Banking Self
Study Guide
Amir Saif
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Banking Self
Study Guide
Financial Series
Amir Saif
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Banking Self Study Guide
• THE GOALS OF A BANK • FOREIGN EXCHANGE
TRANSACTIONS
• RISK MANAGEMENT
OVERVIEW • TREASURY OPERATIONS
• OVERVIEW OF THE FLOW • LENDING AND CARD
OF ROUTINE SERVICES
TRANSACTIONS
• TRADE FINANCE
• THE CENTRAL POOL OF
FUNDS AND MANAGING
• INVESTMENTS
THE SPREAD
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Banking Self
Study Guide
This self study guide is designed to enable management staff
to gain a basic understanding of the activities that a retail
bank performs before they become involved in a banking
engagement.
After completing this guide it you should be able to:-
1. Describe the routine processes that enable a bank to function and
fulfill its objectives.
2. Understand the practical aspect of how banks generate profit
3. Understand how a typical bank is structured by department
4. Understand the various departments interactions and their role in
the objectives of the bank
5. Understand the unique risks faced by each department and how
auditors address those risks
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Banking Self
Study Guide
THE GOALS OF A BANK
The basis of banking is to put capital at risk in the pursuit of
earnings. A bank takes risks, transforms risks and embeds
risks in banking products/services.
The goals of a bank are also driven by regulatory
requirements laid down by central banks. The central role of
risk based capital in regulations focuses on the capital
adequacy principle, which states that capital should match
risks. As capital is a limited and expensive resource the
advancement of regulation has contributed to the above shift
in goals.
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Banking Self
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RISK MANAGEMENT OVERVIEW
In its core principles, the Basle Committee on Banking
Supervision 1 sets out eight key risks which must be
managed by banks. Banks’ organizational structure is
designed to manage these risks either on a process basis or,
more commonly, by department such that the institution can
meet its goals.
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Banking Self
Study Guide
RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Credit risk
a major risk that banks face is credit risk or the failure of a
counterparty to perform according to a contractual arrangement. This
risk applies not only to loans but to other on- and off-balance sheet
exposures such as guarantees, acceptances and securities
investments. Serious banking problems have arisen from the failure
of banks to recognize impaired assets, to create reserves for writing
off these assets, and to suspend recognition of interest income when
appropriate.
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Banking Self
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RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Country and transfer risk
In addition to the counterparty credit risk inherent in lending,
international lending also includes country risk, which refers to risks
associated with the economic, social and political environments of the
borrower’s home country. Country risk may be most apparent when
lending to foreign governments or their agencies, since such lending is
typically unsecured, but is important to consider when making any
foreign loan or investment, whether to public or private borrowers.
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Banking Self
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RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Market risk
Banks face a risk of losses in on- and off-balance sheet positions
arising from movements in market prices. Established accounting
principles cause these risks to be typically most visible in a bank’s
trading activities, whether they involve debt or equity instruments, or
foreign exchange or commodity positions. One specific element of
market risk is foreign exchange risk. Banks act as “market-makers”
in foreign exchange by quoting rates to their customers and by
taking open positions in currencies.
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Banking Self
Study Guide
RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Interest rate risk
Interest rate risk refers to the exposure of a bank’s financial
condition to adverse movements in interest rates. This risk impacts
both the earnings of a bank and the economic value of its assets,
liabilities and off-balance sheet instruments. Interest rate risk can
arise in both the banking and trading book. Although such risk is a
normal part of banking, excessive interest rate risk can pose a
significant threat to a bank’s earnings and capital base.
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Banking Self
Study Guide
RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Liquidity risk
Liquidity risk arises from the inability of a bank to accommodate
decreases in liabilities or to fund increases in assets. When a bank
has inadequate liquidity, it cannot obtain sufficient funds, either by
increasing liabilities or by converting assets promptly, at a reasonable
cost, thereby affecting profitability. In extreme cases, insufficient
liquidity can lead to the insolvency of a bank.
