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Introduction to Banks

The bulk of all money transactions today involve the transfer of bank deposits. Depository institutions, which we normally call banks, are at the very center of our monetary system. Thus a basic knowledge of the banking system is essential to an understanding of how money works.

Bank Deposits and Reserves


The monetary base is created by the Fed when it buys securities for its own portfolio. Bank deposits themselves are not base money, rather they are claims on base money. A bank must hold reserves of base money in order to meet its depositors' cash withdrawals and to cover the checks written against their accounts. Reserves comprise a bank's vault cash and what it holds on deposit at the Fed, known as Fed funds. The Fed requires banks to maintain reserves of at least 10% of their demand deposits, averaged over successive 14-day periods.

The Movement of Bank Reserves


When a depositor writes a check against his account, his bank must surrender that amount in reserves to the payees bank for the check to clear. Reserves are constantly moving from one bank to another as checks are written and cleared. At the end of the day, some banks will be short of reserves and others long.

Banks redistribute reserves among themselves by trading in the Fed funds market. Those long on reserves will normally lend to those short. The annualized interest rate on interbank loans is known as the Fed funds rate, and varies with supply and demand.

The reserve requirement applies only to the bank's demand deposits, not its term or savings deposits. Thus when a bank depositor converts funds in a demand deposit into a term or savings deposit, he frees up the reserves that were held against the demand deposit. The bank can then use those reserves in several ways. For example, it can hold them to back further lending, buy interest-earning Treasury securities, or lend them to other banks in the Fed funds market.

Controlling the Fed Funds Rate


The supply of reserves changes whenever base money enters or leaves the banking system. This occurs when the Fed buys or sells securities or when the public deposits or withdraws cash from banks. The demand for reserves changes whenever total demand deposits change, which occurs when banks increase or decrease aggregate lending. The Fed controls the Fed funds rate by adjusting the supply of reserves to meet the demand at its target interest rate. It does so by adding or draining reserves through its open market operations.

The Fed funds rate effectively sets the upper limit on the cost of reserves to banks, and thus determines the interest rates that

banks must charge the public for loans. Bank interest rates influence the demand for loans, and thereby the net amount of bank lending. That in turn determines the liquidity of the private sector, which is important in terms of aggregate demand and inflationary pressures. The selection and control of the Fed funds rate is the key monetary policy instrument of the Fed.

The Effects of Government Spending


The Fed acts as a depository for the Treasury as well as member banks. All government spending is paid out of the Treasury's account at the Fed. Whenever the government spends, the Fed debits the Treasury's account and credits the Fed account of the payees bank. The Treasury replenishes its Fed account with transfers from its commercial bank accounts where it deposits the receipts from taxes, and the sale of its securities.

In order to minimize variations in aggregate banking system reserves, the Treasury maintains a nearly constant balance in its Fed account. In effect, Treasury payments are simply transfers from its commercial bank accounts to the bank accounts of the public. Funds move in the reverse direction when the public pays taxes or buys securities from the Treasury. The Treasury must maintain a positive balance in its commercial bank accounts to avoid having to borrow directly from the Fed. However it has no need for, and does not accumulate, balances in excess of its nearterm payment obligations.

On average, government spending does not affect the aggregate bank deposits of the private sector. The Treasury sells or redeems securities as required to balance its inflows against outflows. However short-term variations occur because receipts cannot be synchronized with spending. Banking system reserves remain essentially unaffected by government spending because the Treasury transfers funds from its commercial bank accounts to replace the funds spent out of its Fed account.

History of Banking
Safe in the temple: 18th century BC
Wealth compressed into the convenient form of gold brings one disadvantage. Unless well hidden or protected, it is easily stolen.

In early civilizations a temple is considered the safest refuge; it is a solid building, constantly attended, with a sacred character which itself may deter thieves. In Egypt and Mesopotamia gold is deposited in temples for safe-keeping. But it lies idle there, while others in the trading community or in government have desperate need of it. In Babylon at the time of Hammurabi, in the 18th century BC, there are records of loans made by the priests of the temple. The concept of banking has arrived.

Greek and Roman financiers: from the 4th century BC


Banking activities in Greece are more varied and sophisticated than in any previous society. Private entrepreneurs, as well as temples and public bodies, now undertake financial transactions. They take deposits, make loans, change money from one currency to another and test coins for weight and purity.

