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Chapter: Business Science - Banking Financial Services Management - Sources And Application Of Bank Funds

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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

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 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.

 

 

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.

 

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