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Banking Self
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RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Operational risk
The most important types of operational risk involve breakdowns in
internal controls and corporate governance. Such breakdowns can
lead to financial losses through error, fraud, or failure to perform in a
timely manner or cause the interests of the bank to be compromised in
some other way, for example, by its dealers, lending officers or other
staff exceeding their authority or conducting business in an unethical
or risky manner. Other aspects of operational risk include major failure
of information technology systems or events such as major fires or
other disasters.
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Banking Self
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RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Legal risk
Banks are subject to various forms of legal risk. This can include the
risk that assets will turn out to be worth less or liabilities to be greater
than expected because of inadequate or incorrect legal advice or
documentation. In addition, existing laws may fail to resolve legal
issues involving a bank; a court case involving a particular bank may
have wider implications for banking business and involve costs to it
and many or all other banks; and, laws affecting banks or other
commercial enterprises may change. Banks are particularly
susceptible to legal risks when entering new types of transactions and
when the legal right of a counterparty to enter into a transaction is not
established.
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Banking Self
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RISK MANAGEMENT OVERVIEW
The risk are as follows:-
Reputation risk
Reputation risk arises from operational failures, failure to comply with
relevant laws and regulations, or other sources. Reputation risk is
particularly damaging for banks since the nature of their business
requires maintaining the confidence of depositors, creditors and the
general marketplace.
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Banking Self
Study Guide
OVERVIEW OF THE FLOW OF ROUTINE
TRANSACTIONS
Profit Centers
All identifiable departments in banks are either profit centers or cost
centers. Profit centers are those that offer products that generate
interest revenue or fee based services. Other departments such as
settlements, accounting, and reconciliations departments do not
offer services outside the bank and therefore are cost centers. In
order to measure the profitability of these various lines of activity the
bank assigns a cost of funds for all banking activities. This cost of
funds is the rate at which money can be invested risk free in the
money markets.
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Banking Self
Study Guide
OVERVIEW OF THE FLOW OF ROUTINE
TRANSACTIONS
Deposits
When customers choose to place their excess money with a bank
the bank records this liability to the client and either invests the
money or lends it to another bank client. Banks accept many more
deposits than they can lend out so excess deposits are invested in
interest earning assets such as Treasury bills and other money
market products. The branch then earns LIBOR on all of its deposits
and pays something less than LIBOR to its client leaving an interest
rate spread that yields profits.
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Banking Self
Study Guide
OVERVIEW OF THE FLOW OF ROUTINE
TRANSACTIONS
Loans
Loans are granted by the branch to its clients and these are
assumed to be funded by borrowing money at LIBOR and lending it
to a client. The branch then charges its client interest greater than
LIBOR to generate a profit on the interest rate spread. Therefore all
loans are priced with LIBOR as its basis.
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Banking Self
Study Guide
OVERVIEW OF THE FLOW OF ROUTINE
TRANSACTIONS
Managing interest rate risks with transfer pricing and cost of
funds
Some banks may centralize the management of interest rate risk in
a unit of the bank, usually the treasury unit, using a funds transfer
pricing system. Funds transfer pricing allows the bank to transfer
the impact on earnings of changing interest rates from individual
business lines to the central unit. Profits of the bank are unaffected
however, the earnings of the business lines can then be traced
more directly to the business decisions of management. Funds
transfer pricing also induces line managers to make pricing
decisions that are with the interest rate risk management objectives
of the treasury.
