Financial Framework
The Financial system consists of: Markets (Stock Markets, Bond Markets,) Market Players (Banks, NBFIs) Instruments (Stocks, Bonds etc) Regulators (RBI, SEBI etc)
Banks
The term bank is used generically to refer to any financial institution that is licensed to accept deposits that are repayable on demand, and lend money. Services offered by a bank to a corporate are: Loans: Banks provide short and long-term funds to businesses. Cash Deposits: Corporates deposit surplus funds in a bank. Foreign exchange transactions: Banks act as authorized dealers to facilitate foreign exchange transactions. Advisory Services: Banks provide financial advisory services such as valuations, issue management, mergers & acquisitions, etc. to corporates. Trade and commerce: Banks play the role of the trusted intermediary between parties involved in trade and facilitate trade and commerce.
NBFCs
NBFC stands for Non Banking Financial Company. An NBFC broadly carries out lending and investment functions. Only few permitted NBFCs can accept deposits. The three key differences between a bank and NBFC are: 1. An NBFC cannot accept deposits which are repayable on demand. Some can accept fixed-term deposits. 2. Any deposits accepted by NBFCs (these will be of fixed maturity as explained above) are not insured 3. Only banks can participate in the payment system; hence NBFCs cannot issue cheque books to their customers.
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Public sector Banks: PSBs are those where the government holds a majority (>50%) ownership. Private Banks: Private banks, are banks owned by private (i.e. non-government) Indian entities such as corporates and individuals. Foreign Banks: Foreign Banks are those owned by multi national/non-Indian entities. Regional Rural Banks: RRBs are also banks with a Government ownership. The idea was to create banks which will focus on the rural areas and serve the under banked sector. A scheduled commercial bank acts as a sponsor of an RRB. Urban Co-operative Banks: Co-operative banks are formed by a group of members. Traditionally the thrust of UCBs has been, to mobilize savings from the middle and low income urban groups and ensure credit to their members - many of which belong to the weaker section. State Co-operative Banks: SCBs are set up with state government partnership to help agricultural and rural development.
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Reserve Requirements
Reserve requirements are a certain percentage of deposits taken which are to be maintained with the RBI. Reserve requirements in India are of two types: 1) 2) Cash Reserve Ratio: A certain percentage of all deposits must be placed with the RBI in the form of cash. CRR defines this percentage. Statutory Liquid Ratio: A certain percentage of all deposits must be used to purchase Government securities. SLR defines this percentage.
Agriculture Small enterprises Self Help Groups Micro Credit Educational Loans Housing Loans
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Banking Business
The primary function of a bank is to collect funds (deposits) at a lower interest rate and lend them out at a higher interest rate. A bank makes money via Net Interest Income. Net Interest Income (NII) = Interest Earned on Loans Interest Paid on Deposits However, a sizeable portion of income comes from fee charged on various services such as Demand drafts Advisory services to corporate, Trading income, Commission via selling other (non-bank) financial products like insurance and mutual funds.
Spread The difference between the average deposit rate and the average lending rate is called the spread. Spread = Average Lending Rate Average Deposit Rate In India, banks typically work on spreads of 3-5%. So, if SBI says its spread is 3%, it means that the difference between its average deposit rates and lending rates is 3%. Difference between Spread and NII NII is the income earned (difference of the actual interest earned and paid) by the bank in absolute terms. Spread is the difference between the interest rates.
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1. Line Functions - Business units which are a key part of banking operations, are called Line Functions
and are customer facing or part of the Front Office. This means they are interacting with the customer. These include the sales functions, the channels and each specific group of offerings like retail banking, corporate banking, etc. as shown.
2. Back Office & Support Functions - The second category also comprises key line functions, but these are
back office or operations. They support the front office. These include all operations such as account opening, loan documentation processing; also risk management, payments, new product development and Asset & Liability Management or ALM.
3.
Staff Functions - The third set is the staff functions they are not key banking or line functions, and would be there in any large organization. These are functions like Human Resources, IT, Legal, Finance & Control, etc.
Let us know about each section in brief. Channels: Systems/Infrastructure which enables a customer to access the banks services. Sales & Marketing: Division managing sales of all the products of the bank.
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Retail Banking: Division which handles banking requirements of domestic individuals and small businesses proprietorships and partnerships. NRI Banking: Specific to India handles banking requirements of NRIs. This can be clubbed in the Retail Banking Division. Rural/Agricultural Banking: Division seen mainly in Public Sector Banks (PSBs) in India, as they must, by mandate, cater to the needs of this sector. SME Banking: Small and Medium Enterprises division. Sometimes also included under Corporate Banking depends on the bank. Corporate/Wholesale Banking: Division which handles the banking needs of corporates only. Pvt. Banking & WM: Managing the investment needs of wealthy individuals, called High Networth Individuals (HNIs). Investment Banking: A specialized division that caters to the niche requirements of corporates. For example, Mergers and Acquisitions advisory (M&A). Financial Markets & Treasury: Trading division of the bank. This could be proprietary (for their own books) or on the behalf of clients. Product Development: Designs new product offerings based on market requirements. Product Development: Designs new product offerings based on market requirements. Operations: Entire set of processes to enable banking services. Can be divided into Operations for each division or merged for economies of scale. Risk Management: Handles credit, market, operational, liquidity risks for the bank can be segregated for each division. Payments/Remittances: Handles all the payments processing. Large operational area, hence separate division. ALM: Manages a bank's balance sheet to minimize interest rate and liquidity risk. HR: Manages Human Resources function such as recruitment, training etc. Legal & Compliance: Ensures compliance to regulatory requirements. IT: Managing the technology required for the various processes. Audit: Internal function, ensuring processes are within guidelines. Finance & Control: Preparing the financial statements, budgeting, forecasting & internal reporting of the bank.
