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I, Aute Love Kishor, student of S.Y.B&I semester IV (2009-2010) Hereby declare that I have completed the project on Liability Management. I further declare that the information contained in this project report is genuine, true & the fair to the best of my knowledge.

Signature Roll no-40


INDEX Sr. no
1. 2. 3. 4. 5. 6. 7.

Preface What is liability management? Introduction of liability management Need for liability management Management of liability Asset liability management Conclusion

Page no.
01 02 11 13 16 23 27


I have selected the project Liability Management for completing the curriculum of IV semester of Banking and Insurance. For the past three semesters I have been walking through various concepts of Banking and I believe that Liability Management is one of the key factor to make any bank successful and survive in difficult circumstances. To broaden my ideas I have opted for this subject. It was not so easy for me to collect information and data related to my project topic. I have seen various books related to my topic but I have selected only that information which is relevant to my project. I have also visited various websites for project purpose but information which is website provided is not so much relevant to my project. In that case the college library and college faculty has helped me in getting true and fair information relating to my project.


The development of Banking is evolutionary in nature. There is no single answer to the question of what is banking? Because, a bank performs a multitude of functions and services which can be comprehended into a single definition. For a common man a bank means a store house of money, for a business man it is an institution of finance and for a worker it may be a depository for his savings. It may be explained in brief as Banking is what a bank does. But it is not clear enough to understand the subject in full. The oxford Dictionary defines a bank as an establishment for the custody of money which it plays out on customers order. According to section 5 (b) of the Banking Regulation Act 1949, Banking means, accepting for the purpose of lending or investment of deposit of money from the public repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. According to above definition, the main function of a bank is to collect deposits from the public and use these funds for lending and investment. For the deposits collected from the public interest paid to the depositors. Similarly, interest is earned on lending and investment.


In this process, bank creates liabilities by way of deposits and borrowing and assets by way of lending and investment. For each rupee collected in the form of deposit, equal asset is created in the form of advances and investments or cash/balance with banks.

Functions of Banks:Following are the functions perform by Bank:I) II) III) IV) V)

Primary Functions. Agency Functions. General Utility Functions. Foreign Trade Management. Credit Creation.

Primary or Traditional Functions:These functions are classified into 2 categories,

namely:1) 2) Accepting Deposits. Advancing of Loans.



Accepting Deposits:-

The primary function of bank is accepting deposits and advancing of loans. Banks require money to make loans and advances. Their share capital does not create adequate funds for advancing loans. Hence they accept deposits as interest. For the safety point people and institutions deposit their money with the banks and they get interest. For this purpose bank operate various types of accounts as given under:-

i) Fixed Deposits Account:It is also called time deposit account. In such accounts money is deposited for a fixed period. After the maturity of the account the bank repays the principal plus interest for that given period. The interest on such accounts is pre-decided. Generally, such accounts are having duration of 6 months to 10 years. The rate of interest varies as per the duration of the account. Generally, the rate of interest is high as such accounts as the bank is free to use the deposits for a long period. Bank gives a receipt to the depositor. The receipt is returned to the bank while getting the payment.


Current Account:-

This account is generally open by traders, businessman and industrialist. Customers have facility to deposit and withdraw from such account as many times as


they wish. The daily transactions of such account holders are frequent and many. Hence they open such accounts in the bank. There is uncertainty in the withdrawals from such accounts and bank cannot use the deposits. No interest is paid on such accounts. Customers are also given overdraft facility as per their credit.

iii) Saving Account:Such accounts are opened for the convenience of middle and lower salaried or income groups. There is no restriction of the deposits but there is a restriction on the withdrawals. A customer cannot withdraw more than 50 times during 6 months from the accounts. Bank pays rate of interest, which is generally 4.5% per annum.

iv) Other Deposits Accounts:Bank also accepts deposits for the accounts other than the above mentioned. Some of these accounts are as under:-

a) Recurring deposit Account:Account holder deposits a given amount every month and it is deposited for a given period. At the time of maturity the principal and interest earned is paid to the account holder. The rate of interest is higher than the saving bank account and lower than fixed deposit account.

b) Daily Saving Deposit Scheme:-


Under this scheme bank employee goes to residence of account holder and daily is collected by him. It is useful to daily wage earners and small shopkeepers.

c) Retirement scheme:Under this scheme saver saves a given amount for a given period. After a given period the amount is repaid in installments with the interest. It assists the pensioners in their old age.