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Banking Self
Study Guide
OVERVIEW OF THE FLOW OF ROUTINE
TRANSACTIONS
Funds in Foreign Currencies
All banks deal in foreign currencies so that their clients can convert
money earned outside the country into domestic currency and
convert domestic currency into foreign currency when they have to
make payments outside the country.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Introduction
Refer to Diagram on Operations in Foreign Currency
Foreign currencies in general and the process of exchanging the currency of
one country for the currency of another country are both referred to as
‘foreign exchange’. This exchanging process or the conversion of one
currency into another can take place locally, for example, when members of
the public purchase foreign currency notes and travelers cheques or
internationally when the conversion involves the receipt or payment of one
currency for that of another. The market in which international conversions
take place is known as the foreign exchange market. The price at which the
exchange of currencies takes places is known as the rate of exchange.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Reasons behind foreign exchange transactions
The market for foreign exchange mirrors the physical trade that
occurs between countries. For every sale/purchase of goods or
services, there is a corresponding monetary transaction. It also
reflects capital flows between countries. In simple terms, the market
for foreign exchange enables debts between different countries to
be settled by the exchange of one currency for another. The
originators for foreign exchange funds are usually the large
corporate entities. The foreign trade that they undertake e.g.. Buy
foreign raw materials necessitate the need for foreign funds to pay
for such goods and services. Banks may be approached if the size
of funds required is huge but usually foreign exchange brokers are
used. They in turn will contact the banks and transact on their
clients behalf.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
“SQUARING” the balance sheet:
Once the USD 100 is sold, the assets in USD will equal the
liabilities and the bank is no longer exposed to adverse changes in
exchange rates. That is, the balance sheet is “squared”. Similarly
once the DM 500 loan is borrowed from another bank, the liabilities
in DM will equal the assets and the bank is no longer exposed to
changes in exchange rates.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transaction Defined
a. Spot
When a sale or purchase is made spot, it means that delivery of
the foreign exchange and the corresponding base currency must
be made simultaneously at a fixed date within a few days after
the sale or purchase was contracted (normally two business
days for most currencies).
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Banking Self
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FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transaction Defined
c. Rates
The value of the world's currencies in the forward market is
expressed in the forward rates which reflect current expectations
and a large variety of related market forces. If a certain foreign
currency is quoted at a higher rate ‘spot’ than ‘forward’, its
forward rate is a ‘discount’. If the forward rate is higher, it is said
to be trading at a ‘premium’. Different forward rates are quoted
for different periods (one, two, three, six, or twelve months
forward). It is possible that forward rates may be at a premium
for one period and at a discount for the next.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transaction Defined
b. Forward
A forward exchange transaction involves the purchase or sale of
foreign currency for delivery at some fixed future date. The rate
at which the transaction is concluded is also fixed at the time of
sale, but settlement is not made until the foreign currency is
delivered by the seller at the fixed future date. The majority of
forward exchange transactions are concluded for periods up to
six months but can be concluded for considerably longer
maturities, particularly in the more stable currencies.
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Banking Self
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FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transaction Defined
c. Arbitrage
An arbitrage deal involves the simultaneous spot and forward
transactions to take advantage of differences in exchange rates
and interest rates. The most common form of arbitrage deal is
interest arbitrage, whereby a bank attempts to take advantage of
interest differentials between currencies and
make a profit or derive funds for on-lending in currencies other
than dollars at a cost which should be offset by the additional
interest obtainable by lending in those other currencies.
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Banking Self
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FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Transaction Defined
d. Swaps
Swaps involve two linked exchange transactions for an identical
amount of a currency with different value dates, for example, a
spot purchase and a forward sale. A swap can take place when
each party can access a particular market (either interest basis
or currency) on comparatively better terms than the other.
Parties will enter the markets where they have the advantage,
and will agree to exchange (swap) payments and receipts
between them which will result in better terms in their preferred
market than if they had entered it directly themselves. The most
usual types of swaps are interest rate swaps and currency
swaps
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Foreign Exchange Profit are made
The two most common ways in which a bank makes a profit from
the foreign exchange market are:-
- From the \"spread\" in quoting currency prices
- From holding a currency position.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Risks involved in foreign exchange
(a) Open positions
As explained above, a position in a currency arises when a bank
is unmatched in that currency i.e. an excess of assets or
liabilities in that currency. If there is a long position and the value
of that currency falls in home currency terms, a loss will arise.