Channels
Banking channels refer to the means by which customers access a banks products and services. Typical channels offered by banks include:
1.
Branch Banking Branch banking refers to a physical location where a bank offers a wide array of services to its customers. It involves large investment in infrastructure and employees. Branch banking is the most popular channel and also the most expensive channel for a bank. Functions of a branch - The functions of a branch are illustrated below. They can be divided into:
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a) Front-office or customer interfacing functions - The front office or customers facing functions are those of the teller, customer service and sales staff. Often, as shown, one person can have dual responsibilities: A teller can also answer customer queries or a customer service staff can use his interaction time to sell a bank product. Back office or operations - The typical back office operations are payments, check book processing, loan processing etc. These operations are usually centralized in a region. Hence for large banks, operations within each branch are minimal.
b)
2.
ATMs An Automated Teller Machine (ATM) is a computerized device that provides the customers of a bank easy access to transactions, without the need for a branch. ATMs can be just cash dispensers or evolved facilities offering facilities such as: Balance Enquiry Statement of Accounts Cash Withdrawal Cash deposit Check deposit Check cashing Funds transfer Bill Payment Currency Exchange Loan Application Investment Advice MF, Insurance sales Electronic Purse loading Ticketing
3.
Internet Banking Internet Banking refers to the ability to access banking services/products via the internet. It is one of the cheapest channels for a bank. Typical Internet Banking offerings include: Static information about the banks offerings, application forms Specific account information: Statements, Alerts, Ability to change/edit account information Stop payments, cheque book requests/other instructions Payment transactions to other accounts within and external to the bank Bill Payments
4.
Phone Banking Call centers enable customers to access services as described below: Enquiries about Loans and Deposits - Check your account balance, enquire the last five transaction details, make general foreign exchange rates enquiry etc. Transactions - Request for a cheque book or account statement, transfer funds between accounts (same currency), make bill payments etc.
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5. Mobile Banking Banking using a mobile phone network can use either SMS or WAP technology. Interactions can be classified as either transactions or enquiries; as also if they are bank initiated (Push) or Customer initiated (Pull), as shown in the table below.
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Retail Banking
Retail banking is a division that handles banking requirements of individuals and small businesses. The retail bank acts as a key channel to collect deposit funds, which are in turn used to generate profits for the bank. The retail bank broadly offers two categories of products: Liability (Deposit) Products Asset (Loan) Products
Liability Products
A deposit is a contract between the bank and the customer. The bank must repay the deposit per the terms of the contract. Hence deposits are liabilities for the bank. Bank deposits are insured. Some deposit accounts pay interest. In India, RBI mandates four basic types of domestic deposit accounts: a) Savings Accounts: These accounts are meant for individuals. The key features of a savings account are: Meant only for individuals. There is some restriction on the number of times a customer may withdraw or deposit funds. It pays interest. Currently (Oct 2011), RBI has deregulated the savings rate. The interest is calculated on the daily balance in the account. The interest is credited to the accounts on a quarterly or longer rests.
Interest rate
b)
Current Accounts: The key features of a current account are: They are held mainly by businesses. Legally speaking, they can also be opened by individuals, but unless they have a large (say, more than a hundred per month) number of transactions, theyd be better off with a savings account which pays them interest. These are accounts primarily meant for transacting, and hence have no restrictions on the number of transactions. Banks do not pay any interest on current accounts, though RBI allows Urban Cooperative Banks to pay some interest if they wish.
Users
Withdrawal frequency
Interest rate
c)
Term/Time/Fixed Deposits: These are deposits with a fixed maturity, hence also called Fixed Deposits (FDs).The key features of a fixed deposit are:
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Users Either an individual or a business.
Withdrawal frequency
The customer cannotadd to, or withdraw from, this deposit till maturity i.e., transactions are not allowedon an FD. FDs earn higher interest than savings deposits, and banks are free to fix the interest rates.
Interest rate
As there are no transactions, FD accounts do not come with means of withdrawal, such as cheque books or ATM cards. Recurring Deposits - These are a fixed deposit variant. The only difference being that, the customer has the flexibility to deposit the amount in installments. Users Withdrawal frequency Meant only for individuals. No withdrawals are allowed. One can, however avail a loan against the deposit.
Interest rate
d)
Public Provident Fund Accounts: These are accounts meant for retirement savings. In India, they are fully tax exempt you pay no tax on the principal or interest earned. They currently earn a tax free interest rate of 8.7% p.a., compounded annually.
