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Chapter: Business Science : Banking Financial Services Management : 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

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




 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.




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








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


Parameters to determine the fund mobilization




    Cost of funds


    Tax  implications


    Regulatory Framework


    Market conditions




3 Sources of deposits



    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.




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




      Do not get approval from RBI& GOI


      Amount of maturity


      End use permitted


      Prepayment of ECB




3.Export refinancing from RBI


offer Refinancing for credit




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 pricingL 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.









    Primary function of a bank.


    Major sources of income


    Risk also involved


Some of the securities against which the banks lends are





    Financial instruments


    Real estate




    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



    Cash credit




    Purchase of bills of exchange




    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.







    Less formalities



    Over borrowings


    Division of funds


    Non utilization of funds.




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


    security (assets& personal)


    Charging of interest





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


    Quickly arrangement


    No additional expenses for prepayment of BOD.





    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



    High leverage


    Tax benefits


    Borrowing capacity


    Risk limitations


    Risk spreading/joint ventures



    Complexity of project  financing


    Indirect credit support


    Higher transaction costs




    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





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



    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



    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




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




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)






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.




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.


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Business Science : Banking Financial Services Management : Sources And Application Of Bank Funds : Sources and Application of Bank Funds |

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