Similarly, if there is a short position and the currency rises in
home currency terms, again the bank will experience losses.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Risks involved in foreign exchange
b. Liquidity exposure
This is the risk that a bank may not be able to cover, on a
particular day, net cash outflows which arise from sizeable
mismatched exchange positions. Examples whereby the bank
may not be able to cover such cash outflows are tight liquidity
resulting from a central bank squeeze, (i.e. when the
government reduces the amount of money in the economy),
temporary market closure, sudden concern over the bank's
credit standing or where selling new deposits and assets in
adverse market conditions is insufficient to meet these outflows.
This risk could lead to a forced sale of the banks assets which
may not realize the full value of the assets. Large losses to the
bank may not be avoided.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Risks involved in foreign exchange
c. Maturity mismatch
This is due to spot and forward transactions which may be
matched as to amount but individual transactions may mature on
different dates. Maturity mismatch can therefore occur even
though the bank may only have small open position but
significant mismatching of maturity dates.
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Banking Self
Study Guide
FOREIGN EXCHANGE TRANSACTIONS
Risks involved in foreign exchange
d. Credit risk
This is the risk that the counter party may be unable, or unwilling
to complete his part of the transaction. The potential loss when
the bank becomes aware of the counterparty not being able to
complete the transaction is the difference between the
contracted value of the transaction and the cost of completing it
with another party. Unlike credit risk in lending, the bank is not
subjected to total loss in the value of transaction. This is
because, in the event of default, the bank can undertake another
equivalent transaction, albeit not at such favorable terms, and
thus suffer partial loss.
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Banking Self
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FOREIGN EXCHANGE TRANSACTIONS
Risks involved in foreign exchange
e. Settlement risk
This is where, on value date, the bank transmits and pays funds
to the benefit of the counterparty but the counterparty is unable
to meet its obligations. The bank is therefore at risk of losing all
the funds transmitted. This usually results from the time gap
between paying out funds in one centre (e.g.. London) and the
confirmation of receipt of funds in another centre (e.g.. New
York), a 5-6 hour time zone difference. To minimize such risks,
limits on the value of unmatured deals with individual customers
should be set and regularly monitored.
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Banking Self
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TREASURY OPERATION
Dealing Activity
When a customer calls the desk a dealer completes the transaction for the customer as
follows:
1. The dealer checks that deal amount is within his limits and quotes a rate that
currently the market is willing the purchase the dollars at plus a small
commission.(spread)
2. He then checks counterparty limits (to ensure they are within authorized limits) and
sell the dollars. At this point the settlement date and correspondent banks brokers
are also agreed between the dealers.
3. The dealer fills out his deal ticket as the deal was agreed with the counterparty
4. A confirmation comes to the dealer either from Reuters (a secure information
gathering system) or by fax if it is with a broker not on the Reuters system.
5. The deal ticket is then agreed to the confirmation to ensure that both parties agree
to the terms of the deal.
6. Both the deal tickets and confirmations are numerically sequenced as a
completeness control over recorded deals.
7. The dealer then updates his own foreign currency position and passes a copy of
the deal ticket to the back office.
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Banking Self
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TREASURY OPERATION
Back office
The back office is segregated from the dealing function and is an integral
control over treasury operations. They manage the cash flow of the bank
by producing all the reports regarding the bank’s positions as follows:
Once the back office gets the deal ticket it also obtains its own
confirmation either from a printer running in parallel with the dealing
room or from Reuters itself. It is crucial that the confirmation function is
segregated from the dealing function.
The back office agrees the deal tickets to the confirmation and ensures it
is within limits and with a suitable counterparty.
The deal is then coded for input to the bank’s records by assigning the
appropriate bank accounts the deal will be settled from with
correspondent banks. If a broker is used with accounts in common with
the bank a draft is issued to settle the deal.