Combination Accounts Apart from the above, banks also offer some combination structures. They are: 1. Book the FD in small pieces: Here the F.D is booked as multiple FDs of small equal amounts. Hence a customer can withdraw or break these small amounts without disturbing the other parts of the FD. Loan against the F.D: This is actually a loan an OverDraft (OD) - against the security/collateral of your FD. Banks charge a higher interest rate on loans against F.D. If the customer doesnt repay the loan, the FD (on which there is a lien) is seized to repay both principal and interest. Savings/Transaction Account with F.D: The customer is offered the option of having surplus money in a savings account /Current account moved automatically into an FD, thereby earning higher interest. In case an amount more than whats there in the savings account is needed, the linked FD is broken and money swept back into the savings account. These are typically called Sweep -in/Sweep-out accounts or an Auto Sweep facility.
2.
3.
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NRI Banking There is a separate category of accounts for NRIs. If a bank has a large NRI deposit base, they may have a separate business division for NRI deposits. An NRI can hold only any one of the following three types of NR (Non Resident) accounts. Non Resident Ordinary (NRO) Account Deposit Currency Withdrawal Currency Currency Risk for Customer Repatriable Foreign Currency/INR INR No No limit on interest amount. Principal capped at USD 1 Mn. Non Resident External (NRE) Account Foreign Currency INR Yes Principal and interest Foreign Currency Non Resident (FCNR) Account Foreign Currency Foreign Currency but no interim withdrawals No Principal and interest
Liability Processes
The liability process is as follows: a) Account Opening: An account can be opened only after various checks like identity, source of funds etc. are done. Relationship Management: Relationship management involves ongoing interaction with the customer in order to service any requests. Operations/Servicing: The operations around the lifecycle of a deposit are reasonably complex and large. They involve interest accrual, statements, any modifications to the customer details (such as address, phone number etc), managing transactions and closure. Monitoring: With countries coming together to fight terrorism via tracking and blocking terrorist and illegal funds, banks have the additional responsibility of monitoring the transactions of deposit accounts.
b)
c)
d)
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Asset Products
Asset products can be categorized based on certain parameters. They are: 1) Basis Security There are two types of products under this category a) Secured Loans: Loans in which an item of value is collateral for its repayment. b) Unsecured Loans: Unsecured loans do not involve the pledge of collateral. Assurance of repayment is the borrowers promise to repay the loan. Basis Repayment The following products are offered based on repayment a) Single Payment Loan - The borrower repays the loan in one lump sum with the single-payment plan. b) Installment Payment Loan - Borrowers repay loans over a period of time at periodic intervals (for example, monthly, quarterly, or semiannually). Basis Disbursal a) Open Ended Loan - Also called a revolving loan or an overdraft (OD), borrowers are assigned a limit or line of creditupto which they can borrow. They can repay and borrow again upto the limit, hence the term revolving. b) Close Ended Loan - A lender extends a specific amount of funds to a borrower, after which no additional advances can be made, even if the borrower makes payments on the loan. Basis Interest Rate - Interest rates on the loan can be fixed-i.e., the rate remains the same for the period of the loan, or floating (adjustable) i.e., the rate floats, tied to a benchmark interest rate.
2)
3)
4)
Typical Loan Products The typical loan products offered by a retail bank are: Home Loans Loans against Property Vehicle Loans Loans Against Fixed Deposits Credit Cards Personal Loans Education Loans
Asset Processes/Roles
Irrespective of the type of loan, the retail lending process typically follows the following stages: a. Origination: Informing the prospective applicant about the features of the loan, collecting the completed application and required additional documentation and verifying the collected information, are all parts of this stage of the loan process. b. c. d. e. Underwriting/credit appraisal: The bank evaluates the prospective borrower and decides how risky s/he is. Documentation: The documents required for closing the loan such as title papers of any collateral are collected and verified. Loan Closing: All parties to the loan sign the contract. Disbursal: The loan is then disbursed, either at one go or in stages, depending on the terms of the loan.
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f.
Servicing: The loan does not end with disbursal. The principal and interest repayments need to be collected in a timely manner. Also the servicing function has to ensure that the title and value of the collateral remains secure.
g.
Collections and recovery: In case the borrower delays payment, the process of collections starts. If there is no payment on a loan for more than 90 days, it is classified as a Non Performing Asset or NPA. If a loan shows no signs of repayment after that, then the process of recovery seizing any collateral and recovering the loan amount starts.
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Corporate Banking
Corporate banking is the name given to the different banking services which companies need for their day to day operations. It is also called wholesale banking. Structure of Corporate Banking Division A typical Corporate Banking structure looks like this:
The relationship chain manages the customer relationship. This can be called the front office. They interact with the customers and understand their requirements. The credit chain, on the other hand, rarely meets the customer. Their role is to evaluate the credit requirements of the company, as presented by the relationship chain, and evaluate them. Product management is responsible for customizing the banking products and services to suit customer needs. Transaction banking is often separated from the relationship chain & the credit chain and can be an individual business unit called TBG (Transaction Banking Group). TBG is responsible for ensuring product and service delivery to the customers.
1.
These are products in which a bank is out of funds by lending money to its customers hence, they are loan products. The earning of the bank for such facilities is mainly interest income.
2.
Here, the bank primarily stands guarantee for its customer. Examples of non-fund based facilities are letters of credit and guarantees. They are called non-fund facilities as they do not involve actual lending of funds.
