BN101 Banking Fundamentals I

FDN-BN101-DB

Foundation Course in Banking – I

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Table of Contents 1

Evolution of Banking ________________________________________ 6

1.1

What is banking? ______________________________________________________6

1.2

History of Banking _____________________________________________________7

1.3

Services Offered by Banks ______________________________________________10

1.4

Trends in Banking Services _____________________________________________12

1.5

Classification of Banking Systems________________________________________13

1.5.1

Central Banking System__________________________________________________13

1.5.2

Commercial Banking System ______________________________________________19

1.5.3

Classification of Commercial Banking Services ________________________________21

1.6

Structure of Financial System____________________________________________22

2

Introduction to Retail Banking

2.1

Types of Deposit Accounts ______________________________________________26

2.1.1

Savings Account________________________________________________________27

2.1.2

Current Account ________________________________________________________27

2.2

Overview of Lending Process ____________________________________________27

2.2.1

Loan Origination________________________________________________________27

2.2.2

Loan Servicing _________________________________________________________31

2.3

Credit Appraisal in the Retail Market ______________________________________31

2.3.1

Traditional Approaches __________________________________________________32

2.3.2

Modern Approaches_____________________________________________________34

2.4

Retail Payment System _________________________________________________38

2.4.1

A Standardized Payments Model ___________________________________________39

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2.4.2

Types of Inter-bank Transfers _____________________________________________40

2.4.3

Check Payment System __________________________________________________42

2.4.4

Automated clearing House (ACH) System ____________________________________45

2.4.5

Debit and Credit Card System _____________________________________________48

2.5

Private Banking or Wealth Management ___________________________________50

2.5.1

Products in Wealth Management ___________________________________________55

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Wholesale Banking

3.1

Commercial Credit Products_____________________________________________58

3.2

Fund Based Credit Facilities _____________________________________________59

3.2.1

Lines of Credit _________________________________________________________60

3.2.2

Revolving Loans________________________________________________________60

3.2.3

Term Loans ___________________________________________________________61

3.2.4

Syndicated Loans/Club Loans _____________________________________________62

3.2.5

Export-Import Finance ___________________________________________________63

3.2.6

Factoring _____________________________________________________________64

3.2.7

Bill Discounting_________________________________________________________64

3.3

Structuring of Loans ___________________________________________________66

3.3.1

Fixed Rate Vs Floating Rate ______________________________________________66

3.3.2

Types of Repayment ____________________________________________________68

3.4

Concept of Default _____________________________________________________69

3.5

Non-Fund Based Credit facilities _________________________________________70

3.5.1

Letter of Credit or Documentary Credit_______________________________________70

3.5.2

Types of LCs __________________________________________________________75

3.5.3

Guarantee ____________________________________________________________81

3.6

Non-Credit Fee Based Products/Services __________________________________84

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3.7

Cash Management Services _____________________________________________85

3.7.1 Collection Services or Receivables Management _______________________86 3.7.2 Payment Services/ Payables management ____________________________87 3.7.3

Benefits of CMS ________________________________________________________88

3.8

Trade Finance_________________________________________________________90

3.8.1

Role of Banks__________________________________________________________90

3.8.2

Import Financing________________________________________________________92

3.8.3

Export Financing _______________________________________________________95

3.9

Lending Process ______________________________________________________96

3.9.1

Stage in a lending process ________________________________________________97

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Financial Statements of Banks

4.1

Balance Sheet

100

4.1.1

Assets

104

4.1.2

Liabilities

107

4.2

Income statement (Report of Income)

111

4.2.1

Interest Income

116

4.2.2

Interest expenses

116

4.2.3

Net Interest Income

116

4.2.4

Loan-loss expenses

116

4.2.5

Non interest income

117

4.2.6

Net income

117

4.2.7

Appropriation of profits

117

100

4

5

Questions

118

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In this chapter, the reader will learn the process of evolution of banking and its contribution to the growth of world commerce. The chapter will provide the rationale for banking and its supervision. A brief mention has been made of the high level segmentation of banking, which will be explored further in the next chapters. The chapter ends with the description of typical financial statements in a bank. The description of the terms in a financial statement have been kept to a level suitable for an introductory course.

1 Evolution of Banking 1.1

What is banking?

Traditionally banking is defined as the process of accepting deposits from surplus units in the economic system (lenders) with the objective of lending these funds to the deficit units in the economic system (borrowers).

A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and Greece, which loaned at high rates of interest the gold and silver deposited for safekeeping. Private banking existed by 600 B.C. and was considerably developed by the Greeks, Romans, and Byzantines. Medieval banking was dominated by the Jews and Levantines because of the strictures of the Christian Church against interest and because many other occupations were largely closed to Jews. The forerunners of modern banks were frequently chartered for a specific purpose, e.g., the Bank of Venice (1171) and the Bank of England (1694), in connection with loans to the government; the Bank of Amsterdam (1609), to receive deposits of gold and silver.

Banking developed rapidly throughout the 18th and 19th centuries, accompanying the expansion of industry and trade, with each nation evolving the distinctive forms peculiar to its economic and social life. Over a period of time banking has undergone lot of changes and now banking is not restricted to only taking deposits and lending. Though deposit taking and lending still remains the core banking activity, now banking includes services like wealth management services for ultra rich high net worth individuals,

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housing finance, mergers and acquisitions advisory services, leasing, trade finance, automobile finance, education finance, and the list goes on.

The following section describes how banking has developed over all these years since its inception.

1.2

History of Banking

Banking is one of the most important services in financial sector. It also provides fuel for economic growth of a country. It offers safety and liquidity for the investors, both on short and long term basis, offering comparatively a fair return for them. Banks are the principal source of credit for dealers, households, small businesses like retail traders and large business houses. Efficiency of a bank depends on their ability to satisfy their investors by offering comparatively a better interest rate to depositors and at the same time offering credit to their borrowers comparatively at cheaper interest rates. With a narrow interest rate spread (difference between borrowing and lending rate), they should make profit also. Looking into the present profile of a bank, it has grown up phenomenally offering large number of products other than the traditional functions of accepting deposits and lending funds. It is worth analyzing the historic background of evolution of banking services.

When and how the banks appeared?

Linguistics (the science of language) and

etymology (the study of origin of words) suggest an interesting story about the origin of banking. Both the old French word ‘banque’ and the Italian word ‘banca’ were used centuries ago to mean a ‘bench’ or ‘money changers table’. This describes quite well what historians have observed concerning the first bankers who lived more than 2000 years ago. They were money changers situated usually at a table or in a small shop in the commercial district aiding travelers who came to town by exchanging foreign coins

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for local money or discounting commercial notes1 for a fee in order to supply merchants with working capital.

European Banks during early stages were only for safe keeping of valuables like gold, silver bullion as people had the fear of loss of their assets due to theft, expropriation by government or war. Merchants who collected their payments, in the form of gold and silver in other countries, deposited their collections in the nearest bank instead of carrying such assets and exposing themselves to the risk of sea piracy or storms in the sea.

During the reigns of King Henry VIII and Charles I in England government’s efforts to seize the gold and silver from the public made them to deposit their stock of gold and silver with goldsmith shops who in turn issued paper tokens or certificates indicating the details of gold and or silver deposited with them. This certificate began to circulate as money because it was more convenient and less risky for them to carry this certificate. These goldsmiths also offered the service of valuing the gold and silver and issuing ‘valuation certificate’. Most of the customers brought gold, silver or ornaments to these goldsmiths and got it examined to find out whether they were genuine or fake. Even today certain ‘approved valuers’ provide this service.

The early bankers might have used their own capital for funding such activities but it was not long before the idea of attracting deposits and securing temporary loans from wealthy customers became an important source of bank funding. Loans were then made available to shippers, landowners and merchants at lowest interest of 6% per annum and as high as 48% per month for riskier ventures. Most of the banks in early stages were of Greek origin.

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Short-term unsecured promissory notes acknowledging a loan/obligation of one party

against the other.

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Gradually the banking industry spread outward from the classical civilization of Greek and Rome into northern and western parts of Europe. Banking industry encountered religious protests during the Middle Ages primarily because the loan given to the poor was at higher interest rate. However, in Europe, when the Middle Ages drew into close and the Renaissance started, bulk of deposits and loans were from wealthy customers and the religious opposition died down slowly.

Between 15th to 17th centuries, due to the development of navigation facilities, new trade routes and cross country trade activities, nucleus of world commerce gradually shifted from Mediterranean region towards Europe and British Islands where banking became a primary leading industry.

Industrial revolution was planted during the same period, which demanded a welldeveloped financial system. When production activities expanded at a mass scale, it required an equal quantum of expansion of global trade to absorb the output produced and new methods of trade payments and credit availability. Banks, which had the competency and capacity to manage the needs, grew faster. Some of the institutions that had the fastest growth during this period were Medici Bank in Italy and Hochstetter Bank in Germany.

When colonies were established in North and South America, banking practices were revised and new practices were introduced. In the beginning of 19th Century, however, the state governments in US began chartering banking companies. Many of them were simply extensions of other commercial enterprises in which banking services were largely secondary to merchant’s sales. Developments of large professionally managed banking firms were centered in few commercial centers especially in New York. During Civil War, federal government became a major force in US banking.

Congress

established office of the Comptroller of Currency (OCC) in 1864 for the purpose of chartering national banks. This divided the bank regulatory system with both federal

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government and the states playing key roles in the control and supervision of banking activities, which continues even today.

1.3

Services Offered by Banks

Financial institutions can be defined according to the services they provide to public. In United States any institution accepting deposits subject to withdrawal on demand such as drawing a check or by making an electronic withdrawal and making loans of commercial or business nature is defined as a ‘bank’.

Several financial service

companies and leading bank holding companies filed application for ‘non-bank banks’ because they could establish these service units freely across state lines and also have an access to federal deposit insurance.

In 1987 Congress put a halt to further non-bank

bank expansion by subjecting the parent companies of non-bank banks to the same regulatory restrictions that traditional banking organizations are subjected to. Moreover Congress defined bank as ‘a corporation that is a member of the Federal Deposit Insurance Corporation’. By this law a bank’s identity depends on which government agency insures its deposits.

With all the legal maneuverings the safest approach to identify what is a bank is probably to view these institutions in terms of what types of services they offer to public. Banks are to day offering a wide range of financial services and can be labeled as ‘financial departmental stores’.

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1.3.1.1 Traditional Services Offered by Banks Carrying out currency exchanges Discounting commercial notes and making business loans Offering savings deposits Safe keeping valuables Supporting government activities with credit by purchasing government bonds Offering checking accounts demand deposits Offering trust services managing financial affairs and property of individuals and business forms for a fee

1.3.1.2 New Services Offered by Banks Granting consumer loans Financial Advisory Services Credit and debit cards Cash management Equipment leasing Venture capital loans Insurance services Retirement plans Security brokerage investment services Mutual funds and annuities Investment banking and merchant banking services

Looking into the additional services that are extended by a bank today, it is evident that beginning with a safe custodian for gold and silver, banking has moved into an era of offering all types of financial services under one unit. Their service menu is constantly growing leading to a trend of ‘banking revolution’. These rapid changes may leave banks of next generation almost unrecognizable from those of today.

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1.4

Trends in Banking Services

While tracing the evolution of banking services one cannot loose sight of the following trends: Proliferation of new services and innovation of new customer friendly products Rising competition Deregulation of banking and financial markets Raising operational costs Invasion of information technology – electronic funds transfer – data transfers Consolidation of banking industry – mergers and acquisitions Globalization of financial services Transparency in banking operations Capital adequacy to withstand credit and operational risks.

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1.5

Classification of Banking Systems

Banking systems have evolved to meet the requirements that arose at different points of time in various economies and also the regulatory intervention that followed.

Banking can be broadly classified as:

Banking

Central Banking

Commercial Banking

1.5.1 Central Banking System Central Banking system is a non-commercial banking system which consists of the national supervisory framework for regulation of banking and controlling the money supply in the economy.

The need for a central bank is felt only when there is a banking system in place. Most central banks evolved in order to take care of actual or potential problems in the banking system. Central banking was initially practiced with the help of a large number of informal norms, conventions and self-imposed codes of conduct. These were later formalised into theory and institutionalised into laws that apply to today’s central banking institutions. The first central bank, the Sveriges Riksbank,was established in

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Sweden in 1668; and the second was the Bank of England (BoE), set up in 1694 under a Royal Charter. Most of the bigger European central banks were established in the nineteenth century, while the German Bundesbank and the U.S. Federal Reserve System in the twentieth century. The early central banks were established primarily to finance commerce, foster growth of the financial system and to bring about uniformity in issuance of currency notes.

After the First World War, the role of central banks became even more important. Their role of supervising the business of private commercial banks was extended and lenderof-the-last-resort function2 to stabilise the banking system during financial panics was strengthened. The First World War also led to the central banks’ increasing involvement in extending credit to their governments. In order to handle their new role as brokers for government debt, central banks were allowed to trade government paper in the open market and were entitled to develop open market policy instruments for fine-tuning of interest rates and for credit and money supply expansion. This gave rise to more discretionary powers to central banks to conduct their operations. Since 1933 in the US and shortly after the Second World War in Germany, central banks were empowered to change minimum reserve requirements, which constituted an important direct tool of monetary policy.

Central banks have evolved in accordance with the specific requirements of the economies in which they are situated and in response to the kind of demands made on them. The genesis of central banking is different between developed and developing countries. As a result, the role of central banks in developing countries of today is typically different from that of the developed country central banks when they were developing. In industrial countries this purpose centred on the need to have a lender-ofthe-last-resort, in developing countries such as India, central banks came into existence when banking was underdeveloped. In fact, the central banks were instrumental in influencing the spread of commercial bank networks in developing countries.

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Central banks act as lender of last resort for banks/financial institutions that do not have

any other means of borrowing left and whose failure would adversely affect the economy

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1.5.1.1 Regulatory Evolution The origin of banking regulation in a broad sense or the primitive form of banking regulation can be traced back to the end of the Middle Age right after the emergence of banking industry. But systematic and extensive banking regulation originated only in the mid-nineteenth century when the government involvement in the national economy began to expand. Before that, banks were not or

little regulated, a situation often

referred to as free banking or laissez faire banking.

Late Medieval Period The late medieval (late 13th century) experience of Aragon demonstrates vividly the genesis of banking regulation as a response to moral hazard following government guarantees. In some city states such as Barcelona, Valencia, and Tortosa, the economy was booming and the government had relatively abundant fiscal resources. Understanding well the importance of bank stability to the society, the kings of these cities offered guarantees to bank deposits. Government insurance caused moral hazard problems: irresponsibility, speculation, and lack of foresight on the part of some early bankers led to fraudulent bank failures during the last third of the thirteenth century. In response to fraudulent bankruptcies, the legislatures in Barcelona and Lerida passed the first laws governing banking in Catalonia in 1300 and 1301, respectively. The law in Barcelona provided stringent rules to punish those bankers who went bankrupt: they should be publicly denounced, not only in the streets of Barcelona but also in all the towns where they had done business. They could not open any exchange or bank thereafter, and would be imprisoned and kept on bread and water until they paid off all their creditors. The government also strengthened regulation of bank accounting system and enhanced the creditor’s rights. The banker was declared responsible for all entries made for his clients, and no one, not even the king, could postpone settlement of credit beyond the set time. In Lerida, the king decreed that money changers were responsible to their creditors and that their goods could be confiscated in cases of default.