2) Advancing of Loans:Another important primary function of commercial bank is advancing of loans. It is performed because banks have to pay interest on various deposits. Thus bank charge high rate of interest on advancing of loans and earn profit. Banks collect small savings and are used for advancing of loans for production purposes. Bank makes advancing of loans to industrialist, traders, farmers, self-employed persons. Generally commercial banks advance loans for the following purposes:-

i) Cash Credit:Under this scheme bank advances the loans for a given period on the security of shares, debentures and movable and immovable properties. The loanee withdraws money from the bank as per his requirements from time to time. Generally bank charges interest on the amount which has been


withdrawn by the account holder. Sometimes traders borrow from banks on the security of goods. Borrower has the right to get the dividend and interest on the securities pledged for loan.

ii) Loans and Advances:Under it banks provide loans and advances to its customer on adequate security. Such amount of loans and advances are deposited in the account of the borrower and the borrower can withdraw the amount as and when he requires. Such facility is given for a specific period. After the specific periods the loans and advances are repaid to the bank.

iii) Overdraft:When a bank allows its customer having current account to withdraw the amount more than the deposits in the account it is called overdraft. The overdraft depends on the credit of the customers. Such facility is given for short term and emergency purposes. Such facility is given on current account only.

II) Agency Function:Commercial banks act as agent of their customers and rendered services. Some charges levied by the banks on such services. Some services rendered free of charges. The following are the agency functions of commercial banks provided to their customers:-


1) Collection of payment of cheques, Bills of Exchange and Other letters of credit:Bank collect payment of cheques, bills of exchange, and other letter of credit deposited by the customers in the bank. Banks act as an agent on behalf of the customers and collect deposit. The local collection is free of charge while outstation collection of these instruments attracts charges.

2) payment of cheques, Bills of Exchange and other letters of credit:Banks make payment on the basis of various instruments written by the customers and the amount is debited. Many a times, bank accepts a bill of exchange on behalf of customers makes payment in time.

3) Receiving payments for customers:Banks also received rent, interest, installment of loan, pension, dividend, etc. on behalf of their customers and the amount is deposited in their accounts.

4) Payment on behalf of customers:Banks not only received payment on behalf of their customers but also make payment on behalf of customers in the form of rent, interest, dividend, installment of loan, insurance premium, commission, etc, such amount written in customers account and banks charge commission for these functions.


5) Transfer of money:Banks transfer money from one place to another as directed by their customers. Bank draft, postal and telegraphic transfers are the methods through which such transfers take place. Bank charges some commission for conducting these functions.


Purchase and sale of shares securities:-

Banks purchase and sale shares and securities on behalf of their customers. Generally, banks have more knowledge regarding such activities. Banks charges commission for this purpose.

III) General Utility Function:Banks also carry on some utility functions, which are useful to their customers. These functions are as under:-

1) Security of wealth and Assets:Lockers are provided by banks to their customers. Their valuables namely important documents, ornaments, gold, shares, debentures, deposit receipts, etc. are kept in these lockers. Some annual charges are charged by the banks for the purpose.

2) Financial Adviser:-


Banks advise their customers on economic and financial matters. It helps customers to take correct decision.

3) Personal Credit:Banks provide customer loans to their customers on the basis of personal credit. These loans are provided to purchase consumers goods like car, scooter, refrigerator, washing machine, air conditioner, etc. such loans are repaid in installments.


Management of public debt:-

Commercial bank manages public debt on behalf of central bank when central and state government raise loans through debentures or bonds.

5) Share Market Function:Banks also settle the accounts on behalf of their customers when they are purchasing and selling shares and debentures in the share market.

IV) Financial and Managerial Arrangement for Foreign Trade:Commercial banks have played a dominant role in the expansion of foreign trade. Short term credit is provided for foreign trade by banks. These banks accept and discount the commercial bills, letter of credit. It facilitates in the international transactions. Banks contract the importers and


exporters and finalize the transactions between two parties. It facilitates the international payment and increases the international payments and increases the foreign trade.


Function of credit creation:-

Banks attract deposits from the public on the basis of these deposits; they make loans and advances to the public. Such amount of loan is deposited in the account of loanee. Thus loans create deposits. On the basis of these deposits loans are further granted. Thus loans from deposits and deposits from loans are encouraged. This process is called credit creation.



In recent years, commercial banks have devoted increased attention to the concept of liability management. Liabilities management is concerned with the activities related to the collection of funds from depositors and other creditors and the determination of an appropriate mix of these funds. Mobilization of deposits is become a challenging task for banks in these days. Banks collect funds through different types of deposits having different maturities. A bank invests the funds raised from different creditors to earn income. These activities involved some risk. Liabilities management stresses that a bank should consider the cost and risk of different sources of funds as well as the expected return on their investments. In this way the inter relationship between assets management and liabilities management is the determining factor in the context of profitability. A commercial bank serves as a financial intermediary between those having funds and those needing funds. While raising and lending funds banks have to consider liquidity and profitability factors. In this connection there is need for the use of financial leverage to improve return on capital. In recent years special attention is being paid to liabilities management to improve the profitability of banks. Large banks are stressing credit instead of assets conversion to meet their liquidity needs, particularly since nationalization.