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Banking Self
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TREASURY OPERATION
Input processing
The processing department consists mainly of input clerks who will input the
details of the deal tickets into the computer as well as other tasks as
follows:
Enters the approved deal ticket into the computer (i.e.. the date the
transaction will be paid and from what accounts)
Various reports will be generated such as daily deal listing, credit limits
exceeded report.
The deals are then printed as they have been input into the computer
and returned to back office for further checking.
Accounting records of the bank are now updated as soon as deals are
input
A settlements listing featuring amounts, currencies, dates and account
numbers is sent to settlements department to ensure all amounts are
paid as agreed on original deal tickets.
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Banking Self
Study Guide
TREASURY OPERATION
Input processing
The processing department consists mainly of input clerks who will input
the details of the deal tickets into the computer as well as other tasks as
follows:
Enters the approved deal ticket into the computer (i.e.. the date the
transaction will be paid and from what accounts)
Various reports will be generated such as daily deal listing, credit limits
exceeded report.
The deals are then printed as they have been input into the computer
and returned to back office for further checking.
Accounting records of the bank are now updated as soon as deals are
input
A settlements listing featuring amounts, currencies, dates and account
numbers is sent to settlements department to ensure all amounts are
paid as agreed on original deal tickets.
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Banking Self
Study Guide
TREASURY OPERATION
Settlements and Nostro/Vostro accounts
Once the settlements listing is obtained the settlements department actually moves the
funds around the bank. Banks have current accounts with each other in order to
settle transactions. These are called Nostro/Vostro accounts. Nostro is our account
with you and Vostro is your account with us. If a bank has to pay money to another
bank it is placed in a Nostro account with them. If a bank is owed money they
collect it from its vostro account. A facility known as “SWIFT”(Society for Worldwide
Interbank Telecommunication) then simultaneously collects the funds from the
Nostro account and deposits them in the Vostro account on the value date.
1. They ensure that funds are deposited to accounts by the value dates so that SWIFT
can collect the funds.
2. If Nostro accounts go overdrawn because funds are not there according to value
dates high
3. penalty interest is charged. Nostro accounts don’t earn interest for excess funds
either.
4. Since interest is not earned on Nostro accounts it is up to Settlements department
not to deposit funds too quickly or opportunities to generate interest are lost.
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Banking Self
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TREASURY OPERATION
Reconciliations department
Once the deal has been settled the reconciliations department reconciles all of the
Nostro accounts daily to ensure all deals that were intended to settle have been
completed. That is, all funds have been withdrawn by SWIFT from the Nostro
accounts.
1. Reconciliations department looks at each Nostro and ensures that SWIFT has
taken the specified
2. amount of funds from the accounts. If there are discrepancies they are investigated.
3. This is a key control to ensure that all deals have been completed as were
originally agreed to.
4. If there are old outstanding items in these accounts an enquiry is raised and sent to
the
5. counterparty to investigate the reason for the discrepancy.
6. Statements are sent by the correspondent banks detailing all the activity in the
accounts to help facilitate the reconciliations process.
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Banking Self
Study Guide
CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
Cheques drawn on a domestic bank
If a customer deposits a cheque into his account the bank has to “clear” it. That is, the cheque must be
paid by the financial institution it is drawn on. In this case the process of clearing a cheque drawn
on a domestic bank will be detailed.
A customer deposits a cheque for USD$500 into his USD savings account. The bank then starts
paying him interest on the money but has not yet received the $500 from the bank it is drawn on.
At the end of the day the teller balances all cheques that were processed that day and sends them
to the clearing department of the bank.
The clearing department then separates all the cheques from that branch into domestic banks and
foreign banks. For each domestic bank all cheques drawn on that bank are bundled together and
that total amount of money is owed by that bank. The bundle is then taken that night to a Central
Clearing agent where all the other domestic banks have sent their cheques drawn on all other
banks.
The Central clearing agent then balances the two positions to reconcile which bank owes the other
more money. That is, if bank A honoured more cheques of Bank B’s then a draft is sent along
with Bank A’s cheques drawn on Bank B or vice versa.