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To curb bankers’ moral hazard problem as a result of deposit guarantee, the government required banks to submit a deposit as guarantee: no one would be allowed to open a bank in Catalonia without first depositing 1000 silver marks in Barcelona and Lerida and 300 marks in all other towns and cities in Catalonia. Only after the deposit was paid could the money changer place the tapestry bearing the shield of the city on his table, indicating that his office was guaranteed. Those who did not pay the fee had to leave the wooden top of their tables bare, without tapestries or other cloths, as a warning to their clients. This is in nature similar to the deposit reserve or capital adequacy requirement in contemporary banking practice, which no doubt can contribute to banking stability.

Early Nineteenth Century As the government’s involvement in the national economy began to increase, the role of governments to intervene in the economic affairs as well as the fiscal and financial capacity of governments increased. The power of taxation and monetary policy equipped the governments in respective economies with ever increasing financial resources. At the same time, governments were subject to the pressure of public opinions and therefore became concerned with social welfare. In this role, governments used to bail out failing banks in order to provide a social safety net. The bailout of the Chilean Mortgage Bank is one of the earliest examples of government bailouts in the 19th century.

During the same period, the concept of laissez faire was made popular by Adam Smith. Laissez-faire is a French phrase meaning "let do, let go, let pass." It became used as a synonym for strict free market economics during the early and mid-19th century. It is generally understood to be a doctrine opposing economic interventionism by the state beyond that which is perceived to be necessary to maintain peace and property rights. Laissez faire banking or free banking refers to the institutions of banking with no or little government regulation. Under this regime, there is no government control of the quantity of exchange media, no state-sponsored central bank, no legal barriers to the entry, branching, or exit of commercial banks, no government restriction on interest rates or bank asset and liability portfolios, and no government deposit guarantee. Furthermore, the government doesn’t have motivation and sufficient financial resources to ensure the solvency of any bank. Contrary to what people might have imagined, free

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banking was not a synonym of banking panics. Individual banks did fail occasionally in the free banking era, but there did not seem to be major banking panics and crises. Some banks did fail, but usually it was not because of bankers’ fraudulence or recklessness. One important reason for bank failure in that period was that banks succumbed to the political authority by extending loans in an inappropriate way. For example, some banks with international business in Britain lent money to British aristocracy under political pressure without daring to ask for collateral. Some British aristocrats simply defaulted on loans to escape liability.

The Scottish experience of free banking in the 18th and 19th centuries presents a classic example of how market discipline can stabilize the banking system. In the absence of government regulation, market generates effective mechanism in disciplining bankers’ behavior. Virtually all bank owners carried unlimited liabilities: all but three of Scotland’s banks operated with unlimited liability during the free banking era. This contributed to banking stability by removing risk-taking tendency on part of bank owners. Bankers made very careful decisions and risk management to avoid financial risk contagion. To protect itself from any spillover effects from other banks’ difficulties, each bank attempted to establish a distinct brand-name identity and reputation, and held as little of other banks’ liabilities as possible.

Late Nineteenth and Twentieth Century Over a period of time, different economies depending upon their stage of development and the specific constraints, formulated and developed national regulatory systems. At the same time, financial liberalization was also becoming popular. To strengthen bank regulation and supervision following financial liberalization often requires the government to choose alternative regulation instruments and methods to monitor banks. Unfortunately, in reality, many countries didn’t establish complementary banking regulations, and as a result suffered from financial turmoil in the wake of financial liberalization. Prominent among these were the Savings & Loans Associations Crisis in US, Chilean and Mexican Crisis, etc.

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When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for harmonizing bank regulation among industrial countries, at least for large internationally-active banks in these countries.

The harmonization was

intended both to enhance safety by reducing the likelihood of individual failures that could spread the adverse effects across national boundaries and to provide for a more level playing field, so that banks in different countries would not benefit from any competitive advantages due to subsidies from their governments, such as lower capital ratios in an environment of explicit or implicit deposit insurance or other government support. In large measure, the call for such transnational regulation reflects both the limited market discipline on banks in most countries because of the existence of actual or conjectural government guarantees and the greater difficulty in monitoring banks in non-home jurisdictions by both private stakeholders and government regulators.

This resulted into a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with active international banks. In June 1999, the Committee issued a proposal for a New Capital Adequacy Framework (Basel II) to replace the 1988 Accord. Following extensive interaction with banks and industry groups, the revised framework was issued on 26 June 2004.

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1.5.2 Commercial Banking System Commercial banking system consists of a network of banks which provide a variety of banking services to the individuals and the businesses in the economy. The commercial banking systems may be of two types:

Commercial Banking System

Unit Banking

Branch Banking

1.5.2.1 Unit Banking System Unit banking involves provision of banking services by a bank in a limited local area. Sometimes, unit banks are also permitted to have branches in a limited area. The unit banks are connected through correspondent bank system which provides for the transfer of funds between unit banks. The advantage of unit banking is that it facilitates the mobilization of deposits and their deployment for needs of the local community where the bank is located. Unit banking gave way to branch banking system due to the following reasons: Economic interdependence among various states Infrastructure development Growth of big business firms Mobility of population Increasing emphasis on convenience

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1.5.2.2 Branch Banking System In Branch banking system the bank has a head office which controls and directs the branches located in multiple locations. The branches may be located in the same city, same state, across states, or even across countries. The head office as well as the branches are under the control of the same board.

Branch banking offers the following advantages:

Facilitate the allocation of savings to their most efficient use across the nation irrespective of their origin i.e. savings may originate at different locations and may be deployed at different locations.

Diversifications of risk as risks are spread over an entire range of commercial assets

Leads to uniform structure of interest rates

Facilitates the penetration of best banking services to the far flung areas of the nation

A major drawback of the branch banking system is that there is excessive centralization and branches have to look up to the head office for many issues. Further, in branch banking the personnel may also get relocated to various branches during their employment with the bank and if they are from a different area or state, they may not be aware of the special problems faced by the locals/natives of that area/state.

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1.5.3 Classification of Commercial Banking Services Commercial banking activities may be classified into:

Commercial Banking Activities

Retail Banking

Wholesale Banking

Universal Banking

1.5.3.1 Retail Banking Retail banking refers to the mobilization of deposits from individuals and providing loans to individuals and small businesses. Retail banking is characterized by large volume of small value transactions. For example, the deposit accounts, personal loans to individuals, credit cards, home mortgage loans, etc come under retail banking.

1.5.3.2 Wholesale Banking Wholesale banking is also known as business to business banking. It refers to the transactions between banks and large customer like corporates and government involving large sums of money. It also includes the transactions between banks. It includes general lending to businesses as well specialized services like mergers and acquisitions advisory services, leasing, investment management services, etc.

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1.5.3.3 Universal Banking Universal banking is the combination of retail and wholesale banking. It includes activities like general deposit taking and lending, trading in financial assets, brokerage services, investment management, insurance, foreign exchange transactions, etc.

1.6

Structure of Financial System

A typical financial system consists of :

• Financial Markets • Financial Instruments • Financial Institutions

Financial System

Financial

Financial

Financial

Markets

Instruments

Institutions

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Types of Financial Institutions Financial Institutions consist of organizations like banks, finance companies, etc. Depending on the degree of specialization and the type of activities performed, financial Institutions can be classified into the following broad categories:

Regulatory Institutions Financial Intermediaries, and Other Institutions

The regulatory institutions supervise the functioning of the various institutions and markets in the economy with a view to regulate and develop the financial system as a whole. The financial intermediaries on the other hand help in channelizing the flow of funds in the economy from surplus/saving units (individuals as well as corporates) to deficit units in the economic system.

Financial intermediaries play an important role of channelizing the flow of funds in the economy. They can be further classified into:

Depository Institutions Non-Depository Institutions

Depository Institutions

These institutions play an important role in the development of the financial markets. These institutions play an important role in channelizing the savings in the economy. Depository institutions mainly include: Commercial Banks, Savings and Loan Associations, and Credit Unions Commercial Banks - These are depository institutions which are in the business of deposit taking and lending. They provide a range of products and services for individuals as well as businesses.

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Savings & Loan Associations – These institutions provide savings account facilities and are also into mortgage lending. Many of them provide a range of services similar to a commercial bank.

Credit Unions - These are not-for-profit financial cooperatives that offer personal loans and other consumer banking services

Commercial banks, savings & loan associations and credit unions together hold a large share of the nations’ money stock in the form of various types of deposits and help in their transfer to effect payments. They also lend these funds directly to individuals and businesses for a variety of purposes and also lend them indirectly through investment in financial instruments.

Non-Depository Institutions These institutions perform a variety of functions other than banking. The following are the common types of non-depository institutions:

Finance Companies Mutual Funds Security Firms – Investment bankers, brokers and dealers Pension Funds Insurance Companies

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In this chapter, readers will be introduced to the types of deposit accounts. The payment system is the backbone of the banking business, and readers are introduced to the types of payment systems which facilitates the transfer of funds between accounts. The retail lending process is covered next. Retail assets will be covered in the next module. This module, also covers the topic of wealth management, and discusses the typical products offered in by the wealth management practitioners.

2 Introduction to Retail Banking Commercial banks perform two functions as financial intermediaries in the economic system:

Commercial Bank Functions

Deposit Function

Loan Function

Deposit Function – Banks act as intermediaries between the surplus or saving units and the deficit units in the economic system. They obtain deposits from savers by offering various types of deposits. These deposits:

Are in variety of denominations, interest rates and maturities Are risk free as they are insured Are highly liquid

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Loan Function – The deposits are used to make loans to individuals and businesses for a variety of purposes. The difference between the interest rate earned on these loans and the interest payable on deposits is the bank’s income (known as the Spread).

Retail Banking is typical mass-banking in which the local branches of banks perform deposit and loan functions by offering various services like savings and checking accounts, mortgages, personal loans, debit cards, credit cards, etc. to individual customers

2.1

Types of Deposit Accounts

A deposit account is an account at a bank that allows money to be held on behalf of the account holder. The account holder retains rights to their deposit.

Typically, the bank will loan the money out at interest to other clients. It is this process which allows banks to pay out interest on deposits.

There are different types of deposit account which differ on the basis of their conditions of withdrawal. Broadly deposit accounts are of two types:

Deposit Accounts

Savings Account

Current Account

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2.1.1 Savings Account Savings Account provides deposit services to the individuals. Banks pay a nominal interest rate (3-4% pa) on this account. The savings account can be with check facility or without a check facility. Depending on whether it is with or without check facility the minimum balance that is to be maintained in the account varies. There are restrictions on the number of withdrawals from this account.

2.1.2 Current Account This can be opened in a way similar to the savings account. There is no restriction on the number of withdrawals from this account but the bank also does not pay any interest on the balance maintained in this account.

2.2

Overview of Lending Process

Retail lending is one of the key businesses of commercial banks. The process of lending consists of two processes:

Loan Origination and Loan Servicing

2.2.1 Loan Origination The process of validating customers, convincing them that the bank is the right source for their loan requirement and finally offering the loan with terms and conditions that make business sense to the bank is called Loan Origination.

Loans are offered to customers for all purposes. For example, customers can avail finance for buying vehicles, small consumer items or houses. They can also avail loans for personal use such as education, holiday, travel, etc. Loan origination process differs for various loan types or portfolios as it is referred to sometimes. Each loan type has its characteristics such 27

as volumes, ticket size, expected turn around time, etc. For example the ticket size of a consumer loan is very small where as the ticket size of a home loan is big. This adds to the complexity of loan origination processes. Bank officials catering to various loan types need to have the knowledge and training of the business. Similarly, the systems supporting these businesses need to cater to specific aspects of various loan types.

Important Phases of Loan Origination

Loan origination caters to processes right from the time the customer walks into the bank with a request for loan, till the time the loan is finally disbursed. Three major phases of loan origination are:

Information Collection, Credit Appraisal and Sanction, Disbursement

Tracking the turnaround time (TAT) and performance of the process is an underlying phase that runs across the application processing cycle and is critical for monitoring and profitability.

2.2.1.1 Information Collection The processes revolve around two key aspects. Critically appraising the credit worthiness of the customer and analyzing the risk in lending. It is necessary to capture all the information required to cater to these aspects. Demographic, employment, financial details are a must for processing. To minimize the risk, it is necessary to check that the customer is not a fraud or black listed within the bank or with other institutes. It is also important to verify that the information supplied by the customer is correct and authentic. Banks achieve this mostly through external agencies. Another method of validation of information is to collect and verify documentary proofs for income, residence, age and other information.

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As a factor of loan amount and the financial product, bank may request for co-borrowers or guarantors to support the loan. This may be required as a risk mitigant. Banks collect fees for processing, documentation, and administration, from customer as part of application processing.

2.2.1.2 Credit Appraisal & Sanction The second phase in loan origination is credit appraisal and sanction. Credit officers scrutinize the information made available to them and arrive at the loan eligibility and fix the terms and conditions to be offered to the customer. This is an important phase in the origination cycle as decisions made here affect the health of the portfolio. Incorrect decisions increase the risk and may add to bad debts affecting the portfolio performance.

2.2.1.3 Disbursement The third phase is disbursement. Either a check for the sanctioned amount is issued to the customer, or the amount is transferred to the customer account. A repayment schedule stating the amortization is prepared for the customer.

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Each loan type will go through the three phases with some variations.. Consumer loans are generally small ticket and thus low risk loans. The process for credit appraisal may be minimized to adopt auto sanction. On the other hand, home loans are generally high-ticket long-term loans with high risk and may go through multiple appraisals before sanction. Similarly Personal loans may have single disbursement, where as loans for under construction homes may have multiple disbursements. Consumer and auto loans have assets to back the loan where as personal loans have no asset. Risk is typically mitigated with a collateral.

Type

Ticket Size

Associated Risk

Auto Loans

Medium

Low

Consumer Durable Loans

Small

Medium

Home Loans

Big

Low

Credit Cards

Medium

High

Loans against Shares

Medium

Medium

Personal Loans

Medium

High

Loan origination process may vary across countries also. Retail lending is a new trend in developing countries but most of the developed markets have well-established processes evolved over the years. Thus historical data is available with banks and credit bureaus to firm up the risk policies based on behavioral patterns. Developing countries are in the process of assimilating data and need to rely on verification process for information reliability. Most of the developed countries have evolved credit scoring models which has still not been possible for banks in other countries due to lack of historical data.

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2.2.2 Loan Servicing Once the loan is disbursed, the process of managing the repayments from customers and responding to the customer requests for pre payments, early settlement, rescheduling, etc. is known as Loan Servicing. The important phases of loan servicing phase are:

Collection phase Recovery phase

2.2.2.1 Collection Phase This involves the collection of scheduled payments as per the terms and conditions of the loan agreement. This requires that the loan accounts are properly and continuously monitored to find out the payments becoming due in any month. The collection department then follows up with the borrowers to remind them about the loan repayment falling due and request for timely repayment.

2.2.2.2

Recovery Phase

In case the loans become bad due to delayed repayment or non-payment, the recovery department comes into action to recover such loans. The recovery process may differ from bank to bank but usually involves verbal follow up, written follow up and legal action against the defaulted borrowers.