The liability management involves:a) Choosing the source of financing to be used, i.e. choosing between deposits finances and non- deposit financing. b) Determining the amount of funds needed and c) Obtaining funds at lowest possible cost with the least risk exposure.



The basic problem facing a bank manager is to have a satisfactory trade off between liquidity and profitability- the two principle but conflicting goals of a bank. A bank deals in the money of the people. The success of the business of bank depends partly on the efficiency with which it can provide services to its depositors, but mainly on the confidence it inspires among the depositors. It has been able to attract the deposits of the people not only by promising some returns on their money but also by committing itself to repayment on demand. This is why the public accepts bank deposits as being as good as cash. The banker must, therefore, ensure an adequate amount of liquidity in his assets so that he may be able to meet any claims upon it in cash on demand. The perfectly liquid asset is cash itself because it can fully satisfy the depositors claims. The more cash a banker holds, the more obviously he can, without difficulty of any kind, offer cash in exchange for deposits. Further, the bankers with an adequate amount of cash in hand meet the credit needs of the community and can make speculative gains. However, cash in a sterile asset which earns bank is to make earnings on its business which are sufficient to compensate it for the cost which it incurs on raising funds, besides paying the wages of the staff and meeting other expenses. If a banker holds a large portion of his fund in ready


cash without earnings any income on it, his business will result in losses, and sound the death-knell of the offer sometime. He must, therefore, employ the bulk of the banks resources in giving loans and advances, and in investing them in high yielding securities. Such investment are, however, subject to credit risk-the risk arising from default in repaying money lent out and the money rate risk-the risk arising out of fluctuations in the market role of interest. The banker will not able to satisfy the cash requirements of the depositors on demand with the funds deployed in the above investments. Once the depositors cheques are not honoured, the bank will lose the confidence of the public, which will results in a mass run on banks counter and jeopardize the liquidity position of the bank. Ultimately, the very survival of the bank is endangered. Liquidity and profitability are, therefore, inimical to each other. Cash has perfect liquidity but lacks yield. At the other end are some loans and investments, which yield a high rate of interest, but are hardly liquid at all. The conflict between liquidity and income is not as sharp as it appears. In order to ensure long-run earnings, the commercial bank must retain public confidence in order to continue to survive and provide for the liquidity needs of the bank. The art of commercial banking lies in the resolution of the conflicts between liquidity and profitability. It is an art because science has not furnished inviolable rules; banks must be managed with discrimination and good judgment. Rules


and scientific procedures for doing the whole job cannot be framed. A number of approaches, ways and means of resolving the conflicts have been developed from time-totime.


The management of liabilities is very difficult and important job of a banker. For better liquidity and profitability there is a need of liability management. In liability management there are various liabilities are involved, but management of capital and deposits are very much important, because they are major liabilities in banks.

Management of Capital Fund

The capital fund constitutes one of the sources of funds for a commercial bank. It represents owned resources, and includes the share capital subscribed by its shareholders as well as reserve built up by the bank by ploughing back a part of its business earnings. Success and survival of a bank depend on its strength, which in turn, dispenses public confidence in it. Failure of individual banks, particularly large ones, might erode public confidence in the banking system. This is why regulators all over the world strive to minimize the magnitude and scope of bank failures by clamping minimum capital requirement for banks. Management of capital funds entails risk returns trade off. Increasing capital fund reduces the risk of bank failure by acting as cushion against the losses. On the other hand, it also reduces expected returns on equity, a measure that the investors focus on increasingly as the basis for valuing a banks share.