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Both fund-based and non fund-based facilities can be classified on the basis of: 1. 2. 3. 4. Purpose Maturity Revolving or one-off Security
To understand the various facilities, we will use the funded and non funded classification. Funded facilities: Working Capital Loans Overdraft Facility Cash Credit Facility Working Capital Demand Loans (WCDL)
Non Funded facilities: Trade Products Intermediaries Letter of Credit (LC) Bank Guarantee
Working Capital Loans: Banks provide various forms of loans to meet the daily requirements of businesses. These are generally for a short term (up to 1 year). Overdraft Facility: An overdraft facility or OD is a revolving credit facility that allows a borrower to overdraw funds beyond the available balance, up to an agreed limit, from her account. Cash Credit Facility: As in an OD, the business can withdraw up to the sanctioned limit when needed, paying interest only on the amount withdrawn and for the period withdrawn. This is a facility against collateral of receivables and inventory of the business. The limit is typically 60-70% of the value of the collateral. The buffer (30-40%) which the bank keeps on the value of the asset is called the margin. Working Capital Demand Loans (WCDL): Working Capital Demand Loan (WCDL) is, in essence, a short term revolving loan facility given for the working capital requirement of the company.
Long Term Loans: Banks provide secured or unsecured long term loans to corporations these could be to finance expansions, buy real estate or machinery etc. Trade Finance: Corporate banking provides services to facilitate international trade. These include loans to the seller, to bridge his funding requirements till he/she gets payment from the buyer. These can be both pre-shipment and post-shipment loans. Bill Discounting: It serves to provide liquidity to an exporter. This is done by advancing him/her a portion of the face value of a trade bill drawn by the exporter. The bill must have been accepted by the buyer, and then endorsed to the bank.
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Trade Products Intermediaries: Banks also act as intermediaries for documents and funds flow in an international trade transaction. This is because transfer through banking channels is far more secure, than if the buyer were to send money directly to the seller, or the seller trying to send documents directly to the buyer. Letter of Credit: The Letter of Credit (LC) allows the buyer and seller to contract a trusted intermediary (a bank), that will guarantee full payment to the seller provided he has shipped the goods and complied with the terms of the agreement. Bank Guarantee (BG): A Bank Guarantee (BG) is an instrument by which the issuing bank guarantees the satisfactory performance of a contract, or of the non-happening of an event (such as an event of default), to the beneficiary. It can be a financial or performance guarantee. Cash Management Services (CMS): CMS involves no credit risk for the bank. The bank provides a pure administrative service for the corporate by managing the companys receipts and payments across the country. Hence, credit evaluation (that is, evaluating whether or not to grant a credit limit for the company) is not relevant here. Credit Evaluation: Before granting a facility/loan, the bank must follow a stringent credit evaluation process, to determine whether or not to give the loan to the company. This function analyses the credibility of an organization. The credit process involves a qualitative and quantitative appraisal of the client. Qualitative analysis includes analysis of: Promoters reputation Industry outlook Past track record Extent of competition etc.
Quantitative analysis includes comparing the financials over a period of time to evaluate performance.
SME Banking
An SME Small and Medium Enterprise is also a corporate. So the facilities offered are similar. The most popular products a bank provides to an SME are working capital products. They are: Cash Credit: As described earlier, this is an overdraft facility which is secured by a business inventory and receivables. A bank will offer 60-70% of the value of the collateral as a cash credit facility. While the receivables & inventory should be revalued periodically, usually a bank will do this once a year. Overdraft (OD) Facility: This is an unsecured line of credit. The bank will allow the SME to overdraw their current account upto a certain limit. Interest is charged only on the overdrawn amount for the period it is overdrawn.
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b)
c)
d)
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Traditional Banking Services Personalised check books Separate counters Banking at your doorstep Instant wire transfers Advisory Services These are divided into a) Investment Management & Advice: A client relationship manager understands the clients liquidity, capital and investment needs. Advisory services can relate to investments, tax planning, real estate management and art advisory. The investment advice can be of two types: Self-Directed or Non-discretionary - This is investment advisory in which the bank offers investment recommendations based on the Clients approval. The client may choose to ignore this. Discretionary - In this case, the banks portfolio managers make investment decisions on behalf of the customer. b) Liquidity Management: This involves management of a Clients liquidity (cash etc) needs through short term credit facilities, flexible cash management services etc. An exclusive cash management service with "sweep" facility is a Private Banking feature. Private banking clients typically demand higher returns on their investment, and as a result banks offering these services are heavily dependent on efficient systems and processes to achieve this. Private Banking Workflow The high-level process flow for private banking is shown below.
The front office manages the client interaction and trade execution part. He gets inputs from the middle office in terms of investment research reports. The back office handles the processing and settlement of the transactions. This includes sending regular statements, payment messages, to the client etc. Certain activities are outsourced to the service providers such as safe custody of securities, tax processing etc. 4. Rural & Agricultural Banking A banks involvement in rural banking can be to take deposits and lend money. However, the branch network required to access rural areas vs. the typical deposit amounts gathered, make it an unviable proposition for private sector banks.
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An important vehicle for funding in rural areas tends to be microfinance which can be retail (to SHGs) or wholesale (to Micro Finance Institutions who then lend the money to SHGs). Broadly, credit or funding can be focused on three parts of the agricultural chain described below:
Individual loans against crops For Land development Mechanisation Poultry, piggery, dairy farming support Warehousing financing Funding of fertiliser and seed distribution
Working capital funding Short term and long term loans Warehouse financing
The risks a bank faces specific to agricultural lending are the risk of crop failure and drop in crop prices, as both will impact repayment.