2.3

Credit Appraisal in the Retail Market

The techniques for credit appraisal can broadly be classified into two categories: Traditional Approaches Modern Approaches

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2.3.1 Traditional Approaches The traditional approaches focus on some broad parameters to determine whether the credit worthiness of the borrower. One of the common traditional approaches is the Expert System or the Five Cs approach.

Expert System or Five C's of Credit

Every credit proposal, howsoever, small or big, is backed by an entrepreneur. Every project which may be considered technically feasible, economically viable and financially sound may run into difficulties if it is not backed by a competent person who understands the risk and is willing to take and manage them. Thus, the man behind the project is always the key to understanding the risk in a credit application. Confidence is the basis of all credit transactions. This is cornerstone of every credit application. A lack of confidence in the management leads to an outright rejection of the credit proposal. The basis of this confidence is generally derived from the 5 ‘C’s of the borrower i.e. character, capacity, capital, collateral and conditions. In addition to the 5 C's reliability, responsibility and resources are also looked into for gaining the confidence.

2.3.1.1 Character Character is the greatest and the most important asset, which is assessed first. It is the character of the borrower, which indicates his intention to repay and is key, even if a borrower has the capacity and capital to repay a loan. A questionable integrity would make every banker shun him, even if backed by sufficient collaterals.

Character of a borrower is constituted by honesty, sobriety, good habits, personality, the ability and willingness to keep his word under all circumstances, reputation of the people with whom he deals etc.

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2.3.1.2 Capacity It deals with the ability of the borrower to manage an enterprise or venture successfully with the resources available to him. His / the management team’s educational, technical and professional qualifications, antecedents / the past track record of the enterprise, present activity, experience in the line of business, experiences of the family, special skill or knowledge possessed by him / the collective knowledge base of the enterprise, his past record etc. would give a insight into his capacity to manage the show successfully and repay the loan.

2.3.1.3 Capital It is the amount of owned funds involved in the business as well as his ability to meet the loss, if any, sustained in the business or venture from his own investment or capital without shifting it to his creditor or banker. Unless a borrower has some stake in the business, he may not take much interest in its success.

2.3.1.4 Collateral Collateral refers to the security provided by the borrower in a credit transaction. The fact that the collateral may be seized by the bank acts as an motivator to the borrower to repay the loan as per the terms and conditions of the loan agreement.

2.3.1.5 Conditions Conditions mean the external factors which are beyond the control of the borrower but which may affect his ability to repay the loan. These include economic, social, political, competitive and technological conditions. Though these are not under the control of the borrower, it helps to judge the sensitivity of the borrower to changes in these conditions. If the borrower is too sensitive to any of these conditions his repayment capability may be adversely affected as a result of adverse changes in conditions.

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2.3.2 Modern Approaches The modern approaches for credit appraisal are statistical in nature. These approaches are more objective as they are based on some statistical model. One of the commonly used approach is credit scoring.

Credit Scoring Traditionally banks were using the method of analyzing the financial statement of the applicants by which the bank was able to evaluate the applicant’s capacity to pay back the loan. Though the applicant may be financially sound to pay, it was very difficult to identify whether he or she has the ‘willingness’ to pay the loan.

When the demand for consumer credits in retail market is fast increasing, banks must have a system by which they are able to process the credit applications professionally and at the same time to identify the potential default risk of the borrower.

Most of the banks presently use credit-scoring model to evaluate the loan applications they receive from consumers. Banks, Credit card providers, mortgage lenders and other loan providers develop their own internal credit-scoring model on retail lending and use these models to evaluate their applicants. With the introduction of credit scoring models in the banks, often the customer can phone in with a loan request and within the shortest possible time, bank can convey their decision calling back the customer.

Usually the credit scoring systems are based on discriminant models or related techniques in which variables are used jointly to establish a numerical score or ranking for each credit applicant. If the applicant’s score exceeds the prescribed and defined cut off level, the loan

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application is likely to be approved for credit. If the credit scoring is below the cutoff level, credit is likely to be denied.

2.3.2.1 Credit evaluation using a credit-scoring model Basic concepts of using such scoring models by the banks are to identify the financial, economic and motivational factors that separate good loans from bad loans by observing large group of customers who had borrowers in the past. The same factors may hold in future also with certain percentage of deviation. These underlying assumptions may go wrong if abruptly there is change in the economic and other unforeseen factors. Because of this reason, credit-scoring systems are frequently updated with the current events and retested and revised with the identified current sensitive predictors.

For example, a credit-scoring model can have the following factors: a) Age b) Marital status c) Number of dependants d) Telephone in home or apartment e) Length of stay at the current address f) Status of Housing g) Occupation or line of activity h) Length of service in the current job i)

Bank accounts held

j)

Credit rating

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Each factor has different individual parameters with different score. For example, ‘Status of Housing’ can have the following parameters:

Status of Housing

Score

a) Own home

5

b) Rental home or

3

apartment c) Staying with friends /

2

relative

Likewise, each factor can have a set of identified parameters with assigned score. With the assigned score under each parameter, bank will be able to arrive at the highest and the lowest scoring.

For example, if the bank finds that, out of the customers with a credit score of 30 or less, 90% defaulted and out of the customers with a credit score of 60 or more only 10% defaulted, the bank may use these scores as cut-off limits for identifying the score above which it will lend. If the bank is able to use the data and able to arrive at the optimal break point i.e., cutoff level they can minimize their loss due to bad loans. If credit scoring, model is properly implemented bank is able to remove personal judgment from the lending process and reduce decision taking time considerably. However, the credit-scoring model needs to be flexible and dynamic. The scoring model should allow the bank to change the weightings on various parameters going into the model, to adjust to changing behaviour patterns of the customer demography.

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While implementing a credit-scoring model, banks cannot use certain factors like race, gender, religion, sex and other discriminating factors prohibited by statute or courts. In the USA, a customer can sue a bank under federal anti-discrimination laws like Equal Credit Opportunity Act.

2.3.2.2 Advantages of Credit-Scoring: Able to handle large volume of credit applications quickly with minimum manpower Reduces the operating cost for processing the applications and improving the quality of appraisal system Standardizing loan appraisal system & ensuring the soundness of the system Allowing inexperienced loan officers also to process the applications Controlling selection of risky borrowers Ensuring compliance of regulatory issues Reducing bad debts Improving the profitability

2.3.2.3 Disadvantages of Credit-Scoring: It requires frequent verification of information about the customer to keep the score updated. Such information typically includes the behaviour pattern of their repayments and borrowings with other financial institutions. Inflexible credit scoring system can drive away good borrowers and spoiling bank’s reputation.

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2.4

Retail Payment System

The availability of bank accounts (current or savings) facilitate the transfer of money amongst individuals ,corporates and merchants via paper and electronic instruments. These instruments mitigate risk of carrying cash and also ensures that money can be sent/ received across distant locations. In addition, loans and repayments are made via these bank accounts which necessitate the availability of a mechanism to transfer funds across accounts. The retail payment system is the backbone to faciliate these transfers. The instruments used are traditional paper based instruments (Cheques) and electronic transfers (ECS, Credit Transfers, Debit Transfers). We shall explore some of these transfer mechanisms in the next section.

Payment system facilitates settlement of financial transactions. Retail payment system is used by individuals for paying their bills and receiving funds into their bank accounts.

Retail payments usually involve transactions between consumers and businesses. Although there is no definitive division between retail and wholesale payments, retail payment systems generally have higher transaction volumes and lower average dollar values than wholesale payments systems. This section provides background information on payments typically classified as retail payments. Consumers generally use retail payments in one of the following ways:

Purchase of Goods and Services—Payment at the time the goods or services are purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending machines), and remote purchases (e.g., Internet and telephone purchases). A variety of payment instruments may be used, including cash, check, credit, or debit cards.

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Bill Payment—Payment for previously acquired or contracted goods and services. Payment may be recurring or nonrecurring. Recurring bill payments include items such as utility, telephone, and mortgage/rent bills. Nonrecurring bills include items such as medical bills.

P2P Payments—Payments from one consumer to another. The vast majority of consumer-to-consumer payments are conducted with checks and cash, with some transactions conducted using electronic P2P payment systems. For example, Paypal, Yahoo Direct, C2IT, etc. are some of the popular P2P payment systems.

Cash Withdrawals and Advances—Use of retail payment instruments to obtain cash from merchants or automated teller machines (ATMs). For example, consumers can use a credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash from an existing demand deposit or transaction account. Consumers can also use personal identification number (PIN)-based debit cards to withdraw cash at an ATM or receive cash-back at some point-of-sale (POS) locations.

2.4.1 A Standardized Payments Model The clearing and settlement process for retail payments can be represented using a standard four-corner payments model as follows:

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While the flow of information, data, and funds is different for each payment instrument, there is a common set of participants for retail payments. The initiator of the payment (payer or consumer), is located in the upper left-hand corner of the diagram. The recipient of the payment (payee or merchant) is in the upper right-hand corner of the diagram. The bottom two corners of the diagram represent the relationship of the consumer and merchant to their financial institution. In some cases, third-party service providers act on behalf of financial institutions. The payments networks or clearinghouse organizations that route the transactions between financial institutions are in the middle of the diagram.

2.4.2 Types of Inter-bank Transfers There are two basic types of inter-bank transfers: Credit transfers and Debit transfers.

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2.4.2.1 Debit Transfer In a debit transfer, a payer sends a payment instrument, usually a check, to a payee. The payee then deposits the check in its bank, which collects the check through the inter-bank payment system. Hence, the payee has a provisional credit to its account; contingent on the check being honored upon presentment. The risk is that the payer (the counterparty) does not have sufficient funds to honor the check. Only when the check clears is the payee free from the counterparty risk.

2.4.2.2 Credit Transfer In a credit transfer, the payer notifies its bank to transfer funds to the account of the payee in the payee’s bank. Thus, the recipient of the communication, the payee’s bank, does not need to worry about counterparty risk. Either the payer has sufficient funds to make the transfer, or the payer’s bank advances sufficient funds to make the transfer.

There are a number of different payment networks that have evolved over time. These include the following:

Check Payments System Automated clearing House (ACH) System Debit and Credit Card System

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2.4.3 Check Payment System Check is similar to a bill of exchange. A bill of exchange is a kind of promissory note without interest and is a written order by one person (drawer, maker, payer) to pay another (payee) a specific sum on a specific date sometime in the future. The bank making the payment is known as the drawee bank or the paying bank.

Payer/Drawer

Payee

Drawee Bank

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Check payment system is a debit transfer system. The check payment system does not function through a single channel. When a payee receives a check, he or she deposits it in a bank. That bank then has a number of choices available to collect the check:

It is possible that the payer and payee do business with the same bank. In that case, balances are shifted on the books of that bank, and there are no inter-bank transactions. This is known as an “on-us” transaction, in which there is no delay in settlement. Also, the processing costs are lower.

The bank of first deposit may decide to present the check directly to the bank on which the check is drawn. This occurs in situations where two banks are in close proximity and have a lot of bilateral transactions. This is known as a “direct send.”

The bank of first deposit may present the check to a local clearing house, an arrangement whereby a number of banks agree to meet for the purpose of presenting checks to each other and settling the net differences at the end of an agreed-upon period.

The bank of first deposit may avail itself of the services of another bank—a correspondent bank—to collect the check on its behalf.

The diagram below depicts the typical inter-bank check clearing and settlement process through a Central Bank or Clearinghouse. The steps are as follows:

Step 1: The consumer uses a check to pay a merchant for goods or services.

Step2: The merchant, after authenticating the check, accepts the check for payment. At the end of the day, the merchant accumulates the checks and deposits them with its financial institution for collection. Depending on the location of the paying institution, the funds may not be immediately available.

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Step 3: For deposited checks payable at other financial institutions, the merchant’s financial institution sends the checks to the clearinghouse. Step 4:. At the clearinghouse, the cheques are exchanged. Merchant’s financial institution will hand over all the cheques they have collected drawn upon the other members of the clearing, and collect all the cheques drawn on themselves. Thus the consumer’s check will go back to the consumer’s financial institution and the consumer’s account will be debited. Step 5, 6 & 7: In case sufficient funds are not there in the consumer’s bank, the check is returned.

Check Clearing and Settlement Consumer

Merchant

(Payer)

(Payee) 1

Clearing 7

House

Financial Institution/Third Party

2

6

5 4

3

Financial Institution/Third Party

Attempts are being made to make the check clearing and settlement more efficient through the “electronification” of checks. This will require the development of electronic systems which use the check as a device to trigger a debit transfer on Automated Clearing House (ACH) network. For example, when a merchant receives a check in payment for goods or services, instead of depositing the check in the familiar process, the merchant uses a 44

terminal to scan the information on the bottom of the check (the “MICR” (Magnetic Ink Character Reader) line) and the amount of the sale. The merchant then returns the check to the customer with the word “void” printed on it and informs the customer that the check amounts to authorization for the merchant to initiate a debit transfer transaction through the ACH network.

Another advance in the check clearing process is Check Truncation. In check truncation, a digital image of the check will move electronically through the process. This will eliminate the physical transportation of checks and allow the images to be retrieved as needed by customers to show evidence of having made payment.

2.4.4 Automated clearing House (ACH) System This is an electronic batch-processing electronic payment system for small- value payments. Unlike the large-value payment systems (Fedwire3 and CHIPS4), which process only credit transfers, the ACH system processes both credit and debit transfer payments. Financial institutions participate in the ACH system as either originating depository financial institutions (ODFI) or receiving depository financial institutions (RDFI) or both. Originators and receivers are customers. The originator prepares a file of transfers, delivers it to the ODFI, and the ODFI delivers the data to the ACH operator, who then transmits the information to the RDFI, who either credits or debits the account of the receiver depending on the nature of the transaction.

3

A wholesale wire transfer system operated by the Federal Reserve System. Primarily it is used for transferring reserve account balance of depository institutions, high value domestic payments, inter-bank transfers, third party transfers and high value inter-corporate payments. 4 This is a private electronic funds transfer system operated by large private banks in New York for international movements of funds. Financial transactions like foreign/domestic trade services, international loans, syndicated loans, foreign exchange sales/purchases, etc. are done through CHIPS. Domestic EFT (Electronic Funds Transfer) payments are also done through CHIPS. 45

The diagram below depicts a typical ACH credit transaction. In this example, the payer is the employer and the payee is the employee. The ODFI is the employer’s financial institution and the RDFI is the consumer’s financial institution.

ACH Credit Clearing & Settlement

The steps in this process are as follows: Step 1: The payee authorizes an employer to deposit his or her paycheck through direct deposit.

Step 2: The employer submits its direct deposit payroll ACH files to the ODFI.

Step3: The ODFI verifies the files and submits them through the corresponding ACH operator.

Step 4 & 5: The ACH operator routes the transaction to the payee’s financial institution. The financial institution makes the funds available to the payee by crediting his or her account.

Step 6: The ACH operator settles the transaction between the participating financial institutions.

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The diagram below depicts a typical ACH debit transaction. The example considered here is that of a recurring monthly insurance premium remittance.

ACH Debit Clearing & Settlement

The steps in this process are as follows: Step 1: The payer sends the ACH payment information and authorization to the payee, in this case an insurance company.

Step 2: The payee submits this information to its financial institution.