Functions of Capital Fund in Commercial Banks: Bank Capital Acts as Loss Absorber:Like other business, a commercial bank needs capital to commence its operations, and to continue its existence as a running business. Commercial and industrial companies require capital initially to finance their operations and secondly to provide a bailout for creditors or to cover possible losses. From the standpoint of a bank, the reverse is generally true. The primary role of bank capital is to act as buffer. It provides a cushion to absorb possible losses so that depositors may be fully protected at all times. Although the capital fund is regarded as the absorber of losses arising from the realization of assets and from other contingencies, yet this function can be fulfilled only in the extreme case of the liquidation of the bank. The true nature of the protection function of the capital fund is that it is ultimate of final protection from the risk of insolvency. In the short run, a major portion of the banks losses may be offset by its current earnings, not by its capabilities. Even in the long run, the capital fund may not fulfill the protective role because, if a bank had poor earnings, losses internal control and a large quantity of risk assets- symptoms of bank liquidation the bank management would step in long before the capital funds were severely impaired. In a recent decision, it was held that the primary function of the bank capital fund is to absorb the losses resulting from


events that are managerial foresight cannot be reasonably expected to anticipate. It should provide a margin of safety that preferably would allow bank to continue operations without loss of momentum and, at the least, would by time for it in which may re-establish its operational momentum. Normal risk- risks that cannot be anticipated should be cover by gross earning and not by the capital fund. Banks Capital Supplies Working Tools of Banks:The secondary function of the capital fund is to provide the where withdrawal from the acquisition of such fixed assets as buildings, equipments, furniture, etc. The provision of the permanent assets is a continuous function of the bank capital fund, mainly because depositors cannot be expected to supply the funds for such assets, say a new branch building. Under condition of expansion, therefore, the capital base must, of necessity, be strengthened in line with the expansion of the bank. Banks Capital Acts as a Source of Loan Funds:Another important function of bank capital is the assurance that the bank will be able to fulfill the credit needs of the community and assume the risks inherent in its safety. In other words, there are certain types of investments for which borrowed funds may not be helpful; reliance is placed on capital funds. Bank capital represents the private ownership of commercial banks, which distinguishes these institutions from the mutual savings associations, co-operative banks, co-


operative credits and thrift societies and post office savings, banks, etc., which compete with commercial banks for savings.

Management of Deposits:The survival of a commercial bank depends, on the quantum of deposits held by it and the way deposits are managed. Deposits in fact, constitute a vital source of funds in a bank, which places an almost exclusive reliance on public deposits for its operation, for the fact that equity capital invested in a bank is very insignificant part of the total funds of the bank. Lending and investment operations of a bank are influenced essentially by the magnitude of deposits, their composition and ownership. This is why a banker always thinks of ways and means of increasing his deposits. It is true that individual banks do not have complete control over the level of the total deposits with the banking system and savings of the community because a host of factors including the monetary policy of the Central Bank determine it. However a banker can influence, to some extent amount of deposits held by it by adopting marketing approach.

In practical sense deposits are managed as given below:Suppose the borrower, Mr. X, pays a cheque of Rs. 800 to Mr. Y, who has an account in Bank of Baroda. Then Bank of Baroda receives Rs.800 as primary deposits, which


increases the liabilities of the bank by Rs. 800. It balance sheet appears as follows:

BANK OF BARODA Liabilities Demands deposits ( primary) Assets Rs. 800 Cash received Cash reserves Excess reserves Rs. 800 Rs. 160 Rs. 640

As noted in the balance sheet of the Bank of Baroda, the increased deposit liabilities of Rs. 800, accompanied by equivalent in cash reserves of Rs. 800 have resulted in excess reserves of Rs. 640, on account of the 20 percent cash reserves ratio. Thus, Bank of Baroda is now in position to expand its loan and deposits by the amount of its excess reserves. If Bank of Baroda expanded its loans and deposits by the amount of its excess reserves, its balance sheet would then change to:


BANK OF BARODA Liabilities Demand deposits (Primary) Demand deposits (Derivative) Rs. 640 Loans Rs. 640 Rs. 800 Assets Cash received Rs. 800

Now, suppose the borrower, Mr. Z, passes on the amount of (Rs. 640) to somebody (in meeting his business obligations), who is turn may deposit it with the Canara Bank. That increases the liabilities of the Canara Bank, by Rs. 640 and its balance sheet appears as: CANARA BANK Liabilities Demand deposits (Primary) Assets Rs. 640 Cash received Cash received Excess reserves Rs. 640 Rs. 128 Rs. 512

The balance sheet shows that Canara Bank now has an excess reserve of Rs. 512 which can be loaned out and which in turn creates a derivative deposit of Rs. 512.


It follows from this that, as the process continues, every time- the liabilities with the banks go on increasing at diminishing rate. This process will continue to operate until all the original excess reserves of Rs. 800 with the first bank have been parceled out among the various banks and have become the required reserves. As a result, it may be found that the aggregate of derivative deposits in the entire banking system, over a period of time approximates five the initial derivative deposit (credit).