Support Functions
Below are some of functions that encompass the whole bank, and are not restricted to a specific division. a) Sales & Marketing: The sales function is largest for the Retail Bank (offerings for individuals). The sales staff can be divided by product. Banks and NBFCs achieve their sales for Retail Banking through: External/outsourced agencies: These are called Direct Sales Agencies (DSAs) or Direct Marketing Agencies (DMAs). They are paid a commission on every sale. Other outsourcing agencies are telemarketing and direct mailing agencies. Internal sales staff: Every interaction with the bank is seen as an opportunity to sell its services. Hence branch staff and relationship managers often cross sell various products and services of the bank. b) Asset Liability Management (ALM): For a business, timings of the returns from the asset, must match the due date of the liability. A basic aspect of financial planning encompasses such matching activities of cash flows and is given the generic label: Asset and Liability Management or, in short, ALM. Asset Liability Management consists of managing this interest rate risk to within acceptable limits. ALM also manages liquidity risk for the organization; that is, the bank must always have sufficient funds to service their depositors.
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c) Human Resource Management: As the name suggests, this deals with managing the employees of the bank. This includes recruitment, training, evaluation, compensation and any issues of conflict amongst the employees.
d) Legal and Compliance: This deals with any regulatory requirements of the bank. Any lawsuits will be handled by the legal department. Any new client contracts or legal agreements will also be drawn up and vetted by this division. e) Finance and Control: This manages the internal and external reporting requirements for the bank. This is where the financial statements of the organization are prepared and reported. This department is closely associated with the senior management of the organization. f) Audit: This manages the internal audit requirements for the bank. It is an independent division that evaluates the control systems within the organisation.
g) Technology: This is responsible for managing the existing technology platform of the bank. They also design any new systems and processes that are required to provide the bank with a competitive edge. A lot of this activity could be outsourced to IT companies as well, in which case managing the technology vendors would also be a role of the technology division.
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NBFCs
Introduction
Non Banking Finance Companies (NBFCs) are financial institutions that provide services, similar to banks, but they do not hold a banking license. The main difference is that NBFCs cannot accept deposits repayable on demand.
Classification of NBFCs
NBFCs have been classified into three types: 1. Asset Finance Company (AFC): An AFC is an NBFC, whose principal business is the financing of physical assets. This includes financing of automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments and general purpose industrial machines. An AFC may be either 1. Giving loans to businesses for purchasing the physical assets tractors, machinery etc. 2. Leasing these assets to businesses. Examples of AFCs are Infrastructure Finance Limited, Diganta Finance etc. 2. Investment Company (IC): This is an NBFC whose primary business is purchase and sale of securities (financial instruments, such as stocks and bonds). A mutual fund would come under this category. Examples of an Investment Company (IC) are Motilal Oswal, UTI Mutual Fund etc. 3. Loan Company (LC): Loan Company (LC) means any NBFC whose principal business is that of providing finance, by giving loans or advances. It does not include leasing or hire purchase. Example of a Loan Company (LC) is Tata Capital Limited. NBFCs can be further classified into those taking deposits or those not taking deposits. Only those NBFCs can take deposits, that a) Hold a valid certificate of registration with authorization to accept public deposits. b) Have minimum stipulated Net Owned Funds (NOF i.e. owners funds) c) Comply with RBI directions such as investing part of the funds in liquid assets, maintain reserves, rating etc. issued by the bank.
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2. Leasing & Hire Purchase: An asset finance company, mainly derives revenues from financing assets such as equipment, vehicles, etc. In a Lease transaction two parties are involved: a) Lessor: The person who pays rent for land or property from a lessor. b) Lessee: The person who rents land or property to a lessee. The ownership of the asset rests with the asset finance company. The AFC earns lease rentals, which comprise finance or hiring charge and recovery of the used up value of the leased asset. In hire purchase the ownership of the asset is transferred to the hirer at the end of the HP period. 3. Lending: NBFCs tend to take on higher risk than a bank. They are not constrained by the priority sector lending requirement which banks have. 4. Investment Services: NBFCs offer a wide range of investment services such as: Merchant Banking and Underwriting - Investment Banking functions where a business that wishes to raise capital is provided various services. Stock Broking - Trading on behalf of customers. Asset Management - Managing clients funds. Mutual Funds, Pension Funds, Private Equity Funds all offer these services. Venture Capital & Private Equity - Equity capital to start-up companies; and private (not public) equity capital for other businesses. Custodial services - Settlement of securities transactions.
Most NBFCs tend to focus on a combination of lending, leasing & hire purchase or investment services.
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Only banks can participate in the payment system. Hence the payment syst em concerns itself with the payers and payees banks. They in turn interact with the payer and payee respectively. The two banks can exchange the funds either directly or through an intermediary called a Clearing House (CH) or Clearing Agency (explained later). Lets now understand what a non-cash payment looks like. It consists of two components: 1. 2. The Payment Instruction: The payment instruction, where a message is transmitted between the two banks. Transfer of Funds: Transfer of funds between the two bankscan happen either along with, or later than, the payment instruction.