Now the clearing department has inward clearing negotiated at another bank the previous day.
Therefore, all customers accounts are updated to reflect the cheque clearing their account. If
there are no funds for withdrawal the cheque “bounces back” to the bank who negotiated it. The
Amir Saif honoured the cheque then has to try to obtain the funds back from its customer.
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Banking Self
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CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
Holding funds
When a cheque that bounces is returned to a bank unpaid this places
funds at risk because there is no guarantee that the funds will be
recoverable from the depositor. The bank can avoid this situation all
together by placing a hold on the cheque when it is deposited. That is,
the cheque is deposited but funds aren’t advanced on it until the danger
of it being returned unpaid has lapsed. This is usually 3 days for
cheques drawn on domestic banks.
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Banking Self
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CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
Items sent on collection
The other alternative is for the bank to send the cheque out on
collection. The bank sends the cheque in the outward clearing again with
instructions to the bank it is drawn on to hold on to it for a period of time
(usually 30 days). In this time period the bank tries to withdraw the funds
from the account each day for the next 30 days in hopes of recovering
the funds. If, after 30 days the cheque can’t be paid the cheque is sent
back again and the bank must take a loss on the negotiation of the
cheque or try more vigorously to recover the funds from the depositor.
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Banking Self
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CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
International payments
When a customer presents a cheque drawn on an international
bank it cannot clear in the same manner as a cheque drawn on
a domestic bank. This is because the central clearing agent
cannot deal with the foreign bank to obtain the funds to pay the
domestic bank.
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Banking Self
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CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
International collections
When a customer presents such a cheque the teller cannot give deposit
value to it or cash it. It can take a substantial amount of time for the
cheque to be paid and if it is in the customer’s account earning interest
during this time the bank cannot invest the proceeds from the cheque in
the money markets. Banks are unwilling to pay interest on funds that
they cannot reinvest. Therefore, the customer obtains an assurance from
the teller that once the funds are paid by the bank the funds will be
deposited in their account.
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Banking Self
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CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS
Correspondent accounts and banks
When the foreign bank receives the cheque on collection it, in effect,
receives instructions from the domestic bank to act as follows:
Withdraw funds from the foreign customer’s account.
Use those funds to purchase a draft drawn on a bank in the same country as
the domestic bank who sent the item on collection.
The foreign bank then interacts with its settlements department to move
funds from the customer’s account and place them in the foreign banks
Nostro account with a bank in that particular country.
The draft is then sent back to the domestic bank who then deposit the draft
drawn on a domestic bank now and sends it through the domestic bank
clearing because it is now merely a cheque drawn on a bank in the same
country.
The domestic bank the cheque is drawn on pays it by releasing the money
from its Nostro account where the foreign bank placed it.
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Banking Self
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LENDING AND CARD SERVICES
Advances repayments
A customer makes an installment or pays his credit card balance
at a branch.
The loan or card account is updated for the transaction on either
the card subsystem or the loans subsystem.
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Banking Self
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LENDING AND CARD SERVICES
Treasury department
The acceptance or advancing of funds whether in foreign currency or
domestic currency requires action by the treasury department
If FC is transacted the treasury department must either buy or sell the FC
as described earlier in the foreign exchange section. The deal is then
settled by the settlements department exactly as any other F/X
transaction.
The treasury department is also given a money market position. That is,
they either have a surplus of funds to invest or a shortfall of funds and
need to borrow. Therefore, as described in the diagram the money is
borrowed in the money market to fund a loan or invested in the money
market in the case of cash surpluses.
The borrowing or placement is then settled by settlements department
exactly as described previously.
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Banking Self
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LENDING AND CARD SERVICES
Credit card transactions
There are a few unique features to card services. These unique transactions are
between the card service provider and the card issuing bank.
When a customer spends money in a foreign location the merchant is reimbursed by
the card service provider, for example, MasterCard or Visa.