Step 3: The payee’s financial institution routes the transaction to an ACH operator.

Step 4: The ACH operator routes the transaction to the receiving financial institution.

Step 5: Funds are made available to the payee and the payer’s account is debited.

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Step 6: The ACH Operator settles the transactions between the participating financial institutions.

2.4.5 Debit and Credit Card System The networks of this system have evolved from automated teller machine (ATM) networks or are owned and operated by a few major card organizations, primarily VISA and MasterCard.

ATM was one of the first electronic banking applications. Whether it can be considered as a payment system is questionable. This is so because the vast majority of transactions are cash withdrawals in which the customer and the bank interact, but there is no third or fourth party to the transaction. However, this application does allow the customer access to cash, which is a payment alternative, and in that sense the banking system is allowing the customer to have efficient access to using cash to make payments.

As the deployment of ATMs continued, some banks started networks that allowed customers of other banks to access their accounts. This required someone, usually a large bank at the outset, to operate a “switch” that would route transactions among the various banks participating in the network. The basic idea was to enhance customer convenience by expanding the locations at which access was available. In addition, networks allowed banks to take advantage of scale economies in processing by increasing the potential number of transactions per machine. Over time these networks expanded and merged.

As these networks expanded, they negotiated reciprocity agreements with other networks, effectively expanding the reach of any single customer’s ATM card. As the ATM networks expanded, it became apparent that they could be used for other transactions as well. Thus, the ATM networks evolved into the point-of-sale (POS) networks accessed by debit cards. Within the debit card industry, there are two types of transactions. One is an on-line transaction activated by a PIN at the point of sale, with immediate debiting of the customer’s account and crediting of the merchant’s account. All this information travels

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over the same networks as the ATM transactions, and there are fees involved for the merchant, who is charged on a fee-per-transaction basis. There are also point-of-sale transactions that are known as off-line, signature-based transactions. In this case, the information flows over the credit card networks managed by Visa or MasterCard. In the online transaction, there is a PIN to identify the cardholder, whereas in the offline transaction the merchant is responsible for verifying the identity of the cardholder. In the off-line transaction, there is also a delay in transferring the funds, and, most importantly, there is a difference in the fee structure - the merchant is charged a fee based on the size of the transaction, and the fees to the bank are generally larger in that case.

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2.5

Private Banking or Wealth Management

Wealth management is defined as a comprehensive service to optimise, protect and manage the financial well being of an individual, family or corporation. Its basic definition covers advice on loans, investments and insurance to give a broad picture of how individuals should best deploy their financial resources. A broader picture may include tax advice, estate planning, business planning, and other financial needs.

Wealth management means taking care of the needs of clients, their families and their businesses as part of a long-term, consultative relationship. It’s best conceptualized as a platform where a number of different sets of services and products are provided. It’s a fullservice model, which can offer advice on investment management, estate planning, retirement, tax, asset protection, cash flow, and debt management.

Wealth Management is the next step in financial planning. It challenges advisers, especially those with high-net-worth clients, to bring together all aspects of a client's financial life into a single plan-from investment advice to estate planning to long-term-care insurance. The components, and the methods of approaching them, vary as widely as the number of practitioners who are moving into this area.

As any professional financial planner, the wealth manager's focus is the client. His efforts are devoted to assisting clients achieve life goals through the proper management of their financial resources. While the money manager may not necessarily know about the background information his client, the wealth manager will know all of this, as well as the client's goals and fears. The practice of the wealth manager is holistic and individually customized. It is holistic because there is very little about the client's global fiscal life that is not important information.

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Wealth management is a broader term than Investment management.

Investment management is the science of choosing investments — such as stocks, bonds and derivatives — and combining them in a way that respects a client’s specific risk-to-reward needs. It is also frequently called “money management” or “asset management.” On the other hand, the Wealth Management process is founded on the values of the client first. What is important to them? What goals do they have and how do they want to accomplish them? What is their timeline for implementing these values and accomplishing these goals? Answering these questions will establish the foundation upon which the wealth manager and client work together.

Wealth management is an ongoing process. It involves keeping track of the needs of the clients and their changing definition of success. Constant attention should be paid to the portfolio and performance of investment should be monitored.

A wealth manager examines a client’s financial situation then suggests a combination of banking and investment services that best addresses their unique wealth management issues. These include:

• Current lifestyle needs. The income a client needs for living, the needs of their children and short- or long-term goals.

• Legacy goals. To whom the client wants to entrust their money and how much control to bestow upon potential heirs.

• Philanthropic pursuits. The charities a client would like to support as well as when and how they wish to gift their money or assets (a decision that determines any tax benefits to the client).

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• Income tax considerations. The timing of stock or bonds purchases and sales might affect total tax liability, or the form in which money is gifted to others, triggers taxes due.

Constructing a Financial Plan There are three basic steps in establishing and maintaining any sound financial plan:

•

Determining client’s needs or customer profiling First step is to set the financial goals before start working towards them. Everyone who has aspirations for the future—such as buying a house or saving for a child's education—needs a detailed plan to make those dreams a reality. Effective financial planning is a process that first requires the answers to several important questions from the client:


What is the client saving money for (i.e. car, house, college education, retirement, etc.) and how much do you want to save?




What is the client’s timeline for achieving these goals?




What are the client’s investment preferences?




Does the client consider himself/herself a conservative or an aggressive investor?

•

Building the plan Next, step is the need to choose overall investment strategy and the specific investment vehicles that will help best to achieve client’s goals. A variety of investment types—including stocks and bonds, life insurance and annuities—all have a place in the overall plan. It's important to understand these options and how they can help to achieve success. Before selecting the best mix of investments for client’s portfolio, the bank will seek an answer from the client to several factors so as to develop overall investment strategy: •

The length of time the client plans to invest the funds.

•

The availability of emergency cash.

•

The preferred risk level for investment choices.

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•

The client and the bank’s past experience investing in different financial options.

•

The client’s current income tax rate.

Ongoing management All successful financial portfolios require constant attention and monitoring—as goals and needs evolve, so too should the investment mix.

Changing role of wealth manager Wealth management is becoming an extremely important part of financial services. Wealth management requires a more comprehensive relationship with a customer. Therefore, the relationship involves more trust and requires the wealth manager to be more intimately involved with customers' overall facts, financial circumstances and risk profile. It will require spending more time with each customer and their broader needs, whether those needs are for mutual funds, life insurance, annuities, asset management or long-term care. More importantly, the future will be about retirement income; creating appropriate personalized "draw-down" strategies for people who will need to live off those assets for 25 or 30 years.

Advice given by wealth manager cannot be static--it needs to be dynamic because individuals' circumstances change over time.

Because of the rapidly changing nature of the financial markets, most wealth management accounts are managed on a “discretionary” basis. This means that the wealth management firm makes specific buy and sell decisions on behalf of clients (according to their risk-toreward needs), while frequently informing them of portfolio decisions and performance updates. The investment manager has a fiduciary responsibility to manage clients’ assets prudently and according to established goals and guidelines. This fiduciary role is a legal duty to make portfolio decisions in the clients’ best interests.

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On the other hand, in a ‘non-discretionary’ investment authority given to the wealth manager to acquire, manage, and dispose off the assets on behalf of the client is limited. There are controls imposed on what actions the wealth manager can or cannot take without prior approval of the client. Typically in the non-discretionary relationship, the wealth manager acts according to an investment strategy that is agreed upon by the wealth manager and the client. However, the wealth manager may not have the authority to purchase or dispose of any assets, or implement major investment decisions, without the prior review and approval of the client.

Importance of KYC in Private Banking Supervisors around the world are increasingly recognising the importance of ensuring that their banks have adequate controls and procedures in place so that they know the customers with whom they are dealing. “Know Your Customer” (KYC) policies are most closely associated with the fight against money laundering. Especially as Wealth Management deals with large value transactions, KYC is more critical in this business.

Certain key elements should be included by banks in the design of KYC programmes. Such essential elements should start from the banks’ risk management and control procedures and should include (1) customer acceptance policy, (2) customer identification, (3) on-going monitoring of high risk accounts and (4) risk management. Banks should not only establish the identity of their customers, but should also monitor account activity to determine those transactions that do not conform with the normal or expected transactions for that customer or type of account. KYC should be a core feature of banks’ risk management and control procedures, and be complemented by regular compliance reviews and internal audit. The intensity of KYC programmes beyond these essential elements should be tailored to the degree of risk.

All well run private banking operations have written "Know Your Customer" policies and procedures that require banking organizations to obtain identification and basic background

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information on their clients, describe the clients' source of wealth and lines of business, request references, handle referrals, and identify red flags and suspicious transactions.

2.5.1 Products in Wealth Management The main products being offered to the wealth clients by the private banking group are: •

Portfolio Management Services (PMS)

•

Mutual Funds Investment

•

Insurance Products

•

Equity

•

Fixed Income instruments

Derivatives are less popular given the risk involved. Real Estate is specially popular with HNWIs. Art and commodities are also becoming popular asset classes.

Portfolio Management Services (PMS): PMS is one of the popular products offered to wealth clients. The bank provides advisory services to the client to better manage the portfolio of the client. The service may be ‘discretionary’ or ‘non-discretionary’.

Mutual Fund Investment: The bank advises the client regarding investment in mutual funds. Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.

Insurance Products: This is an important financial planning product used by wealth managers. They offer various insurance policies to their clients to cover the risks facing the client adequately.

Equity: This is the most important asset class from the point of view of yield enhancement. Wealth managers usually advise their clients to remain invested in this asset class for a longterm.

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Fixed Income instruments: These are the bonds/debentures issued by corporates or by government. These are debt instruments and help the client in earning interest periodically over the life of the bond and getting back the principal at the time of maturity. Wealth Management Poised to Grow Private banking is emerging as an important segment of business for some banks and non-banking financial companies (NBFCs) in India. Banks and NBFCs say there has been an increase in the number of private banking or wealth management clients they are dealing with today. Foreign banks, which mostly cater to high net worth individuals, with financial surplus or investible incomes of over Rs 2 crore per year, say that this segment is expected to grow by almost 20 per cent over the next couple of years. The recently released study, 2005 World Wealth Report, by Capgemini and Merrill Lynch, indicating that the number of High Net Worth Individuals (HNWI) in India grew at 14.6 per cent, twice that of the world's growth of 7.3 per cent in 2004, augurs well for some of these banks. DSP Merrill Lynch caters to 450 HNWI families, which is an increase of 50 per cent over last year. ABN Amro had about 500 client groups in 2000 and plans to target 3,000 to 4,000 client groups every five years. Sensing the potential in this segment, HSBC, too, has thrown its hat into the ring and launched its private banking operations in India in May 2005. Wealth management is a fast evolving domain with tremendous growth opportunity in India. In the current interest rate and taxation environment, more individuals are seeking professional management of their finances. As the economy grows and the GDP grows, the potential for the growth of this business is huge. We offer all solutions from cradle to grave like banking, investment, tax management, legal solutions and transmission of wealth to the next generation. Such a client is typically a promoter or an owner of a small medium enterprise, a topranking official with employee stock options, a professional such as a lawyer or an NRI. The services would normally comprise investment under assets such as equity, mutual funds, debt, insurance and specialised services such as estate management. The asset allocation plan is formed after taking into account risk appetite and time horizon of each client. Regular monthly or quarterly review of the client's portfolio is also part of the service providers' job. Customisation is the key. Source: Business Line, June 11,2005

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This chapter discusses the Wholesale Banking Business, by covering the fee and non-fee based products in the business. Cash Management and Trade Finance are introducted to the readers. The Lending Process is also discussed at a high level.

3 Wholesale Banking

Wholesale banking is also known as business-to-business banking. It refers to the transactions between banks and large customer like corporates and government involving large sums of money. It also includes the transactions between banks.

The aim of Wholesale Banking is to meet requirements of corporate clients by offering a full range of banking products and services, which include:

•

General Lending

•

Structured Finance

•

Debt Capital Market Instruments and Equity Capital Market Instruments

•

Export Finance

•

Treasury Products

•

Payments and Cash Management

•

Asset Based Finance

These products and services can be broadly classified into two categories: •

Commercial Credit Products, and

•

Fee Based Products & Services (Transaction Banking Services)

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Wholesale Banking

Commercial Credit Products

Non-Credit Fee Based Products

All of these products and services are important. However, lending is the crucial activity for any bank. Most of the commercial credit products are in the form of loans.

3.1

Commercial Credit Products

Banking is defined as the “accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawable by checks, draft, order or otherwise."

The very definition of banking stresses the importance of lending function, when it defines banking as 'Borrowing for the purpose of lending'. Hence the basic objective of bank is presupposed to be lending.

Banks need to deploy funds borrowed from the public to be able to pay the contracted returns to the depositors. The most important source of deployment of funds & earning revenue as interest and commission is through lending. The banks act as intermediaries between the depositors and borrowers.

Lending, which is also called as ‘extending credit ‘ by Banks, may take the form of fund based or Non fund based products, based on the fact whether the Banks lend funds to the borrowers or provide their guarantees on behalf of customers.

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Commercial Credit Products

Fund Based

3.2

Non-Fund Based

Fund Based Credit Facilities

When a bank agrees to lend money to a borrower, either against a tangible security or not, but against a borrower’s promise to repay the amount at a future date, with interest for the amount used for the period, is a form of fund based lending.

Most of the commercial credit products are in the form of loans. Loan is a comprehensive term used to refer to the various types of short, medium and long term credit facilities made available by banks. Loan is a contractual agreement between the borrower and the lender of the funds which states the underlying terms and conditions such as loan amount, repayment period, rate of interest, penal provisions for breach of the contract, etc.

The fund Based lending may be via any or a combination of the following products: •

Lines of Credit

•

Revolving Loans

•

Term Loans

•

Export-Import Finance

•

Factoring

•

Syndicated Loans/Club Loans

•

Bills Discounting

Banks set limits for each of these product types. This limit determines the maximum amount that the borrower can borrow under the given product. The actual borrowing can therefore

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be different from the limit. The actual borrowing amount is called the ‘drawing’ or ‘drawdown’ or ‘utilisation’ under the product.

3.2.1 Lines of Credit A Line of Credit allows a company to borrow up to a pre-fixed amount called the credit limit for short-term business requirements. This allows borrowers to obtain a number of loans without re-applying each time as long as the total of borrowed funds does not exceed the credit limit. The bank usually charges some amount of fee as well as interest on such borrowings. A Line of Credit can be secured or unsecured. If secured, the customer is required to offer some collateral security to cover up the borrowing. In case, the customer fails to repay, the bank may take charge of the collateral. The collateral is usually "shortterm" assets, such as receivables and/or inventory.

It can also be by way of an overdraft where a 'credit limit' up to the amount to be lent is set in the current account. It may be a ‘Cash Credit Account', where the bank lends against the security of stocks5 or receivables6 up to a certain limit in a form of checkable account7 allowing multiple withdrawals and deposits as per his business needs. The interest is payable only on the utilized amount.

3.2.2 Revolving Loans Unlike a Line of Credit, a Revolving Credit is firm commitment by the bank to lend up to a certain amount until a specific maturity date (up to five years). The duration of a commitment to lend against a revolving loan is therefore longer than a Line of Credit. This commitment is subject to a loan agreement containing mutually agreeable terms and conditions. Revolving credits are to be paid in full at maturity, and the revolving credit line 5

Inventory of raw materials, semi-finished goods or finished goods.