They even engage in book transactions. Moneylenders can be found who will accept payment in one Greek city and arrange for credit in another, avoiding the need for the customer to transport or transfer large numbers of coins.

Rome, with its genius for administration, adopts and regularizes the banking practices of Greece. By the 2nd century AD a debt can officially be discharged by paying the appropriate sum into a bank, and public notaries are appointed to register such transactions. The collapse of trade after the fall of the Roman empire makes bankers less necessary than before, and their demise is hastened by the hostility of the Christian church to the charging of interest. Usury comes to seem morally offensive. One anonymous medieval author declares vividly that 'a usurer is a bawd to his own money bags, taking a fee that they may engender together'.

Functions of a Bank
1. Recognition of Right to Credit
The view thus given of bank credit in general furnishes the key to the view which should be taken of the bank itself. It is, as we have already seen, a credit institution - an institution for the investigation, discussion, and recording of credits. It is not, in this aspect, what some have described it, an enterprise for "manufacturing" credit. The "manufacture" of credit, as clearly appears from what has already been said, is impossible. A basis of credit is automatically created whenever real buying' power or value is in process of being brought into existence. Such power is created during the expenditure of labor and capital, but the real worth or value is often intimately associated with the other elements that appear in the general operations of his concern. The basis only appears when it is dissociated from the other elements in the aggregate of goods and expert means are needed to recognize it. The first function of a bank, then, is that of

recognizing through scientific analysis the real nature and amount of the values which are presented. Fundamentally, therefore, the credit department of a bank is the basic element in its organization. It is true that in the past many banks have been able to do without credit departments and that at the present time there are not a few of them - chiefly the smaller and less advanced types of institution - which have no credit departments, or only very rudimentary organizations of the sort. These, however, usually accept the work of credit departments operated by their city correspondents. The true work of a bank credit department is done whenever any loan is made. It may be that the work of credit analysis is incidentally performed by the president or a vice-president of the bank or by some other officer who happens to have charge of the work of lending, but the function is there.

2. Guaranteeing of Values
Secondly, the bank, after recognizing or analyzing credit, guarantees it. It does this by substituting its own credit for that of the "borrower" or owner of wealth. If A, for example, is producing steel from pig iron, the bank ascertains the value of the products which he has in process, which, we may say, is $25 per ton. It undertakes to loan, say, $10 per ton, and in order to carry out its part of the agreement it obligates itself to pay $10 on demand to anyone who may be designated by the owner of the plant. The owner leaves with the bank his own note, which may be secured or may be simply a claim upon his general assets. In either case, however, the loan is made on the strength of existing value. It represents that part of the value of the product which the bank is willing to guarantee. The bank does not expect to be called upon to meet this obligation for $10 per ton. On the contrary, it expects to offset the obligation against other claims, and as a net result it believes that it will not be called upon to reduce its holding of specie. That, however, is to be determined at a later time. The

bargain which the bank makes when it enters into relationships with the borrower involves the substitution of its own obligation for that of the owner of the goods, and this is the essential point in the whole operation.

3. Transferring of Titles
Thirdly, the bank not only undertakes to put its obligation in place of that of the borrower, but it undertakes to keep this obligation steadily redeemable on demand in money, or in lieu of such redemption, to shift the "credit" from A to B and from B to any other that the latter may indicate, through a process of bookkeeping which involves the receiving, recording, and paying of claims drawn against the total credit which has been allowed. Closely connected with this function are the subordinate duties of exchange and remittance, which, as will be seen at a later point, are variants of the same general function.

Corporate Governance of Banks


Introduction
The concept of corporate governance, which emerged as a response to corporate failures and widespread dissatisfaction with

the way many corporates function, has become one of the wide and deep discussions across the globe recently. It primarily hinges on complete transparency, integrity and accountability of the management. There is also an increasingly greater focus on investor protection and public interest. Corporate governance is concerned with the values, vision and visibility. It is about the value orientation of the organisation, ethical norms for its performance, the direction of development and social accomplishment of the organisation and the visibility of its performance and practices.

