Sources and Application of Bank Funds

SOURCES AND APPLICATION OF BANK FUNDS

1 Capital Adequacy

2 Deposits and non-Deposits Sources

3 Sources of Deposits

4 Classification of Deposits

5 Non Deposit sources

6 Designing of Deposit schemes &Pricing of deposit services

7 Investment and lending Functions

8 Types of lending-fund based

8.1 Non fund based lending

8.2 Asset based lending

9 Different types of loans and their features

10 Major components of a loan policy document

11Steps involved in credit analysis

12 Credit Delivery and A dministration

13 Pricing of loans

14 Customer profitability analysis

1 CAPITAL ADEQUACY: Capital to risk (weighted) asset ratio

 A bank should have a sufficient capital to provide a stable resources to absorb any losses arising from the risks in its business

    Ratio of a bank‘s capital to its risk.

 Bank for international settlements(BIS) banks must have a primary capital base equal at least to 8% of their assets& a bank that lends 12 dollars for every dollar of its capital is within a prescribed limit

Norms

 Basel committee for bank supervision(BCBS)- framed norms(capital requirements) 1988 known as Basel Accord I

    To absorb unexpected losses or risks involved.

    Higher the risk , it would be needed to back up with capital &vice versa.

Formula

CAR= Tier one capital+ Tier two capital / risk weighted assets

Tier one capital= (paid up capital +statutory reserves+disclosed free reserves)- (equity investments in subsidiary+ intangible assets +current & profit/loss)

Tier two capital= General loss reserves + hybrid debt capital instruments & subordinated debts.

Risk weighted assets: Risk& weight is calculated differently for each types of loan

2 DEPOSITS AND NON DEPOSITS SOURCES

Deposits

Meaning

It is a sum of money paid into a bank (or) building society account

Parameters to determine the fund mobilization

    Maturity

    Cost of funds

    Tax  implications

    Regulatory Framework

    Market conditions

DEPOSITS

3 Sources of deposits

Parameters

    Type of deposit customers

    Tenure of deposits

    Cost of banks

4 Classification of deposits

1.Transaction deposits/payment deposits

^Ø   These deposits are repayable by the bank on          demand from the depositors.

    interest bearing deposits(individual & saving a/c)

 Non interest bearing deposits(low rate of interest) 2.Term deposits:

The customers receives a stream of cash flows in the form of interest. These deposits typically the high rate of interest.

Example

USA –MMDA(Money market deposit accounts)

DDA(Demand deposit accounts)

UK- Saving deposits

Canada- term deposits,saving accounts

5 Non deposit sources/whole sale funding sources

Funding gap:

It is calculated as the difference between current and projected credit non deposit flows. Shows the projected need for credit exceeding the expected deposit flows

Alternative funding sources

    Central bank funds

    Certificate on deposits(cd)

    Foreign funds

 Other money market funds Types of non deposit sources

      Call & notice money

      External commercial borrowings(ECB)

      Export refinance

1.Call & notice money

    it is a money market instrument

 Money market is a market for short term financial assets. Features

    Banking &all co-op banks

    Outstanding borrowing should not exceeding 100% of banks capital

    Non banking institutions cannot operate.

2.External commercial borrowings:

 Commercial loan in the form of bank loan,buyers credit,suppliers credit,fixed rate of bonds taken from non resident lenders with a minimum maturity period of 3years

Features

      Do not get approval from RBI& GOI

      Amount of maturity

      End use permitted

      Prepayment of ECB

      Security

3.Export refinancing from RBI

offer Refinancing for credit

Ex: SIDBI

6 Designing and Pricing Of Deposit Services

Pricing of deposit sevices

Key aspects

    Servicing costs Vs minimum balance requirements

    Deposits volumes and their cost in relation to profits

    Lending and investment avenues

    Relationship with customers

    Promotional pricing

    Product differentiation

6.1 Approaches of deposit pricing

Cost plus margin deposit pricing^L Banks determine deposit rate

Cost of offering services plus small profit of margin formula: operating expenses per unit of deposit service Estimated overhead expenses allocated to deposit function Market penetration deposit pricing Based on market share (or) Growth of market ,the rate is fixed Conditional pricing - Attracive scheme, Larger volume of amount& higher interest rate- vice versa Upscale Target Pricing Customers are targeted ,Ex:Doctors,managers, lawyers Relationship pricing Banks best customers get best pricing Create good rapport b/w banks & customers

Designing of deposit schemes and pricing of deposit services, application of bank funds – Investments and Lending functions, Types of lending – Fund based, non-fund based, asset based

– Different types of loans and their features, Major components of a typical loan policy document, Steps involved in Credit analysis, Credit delivery and administration, Pricing of loans, Customer profitability analysis.

7 LENDING FUNCTIONS

LENDING

    Primary function of a bank.