6

Money owed to the company by the customers who purchased the goods on credit.

7

A bank account on which a check may be drawn.

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can be re-used again for a fresh borrowing, if required. A fee generally is charged for a Revolving Credit commitment. This is a monthly charge from 0.25% to 0.50% per annum on the average daily-unused portion of the committed amount.

3.2.3 Term Loans Terms loans are normally given for financing the long-term assets such as buildings, equipment, leasehold improvements, etc. Term loans are unlike Lines of Credit or Revolving Credit as its repayment does not allow the borrower an automatic right to re-borrow the unused credit limit (unused credit limit = Limit for Term Loan – Drawing under the term loan). The interest rate can be either fixed or floating. If it is fixed, it remains constant for a certain time period after which re-fixing is done. For example, if the repayment period is 15 years and re-fixing is to be done after every three years, the interest rates will remain fixed for a period of 3 years and after every 3 years, the interest rate for the next three year period is determined and fixed. In case of floating rate loans, the interest rate is linked to a benchmark and the rate of interest on the loan keeps changing depending on the changes in the benchmark.

The term loan can be of two types: •

Short-term loan

•

Long-term loan

Short-term loan as the name suggests is given for a shorter period and the purpose of such a loan is meet the short-term requirements. It differs from a line of credit in that it is taken for a specific purpose and a fixed amount of money is usually borrowed for a given time period and interest is payable on the lump sum amount.

Long-term loans on the other hand, are loans which are taken for a long period of time, say 5-10 years and usually the purpose is acquire some fixed asset or expansion of the existing facilities, etc. Interest is payable periodically (say at the end of each quarter). Principal

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repayment can occur at the end of the term loan (bullet repayment) or periodically during the tenor of the term loan

3.2.4 Syndicated Loans/Club Loans A syndicated loan/club loan is an arrangement between two or more banks to provide a term loan (either short term or long term) to the borrower using common loan documentation. This arrangement is usually opted for when the amount required by the borrower is huge and exceeds the exposure limits of a single bank. The lead manager/banker of the syndicate is given a mandate by the borrower, which details out the commercial as well as legal terms of credit.

In a syndicated loan, all the lenders have a common position relative to the borrower. Each lender lends only the amount it has agreed to. If any bank in the syndicate fails to fulfill its obligation, the other banks are not legally bound to make up the difference. In the event of default, banks may also take legal action against the borrower either independently or jointly as specified in the contract.

Bank A

Borrower Bank B

Bank C

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3.2.5 Export-Import Finance Also known as trade finance, financing of exports and imports of goods and services is an important activity of wholesale banking. These loans are normally provided by the designated trade promotion bank in the country. For example, in India, Export Import finance is provided by Exim Bank of India. In US, it’s the Export Import Bank of the USA. The services provided include loan guarantees 8 to help U.S. exporters obtain working

8

A guarantee that in the event of default by the borrower, the guaranteeing bank will repay

the loan.

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capital loans to finance the raw materials used in preparing the goods to be exported, export credit insurance to cover risks of the default of a buyer in providing a payment, and medium-term and long-term financing for international buyers.

3.2.6 Factoring This is also known as account receivables financing. Account receivables represent the funds which are owed by the customers of a company to the company. Usually, every company has a credit policy according to which a credit period is allowed to the customers buying on credit. The customers are expected to make the payment on or before the end of the credit period. As a result, some of the company’s funds remain tied up as ‘money to be received from customers’ or accounts receivables. In order to free such funds, a company may approach a bank and pledge9 its receivables. The bank will then credit the client’s account with the value of the receivables less some charge which represents the interest on the amount for the period between purchase date and due date of such receivables. The company will repay the bank on the receipt of the receivables.

3.2.7 Bill Discounting Whenever there is a financial transaction, a bill of exchange is generated. It is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to or to the order of a specified person, or to bearer.

3.2.7.1 Parties in a Bill of exchange Drawer: The person who gives the order is called the drawer. Drawee: The person thereby required to pay is called the drawee. 9

A deposit of personal property as security for a debt. In case of pledge of receivables, the

company will entitle the bank to be the rightful owner of the company’s receivables.

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Payee: The person to whom the money is payable is called the payee. Endorsee: The person to whom a bill is transferred by endorsement is called the endorsee. Bearer: The holder (the rightful holder) of a negotiable instrument Holder: The generic term holder includes any person in possession of a bill who holds it either as payee, endorsee or bearer.

A Bill of Exchange can be payble either at sight or after a given pre-specified period (called usance period) A bill of exchange is payable on demand if it is expressed so in the instrument or if the instrument is due for payment as per the time period expressed in the instrument. In calculating the maturity of bills payable at a future time, three days, called days of grace, must be added to the nominal due date of the bill. For instance, if a bill payable one month after sight is accepted on January 1, it is payable on February 4, and not on February 1 as its tenor indicates. A Bill of Exchange is transferable i.e. the holder of a bill of exchange (the holder receives the money on a pre-specified date from a counterparty) can transfer the bill of exchange by endorsement10 to a new holder.

In bill discounting, the bank purchases the bill from its client before the bill is due for payment (the customer endorses the bill in favour of the bank, and the bank becomes the holder of the bill). The bank credits the amount to the client’s account after deducting a charge called the discount charge. The discount charge basically represents the interest on the amount given to the client from the date of purchase of the bill till the due date of the bill.

Bill discounting may be done by the bank on a recourse basis or a non-recourse basis. If it is done on a recourse basis, it implies that the bank can approach the client and ask for payment if the counterparty fails to make payment on the due date. If it is done on a non-

10

The legal transfer of title of a document by signature, usually, but not necessarily, on the

reverse.

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recourse basis, it implies that the bank cannot approach the client in case of non-payment on the due date. Comment [PKS1]: A better diagram please!!

Sample Bill of Exchange

Comment [DB2]: Done

First of Exchange (Second Unpaid) and Second of Exchange (First Unpaid) In practice, it is not uncommon that two drafts are drawn on the drawee bank in a letter of credit (L/C) to ensure that at least one draft reaches the drawee when they are dispatched separately.

3.3

Structuring of Loans

Loans can be structured in a variety of ways depending upon the need of the borrower and the lender. The structuring is done with respect to the interest rate payable and the repayment arrangement.

3.3.1 Fixed Rate Vs Floating Rate Loans can be fixed rate loan or floating rate loans depending upon the interest rate payable on the loans. In case of fixed rate loans, the interest rate is fixed at the time of loan origination and remains constant during the life of the loan. Such loans are preferred by the borrowers when the interest rates in the economy are expected to move up.

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In case of floating rate loans, the interest rate on the loan is linked to some benchmark like LIBOR11 (London Inter-bank Offer Rate). E.g. the interest rate can be expressed as LIBOR + 1%. For example, a ten year loan can be priced at LIBOR + 1%, payable six monthly and fixed six monthly. In this example, the interest rate for the first six months is determined by the value of LIBOR + 1% at the time of disbursing the loan. The determination of the interest rate for the next six months is done at the end of the first six months. Depending upon how the LIBOR changes, the interest rate on the loan will also change. Such loans are preferred by the borrowers when the interest rates are expected go down. This is graphically represented below:

11

This is the interest rate at which banks can borrow funds, in marketable size, from other

banks in the London interbank market.

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3.3.2 Types of Repayment Loans can have different types of repayment arrangements also depending upon the requirements of the borrower. The common types of repayment arrangements are as follows:

•

Equal Periodic Installments

•

Stepped Up Installments

•

Bullet Repayment

•

Deferred Repayment

Equal Periodic Installments This is the most common type of repayment option usually offered by banks and other financial institutions to their borrowers. In this type of repayment arrangement, the borrower is required to repay an equal amount at periodic intervals (which may be monthly, quarterly, semi-annually or annually) to the bank. This payments from the borrower goes towards meeting the payment of interest as well as the amortization of the principal outstanding.

As can be seen from this structure, the payments stay constant at 4.39 per month. However, as time progresses, the share of principal repayment in 4.39 increases.

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Stepped Up Installments In this type of repayment arrangement, the installments payable on the loan are gradually stepped up or increased. To begin with the amount of installment is less, however, with time the amount keeps on increasing either by the constant amount or by a constant percentage. This type of repayment arrangement is preferred by borrowers who expect an increase in their income over a period of time.

Bullet Repayment In this type of repayment arrangement, most of the repayment is made on the maturity of the loan (known as balloon or bullet installment)

Deferred Repayment In this type of repayment arrangement, the repayment starts only after a given period of time after disbursement. For example, a the repayment may start only six months after disbursement and then continue for the entire life of the loan. The deferred repayment can be further structured as equated periodic repayment, or stepped up repayment or even a bullet repayment arrangement.

3.4

Concept of Default

All loans carry a credit risk. Credit risk may be defined as the chance of counterparty or borrower failing to fulfill its contractual obligations. When the borrower fails to repay the loan in a timely manner or does not repay at all, a default is said to have occurred. Default may be a willful default (when the borrower intentionally does not repay the loan) or a compulsive default (when some factors, internal or external to the business lead to a default). Since default may take place on every potential credit, every credit decision requires an assessment of credit risk or probability of default.

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3.5

Non-Fund Based Credit facilities

The form of lending which does not involve deployment of funds at the initial stages is classified as Non-fund based lending.

The Non fund Based lending may take the following forms:

3.5.1 Letter of Credit or Documentary Credit A Letter of Credit (L/C) is a financing vehicle that essentially substitutes the credit strength of the bank for that of a company. This product is typically used in financing and securing purchases goods between companies. An L/C is issued by a bank, at the insurance and responsibility of a buyer of goods, to the seller of goods. The L/C indicates that once the goods are received by the buyer, the seller can raise bills of exchange against the buyer and in case the buyer does not pay, bank issuing the L/C will make the payment.

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3.5.1.1 Processing of establishing a Letter of Credit / Documentary Credit STAGE I Importer and the overseas seller while finalizing the commercial contract decide the terms of payment. Since the overseas seller is not fully aware about the financial capacity of the importer, insists a bank to undertake the payment obligation on behalf of the buyer and payment should be made available to him immediately on dispatch of goods from his country.

On the basis of this agreement importer (Applicant) requests his bank (Issuing Bank) for undertaking the payment obligation on his behalf in favor of the overseas seller (beneficiary). The arrangement under which a bank undertakes the payment obligation on behalf of the importer, subject to fulfillment of certain documentary conditions, is known as Documentary Credit or Letter of Credit. •

To comply with the payment terms prescribed in the commercial contract for establishing a documentary credit in favour of the overseas seller, importer submits an application to his banker.

•

Issuing Bank, after checking the credit status of the their importer customer establishes the documentary credit in favour of the overseas seller (beneficiary)

and forwards the documentary credit to its Correspondent

Bank (Advising Bank) in the Seller's country, with a request for advising the documentary credit to the Beneficiary with their authentication. •

Correspondent bank12 receives the documentary credit from the Issuing bank and advises the credit to the beneficiary.

There are two possibilities at this stage:

12

Bank that accepts deposits of, and performs services for, another bank (called a

respondent bank); in most cases, the two banks are in different cities

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In case the issuing bank’s financial status is not acceptable to the overseas seller who is the beneficiary in the documentary credit, may request the importer for establishing a documentary credit, which should be payable by a bank in the seller’s country. Importer requests Issuing Bank to make suitable arrangements with a bank in the overseas seller's country for payment to the overseas seller on submission of prescribed documents. In such cases, the Issuing Bank requests a bank in the overseas seller’s country or in any third country with whom they have prior arrangement, for undertaking the payment obligation on their behalf for this transaction. This bank may agree for this arrangement subject to their relationship/arrangement with the Issuing Bank.

If they agree for paying the

beneficiary they are known as confirming bank.

Thus, overseas seller is holding an instrument known as documentary credit by which his payment risk on the importer is secured. Issuing bank by extending this product to the importer facilitates the importer for conveniently managing his imports.

Establishing Documentary Credit

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STAGE II Step 1: The beneficiary after shipping the goods presents the prescribed documents for payment to the confirming bank Step 2: On receipt of the documents, the Confirming Bank scrutinizes the documents thoroughly and if the documents are drawn in order without any discrepancy makes payment to the exporter/beneficiary of the LC. Step 3: Confirming bank dispatches the documents to the Issuing bank.

Step 4: Issuing bank on receipt of documents from the confirming bank, scrutinizes the documents and reimburses the confirming bank and debits the importer.

Step 5: Issuing Bank sends the documents to the importer for collection of payment

Step 6: Importer makes the payment to the issuing bank

Negotiation of Documents under Confirmed Credit

Thus, documentary credit is one of the prominent instruments, which helps the importer to import the consignment from the overseas seller even though he does not know the seller. Under wholesale banking this is one of the products, which is aggressively marketed by commercial banks under import finance.

Documentary credit transactions are regulated by the guidelines issued by International Chamber of Commerce (Paris). This set of guidelines are known as Uniform Customs and

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Practice for Documentary Credits (UCPDC) ICC 500. ICC 500 is the publication number. More than 150 countries have agreed to issue and operate the documentary credit transactions under this set of guidelines. Disputes relating to documentary transactions are settled through UCPDC ICC 500

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3.5.2 Types of LCs There are various types of letters of credit available such as: •

Revocable

•

Irrevocable

•

Confirmed

•

Back-to-back

•

Standby

•

Revolving

3.5.2.1 Revocable A revocable LC can be amended or cancelled at any time by the importer without the consent of the exporter. This option is not often used, as there is little protection for the exporter. By default all LCs are irrevocable, unless otherwise stated.

3.5.2.2 Irrevocable An irrevocable LC once issued can only be changed or cancelled with the consent of all the parties. The seller must merely comply with the terms and conditions of the LC in order to receive payment.

3.5.2.3 Confirmed LC A confirmed LC is one which has an additional confirmation from some other bank in addition to the issuing bank. The confirming bank takes an obligation to pay exists even if the issuing bank defaults.

3.5.2.4 Back-to-Back LC The original letter of credit is used as security by the exporter to open another credit in favour of the exporter's own supplier. The bank issuing the original L/C may not necessarily be the issuing bank of the second L/C.

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3.5.2.5 Standby Credit Similar to a normal letter of credit, this differs in that it is a default instrument, whereas a normal L/C is a payment instrument. A standby credit is only called upon in the event of the applicant’s failure to perform.

Standby letter of credit is very similar in nature to a bank guarantee. Standby credits were first developed by banks in United States after World War II and enable domestic banks to compete with foreign banks in international business transactions. It is an alternate to guarantee bonds because of legal restrictions on banks from issuing guarantees. Japanese banks also issue Standby credits for similar reasons.

Standby credit differs with traditional letter of credit. In a traditional credit the beneficiary is entitled for payment once he is able to submit the documents prescribed in the credit within the stipulated time. In Standby credits the beneficiary is eligible for payment from the issuing bank when the applicant fails to perform his obligation.

A Letter of Credit is a simple payment mechanism. Rather than a buyer promising to pay seller, a buyer / account party (applicant) has an issuer promise to pay a seller / beneficiary: payment is expected to occur through the issuer. In contrast, the 'standby' letter of credit is merely a backup. The beneficiary makes proper demand upon the issuer only if the account party (applicant) fails to pay or perform."