Indian Banking Industry


Indian banking has around 200 years of history and has undergone many transformations since independence. But, Liberalisation, Privatisation and Globalisation and Information Technology are currently changing the Indian banking radically.

Earlier, banking was virtually a monopoly of the public sector banks with full protection from the State. But the process of reforms in the Indian banking system has thrown them out to more liberal and free market forces. Now the banks, more particularly the public sector ones, feel the real heat of the competition. The interest rate cuts, dwindling margins and more number of players to serve a reduced number of bankable clients have all added to the worries of the banks. The customer has finally come to hold the center stage and all banking products are tailor-made to suit his tastes and preferences. This sudden change in the banking environment has bereaved the banks of all

their comforts and many of them are finding it extremely difficult to cope with the change.

Need for Corporate Governance in Banks


1. Since banks are important players in the Indian financial system, special focus on the Corporate Governance in the banking sector becomes critical.

2. The Reserve Bank of India, as a regulator, has the responsibility on the nature of Corporate Governance in the banking sector.

3. To the extent that banks have systemic implications, Corporate Governance in the banks is of critical importance.

4.Given the dominance of public ownership in the banking system in India, corporate practices in the banking sector would also set the standards for Corporate Governance in the private sector.

5. With a view to reducing the possible fiscal burden of recapitalising the PSBs, attention towards Corporate Governance in the banking sector assumes added importance.

Prerequisites for Good Governance


There are some pre-requisites for good corporate governance. They are:

1. A proper system consisting of clearly defined and adequate structure of roles, authority and responsibility.

2. Vision, principles and norms which indicate development path, normative considerations and guidelines and norms for performance.

3. A proper system for guiding, monitoring, reporting and control.

Recommendations by the Birla Committee


The report of the Committee on Corporate Governance, set up by the Securities and Exchange board of India, under the Chairmanship of Kumar Mangalam Birla, is the first formal and comprehensive attempt to evolve a Code of Corporate Governance, in the context of prevailing conditions of governance in Indian companies, as well as the state of capital markets. The committee has identified the three key constituents of corporate governance.

Shareholders' Role
The role of shareholders in corporate governance is to appoint the directors and the auditors and to hold the board accountable for the proper governance of the company by requiring the board to provide them periodically with the requisite information, in transparent fashion, of the activities and progress of the company.

Board of Directors' Role


The board of directors performs the pivotal role in any system of corporate governance. It is accountable to the stakeholders and directs and controls the management. It stewards the company, sets its strategic aim and financial goals, and oversees their implementation, puts in place adequate internal controls and periodically reports the activities and progress of the company in a transparent manner to the stakeholders.

Management's Role
The responsibility of the management is to undertake the management of the company in terms of the direction provided by the board, to put in place adequate control systems and to ensure their operation and to provide information to the board on a timely basis and in a transparent manner to enable the board to monitor the accountability of management to it.

The Basel Committee Recommendations


The Basel Committee published a paper for banking organisations in September 1999. The Committee suggested that it is the responsibility of the banking supervisors to ensure that there is an effective corporate governance in the banking industry. It also highlighted the need for having appropriate accountability and checks and balances within each bank to ensure sound corporate governance, which in turn would lead to effective and more meaningful supervision.

Efforts were taken for several years to remedy the deficiencies of Basel I norm and Basel committee came out with modified approach in June 2004. The final version of the Accord titled " International Convergence of Capital Measurement And Capital Standards-A- Revised Framework" was released by BIS. This is popularly known as New Basel Accord of simply Basel ll. Base ll seeks to rectify most of the defects of Basel l Accord. The objectives of Basel ll are the following:

1. To promote adequate capitalisation of banks.

2. To ensure better risk management and

3. To strengthen the stability of banking system.

Essentials of Accord of Basel ll


1. Capital Adequacy: Basel ll intends to replace the existing approach by a system that would use external credit assessments for determining risk weights. It is intended that such an approach will also apply either directly or indirectly and in varying degrees to the risk weighting of exposure of banks to corporate and securities firms. The result will be reduced risk weights for high quality corporate credits and introduction of more than 100% risk weight for low quality exposures.

2. Risk Based Supervision This ensures that a bank's capital position is consistent with overall risk profile and strategy thus encouraging early supervisory intervention. The new framework lays accent on bank managements developing internal assessment processes and setting targets for capital that are commensurate with bank' particular risk profile and control environment. This internal assessment then would be subjected to supervisory review and intervention by RBI.