When MasterCard or VISA interact with the customer’s bank, the card account is
updated in domestic currency at the same rate the card company reimbursed the
merchant at.
credit extended to corporate and personal customers, lending often carries the
greatest risk to the bank, to which much emphasis and importance is placed by
us as auditors.
Loans and advances may be categorized in various ways:
1 Retail or wholesale - these terms are vaguely used to distinguish between
local, often branch based lending as opposed to the larger corporate inter
bank and institutional lending which is usually head office based.
2 Personal or corporate.
Amir Saifterm, medium term or long term.
3 Short
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Banking Self
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LENDING AND CARD SERVICES
Types of Lending Facility
Overdrafts
This is an agreed line of credit or borrowing facility (in writing) that a
customer may use by drawing on a specified current account. Originally
overdrafts were regarded as temporary facilities but in the Middle East it
is far from unusual for a customer to maintain a ‘permanent’ overdraft
albeit the balance fluctuating from day to day.
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Banking Self
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LENDING AND CARD SERVICES
Types of Lending Facility
Term Loans
These are made for a fixed period of time and can be repayable either in
installment or in full at the maturity date. A short term loan is generally
regarded as being a loan which is repayable within one year from when it is
granted. A medium term loan is generally regarded as being repayable after
at least one year but before the expiry of five years. A long term loan is
generally regarded as one that is not finally repayable until at least five years
after it was granted. The interest rate is normally predetermined for short
term loans and is likely to be of a floating nature for medium to long term
loans.
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Banking Self
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LENDING AND CARD SERVICES
Types of Lending Facility
Syndicated Loans
A syndicated loan is one that is provided jointly by a number of banks or
financial institutions who would be individually either unwilling or unable to
provide in view of the size and nature of the amount. These banks or
financial institutions are usually brought together by one or possibly more
managing banks which have organized and negotiated the whole package.
The managing (or sometime it's called lead) bank handles the negotiations
with the borrower, perhaps the documentation, collects the funds from
participants and then disburses the full amount to the borrower.
Subsequently the managing bank is responsible for collecting all sums due
from the borrower (both principal and interest) and for passing their share of
these sums to the participants. Apart from the managing bank, the syndicate
participants do not have any direct dealing with the borrower as all their
information needs and any required action (e.g.. default) is dealt with solely
by the managing bank.
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Banking Self
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LENDING AND CARD SERVICES
Types of Lending Facility
Personal (or Consumer) Loans In addition
1 Fixed rate loans are generally provided to finance the purchase of cars or consumer
durables. Often up to 3 year periods the documentation is simple and provides for
usually equal monthly repayments of both principal and interest. Interest is usually fixed.
2 Mortgage loans are becoming more usual and are for longer periods usually over 5 years.
Loans are specifically granted for the purchase of property and are repayable in
installment (monthly, quarterly or half yearly). Interest is seldom of a fixed nature but
likely to be floating.
3 Credit cards are becoming more and more common and regarded as a strong marketing
tool. Please note there is a difference between a ‘charge’ card (e.g.. American Express,
Diners Club) and a ‘credit’ card (e.g.. Visa, MasterCard). Only the latter permits any form
of extension of credit and the former requires immediate settlement on issue of the
statement. Obviously in the case of the charge card there is an interest free credit period
between when the card is used and the issue of the statement. Credit cards usually earn
interest on the unpaid monthly balance at fixed monthly rates of interest and also the
bank earns commission of varying amounts based on gross sale value of the transaction
Amir the retailer or service company.
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Banking Self
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LENDING AND CARD SERVICES
Types of Lending Facility
Sovereign Loans
Banks in the Middle East lend substantial sums to foreign governments,
public sector organizations and large corporations in overseas countries.
These loans are usually large in amount and of a medium or long term
period. Often there is little or no security and reliance is placed on the credit
worthiness of the country and also sometimes the guarantee of the
borrowing government is provided. See also c), Syndicated Loans, which
may also be part of the bank's overall sovereign risk.