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Sample Irrevocable Standby Letter of Credit (Date) ISLC No.

Expire Date:

State of Idaho Department of Lands Statehouse Boise, ID 83720 Dear Sir/Madam We hereby establish our Irrevocable Standby Letter of Credit in your favor for the account of (Name of Plan, Permit, or Lease Holder) to the extent of U.S. Written Amount ($ Numerical Amount). Drafts are payable at sight when presented to (Name of Bank or Other Institution) and must bear (Plan, Permit, or Lease Number). It is a condition of this Letter of Credit that it shall be automatically extended without amendment for additional periods of one year from the present or future expiration date hereof unless one hundred and twenty (120) days prior to such expiration date we shall notify you, in writing, via certified mail, return receipt requested, that we elect not to renew this letter of credit for such additional period. Upon receipt of such notice, the balance of the Letter of Credit may be drawn upon prior to its expiration date by your clean draft drawn at sight on us presented at the Office of the (Name of Bank or Other Institution). Drafts drawn under this credit must bear the following clause: "Drawn under (name of bank or other institution), Letter of Credit No. , dated ," and the amount of each draft must be endorsed hereon. Unless otherwise expressly stated, this credit is subject to the "Uniform Customs and Practice for Documentary Credits (1993 Revision) International Chamber of Commerce Publication No. 500" or by subsequent Uniform Customs and Practice fixed by subsequent Congresses of the International Chamber of Commerce. We hereby engage with the drawers, endorsers and holders in due course of drafts drawn under and in compliance with the terms of this credit that such draft(s) will be duly honored on presentation to the drawee bank.

Sincerely, Bank Signature Title

In short, standby credit is a document which:

a) The Issuer, usually a bank b) At the request of its customer, applicant c) Agrees that the beneficiary will be paid d) Before the credit's expiry e) Upon the beneficiary's presentment of

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i. Its demand for payment and ii. Any documents evidencing the applicant's non-performance or default

This gives the applicant an opportunity to specify the documents that are to be presented by the beneficiary for claiming payment. In most of the cases it will be a certificate of default of payment by the importer / applicant on due date.

This is one of the most convenient facilities preferred by the importer client and also the overseas seller. Under this arrangement, importer client can get the consignment directly from the overseas seller. Bank undertakes to pay the overseas seller only in case of default by the importer. Less number of documents are called for in this transaction.

Step 1: Goods are dispatched to the buyer

Step 2: Buyer fails to make the payment

Step 3: On default by the buyer, the beneficiary presents the prescribed documents for payment to the confirming bank

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Step 4: On receipt of the documents, the Confirming Bank scrutinizes the documents thoroughly and if the documents are drawn in order without any discrepancy makes payment to the exporter/beneficiary of the LC.

Step 5: Confirming bank dispatches the documents to the Issuing bank.

Step 6: Issuing bank on receipt of documents from the confirming bank, scrutinizes the documents and reimburses the confirming bank and debits the importer.

Step 7: Issuing Bank sends the documents to the importer for collection of payment

Step 8: Importer makes the payment to the issuing bank

3.5.2.6 Revolving LC This type of LC allows for the L/C to be automatically reinstated under certain circumstances. It is normally used where shipments of the same goods are made to the same importer.

In a Revolving Credit the amount of drawing is re-instated and made available to the beneficiary again unto the agreed period of time on notification of payment by the applicant or merely on submission of documents. The maximum value and period unto that the Credit can be revolved is specified in the Revolving Credit. The re-instatement clause and the maximum amount of utilization under the credit are incorporated in Revolving credit.

If the importer wants to import a specified material from the overseas seller for a specified period at regular intervals, this type of credits are useful. To illustrate, importer customer has placed an order for importing certain raw materials from Japan and the contract for import is for one year on monthly basis. Every month importer imports material worth of

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USD 250,000. His annual consumption is USD 3,000,000. Overseas seller insists for entering into one-year contract and also wants the transaction to be covered under letter of credit.

Importers bank established a letter of credit for USD 250,000 for a validity period of 12 months. At the same time, it is also specified in the credit that this credit will be available on monthly basis, twelve times during the validity period and the total utilization under this credit should not exceed USD 3,000,000.

Under this arrangement importer is able to receive continuous supply of raw materials for the contracted period of one year.

Instead of opening documentary credit for each

transaction every month, one set of credit opened at the commencement of the contract remains valid till one year.

Importer saves time for opening documentary credit for 12

times. Every time when the credit is reinstated, bank charges reinstatement charges instead of Credit opening charges.

3.5.2.7 Deferred Payment Credits When the importer client wants to import capital goods for a project and overseas seller has agreed for payment under deferred terms such as, 10% advance payment, 80% after 12 months from date of shipment and the remaining 10% after one year of successful commissioning of the equipment, the bank which offers documentary credit facility to their client, establishes

a credit undertaking their payment obligation on deferred basis.

Payment is not made in one instant; it is deferred at three stages, in the above example. This product is offered to the clients who have large value of equipment imports.

3.5.2.8 Acceptance Credits Under this product, credit issuing bank’s liability comes into force only after acceptance of drafts drawn on them. The payment has to be made by the issuing bank on the due date, typically three months ahead. Documentary credit stipulates that bill of exchange or draft to be drawn as one of the documents and it is to be drawn on the credit-issuing bank.

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Credit issuing bank on receipt of the documents at their counters under their credit, examines the documents and if in order accepts the bill of exchange and communicates the due date on which they are to reimburse the sellers bank.

3.5.3 Guarantee Bank guarantee (BG) is guarantee given by a bank for a business. Thus a bank guarantee implies a promise by the bank to repay the outstanding amount of an individual or a business if that individual/business fails to repay his debt. BGs are generally used as collaterals by corporates. When any business wants to enter into a financial transaction with counterparty, the counterparty may insist that a bank guarantee is put in place. Bank guarantees may be issued for domestic as well as foreign business purposes.

This is a document issued by the bank on behalf and at the request of a customer to third party for fulfillment of terms of contract as agreed between them.

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Sample Bank Guarantee Date Issuing Bank’s Name & Address Re: (Counterparty's Name) Dear Sir/Madam This letter will serve as your notification that (Bank name) will irrevocably honor and guarantee payment of any check(s) written by (Customer's name) up to the amount of (Amount Guarantee) and drawn on Account Number (Customer's account number). This guarantee is for the purpose ____________________. This guarantee shall remain irrevocable throughout the event, and no stop payment will be issued. Sincerely, ___________________________________________ Bank Officer's Signature and Title

Types of Guarantees Different types of bank guarantees issued by a bank are as follows:

3.5.3.1 Tender Guarantee This is usually issued for an amount equal to between 1 and 2 percent of the contract value. It gives the beneficiary compensation for additional costs if the party submitting the tender does not take up the contract and it must be awarded to another party.

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3.5.3.2 Performance Guarantee Normally issued for an amount equal to between 5 and 10 percent of the contact value, this guarantee assures payment to the beneficiary in the event that the contractor fails to fulfill contract obligations.

3.5.3.3 Advance Payment Guarantee This enables the beneficiary to get a refund of advance payments made in the event of default by the contractor. It is issued for the full amount of the advance payment, but may contain reduction clauses, which enable a reduction in the maximum amount upon evidence of progressive performance.

3.5.3.4 Retention Money Guarantee Most major projects call for stage payments as work progresses. Often the beneficiary retains a percentage of the payment (retention money) from the contractor, as cover for any hidden defects in the completed work. A retention money guarantee allows for immediate release of retention money to the contractor.

3.5.3.5 Facility Guarantee This is normally not trade related. Its purpose is to provide security to another bank to advance money to an individual or company. It is often used when a company does not have any credit record and wishes to expand offshore.

3.5.3.6 Maintenance Guarantee This ensures that the contactor does not abandon the contract after completion of the construction phase, but continues to honor any maintenance obligations as per the original agreement.

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3.5.3.7 Customs Guarantee Contractors often need to import equipment temporarily to carry out a contract. Import duty would normally be payable, but the customs authorities will grant exemption if the contractor undertakes to re-export the equipment on completion of the contract. The contractor then has to provide the customs authority with this guarantee, which prevents the contractor from selling the goods in the domestic country, instead of re-exporting them.

3.5.3.8 Shipping Guarantee This enables the buyer to obtain release of the goods from the carrier, despite the bill of lading13 being lost or delayed.

3.6

Non-Credit Fee Based Products/Services

The non-credit fee based services also known as transaction banking services offered by banks include:

13

•

Cash Management Services

•

Trade Finance

•

Treasury Products

A document which is issued by the transportation carrier to the shipper acknowledging

that they have received the shipment of goods and that they have been placed on board a particular vessel which is bound for a particular destination and states the terms in which these goods received are to be carried. Separate bills of lading are issued for the inland or domestic portion of the transportation and the ocean or air transportation, or a through bill of lading can be obtained covering all modes of transporting goods to their destination.

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3.7

Cash Management Services

Cash is an asset with unique features. On one hand, it is an idle asset as it does not generate any returns if left alone. On the other hand, keeping too little cash may cause liquidity problems for any organization.

Banks would like to hold less idle cash for the same reason. However, holding too little cash may result into: •

Deposit runs by individuals, if they feel that it does not have enough cash for withdrawals.

•

Liquidity problems and increased borrowing costs.

Similarly, business organizations need to manage the cash properly for the same reasons. Business organizations have receivables from and payables to various counterparties which are spread out far and wide geographically. Managing outstation collections and payments can be very time consuming and expensive.

Given this, the fundamental goal of cash management is to forecast the cash needs accurately and to arrange for the various sources of cash at minimum cost. Banks provide a wide range of cash management services to their customers to put them in a position of control as far as their cash needs are concerned.

Due to the extensive networking and MIS requirements, many banks may not be in a position to offer the cash management services. However, those who offer will definitely enjoy competitive advantage over others. It creates a ‘win-win’ situation for both the bank as well the customer. Customers are more satisfied as their receivables are collected speedily into their accounts. Banks get access to ‘float’ funds. ‘Float’ is defined as the funds in the process of collection. Float arises as there is time gap between the moment a check is written and the moment the funds get credited into customer’s account. If bank can monitor the

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float funds on a continuous basis, these can be deployed profitably by the bank’s treasury. In the competitive environment in which the banks are operating these days, this additional return can significantly affect the bottom line of the bank.

Banks offer a wide range of cash management services (CMS) to their customers. The cash management services offered by banks can be divided into two set of services. These are: •

Collection Services

•

Payment Services

As a result of developments in information technology and MIS banks can provide these services very efficiently. These services help in providing liquidity to the client and at the same time lower the cost of funds to the banks. CMS helps in speeding up the collection process and reducing the collection time for the clients as well as help in making payments across various locations with ease.

3.7.1

Collection Services or Receivables Management

One of the important banking activities is that of collection and payment of checks. Corporates route their funds transfer for the purpose of payment for business transactions via banks. This is so because the various parties to a business transaction for a corporate may be spread geographically and need not be in the same location. Through collection services, banks offer customers an efficient mechanism for collection of funds from their buyers. The buyers of the customer products may deposit their checks payable to the customer at the various branches of the bank across diverse locations. If the bank does not have a branch at any location, it usually has a tie up with other banks which have branches in such locations. These banks are called as Correspondent banks and they help in collecting and realizing the checks from the buyer on behalf of the main bank.

The common collection services are: •

Check Collection Services: This service uses the extensive network of a bank either on a standalone basis or via a tie up with other banks (correspondents) to help corporate collect funds from their outstation cheques. 86

•

Lock-box service: In this service, the bank provides collection boxes at various locations in the city where the checks favoring the customer are collected. The box is operated by the bank and the bank gets the contents of the box removed several times during the day and deposits the checks into customer’s account.

•

Electronic Bill Payment and Presentation (EBPP): EBPP enables the customers to offer an electronic interface for distribution of invoices and receiving payments for their bills. However, while this is a collections service for the bank’s customer, EBPP will be a payment service offered by the customer to its customers. For example, a bank may offer a EBPP service to a utility company (a collection/ receivables management service), but for the customers of the utility company who use the EBPP platform, this is a payments service.

•

Tax-collection services: Under this facility banks accept payment of income taxes, sales tax, customs duty, etc. from their customers on behalf of the government. This is a collection service for the government, but a payment service for the customers.

3.7.2

Payment Services/ Payables management

Payment services are a counterpart of collection services. Payment refers to the means by which financial transactions are settled/paid. The common payment services include:

•

Payroll services: Banks provide payroll processing facilities to the small business clients which help in reducing the fixed costs of maintaining a payroll processing department by the business.

•

Overdraft: This facility is provided by banks to their business customers whereby even if adequate funds are not available in the account of the customer, the incoming

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checks are still cleared by the bank. This facility could be offered, both for payables as well as receivables management.

Collection as well as payment services require an efficient payment system. An efficient payment system accelerates the flow of liquidity in the economy.

The payment system can be of divided into two types:

•

Retail Payment System

•

Wholesale Payment System

Retail Payment System - This is used by individuals for paying their bills and receiving funds into their bank accounts.

Retail payment system in the United States makes extensive use of paper checks. About 50 billion checks are processed every year. However, credit card and ATM transactions are also popular.

Wholesale Payment System – This is used by businesses and governments for handling large value domestic and international transactions.

Clearing of payment instructions/ checks occurs through the check clearing/ ACH clearing mechanism described earlier (give section 2.4.3 & 2.4.4, page 41)

3.7.3 Benefits of CMS 1. Reduction in Interest Costs: The collection services provided by banks result in receipt of funds by the customers into their account with the banks in very short period of time. This means reduced interest costs for the customer. In addition, the 88

banks might provide funds to their customers a little later than they receive funds from the check clearing. This provides banks with zero-interest money, which brings down the average interest cost for the bank.

2. Increased Liquidity: Since funds get collected quickly, it results into enhanced liquidity for the customer.

3. Ease in Reconciliation: Customers can obtain detailed information about the instruments like checks, demand drafts, etc. collected by their bank. This results into ease in reconciliation of their books with the bank’s books.

4. Better Customer Service: Since CMS offers so many benefits to the customer, it translates into more satisfied customers and hence a larger customer base.

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3.8

Trade Finance

Global markets have opened up and trade and financial services are moving freely from one country to other and banking services are becoming more responsive to such rapid changes. Inputs and accessories can be sourced from country A, assembling and manufacturing can be done in country B, Seller may be in Country C and the ultimate user or the consignee can be in country D and the financing institution can be in Country E. This is become possible today since borders are not the barriers for movement of goods or finance or manpower.

3.8.1 Role of Banks

Banks are offering variety of products under wholesale banking to their clients, starting from assisting their client financially for importing accessories or raw materials from any country and funding their working capital requirements for their manufacturing activities and extending credit against their receivables.

Under wholesale banking, banks are also

offering risk management solutions to corporate clients to mitigate credit risk protection against the default of the buyer, political risk cover for the country exposure and currency risk management against the currency exposure.

For example, if a client wants to expand his production capacity and enlarge his client’s list to different countries he may require following financial solutions from their bank:

• For expansion of their production / manufacturing capacity they may like to avail loan facilities to import / buy capital equipments and modernization expenses.

