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

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

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





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.




    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.








   Department of economic affair(DEA)


   Department of company affair(DCA)







    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




 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 .




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



   Medical Examinations


   Inspection Reports


   Medical Information Bureau


   Underwriting in the Field





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.




On the basis of Structure


Open ended Schemes


Closed 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



    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



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



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




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 / 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 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




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 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



   Gilt Security Schemes


   Funds of Funds


   Domestic Funds



   Tax Saving Schemes.


   Insurance business







―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




     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


     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.




    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)]/



   Simple and transparent


   readily available





   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:



    Risk factor level


    Replacing the security


    Measure  VAR



    Estimate VAR


    Revaluating the all position of portfolio


    More time consuming.



    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




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






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




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


Higher the ratio indicates operational efficiency




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


It measures overall profitability.






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




         (M)anagement Capability




         (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.




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.




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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