    Major sources of income

    Risk also involved

Some of the securities against which the banks lends are

    Commodities

    Debts

    Financial instruments

    Real estate

    Automobiles

    Consumer durable goods

    Document of title

Functions of bank lending

    To provide interest income of the bank

    It helps in promoting private sector development

    It helps to stabilize, broaden and increase the efficiency of financial markets.

    Helps to promoting & developing the various financial institutions

    To provide education aloans,housing loan etc to the people.

    To provide direct finance to agriculture which includes short,medium&long term loans

8 Types of lending – Fund based, non-fund based, asset based

Fund based lending

    Loans

    Cash credit

    Overdraft

    Purchase of bills of exchange

Loans

    Oldest & very popular form of lending by banks

    Loans- financial assistance is given for a specific purpose and for a fixed period

    With or without security(advance)

    Loans (demand &term loan)

 Demand loan(payable on demand, short term loans& granted to meet the working capital requirements of the business

    Term loan( repayment is spread over long period .

    Medium Term loan- (repayable 1 to 5 years)

    Long term loan-(repayable after 5 years)

Cash credit

    Banks lend money against the security of commodities and debt.

 It runs like a current account except that the money that can be withdrawn from this account is not restricted to the amount deposited in the account.

 Instead, the account holder is permitted to withdraw a certain sum called "limit" or "credit facility" in excess of the amount deposited in the account.

Advantages

    Flexibility

    Economical

    Less formalities

Disadvantages

    Over borrowings

    Division of funds

    Non utilization of funds.

Overdraft

 An arrangement where by the bank allows the customers to overdraw from its current deposit account.

    security (assets& personal)

    Charging of interest

Advantages

    Flexible

    Interest is to be paid only for the funds that people use

    Quickly arrangement

    No additional expenses for prepayment of BOD.

Disadvantages

    Administrative fees can be charged

    Necessary to maintain the current account

    Difficult in calculation

8.1 Non fund based lending

Does not commit the physical flow of funds

It can be made in two forms

    Bank guarantees

    Letter of credit

Bank guarantees

^Ø issuing bank agreement       client

 to meet the claims put forward by the client against the customer on behalf of whom guarantee is issued.

    guarantee may be oral or written.

    It is non fund based credit.

Sec 126 of Indian contract act (contract of guarantee)

A Contract to perform the promise or discharge the liability,of a third person in case of his default.

surety person who gives the guarantee

principal debtor person in respect of whose default the guarantee is given creditor person to whom the guarantee is given is called

Advantages& Disadvantages

Letter of credit

A binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be tranferred to the seller.

Domestic /inland letter of credit

Foreign letter of credit/board letter of credit

8.2 Asset based lending

^Ø   Which the asset being bought(inventory, land or machine) is used as collateral.

    Quality of the collateral

    Off balance sheet financing

Asset based lender focus on

Collateral value

    Collateral audits

    Inventory turnover rates

    Orderly liquidation asset values

    Forced liquidation asset values

Forms of asset based lending

Project financing

The raising of funds required to finance an economically separable capital investment proposal in which the lenders mainly rely on the estimated cashflow from the project to service their loans.

Ex: highways

Advantages

    High leverage

    Tax benefits

    Borrowing capacity

    Risk limitations

    Risk spreading/joint ventures

Disadvantage

    Complexity of project  financing

    Indirect credit support

    Higher transaction costs

9 DIFFERENT TYPES OF LOAN AND IT‟S FEATURES

    Loans for working capital

WC= (CA-CL) Investment in current assets

Working capital gap determined by borrowers decisions

^Ø Loan for capital expenditure &industrial credit

Diversifying business

Debit service coverage ratio

    Loan for syndication

International financing

2 or more banks agree to jointly to make a loan to the borrower.

    Loan for agriculture

Short term loan

Sales realization(Harvest time)

Long term loan(investment in land,equipment etc) Loans are paid after the harvest

    Loans for infrastructure – Profit finance

Asset based lending

Identifying &Entering suitable contracts

Supplementary credit agreement&        Mode of credit through term loans.

    Loans for customers(or) retail lending

Purchase of durable goods,education,medical care,housing &other expenses Repayement periods from 1-5 years

Credit cards &Removal of default risk To improve profitability

    Non fund based credit (Non interest income) ex: LC

10 COMPONENTS OF A TYPICAL LOAN POLICY DOCUMENT

Major components of a typical loan policy document

    Loan objectives

    Volume &mix of loans

    Loan evaluation Procedure

    Credit administration

    Credit files

^v Lending rates

Loan objectives

communicate to credit officers & other decision makers

Volume &mix of loans

Specific industries,sectors,geographic areas.

Portfolio of loans

Pricing of loans

    Loan evaluation Procedure

Establishment of loans

Consider bank‘s over all strategy Selection of borrowers

Post sanction monitoring

    Credit administration

Lending activities are risky

To ensure credit decision are taken by experienced officers Hierarchical level of banks.