Settlement: Once the payment obligation has been defined, then the bank has to exchange funds, or settle the obligation. Settlement Bank: Settlement happens via debit/credit of accounts which banks hold with a settlement bank. Each of these banks can hold a settlement account with a third bank, designated for this pur pose as the settlement bank. Correspondent Bank/Correspondent: A correspondent bank is one which acts as a representative of another bank. Banks have correspondent relationships with each other across the world and locally.
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Nostro Account: It is a banks foreign currency account with any other bank. This means, our account with them. Vostro Account: This is how a correspondent bank refers to another banks foreign currency account with it. It means their account with us. On-Us: This term is used within a bank, when the payment transaction it receives, is drawn on it. That is, payer and payee belong to the same bank. Off-Us: In case the payer and payee belong to different banks, the transaction is called Off -Us or a transit item/clearing item. Float: Advantage to the payer/payers bank because of delay in the payment system, as he enjoys the usage of the money (over which he has no claim) till it is paid out.
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Paper based payments Cheques: A cheque is a payment instrument in a specified format, using which, the payer instructs (or draws on) his bank to allow a debit from his account. Demand drafts: Similar to acheque except that a cheque, is payable finally by the payer (drawer, in cheque terminology) who holds an account with the paying bank, while a draft is payable by the paying bank itself. Card based payments Debit cards: Plastic card which one can swipe to give electronic instruction to bank to debit his account and transfer funds to recipient. Credit cards: Plastic card which one can swipe to give electronic instruction to bank to transfer funds to recipient but without debiting his account for a specified period. Electronic payments Electronic Clearing Service (ECS): The Electronic Clearing Service clears and settles mainly bulk, repeated electronic payments. In this one time authorization, your account may be debited periodically. National Electronic Funds Transfer (NEFT): NEFT is useful for one time electronic payments. Real Time Gross Settlement (RTGS): RTGS is usedif one wants to make a one time transaction involving amount more than INR two lakhs and funds will transfer immediately.
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Identifying Risk
The first step in the risk management process is to identify the sources of risk.Credit Risk, Market Risk and Operational Risk encompass over 90% of the risk faced by financial institutions today. Market Risk - Risk of loss due to price movements in any market the institution is trading in, such as currency, stocks, bonds, commodities etc. Credit Risk - Risk of loan default Operational Risk - Risk of incurring losses due to manual errors, fraud or system failure. Liquidity Risk - Risk of not having liquid funds when needed. Liquidity risk exists typically in emerging markets.
Let us now map each of these risks more specifically to each division of a bank/financial institution to make it more relevant.
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Current Account and Savings Account (CASA) - Liquidity Risk: The institution should have enough funds to give loans and repay depositors. Loans Credit Risk: The institution should ensure that loans given are recoverable from the parties and there are minimum defaults. Cheque Clearing Operational Risk: The institution should ensure that the clearing process takes place smoothly without any manual errors. Else they would be exposed to operational losses. Letter of Credit Credit Risk: As the institution is providing a guarantee, they are exposed to default risk, similar to loans. Cash Management Service (CMS) Operational Risk: Here again, as this activity is operation intensive, the institution is exposed loss due to system failure, manual errors etc. Trading Market Risk & Operational Risk: As this involves the front office activity of trading in market variables such as stocks and bonds and the back office activity. Underwriting Market Risk: As the institution agrees to buy unsubscribed amount in case of public issues and issuance of other financial instruments. Asset Liability Management Market Risk & Liquidity Risk: Both loans and deposits are subjected to market risk and liquidity risk.
Measuring Risk
The next stage in risk management process is to measure the risk. We all know that risk can be defined as probability of occurrence and deviation from expectation. There are a number of other risk parameters such as Duration used for bonds, Beta- used for equities, Factor sensitivity - used for currencies etc. Let us discuss briefly about a comprehensive measure of risk called Value at Risk (VaR). Value at Risk (VaR) VaR is an attempt to provide a single number summarizing the total risk in a portfolio of financial assets. It has become widely used by corporate treasurers and fund managers as well as by financial institutions. Some of the impetus for the use of VaR has also come from the regulators. Regulators now require all banks to calculate VaR. They use VaR in determining the capital a bank is required to keep, to reflect the risks it is bearing. Remember, risk measures are statistical estimates which can never be made with 100% confidence. The full statement of VaR therefore reads as follows We are X% confident that we will not lose more than V rupees over the next N days. There are various methodologies for computing VaR. Variance -Covariance Methodology o J.P Morgan's Risk Metrics o FEDAI methodology for currencies in India Simulation Methodology o Historical Simulation (using past data) o Monte Carlo (using random sampling)
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Basel I Norms Basel I norms defined the minimum capital required to be maintained by internationally active banks. This capital required, was linked directly to the risk faced by them in their operations. The norms established a standard of risk weights applied to different classes. So, riskier lending (such as unsecured loans to borrowers of doubtful credit history) attracted higher risk weights, and hence, higher capital requirements. The risk weights suggested to banks were as follows: Lending to your own branch 0% Lending to another bank 20% Lending to a corporate of certain credibility 50% Lending to other entities 100%
Basel II Framework The Basel II framework is based on three pillars -Pillar I Minimum Capital: This part of Basel II covers the Capital Adequacy norms. It defines different ways of measuring credit, market and operational risk, and how much capital banks must have in order to protect against each risk. Pillar II Supervisory Review: This part of the Basel II process provides for Supervisors to the first pillar. This means, that every bank should have an internal audit division that checks that the method of risk measurement chosen is most appropriate; that the tracking and measurement is being done correctly. Pillar III Market Discipline: The third pillar of the Basel II norms recommend that banks need to become more transparent by disclosing information. What information? Well, the methods they are using to calculate risk, what is the quantum of risk being faced using these methods and hence what is the capital being maintained.