Credit

facilities can be of medium or long-term requirements and it can be either in home currency or in foreign currency.

Their bankers locally or through their foreign

correspondent banks abroad can arrange foreign currency loan at a competitive international interest rates.

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• For importing equipments or accessories, bank can establish letter of credit or standby credit or guarantees or bankers acceptance facility in favour of the overseas suppliers. • For working capital expenses to meet any export obligations, bank can sanction export credit facilities either by themselves or through any of the global credit agencies like EXIM Bank. • Once manufacturing activities are over and sales starts banks can discount clients receivable by offering receivable management solutions. • Credit risk insurance is offered by insurance agencies to protect the default risk of the buyers. Instead of involving two agencies one for allowing credit and another agency offering insurance for managing credit risk, bank can offer a wholesale product like factoring or forfeiting whereby bank can allow credit facilities against the receivables and also offer credit protection i.e., insurance against the default of the overseas buyer. • Besides, banks can offer buyers credit to the overseas buyers.

Ultimately, the client is able to reduce the cost of funding by availing the cheapest trade finance from their banks and also able to manage the attendant risks opting appropriate instruments.

Trade Finance Products

•

•

Import Financing 

Documentary Collection



Letter of credits



Bankers Acceptance facility



Standby Credits Discussed earlier in section 3.1, page 85)



Guarantees

Export Financing 

Export LC advising

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Export LC confirming



Transferable letter of credits



Export documents collection



Export financing – working capital facilities



Export financing – receivable financing



Buyers credit



Line of credits



International factoring



Forfaiting

3.8.2 Import Financing 3.8.2.1 Documentary Collection This is a product where the bank acts as a conduit between the importer and the seller, by handling the transport and related documents and releasing the documents to the importer on the availability of funds/ promise to pay the funds on a specified date.

The process for documentary collection is graphically represented below:

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Step 1: Overseas seller submits the documents to the remitting bank. Step 2: Remitting bank forwards all the documents to the collecting bank. Step 3: Documents are presented to the buyer or the importer of goods. Step 4: Importer makes the payment to the collecting bank when the bank presents the documents. The importer will then receive the documents, which will entitle him to collect his imported goods from the transport agency. The importer is not entitled to the goods unless the payment has been made to the bank. Step 5: Collecting bank transfers the payment received from the importer to the remitting bank. Step 6: The Bank, which receives the payment from the importer, will transfer the amount collected to the overseas seller.

Bank, which offers this collection product to his importer client, does not undertake any responsibility for payment.

Bank acts as an agent for collection.

Importer has an

opportunity of verifying the documents and ensures that he makes payment only after the consignment has landed in his country.

Bank acts as an intermediary and helps the

importer to ensure landing of consignment in his country.

3.8.2.2 Establishing Documentary Credits Establishing letter of credit on behalf of the importer is one of fee-based business a bank undertakes. Under this arrangement importer’s bank undertakes the payment obligation behalf of the importer to the overseas seller on certain conditions. Conditions are always relating to presentation of prescribed documents. When the overseas seller is not fully aware about the financial states of the importer, importer’s bank gives undertakes the payment obligation of the import subject to submission of prescribed documents by the overseas seller. This has been covered in the fee-based products offered by the bank (Discussed in Section 3.5.1, Page 69)

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3.8.2.3 Bankers’ acceptance facility Under import financing, bank approves a line of credit to the importer.

Under this

arrangement the bank is prepared to accept the bill of exchange drawn by the overseas seller on them on account of their importer. When the overseas seller supplies the materials to the importer, he also agrees for this arrangement by which importer’s bank pays the overseas seller on the due date.

3.8.2.4 Shipment Guarantees When the importer wants to take delivery of the consignment under a bill of lading or any transport documents he has to produce the original transport document to the transport agency. At times the consignment might have landed in his country before the documents are received through the banking system.

Shipping company will not deliver the

consignment unless the importer consignee produces original transport document.

To

avoid delay in clearing the goods from the shipping company without producing original transport document, importer requests his bank to issue a guarantee on his behalf in favour of the shipping company.

Under this guarantee, the bank indemnifies the shipping

company for any loss that may be incurred by the shipping company in releasing the consignment to the consignee (importer) without submission of original documents.

Under wholesale banking, bank sanctions this shipping guarantee facility to the importer as one of their services.

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3.8.3 Export Financing Banking services under export financing can be under two stages. Services that are offered to a client till the shipment of goods are known as pre-shipment credit facilities. Facilities under this stage help the exporter client:

To receive the authenticated documentary credit through his bank from the overseas buyer – Advising of documentary credits. To get the credit confirmed thereby securing a payment undertaking from the confirming bank on behalf of the overseas buyers bank, (i.e., Issuing Bank) - Confirming of documentary credits Arranging to transfer the documentary credit, which was received in favour of his subsupplier enabling him to procure the inputs from his vendor – Handling transferable credits Allowing working capital facilities assisting the exporter with credit facilities enabling the exporter to execute his export orders in time - Pre-shipment finance Arranging to collect the payment from the overseas buyer through collection mechanism – Documentary Collection Extending receivable financing against the export documents tendered by the exporter on the overseas buyer – Receivable Financing Extending credit facilities to the overseas buyer – Buyers Credits. Extending credit to overseas financial institutions for the purpose of on lending to their clients – Line of Credit. Providing credit protection (credit insurance) in case if the buyer defaults to pay the exporter. International Factoring / Forfaiting.

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3.9

Lending Process

The process of lending begins even before a loan is made. It is required that the loan officer/credit manager ensures that the loan is in agreement with the loan policy of the bank. Since it is not feasible by the board to oversee each and every loan proposal that is received by the bank and take a credit decision, usually all banks have a written loan policy. Loan policy sets out standards for exposure limits for industry/company/individuals, credit quality of the borrowers, lending rates, acceptable risk level, etc. The loan policy of a bank comprises of the following components:

a. Loan Objectives b. Volume and Mix of Loans c. Loan evaluation procedures d. Loan Sanction e. Loan Administration f.

Lending Rates

Loan Objectives – This will set out the various purposes for which loans can be given by a bank. This will also specify if there are any regulatory guidelines with respect to certain objectives.

Volume and Mix of Loans – T his will specify the targeted composition of the loan portfolio in terms of industry exposure, region exposure, size of loans, etc. This in turn will depend on factors like size of the bank, credit requirements in the region, and the expertise available with the bank. This also sets out the risk exposure which the bank can take across industries, borrower types, countries etc.

Loan Evaluation Procedures – T he policy document also specifies the loan evaluation procedure to be followed by the bank. Usually, it sets out the various types of analysis like

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industry analysis, financial analysis of the company, management appraisal, etc that should be undertaken while making the credit decision. Loan Sanction – This part of the loan policy document specifies the sanctioning powers of the credit officers i.e. how much amount of loan can be sanctioned by which level of credit manager in the bank.

Loan Administration – Loan administration comes into picture once the loan has been sanctioned and continues till the loan is repaid. Loan policy should specify the loan administration procedures like documentation, monitoring, follow-up, etc.

Lending Rates – As mentioned earlier, bank like any other commercial enterprise has the profit motive. To ensure that lending results into profits for the bank, it is required that appropriate rate of interest is charged by the bank for loans of different types. The lending rate should also reflect the risk inherent in the loan. The lending rates are dynamic and the loan policy will provide the process for identifying the right lending rates.

3.9.1 Stage in a lending process The various stages in the lending process are as follows: •

Credit Appraisal

•

Sanctioning and Structuring the Loan Agreement

•

Post-sanction Verification and Disbursal

•

Credit Administration and Monitoring

3.9.1.1 Credit Appraisal The decision to sanction or reject the proposal has to be based on a careful analysis of various facts and data presented by the borrower concerning him and the proposal as assessed by the relationship manager.

Such an objective and in-depth study of the

information and data should convince the sanctioning authority that the money lent to the borrower for the desired purpose will be safe and it will be repaid with interest over the desired period, if the assumptions and terms and conditions on which it is sanctioned, are

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fulfilled. Such

an in-depth study is called the pre-sanction credit appraisal. It helps the

approver to sanction the proposal

Credit appraisal focuses on: a. Borrower/Management Appraisal b. Technical Appraisal of the project c. Market Appraisal determining the viability of the project d. Financial Appraisal determining the viability of the cash flows to meet the loan repayment requirements.

3.9.1.2 Sanctioning and Structuring the Loan Agreement If the credit appraisal is satisfactory and bank decides to grant a loan to the borrower, the loan agreement is structured. Loan agreements usually have the following elements: a. Type of credit facility (fund based/non-fund based) b. Term of the loan c. Method and timing of repayment d. Interest rates and fees to be paid by the borrower e. Collateral14 required f.

Covenants which restrict the borrower from certain actions15 during the period of the loan

3.9.1.3 Post-sanction Verification & Disbursal If the terms and conditions of the loan agreement are acceptable to the borrower, usually a post-sanction verification is done to ensure that the funds will be deployed for the stated purpose only. This may require site visits and discussion with the management of the 14

Some asset like real estate, etc. provided as a security for a loan taken from a financial

institution. 15

For example, the loan agreement may require that the borrower should maintain debt up to

a specified limit.

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company. If the post-sanction verification is also positive, the bank issues a disbursal letter which entitles the borrower to take the loan amount from the bank.

3.9.1.4 Credit Administration and Monitoring Credit Administration is a critical element in maintaining the safety and soundness of a bank. The role of credit administration commences soon after the sanction of the credit facilities by the sanctioning committee/authority. The extent of the activities, given the wide range of responsibilities, its organizational structure may vary with the size and sophistication of the bank and may be specifically defined by each bank. These would normally be independent of the credit origination and approval processes. This will normally include communication of the sanction to the client/ borrower at the unit level, execution of relevant documentation, security creation and perfection, and disbursement and thereafter ensuring on-going compliance of the terms of credit, including keeping a watch over any events which may trigger default.

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This chapter discusses the financial statements of banks and looks at the two main reports which provide information about the bank’s activities – the ‘Balance Sheet’ and the ‘Profit & Loss statement.’

4 Financial Statements of Banks

Like any other business organization the two important financial statements of a bank are:

• Balance Sheet • Income Statement However, given that banks offer different type of services than other commercial organizations, their financial statements differ from the typical financial statements of other business organizations. Let us understand what these differences are and what does the various items appearing in the financial statements of a bank mean.

4.1

Balance Sheet

Banks balance sheet or ‘Report of Condition’ lists the assets, liabilities and equity capital (owner’s funds) held by or invested in the bank on any given date.

Balance sheet is

prepared on a particular date – usually the last date of a month or quarter or year. Balance sheet captures the financial data of an institution at one point in time. It is useful to compare data for several accounting periods by which we can assess the trends in the banks financial condition.

In a bank’s balance sheet, Asset side consists of four kinds of assets. They are: a. Cash at vault and deposits held with other depository institutions – (C) b. Investments in interest earning government securities (S) c. Loans and lease finances allowed to customers (L) d. Miscellaneous Assets (M)

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Likewise, Liability side of a bank’s balance sheet has the following components: a. Deposits made by various customers (D) b. Borrowings of funds by the bank – non deposit borrowings from money and capital markets (NDB) c. Other liabilities, like acceptances made by the bank on behalf of their customers liabilities (OL) d. Equity Capital representing long term funds that the owners have contributed to the bank (EC)

Therefore, contents of a bank’s balance sheet can be written as below: C + S + L + M = D + NDB + OL + EC

In short, the assets in a banks balance sheet are ‘accumulated uses of funds’ and liabilities are ‘accumulated sources of funds’.

Assets are made to generate income for their

stockholders, pay interest to the depositors and compensate the employees for their labour and skills.

On the other hand, liabilities provide the needed capital and sources for

acquiring the assets.

Investors, depositors and regulators are concerned about the real position of the bank. The balance sheet of a bank should disclose the required relevant information transparently.

To have more clear view on the key items appearing in a bank’s balance sheet please refer the following hypothetical balance sheet of a bank:

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Balance sheet of ABC Bank in the USA (Report of Conditions) as on 31st December 2005. (Amount in ‘000 USD)

Assets (accumulated use of funds) Cash and deposits due from bank Cash

10,500

10,500

Investment securities (Liquid portion) Interest bearing bank balances

1,500

Federal Funds sold

14,500

Investment securities (Income generating portion) US Treasury and agencies securities

14,200

Municipal securities

14,100

Other securities

4,500

48,800

Loans Consumer

5,565

Real Estate

46,500

Commercial

10,560

Agriculture

38,500

Financial Institutions

5,600

Total

106,725

Less: Reserve for loan losses

2,450

Unearned income reserves

154

104,121

Miscellaneous Assets (building, equipments etc) Building and other fixed assets

5,450

Customers liability on acceptances

1,240

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Other assets

3,650

Total Assets

10,340 173,761

Liabilities (accumulated source of funds) Deposits Demand Deposits

25,620

NOWs (Negotiable Order of Withdrawals accounts)

10,740

Money Market Deposit accounts

20,155

Savings Accounts

6,345

Time deposits Under $100,000

22,230

Over $ 100,000

50,660

135,750

Non deposit borrowings Fed funds purchased

12,150

Other borrowings

5,340

17,490

Other liabilities Bankers acceptance outstanding

1,240

other liabilities

3,500

Subordinated notes and debentures

2,220

6,960

Equity Capital Stock

8,250

Surplus

2,120

Retained Earnings

1,120

Capital Reserve

2,071

13,561

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Total liabilities

173,761

4.1.1 Assets 4.1.1.1 Cash assets The first asset item listed in the banks balance sheet is cash and deposits due from banks. This includes cash in bank’s vault, deposit with Federal Reserve (which is often known as primary reserves), any deposits the bank has placed with other correspondent banks (for clearing purposes and also to compensate the other bank for providing currency and coin services) and cash items in the process of collection (mainly uncollected checks). This means that these cash assets are the banks first line of defense against withdrawal of deposits and first source of funds when a customer comes in with an unexpected loan request which the bank has to meet. Generally, banks strive to keep the size of this account as minimum as possible, because idle cash balances earn no interest income or little income for the bank. Bank management should always attempt to minimize its holdings in these assets. In the above balance sheet, cash holdings are USD10,500,000 and it is 7.73% of the total deposits.

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4.1.1.2 Investment securities (Liquid Portion) Interest bearing bank balances (USD1,500,000), such as short-term certificates of deposits16 at other banks and federal funds sold17 (USD 14,500,000) are highly liquid, earning assets. They are generally used as part of the bank’s liquidity management program. Most of the smaller banks have more federal funds sold than federal funds purchased 18 , indicating relatively high liquidity. In the above balance sheet both these items are highly liquid and earn a certain amount of return which will help the bank for enhancing their profitability and also manage their short term liquidity.

4.1.1.3 Investment securities (Income-Generating Portion) Bonds19, notes20 and other securities held by the bank primarily for their expected rate of return or yield are known as investment securities. Frequently these are divided into taxable securities and tax-exempt securities.

Taxable securities are mainly US government

bonds and notes, securities issued by various federal agencies (such as The Federal National Mortgage Association, known as Fannie Mae) and corporate bonds and notes. Tax-exempt securities consist primarily of state and local government (municipal) bonds. The latter generate interest income that is exempted from federal income taxes.