    Credit files

Important document

Used for making decision

Continous evaluation of company

Mandatory format is used

Lending rates

Parameters

    Types of collateral bank can accept the security for the loans

    Security should cover the advances made

    Nature of margins/compensating balances

    Proper credit monitoring system is followed

    Procedure for restructuring loan

    Role of credit department in bank

    Role of recovery department in bank

    Role of legal department in bank

11 Steps involved in Credit analysis

Step:1 –Building the credit file

Step:2- Project & financial appraisal

Step:3- Qualitative analysis

Step:4- Due diligence

Step:5- Risk assessment

Step:6-Making the recommendations

Building the credit file

    Gathering information

    To assess the borrowers willingness

    Desire to repay the loan

    To examine the borrowers track record

Project & financial appraisal

    Past financial statement

    Cash flow statement

    Financial risk

    To find out the current financial health

Qualitative analysis

    To assess the quality of team

    Poor credit decisions have been the result of not knowing enough about the customer.

Due diligence -is an investigation of a business or person prior to signing a contract, or an act with a certain standard of care.

    Time consuming activity

    Checking the borrowers details

    Analyse the technology used by the borrowers

    Assessment of debt service capacity

RISK ASSESSMENT

    Identify andanalysis the risk

    Identify internal and external risk

    Standard pricing of loan decisions and terms of loan agreement must be considered.

Making the recommendations

    Analyze of fitness & loan policy

    Accept /reject of lending process

    Specify credit terms including loan amount, maturity,pricing repayment schedule etc

12 Credit delivery and administration,

Credit delivery: it involves the trade off between the perceived default risk of the credit applicant and potential returns from granting requested credit

Objective:

To determine the optimal amount of credit to deliver

Steps :

Understand the customer current transaction behaviour &attitude Customer research to assess their economic impact

Develop an integrated channel migration plan (right initiatives at right customers) Protect sales effectiveness

Design non branch channel

Credit administration(Preparation of loan agreement,Renewal notices are sent systemmatically&Updation of credit files)

Credit administration function

    Credit files are neatly organised

    Borrowers has registered the required insurance policy

    Borrowers should Repay the lease rent properly

    Credit facilities are disbursed only after the contractual terms&conditions

    Collateral value is regularly monitored

    Borrowers should repay the interest,principal &fees &commissions in a particular time limit

13 Pricing of loans

Fixed & floating rate loan

Fixed rate loan are long term debt contracts whose interest rate payments are fixed at the time the loan is made

Floating rate :the interest is fixed for a short period and when that period expires a new interest rate is fixed for the next period

14 Customer profitability analysis(next chapter)

Relationship based pricing

Prime or base rate is established by the bank for its most credit worthiness of customers on short term working capital loans

Cost benefit loan pricing

The bank is charging enough for a loan to fully compensate it for all the costs and risk involved

Steps

Estimate the revenue the loan will generate under variety of loan interest rates &other fees Estimate the net amount of loanable funds

Estimate the before tax yield from the loan(revenue/ net amount of loanable funds

Cost plus pricing

Interest rate is charged for the following components:

    Cost of funds

    Cost of servicing the loan

    Risk premium

    Profit margin

Risk based pricing

A borrower with better credit will always get a lower rate,due to expected lower losses to be incurred from his account

Pricing of loans(process)

Step:1 Arrive at cost of funds

Step:2 Determine servicing cost for the customers

Step:3 Assess the default risk &enforceability of risks

Step:4 Fixing the profit margin

Arrive at cost of funds

    Loan pricing= cost of funds + desired profit margin

    It covers the variable costs.

Determine servicing cost for the customers

    Identify the full list of services used by the customers

    Assess the cost providing for the service

    Multiply with the unit cost with the extent to which such non credit services are availed.

    Cost of credit services depends on the loan size & forms a major portion of service costs.

Assess the default risk &enforceability of risks

It is a credit scoring system

Sanction of loan & analysis the risk.

E(r)= P(R)+P(D)* (R(P+Pr)/P)-1

E(r)=expected rate

P(R)=Probability of recovery

P(D)=probability of default

R=recovery rate in the event of default

P=principal amount

r= contracted rate of interest Step:4 Fixing the profit margin ROE=(ROA* EM)

CUSTOMER PROFITABILITY ANALYSIS.

CUSTOMER PROFITABILITY ANALYSIS

It is a loan pricing method that takes into account the lender‘s entire relationship with the customer when pricing the loan

Step :1

Identify all the services used by the customers (deposit services, loan availed, payment services, service relating to transfer of funds, custodial services and other fee based services.) STEP:2

Identify the cost of providing each services. STEP:3

Cost estimates for non credit related services can be obtained by multiplying the unit cost of each service by corresponding activity levels.

STEP:4

Major portion of costs is in respect of credit related services STEP:5

Credit related expenses has a non cash component the allocation of default risk expenses STEP:6

Assess the revenues generated by the relationship with the borrower. STEP:7

Assess the fee based income generated.fees are charged on the basis of price. STEP:8

Assess the revenue from loans.