Basel III The Latest The financial crisis of 2008 made the Basel committee review and come up with more stringent norms. One of the main outcomes of Basel III is a significant rise in the banking industrys capital requirements. It increased the minimum capital requirement for RWA to 10.5% from 8%. It also increased the weightage of core capital (Tier I) against RWA. It introduced measures for better management of liquidity risk within banks.
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Negotiable Instruments (N.I) Act: The N.I Act covers the rules around transactions of negotiable instruments. Negotiable instruments are payment instruments which are transferrable from one party to another. Example: promissory note, bill of exchange A Promissory Note is a note written by a borrower, promising to pay back the sum borrowed. Bill of exchange is an instrument used in business transactions. A seller will prepare a bill saying Pay (seller or whoever is to be paid) the payment amount, and send it to the buyer. UCPDC: It stands for Uniform Customs and Practices for Documentary Credits. A Letter of Credit (LC) is also called a documentary credit. As trade finance is across countries, there have to be uniform practices followed globally. Hence, the International Chamber of Commerce (ICC) has issued this set of regulations governing international trade. Its commonly called UCP and as the current version is called 600, the UCP 600. SARFAESI Act: SARFAESI stands for Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act. This Act covers the rights a lender has over the collateral, when a secured loan defaults. Reconstruction of an asset, is banker-speak for reworking the terms of a loan to ensure that the money is repaid. The SARFAESI Act in case of default, covers features such as: a) Securitization: Issuing securities financial instruments against the recovered assets. It can be done only by specific registered entities called an asset reconstruction company or securitization company. b) Guidelines for Asset Reconstruction: It covers how a defaulting business should be managed or controlled to ensure repayment. Payments can be rescheduled, and secured collateral repossessed. c) No court intervention needed: One of the main features of this Act is, the lender can take over the collateral without court intervention, which was not possible earlier.
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Regulatory Compliance
Regulatory compliance means, ensuring that the bank is functioning within the regulatory requirements laid down by the regulator-the Central Bank. The compliance requirements for a bank are: 1. Reserve Requirements: These requirements define how much of every deposit must be deposited with the RBI. Currently, 4% of every deposit must be deposited with the RBI under the Cash Reserve Ratio (CRR). And 23% of every deposit must be invested in defined Government securities, under the Statutory Liquidity Ratio (SLR). NBFCs have only SLR requirements, no CRR. This protects the bank/finance company (FC) against liquidity risk and the customer against default risk. Know Your Customer (KYC) & Anti Money Laundering (AML): These compliance requirements come from the Prevention of Money Laundering Act (PMLA). KYC and AML norms have been implemented the world over post 9/11. KYC procedures enable banks to know/understand their customers and their financial dealings better, which in turn help them manage their risks prudently. Here the entire focus is on gathering sufficient information
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on a customers profile, and monitoring his transactions on an ongoing basis for suspicious (unusual) activity. A bank has hundreds of thousands of customers. The effort involved in actually monitoring every transaction is huge. The steps involved in monitoring transactions are: 1. Customer Identification Procedure: to gather adequate information about a customer and his/her financial behavior. The key elements are, to collect and verify proof of identity and address (for individuals), categorise the customer into different risk profiles and review risk categorization regularly. 2. Monitoring Of Transactions: To make monitoring of transactions easy the customers are classified into low, medium and high risk customers. Once customers are categorized, their account profiles are developed. 3. Reporting: As per RBI regulations, all cash transactions greater than INR 1 million must be reported via whats called a Cash Transaction Report (CTR). Further, any suspicious transactions also need to be reported.
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Technology in Banking
As we realize by now, technology is a key requirement for customer convenience and for banks to manage their operations. RBI has made it mandatory for all banks including RRBs to move from manual to technology driven processes.
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7. Security Management system: This feature of CBS ensures that only authorized users access what they are supposed to (you wouldnt want a bank officer to be able to transfer funds from your account to his!), and also that data remains secure.
Each of the above applications is relevant to the entire bank. Hence it has to be connected with every part of the bank, i.e. it has to be available to every division.
Channels Modules: Each channel has its unique work flow, and some standard work flows. Channel specific IT applications will ensure specific functionality. Lets see how ATMs are connected and how they function. 1. ATMs These are connected to each other via a switch or network. Thats the reason why you can withdraw from an ATM hosted by Axis Bank, even if your account is with HDFC Bank. The Axis Bank ATM and the HDFC Bank ATM are connected to the same network via a switch and messages can flow from an ATM to another bank. Branch Banking - A branch banking application will mainly enable teller and customer service functions. Some 3. of these are: Account Opening Regular Account Transactions Payments/Fund Transfer Sale or Purchase Fixed Deposit Transactions Loan Account Transactions
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Internet Banking - The internet banking application is separately built, as it needs a lot of specific functionality. It will need extensive security to ensure that secure customer data is not accessible by unauthorized people on the net.
