adequacy.

 

     Banks to operate minimum capital adequacy.

 

Preventing measures.

     Risk to disclosure to enforce market discipline (pillar III)

 

     It imposes strong incentives to banks to conduct their business in a safe , sound ,and effective manner.

 

Criticism of Basel II norm

     Not suit for difficult situation

 

     Examination or evaluation and supervisors.

 

     Developing countries.

 

     Face difficulties.

 

BASEL III NORMS

 

    To create an international standard that banking regulators can use when creating regulationabout how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

 

    Basel III is a comprehensive set of reform measures, developed by the Basel committee on banking supervision, to strengthen the regulation, supervision and risk management of the banking sector.

 

    Improve the banking sectors ability to absorb shocks arising financial and economic stress whatever the sources

 

    Improve risk management and governance

 

    Strengthen banks transparency and disclosures.

 

The reforms target:

 

Micro prudential

 

Macro prudential..

 

The overall goals of basel III norms are:

    To refine the definition of bank capital

 

    Quantify further classes of risk

 

    To further improve the sensitivity of the risk measures

 

Measurement of operational risk:

 

The frame work from the committee presents three methods for calculating minimum capital charge operational risk under pillar1:

    The basic indicator approach

 

    The standardised approach, and

 

    The advanced measurement approach(AMA)

 

    Basic indicator approach:

 

    Average annual gross income (net interest income+ net non interest income )

 

    Fixed percentage

 

KBIA=[∑(GI1.n *α)]/

 

Advantages:

   Simple and transparent

 

   readily available

 

 

   Risk.

 

   Standardised approach:

 

   Annual gross income per business line

 

   Several indicators – size or volume of banks activities in a business line, where banks

 

activities are divided into eight business lines:

 

HISTORICAL SIMULATION:

    Risk factor level

 

    Replacing the security

 

    Measure  VAR

 

MONTE CARLO SIMULATION:

    Estimate VAR

 

    Revaluating the all position of portfolio

 

    More time consuming.

 

PARAMETRIC SIMULATION:

    VAR estimation directly from the standard deviation

 

    VaR=market price *volatility

 

 Volatilities and correlations are calculated directly from users specified start and end dates Stress testing

 

Marketing value of a portfolio varies due to movement of market parameters such as interests rates ,market liquidity, inflation , exchange rate , stock prices , etc…….,

 

Techniques of stress testing

    Simple sensitivity test:-

 

Short term impact of portfolio value.

    Scenario analysis:-

 

Risk factors simultaneously.

    Maximum loss:-

 

identifying the most potentially damaging combination of moves of market risk factors

 

STEPS FOR STRESS TESTING

 

Step-1: Generate Scenarios`

 

Step-2: Revalue portfolio.

 

Step-3: Summarize results.

 

 

8 Ratio Analysis

 

It‘s a tool which enables the banker or lender to arrive at the following factors :

Liquidity position

 

Profitability

 

Solvency

 

Financial Stability

 

Quality of the Management

 

Safety & Security of the loans & advances to be or already been provided

 

Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

 

Current Ratio = Current Assets/Current Liabilities

 

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

 

The ideal Current Ratio preferred by Banks is      1.33 : 1

 

Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities.

 

NWC  = Current Assets – Current Liabilities

 

ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1.

 

Quick Current Assets    :       Cash/Bank Balances + Receivables upto  6 months + Quickly

 

realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

 

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

 

DEBT EQUITY RATIO  : It is the relationship between borrower‘s fund (Debt) and Owner‘s

 

Capital (Equity).

 

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets

OPERATING PROFIT RATIO :

 

 

It is expressed as     =>     (Operating Profit / Net Sales ) x 100

 

Higher the ratio indicates operational efficiency

 

NET PROFIT RATIO :

 

It is expressed as      =>   ( Net Profit / Net Sales ) x 100

 

It measures overall profitability.

 

 

 

9 CAMELS

 

Camels rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It's applied to every bank and credit union in the U.S. (approximately 8,000 institutions) and is also implemented outside the U.S. by various banking supervisory regulators.

 

The ratings are assigned based on a ratio analysis of the financial statements, combined with on-site examinations made by a designated supervisory regulator. In the U.S. these supervisory regulators include the Federal Reserve, the Office of the Comptroller of the Currency, the National Credit Union Administration, and the Federal Deposit Insurance Corporation.Ratings are not released to the public but only to the top management to prevent a possible bank run on an institution which receives a CAMELS rating downgrade. Institutions with deteriorating situations and declining CAMELS ratings are subject to ever increasing supervisory scrutiny. Failed institutions are eventually resolved via a formal resolution process designed to protect retail depositors.

 

The components of a bank's condition that are assessed:

         (C)apital adequacy

 

         (A)ssets

 

         (M)anagement Capability

 

         (E)arnings

 

         (L)iquidity (also called asset liability management)

 

         (S)ensitivity (sensitivity to market risk, especially interest rate risk)

 

 

    Capital level and trend analysis;

 

    Compliance with risk-based net worth requirements;

 

    Composition of capital;

 

    Interest and dividend policies and practices;

 

    Adequacy of the Allowance for Loan and Lease Losses account;

 

    Quality, type, liquidity and diversification of assets, with particular reference to classified assets;

    Loan and investment concentrations;

 

    Growth plans;

 

    Volume and risk characteristics of new business initiatives;

 

    Ability of management to control and monitor risk, including credit and interest rate risk;

 

    Earnings. Good historical and current earnings performance enables a credit union to fund its growth, remain competitive, and maintain a strong capital position;

    Liquidity and funds management;

 

    Extent of contingent liabilities and existence of pending litigation;

 

    Field of membership; and

 

    Economic environment.

 

Asset Quality

    Asset quality is high loan concentrations that present undue risk to the credit union;

 

    The appropriateness of investment policies and practices;

 

    The investment risk factors when compared to capital and earnings structure; and

 

    The effect of fair (market) value of investments vs. book value of investments.

 

(M)anagement

 

Management is the most forward-looking indicator of condition and a key determinant of whether a credit union possesses the ability to correctly diagnose and respond to financial stress. The management component provides examiners with objective, and not purely subjective, indicators. An assessment of management is not solely dependent on the current financial condition of the credit union and will not be an average of the other component ratings.

 

(E)arnings

 

The continued viability of a credit union depends on its ability to earn an appropriate return on its assets which enables the institution to fund expansion, remain competitive, and replenish and/or increase capital.In evaluating and rating earnings, it is not enough to review past and present performance alone. Future performance is of equal or greater value, including performance under various economic conditions. Examiners evaluate "core" earnings: that is the long-run earnings ability of a credit union discounting temporary fluctuations in income and one-time items. A review for the reasonableness of the credit union's budget and underlying assumptions is appropriate for this purpose. Examiners also consider the interrelationships with other risk areas such as credit and interest rate.

 

L)iquidity - asset/liability management

 

Asset/liability management (ALM) is the process of evaluating, monitoring, and controlling balance sheet risk (interest rate risk and liquidity risk). A sound ALM process integrates strategic, profitability, and net worth planning with risk management. Examiners review (a) interest rate risk sensitivity and exposure; (b) reliance on short-term, volatile sources of funds, including any undue reliance on borrowings; (c) availability of assets readily convertible into cash; and (d) technical competence relative to ALM, including the management of interest rate risk, cash flow, and liquidity, with a particular emphasis on assuring that the potential for loss in the activities is not excessive relative to its capital. ALM covers both interest rate and liquidity risks and also encompasses strategic and reputation risks.

 

 


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