3. Market Disclosures The strategy of market disclosure will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold and maintain adequate capital.

Steps to be taken

To overcome from these challenges, banks are required to emphasize on certain factors, which will increase their transparency and lead to higher foreign investment.

1. Self- Appraisal System: Good governance is like trusteeship. It is not just a matter of creating checks and balance but it emphasizes on customer satisfaction and shareholders value. The law regulates certain responsible areas on borrowing, lending, investigating, transparency in accounts etc. The directors, there fore, evaluate themselves through self-introspection.

2. The Board's Committees: It will be difficult for a board, with all the members acting together on some issues, to achieve its objectives effectively and with apt independence. The board, therefore, needs to be assisted by the some committee.

3. Transparency: Transparency can reinforce sound corporate governance. Therefore, public disclosure is desirable in Board Structure, Senior management, Basic organisational structure and incentive structure of the bank.

Prudential norms on Capital Adequacy, Income Recognition.


1. Risk Weight on Securities Guaranteed by State Governments

In terms of instructions contained in item 4 of paragraph 2 (d) of our Circular DBOD No BP BC 103/21.01.002/98 dated October 31, 1998, banks are required to assign risk weight of 2.5 per cent for market risk for their investment in securities where payment of interest and repayment of principal are guaranteed by State Governments. However, in case of default in interest/principal by the State Government banks are required to assign 100 per cent risk weight on investment in all the securities issued or guaranteed by that State Government. The position has since been reviewed and it has been decided that banks need to assign risk weight of 100 per cent only on those State Government guaranteed securities issued by the defaulting entities and not on all the securities issued or guaranteed by that State Government.

Banks are further advised to pay due regard to the record of particular State Government in honouring their guarantees while processing any further requests for loans to PSUs in that State on the strength of State Government guarantee.

2. Sick SSI Units under rehabilitation


In terms of paragraph 3 of Circular DBOD No. BP BC 36/21.04.048/95 dated April 3, 1995, advances granted to units which are placed under rehabilitation package approved by BIFR/Term Lending Institutions (TLIs) are treated as NPAs and provisions are required to be made. However, for additional credit facilities sanctioned to units under rehabilitation package approved by BIFR/TLI, provision need not be made for a period of one year from the date of disbursement. In other words, our guidelines on income recognition, asset classification and provisioning will apply to such additional credit facilities only after a period of one year from the date of disbursement.

Banks have been representing that the above relaxation is not available in respect of additional credit facilities granted under the rehabilitation package/nursing programme prepared by banks themselves or under consortium arrangements. On a review of the matter,

it has been decided that no provision need be made for a period of one year in respect of additional credit facilities granted to SSI units which are identified as sick (as defined in para 5 (a) of RPCD Circular No. PFNFS. BC. 99/ 06.02.031/92-93 dated April 17, 1993) and where rehabilitation packages/nursing programmes have been drawn by the banks themselves or under consortium arrangements . 3. Provision on Standard Assets A reference is invited to para 3 of our Circular DBOD No. BP.BC.101/ 21.04.048/99 dated 18 October 1999 regarding provision on Standard Assets. In the light of suggestions received from banks in regard to treatment and accounting of provision on Standard Assets, our instructions are partially modified as under:

The general provision of 0.25 per cent on Standard Assets should be made on global portfolio basis and not on domestic advances alone.

Provisions towards Standard Assets need not be netted from gross advances as

advised earlier but shown separately as Contingent Provisions against Standard Assets, under Other Liabilities and Provisions - Others in Schedule No. 5 of the balance sheet.

The above contingent provision will not be eligible for inclusion in Tier II Capital.