Retail Banking Modules: Following are the modules under retail banking division.
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1. The Current Account and Savings Account (CASA) Module - The CASA module, helps in supporting a complete range of savings, current and overdraft accounts (that is loans against the current or savings accounts). The Term Deposits Module - This module helps in handling the full range of retail term deposits, including recurring and sweep-in deposits. The Standing Instruction Module - This is for automating the periodic processing of customer instructions. Thus, if you instruct your bank to transfer INR 10,000 to another account on the first of each month, the S.I module will send a debit instruction to the GL module. The Signature Verification System - This system is used for image capture and retrieval. So when you open an account, your signature is scanned and stored. This is retrieved whenever necessary. If the debit is successful, a confirmation is sent from the S.I module via email or sms to you. No human intervention whatsoever is needed. The Loans Module - A loans module, offers transaction processing services for all events in the lifecycle of a loan. A loans system would broadly cover: a) b) Loan origination which covers the workflow up to the time the loan is disbursed, and Loan maintenance and administration: statements, payment collection, etc.
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Corporate Banking Modules Typical corporate banking modules are: 1. 2. Cash and Liquidity Management Module This module enables a bank to offer sophisticated cash and liquidity management services to corporate treasuries for managing their cash positions. Corporate Deposits Module This module supports all kinds of term deposit products for corporates. It automates processes like interest payment calculations on deposits. The Letters of Credit, Bank Guarantees and Bills Modules These modules offer comprehensive support for a banks trade financing activities. For example, banks can automatically credit the Cash Credit (CC) account of a customer upon receiving its bills.
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Investment Banking Modules: Typical investment banking modules are: 1. The Loan Syndication Module - Addresses the processing requirements of consortium or group loans. For example, a lead banker can input the share of each bank in the consortium; track the repayments made by the borrower and how much and when these have been routed to the various banks, how much is outstanding for each bank, fees/income earned etc.
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2. The Mergers & Acquisitions Modules - This will enable a bank to use different valuation models for pricing M&As. This module has inbuilt valuation models which will give the valuations of companies by varying input data such as revenues, cash flows, growth rate etc.
Financial Markets & Treasury Modules: 1. The Foreign Exchange & Money Markets Modules - These modules support all currency and money market transactions. These are supplemented by an integrated dealing room decision support system which allow a dealer to analyse the result of various possible scenarios and take trading decisions. The Securities Module - Offers support for handling a banks primary and secondary market deals, whether for itself or on behalf of its customers. For example, this module takes data from various sources and feeds the user interface with latest market prices of various securities. This will help the users (traders in the bank) take the trading decisions Mutual Fund Management Modules: These are optional modules, i.e. useful only if the bank also owns a mutual fund. 1. The Asset Management Module - This module helps a bank to create funds and manage all transaction processing activities over the life cycle of a fund. The Mutual Fund Investors Services Module - This module is for servicing the investor interface for mutual funds that means, an investor can directly place orders or view her account details using this interface.
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Domestic and International Payment Modules: 1. 2. 3. The Loan Payments and Collections Module - The local payments and collections module, for processing all local payments and collections, including ECS (Electronic Clearing Service i.e., electronic) instructions. The Cross Border Funds Transfer Module - The cross-border funds transfer module, for processing all types of international inward and outward funds transfers. The Nostro Reconciliation Module - This module is used for automatic reconciliation of balances and transactions in nostro accounts. Nostro accounts, as you know, are foreign currency accounts of a bank, maintained with a correspondent bank. The Electronic Messaging system - This system is for smooth message transfer over SWIFT, with features for supporting straight through processing. SWIFT is a common messaging format used across the world, and enables the sending and receiving banks to process the message without human intervention, called straight through processing.
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A document management module enables a bank to secure, track and manage information that is generated in the form of documents. This enables the bank to save a lot of cost, time and of course, gives them peace of mind. General Administration Modules The following modules cater to the general administration division of bank: 1. The Expense Processing Module - Enables the automation of all processes relating to vendor payments vendor contract details, monitoring of credit limits if any to vendors, contract settlements and making final payments to vendors.
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The Fixed Asset Management Module - Enabling a bank to reduce the cost of maintaining its fixed assets and supporting the processing of all events in the life of fixed assets acquisition, depreciation, revaluation, sale/transfer of assets and disposal of assets. Cost Allocation System - For allocating expenses and incomes across products, branches or divisions
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For staff functions like HR, legal & compliance and audit, usually there will be a separate module which may or may not integrate with the CB solution
Cheque Truncation
There are a large number (over 100 crore!) of cheques which are processed in India every year. Each cheque, to be processed, must travel from the bank where it is deposited, to the paying bank. The costs and time delays are huge in manual processing of cheques imagine 100 crore cheques travelling all over the country! Hence the introduction of the Cheque Truncation System or CTS in India, which is a technology initiative introduced by the RBI to simplify the cheque clearing process. That means, a bank scans the cheque both front and back and sends it electronically to the Clearing House (CH), which also forwards it electronically to the paying bank. This of course, reduces the time for clearing as well as the cost of transmitting paper.
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