Because the business of banking involves the identifying, measuring, accepting managing the risk, the heart of bank financial management is risk management. One of the most important risk management functions in banking is Asset Liability Management (ALM) Asset and Liability Management has today become the most typical subject of any financial institution. It encompasses the analysis and development of goals and objectives, the development of long term strategic plans, periodic profit plans and rate sensitivity management. In one way or another it has always been the function or responsibility or Treasury and other financial/strategic departments. However, of late Asset Liability Management departments are being established and Asset and Liabilities committees are being formed within financial institutions. These committees are often given extraordinary powers regarding the mix and match of Assets and Liabilities and have large influence in winding up activities which do not fit business strategy. Asset Liability management is concerned with strategic balance sheet management involving risk caused by changes in interest rates, exchange rate, credit risk and the liquidity position of the banks. Asset Liability Management can hence be broadly defined as coordinated management of a banks balance sheet


to allow for an alternative interest rate, liquidity and prepayment summaries. It is a flexible methodology that allows the banks to test the inter-relationships between the wide variety of risk factors including market risks, liquidity risk, management decisions, uncertain product cycles, etc. Important of Asset Liability Management:Why do we need asset liability management? In simple terms-a financial institution may have enough assets to pay off its liabilities. But what if 50% of the liabilities are maturing within the same period? Though the financial institution has enough assets, it may become temporarily insolvent due to severe liquidity crisis. Even if the assets and liability maturity is matched to a large extent, the interest rates can change during the period thereby affecting the interest income from assets and interest expenses on liabilities. Depending upon the movement of interest rates the net interest margin may increase or decrease resulting in corresponding increase or decrease resulting in profit during a certain period. Some of the reasons for growing significance of Asset Liability Management are:1. Volatility:-

Deregulation of financial system changed the dynamics of financial markets. The vagaries of such free economic environment are reflected in interest rate structure, money supply and the overall credit position of market, the


exchange rates and price levels. For a business, which involves trading in money, rate fluctuations invariably affect the market value of the bank and its Net Interest Income (NII). 2. Product Innovation:-

The second reason for growing the importance of ALM is rapid innovations take place in financial products of the bank. While there were some innovations that came as passing fads, others have received a tremendous response. In several cases, the same product has been repeated with certain differences and offered by various banks. What ever may be features of the products, most of them have an impact on the risk profile of the bank thereby enhancing the need for ALM. For example, flexi-deposits facility. 3. Regulatory Environment:-

At the international level, the bank for international settlements (BIS) provides a frame work for banks to tackle the market risks that may arise due to rate of fluctuations and excessive credit risk. Central Bank in various countries (including R.B.I) has issued frameworks and guidelines for banks to develop Asset Liability Management policies. 4. Management recognition:-

All the above mentioned aspects forced bank managements to give a serious thought to effective management of assets and liabilities. The management has realized that it is just not sufficient to have a very good


franchisee for credit disbursement, nor is it enough to have just a very good retail deposit base. In addition to these, a bank should be in a position to relate and link the asset side with liability side. And this calls for efficient Asset Liability Management. This is increasing awareness in the top management that banking is now a different game all together since all risk of the game have since changed. Objectives of Asset Liability Management:The basic objectives of ALM is to manage market risk in such a way to minimize the impact of net interest income fluctuations in the short run and protect the net income value of the bank in the long run. Thus, the objectives of ALM are as follows:1) To control liquidity risk. 2) To control the volatility of net interest income and net economic value of a bank. 3) To control volatility in all targets accounts. 4) To ensure an acceptable balance between profitability and growth rate.


The proper management of liability is important for every bank. Liability management is the activity related with the collection of funds from depositors and other creditors and these funds are invested and lent out, in these activities bank earns some interest. There are various liabilities of a bank, but capital and deposits are major liabilities of a bank. Therefore there is a need of proper management of capital and deposits. The capital represents the owned fund and it includes the share capital. If bank have to increase their funds then there is a need to gain public confidence. The deposits are real source of a bank. Without deposits bank cannot do business effectively. Managements of deposits are also an important responsibility of a banker. Management of liability is one of the critical functions of a bank. It is easier said than done. Banks normally devise policies for accepting or creating certain liabilities. The simplest method used for encouraging liabilities in a specific time zone is allotting incentives by way of higher interest rate for a particular time zone and offer lower rate in a time zone where the deposit liabilities are not wanted by the bank. Each bank follows different practices depending upon their need, Geographical spread and such other relevant factors.


Sr. no Book Name 1. 2. 3. 4. 5. 6. 7. Banking and Finance Management of India Financial Institution Practice and Law of Banking Author C.M.Chaudhari R.M.Srivastava Jeevanandan

Banking Theory and Law Practice Sundharam & varshney Modern Banking Banking in India Theory and Practice of Banking K.P.M.Sundharam Khan Masood Ahmad Reddy