4. Advances against Book Debt In terms of instructions contained in para 4 of our Circular DBOD No. BP. BC.24/21.04.048/99 dated 30 March 1999, banks are required to show advances against Book Debt under item B (i)- Secured by tangible assets of Schedule 9. Although such advances are secured, it is likely that they may not be fully secured by tangible assets. Hence, banks may now indicate separately in Schedule 9 that item B (i) includes Advances against Book Debts as shown below: Advances (Schedule 9) B (i) Secured by tangible assets * (* includes advances against Book Debt)

5. Investment Fluctuation Reserve Account


In terms of instructions contained in paragraph 1 of our circular DBOD No. BP.BC.24/21.04.048/99 dated 30 March 1999 the amount held in Investment Fluctuation Reserve Account could be utilised to meet, in future, the depreciation requirement on investment in securities. In this connection, it is clarified that the extra provision needed in the event of a depreciation in the value of the investments should be debited to the Profit and Loss Account and if required, an equivalent amount may be transferred from the Investment Fluctuation Reserve Account to the Profit and Loss Account as a below the line item after determining the profit for the year. In recent years we have across the term 'prudential norms' too often particularly in relation to the non-performing assets of the commercial banks. In the light of the existence of huge nonperforming asset in the balance sheets of the commercial banks leading to the erosion of their capital base the relevance of these prudential has acquired particular significance.

The main elements of prudential norms are income recognition, assets classification , provisioning for loans and advances and capital adequacy. In keeping with latest practices at the international levels, commercial banks are not supposed to

recognize their incomes from non-performing assets on an accrual basis and these are to be booked only when these are actually received.

If the balance sheet of a bank is to reflect the factual and true financial state of affairs of the bank it is pragmatic and desirable to have a system of recognition of income, classification of assets and provisioning for sticky debts on a prudential basis. Banks have been directed not to charge and take interest on nonperforming assets to the income account and classify their assets under three broad categories of Standard Assets, Sub-standard Assets, Doubtful Assets and Loss Assets. Taking into account the time-lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the security and the erosion over time in value of security charged to the banks, banks are required to make provision against sub-standard assets, doubtful assets and loss assets.

The prudential accounting norms which were put into place in 1992-93, have been further strengthened over the years. In respect of accounts where there are potential threats of recovery on account of erosion in the value of the security or absence of security and other factorssuch as fraud committed by the borrowers exist, such accounts are to be classified as doubtful or loss assets irrespective of the period to which these remained as non-performing. All the members banks in a consortium are required to classify their advances according to each bank's own record of recovery. Depreciation on securities transferred from the current category to the permanent category has to be immediately provided for. Banks should value the specified government securities under ready forward transactions at market rates on the balance date.

In recent years we have across the term 'prudential norms' too often particularly in relation to the non-performing assets of the commercial banks. In the light of the existence of huge nonperforming asset in the balance sheets of the commercial banks leading to the erosion of their capital base the relevance of these prudential has acquired particular significance.

The main elements of prudential norms are income recognition, assets classification , provisioning for loans and advances and capital adequacy. In keeping with latest practices at the international levels, commercial banks are not supposed to recognize their incomes from non-performing assets on an accrual basis and these are to be booked only when these are actually received.

If the balance sheet of a bank is to reflect the factual and true financial state of affairs of the bank it is pragmatic and desirable to have a system of recognition of income, classification of assets and provisioning for sticky debts on a prudential basis. Banks have been directed not to charge and take interest on nonperforming assets to the income account and classify their assets under three broad categories of Standard Assets, Sub-standard Assets, Doubtful Assets and Loss Assets. Taking into account the time-lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the security and the erosion over time in value of security charged to the banks, banks are required to make provision against sub-standard assets, doubtful assets and loss assets.

The prudential accounting norms which were put into place in 1992-93, have been further strengthened over the years. In respect of accounts where there are potential threats of recovery on account of erosion in the value of the security or absence of security and other factorssuch as fraud committed by the borrowers exist, such accounts are to be classified as doubtful or loss assets irrespective of the period to which these remained as non-performing. All the members banks in a consortium are required to classify their advances according to each bank's own record of recovery. Depreciation on securities transferred from the current category to the permanent category has to be immediately provided for. Banks should value the specified government securities under ready forward transactions at market rates on the balance date.

Conclusion
Corporate governance has assumed vital role and significance due to globalisation and liberalisation. With the opening of economy and to be in line with WTO requirements, if the Indian corporates have to survive and succeed amidst increasing competition globally, it can only be through transparency in operations. The excellence in terms of customer satisfaction, in terms of return, in terms of product and service, in terms of return to promoters and in terms of social responsibilities towards society and people cannot be achieved without practicing good corporate governance.