16

It is a promissory note issued by a bank entitling the holder to receive back the money

deposited with interest. Withdrawal before the maturity date attracts a penalty. 17

These are the loan of excess reserves held at the Federal Reserve by one bank to

another. These typically are overnight loans although longer-term loans can be made 18

These are the borrowings of excess reserves held at the Federal Reserve by one bank

from another. 19

A security which entitled the holder to receive periodical interest payment and get back the

principal amount at the time of maturity. The maturity period is typically more than one year. 20

This is similar to a bond with the difference that the maturity period is not more than 3

years.

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4.1.1.4

Loans

In most of the bank’s balance sheets, Loan component generally account for more than 60% of the total assets. Bank’s Loan folio consists of Consumer Credits, Real Estate loans, Commercial loans, Agricultural loans and the credit extended by banks to other financial institutions. In Table -1, referred above, USD10,672,5000 represents gross loans owed to the bank forming part of 61.4% of the total assets. . However loan losses are deducted from the gross loan figure.

Unearned income (unearned discount) USD 154,000 represents amount of income that has been deducted from a loan but has not yet been recognized as income on the income statement because it is to be distributed over the life of the loan. For example, consider a loan for a period of five years which is payable in five annual installments including interest The interest to be received on the loan will be considered as unearned income at the time the loan is disbursed. Every year when the installment is received the interest so earned will be deducted from the unearned income and the balance will be carried forward.

The amount USD2,450,000 reported as ‘reserve for losses’ reflects an estimate by the bank management of probable ‘charge-off’ for uncollectible /unrecoverable loans and leases on the date of balance sheet. Although the regulatory authorities have prescribed the norms in the estimation process, ultimately the bank management decides the final valuation of the reserve account. Actual loan losses are deducted from reserve account and any recovery made from uncollectible loans will be added back to reserve account.

Under the current norms recommended by BASEL committee, any scheduled loan or interest dues not repaid and becomes past due for more than 90 days, outstanding loan balance is to be classified as Non Performing Loans. Once the loan is classified as Non Performing Loan, the Bank is not allowed to record any further interest from this loan until a cash payment is actually received in.

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4.1.1.5 Other assets Premises, fixed assets, equipments and capitalized leases represent an important though relatively small portion of the assets. Most of the capitalized leases for banks involve saleand-leaseback arrangements in which the bank ’sells’ the property and leases21 it back from the buyer. Terms are structured to allow the bank to maintain control over the property. These arrangements are done primarily to generate cash. Capitalized leases are recorded under assets rather than under leases, as if the bank still owns the property.

4.1.2 Liabilities 4.1.2.1 Deposits Deposits are the principal liability for any bank. It represents the financial claims held by households, business houses and governments against the bank. Deposits are the main sources of funds for the bank. In the event of a bank’s liquidation, depositors are to be paid their claims first from the sale proceeds of assets. Depositors have the first priority in settlement of claims.

Other creditors and stock holders receive their claim from the

remaining proceeds of the assets sold.

Deposits are of five major types:

a. Non interest bearing demand deposits or regular checking accounts:

These

accounts generally permit unlimited check writing. But under Federal law passed in 1933, they cannot pay any explicit interest rate. Many banks offer to pay postage costs and other ‘free’ services that yield the demand deposit customer an implicit rate of return on these deposits.

21

This is a contractual agreement, which transfers the right to use the asset from the owner

(known as the Lessor) to the user (known as the Lessee) in return for periodical payment (Lease Rental).

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b. Savings deposits: These deposits generally bear the lowest rate of interest offered to depositors by a bank but may be of any denomination. Banks may impose minimum size requirements and permit the customer to withdraw at their will. c. NOW accounts – Negotiable Order of Withdrawal accounts: This can be held only by individuals and non-profit institutions bear interest and permit checks to be written against each account in order to pay to third parties. d. MMDAs – Money Market Deposit Accounts: Under this scheme, bank can offer competitive interest rate to the depositors depending on their short term requirements and liquidity position. privileges.

This scheme offers limited check writing

Minimum maturity and denomination though not prescribed under

federal law, depository institutions reserve their right to require seven days’ notice before any withdrawal being made. e. Time deposits: Time deposits

have a break up of i) deposits under USD 100,000

and ii) deposits above USD 100,000. Time deposits are with a fixed maturity date on which it is payable with a stipulated interest date. It may have any denomination. Deposits above USD 100,000 are large interest payable negotiable CDs 22 mostly collected from their high net worth customers at a competitive interest rate. These categories of deposits are mostly negotiable if it is issued in a negotiable form in a well-established secondary market.

Bulks of bank deposits are held by household individuals and business firms. However, government (local, state and federal) also holds substantial deposit accounts known as public fund deposits. Any time a local school authority sells bonds to construct a new building, proceeds of this sale of bonds will flow into its deposit account with a local bank.

Similarly when US Treasury collects taxes or

sells securities to raise funds, the proceeds normally flow initially into public deposits accounts that the Treasury has established with banks across United States. 22

CDs with a minimum face value of $100,000 and which can be sold in the secondary

market at any time before maturity.

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Looking into the balance sheets of most of the banks, it can be observed that they are heavily dependant on their deposit folio, which is usually between 70 to 80 percent of their liabilities. In Table 1, which we are analyzing, it can be noted that deposits constitute 78.12 percent of the total liabilities.

4.1.2.2 Borrowing from Non deposit sources While deposits represent the largest portion of banks sources of funds, banks also have freedom to raise funds through miscellaneous liability accounts. This can be by Federal funds purchased and securities sold under agreement to repurchase. Borrowings can also be from money market and transfer of funds from one institution to other financial institutions is instant through wire transfers.

Finally, other liabilities account serves as a catch-all for miscellaneous amounts owned by the bank such as deferred tax liability and obligation to pay off the investors who are holding bankers acceptances23.

4.1.2.3 Capital Account Capital account on a banks balance sheet represents the owners’ share of the business. This is also known as ‘stock holders’ interest. Any new bank which wants to enter into banking service starts with a minimum capital and then borrows funds from the public to meet their operational demands. In the balance sheet under study, we can observe that the equity capital is USD 8.2 mn and it is 4.74 percent of the total assets.

Equity Reserves, surplus and Capital reserve is also included with Equity to arrive at the capital account in a banks balance sheet. Usually, the retained earnings (undivided profits) 23

An order by a customer to its bank to make a certain payment at some future date, which is

accepted by the bank.

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which represent accumulated net income left over each year after payment of dividend forms the largest part in capital account. .

In some of the banks capital account, we can observe subordinated notes and debentures. In the balance sheet under Table 1, it is shown as USD 2.220 mn. These are debt securities with long term maturities carrying a claim on the bank’s assets and income that comes after the claims of its depositors (subordinated to). It is a debt instrument floated by the banks and the holders’ claim on the bank resources has a low priority vis-à-vis deposits..

4.1.2.4 Expansion of ‘Off-Balance Sheet’ Banks have converted many of their customers’ services in recent years into fee-generating transactions that are not recorded on their balance sheets. Some of the examples of these off-balance sheet items are:

1. Standby Credit Agreements, in which a bank pledges to guarantee repaying of a customer’s loan borrowed from a third party. 2. Interest rate swaps, in which a bank promises to exchange interest payments on debt securities with another party. 3. Financial futures and option interest-rate contracts, in which a bank agrees to deliver or to take delivery of securities from another party at a guaranteed price. 4. Loan commitments, in which a bank pledges to lend up to a certain amount of funds until the commitment matures. 5. Foreign exchange rate contracts, in which a bank agrees to deliver or accept delivery of foreign currencies on a future date at a pre determined exchange rate.

Even though these transactions are shown as ‘off-balance-sheet’ items, often they expose the bank with added risks.

For example, the standby credit which guarantees the loan

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repayment by the bank’s client, will result in a risk exposure for the bank, if the guarantee is invoked due to default of the bank’s client.

4.2

Income statement (Report of Income)

Income statement of a bank indicates the amount of revenue received and expenses incurred over a specific period of time. The period can be on quarterly or half yearly or annual basis. Since Assets on the balance sheet account for the majority of revenue and liabilities generates banks expenses, Income statement has a close correlation with the balance sheet.

Principal source of banks revenue is dependent on the interest on their loans and securities. Other than these two items, rental income on assets and fee based income earned on their other financial services are forming significant portion of the income side of the statement. Likewise, under expenses side, interest paid on their deposits and borrowings is the major source of expenses. Apart from this, expenses include salaries, benefits paid to staff, and maintenance expenses on fixed assets

In short, Net Income = Total revenue items (-) total expenses items.

Banks can increase their net income by using any of or all the following options:

Increase the average yield on each asset Redistribute their earning assets towards those assets with higher average yields Reduce the interest expenses by going for low cost deposits or non deposits. Shifting their preference towards less costly deposits and other borrowings Reducing the employees or increasing the efficiency of the staff Reducing the loan losses by having an improved monitoring and efficient appraisal system Improving tax management to reduce tax liabilities

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Bank management may not have absolute control on all the above options. Specifically interest payable depends on demand and supply of funds in the market operations. If the bank quotes rate of interest lower than the prevailing market rate, further deposit accretions may suffer.

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Income statement of a bank will have the following major items:

Income statement for the period of …(Report of Income) Financial Inflows

Financial outflows

Loan income

Deposit costs

Security income

Non deposit borrowing costs

Income from cash assets

Salaries and wages expenses

Miscellaneous income

Miscellaneous expenses Tax expenses

Actual bank income statements usually have more details because each item shown above has different components. For example, loan income includes income from mortgage loans, consumer loans and other lending activities.

For the purpose of reviewing the details of an income statement we give below a hypothetical Income statement of a bank.

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Income Statement of ABC Bank in the USA For the period ending December 2005.

Revenue and expenses

Amount In million

Interest Income Interest and fees on loans Interest

on

1,080

investment 376

securities Taxable securities revenue Tax

exempt

240

securities 37

revenue Other Interest Income

--

Total interest income

1,733

Interest cost on deposits

613

Interest on short term debts

181

Interest on long term debts

150

Total interest expenses

944

Interest expenses

Net interest income

Provisions

for

789

loan

355

income

434

possible losses Net

interest

after provision for loan losses

Non interest income Service

charges

on 49

114

customers accounts Trust department income

26

Other operating income

99

Total non interest income

174

Non interest expenses Wages and salaries and 230 other personal expenses Non

occupancy

and 44

equipment expenses

Net

non

interest

Other operating expenses

35

Total non interest expenses

309 (135)

income

Income or loss before

299

taxation Provision for income tax

49

Net income or loss after

250

taxes

Average

number

of

50,000,000

common shares of stock outstanding (actual) Income / loss per share

$5

of common stock (actual

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4.2.1 Interest Income Interest Income generated by a bank account for most of the banks revenue. In the above statement we can observe that around 70 percent of the interest income is earned from loans. Interest income on investments follows the loan revenue. The relative importance of these different items fluctuates from year to year depending on the shift in interest rates, demand for loans. When the interest income is compared with non interest revenue sources (fee based income) it is changing rapidly since fee based business is growing faster.

4.2.2 Interest expenses Above table shows that total interest expenses is almost 74 percent of the total expenses. If the bank is not in a position to manage their liquidity position efficiently, they have to raise short term loans from the market at the market rates which may be costlier at times. Interest expenses for borrowing depends on the demand and supply in the money market also.

4.2.3 Net Interest Income Most of the banks arrive at the net interest income by deducting interest expenses from interest income. This is also known as ‘net interest margin’. It totally depends on the cost of funds and the interest received on the loans. It is one of the key indicators of banks profitability. When the interest margin falls, bank stockholders will usually experience a weakening in the bank’s bottom line and perhaps on the dividends they receive on each share they hold.

4.2.4 Loan-loss expenses In case of loans, which are not recoverable, bank has to make a provision from their current income. It is known as ‘provision for possible loan losses’. It is a non-cash expense, created in the books of accounts to reduce the current income to the extent of the expected loss on

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bad loans. When any of the bad loans which were previously written off is recovered, the recoveries reduce the outstanding in the loan-loss account.

4.2.5 Non interest income Income earned from sources other than loans and securities are called non interest income. Fees earned from offering trust services, service charges recovered on deposit accounts are classified under this group. Recently when the banks are expanding their services in selling insurance, issuing guarantees and standby credits, arranging syndicated loans their non interest income is increasing sharply. Since interest margins are under pressure, banks are presently concentrating on these services to increase their non-interest income.

4.2.6 Net income Net income is arrived by deducting interest expenses and non interest expenses from interest income and non interest income. This will be the income earned before taxation. Federal and State incomes taxes are applied to this income figure to arrive at the banks net after tax income or loss.

4.2.7 Appropriation of profits The net income after taxes is usually divided into two categories by the board of directors. Some of the funds may be distributed to the stockholders in the form of cash dividends and the other portion will be transferred to ‘retained profit’ in order to broaden the banks capital base.

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5 Questions

Sample Multiple Choice Questions

1. An arrangement among the bankers to finance a borrower using common loan documentation is called a. Narrow banking b. Forfaiting c. Syndicated credit d. Securitization

2. In which of the following electronic funds payment and settlement systems will the payee instruct the bank to transfer a certain amount from its customer’ s account to its own account? a. Electronic Credit Transfer Mechanism b. Electronic Debit Transfer Mechanism c. Electronic Clearing Service Mechanism d. Electronic Funds Transfer Mechanism

3. Which of the following is an example of transaction accounts? a. Fixed Deposits b. Recurring Deposits c. Savings Bank Deposits d. Cash Certificate 4. Which of the following is not an example of fund-based limits? a. Letter of guarantee b. Purchase and discount of bills c. Cash credit and overdraft

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d. Demand loans and term loan

5. Letter of Credit means a. A credit card issued by a bank to its valued client for credit facilities b. A letter issued by a financial institution enabling the person named there on to withdraw specified sum of money from its foreign correspondent c. A letter containing details about credit worthiness of a customer d. A letter issued by buyer’s bank in favour of the seller, undertaking to pay a certain sum of money within stipulated period against a specified set of documents provided the terms and conditions contained their in are duly complied with 6. Which of the following is not true regarding Certificate of Deposits (CDs)? a. Banks issue CDs in the form of usance promissory notes b. CDs are freely transferable by endorsement and delivery c. There is no ceiling on the maximum amount that can be raised by CDs d. CDs cannot be subscribed by the individuals, corporations, companies and trusts.

7. A bank on which check is drawn by the customer is called a. Collecting Bank b. Paying Bank c. Advising Bank d. Issuing Bank

8. The portfolio management services offered by banks can be classified into a. Comprehensive and limited b. Advisory and non-discretionary c. Advisory and non-advisory d. Discretionary and non-discretionary

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9. Exporter who require guarantee of payment will ask for a. Trade acceptances b. Bankers’ acceptances c. Irrevocable LC d. Unconfirmed LC

10. Which of the following statements is incorrect? a. Central Banking system is a non-commercial banking system which consists of the national supervisory framework for regulation of banking and controlling the money supply in the economy b. Commercial banking system consists of a network of banks which provide a variety of banking services to the individuals and the businesses in the economy c. Unit banking involves provision of banking services by a bank in an unlimited nationwide area d. Branch banking system the bank has a head office that controls and directs the branches located in multiple locations.

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