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Banking Self
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LENDING AND CARD SERVICES
Factors Governing Lending Decisions
Having now seen the various types of
lending let us look briefly at the basic
Factors taken into account by bankers when
principles and factors governing lending.
taking lending decisions include:
Firstly there is the principle of
the quality of the borrower (includes value
stewardship i.e.. the bank is using money
and quality of security being offered)
deposited with it by members of the
the purpose or nature of loan
public, companies and other banks and
not its own and therefore this places on
the amount of loan, the period of loan,
management a high moral duty to
the repayment schedule proposed
exercise care and integrity. Secondly
the banks own policy limits (e.g.. currency of
banks must make a reasonable return on
loan, country, nature of industry).
their lending. The basis here is that the
higher the risk then the higher the
Essentially a bank will look initially at the
expected rate of return. It is however the
purpose of a loan, relating this to the
ability to strike an acceptable or
amount requested, and of extreme
reasonable balance between these two
importance, their clients demonstrated
conflicting principles which makes
ability to repay.
banking such a fine art and is the
Amir Saif
essence of good banking.
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Banking Self
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LENDING AND CARD SERVICES
Loan Security
A bank may lend with or without security. If the latter it is referred to as
'clean' i.e.. \"clean\" loan or \"clean\" overdraft. However when a bank takes
security it does not usually expect to obtain repayment of the loan by
realizing that security. The security is there to reduce the risk that a loan will
not be repaid if the borrower defaults. Therefore if the risk involved is to be
totally eliminated then the security needs to be sufficient at its realizable
value to repay the bank in full. It can be seen then that security evaluation
against outstanding loans is an on-going and continuing process. There are
two aspects to be considered - (a) Has the market value been maintained or
has it fallen? e.g.. value of land or shares, and (b) Has the outstanding loan
amount been reduced within the terms of the loan agreement. Thus a
comparison of the loan outstanding amount should be regularly made
against the current value of security held.
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Banking Self
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LENDING AND CARD SERVICES
Loan Security
Internal Control
As mentioned earlier bank lending i.e.. loans and advances, usually represents
the largest class of asset as the balance sheet. It is also a bank's greatest
source of exposure to loss, and this necessitates a high degree of internal
control, essentially in the following areas:
• Authorization and terms of credit facilities
• Identification and treatment of potentially doubtful credit risks.
• Authorization and terms of credit facilities
• Identification and treatment of potentially doubtful credit risks
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Banking Self
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TRADE FINANCE
Documentary letters of credit
Where international trade occurs and each counterparty is to be satisfied
as to the creditworthiness of the other, documentary letters of credit are
used. The buyer must be satisfied that the seller has the capacity to
produce, ship and deliver on time, and the seller must be satisfied that
the buyer can and will pay on time. However, the seller may have little
idea of the creditworthiness of the buyer.
The com
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Banking Self
Study Guide
TRADE FINANCE
Procedure
4.Once the seller has received a copy of the Letter of
The buyer and seller conclude a sales contract
Credit and is satisfied that he can meet its terms
providing for payment by way of a Documentary
and conditions he is in a position to dispatch the
Letter of Credit.
goods to the buyer.
1.The buyer then approaches his own bank, \"the
5.Having dispatched the goods and accumulated the
Issuing Bank\", and requests the bank to issue a
required documents, the seller then sends the
Documentary Letter of Credit in favor of the
documents stipulated in the Letter of Credit to the
seller.
advising/confirming Bank.
2.Assuming the Issuing Bank is satisfied with the credit
6.The advising/confirming Bank then checks the
standing of the buyer, it will issue the
documents against the Letter of Credit. Assuming
Documentary Letter of Credit and request a bank
the documents meet with the requirements of the
in the seller's country to advise or confirm the
Letter of Credit, the seller will receive payment in
credit. However, if the Issuing Bank is
accordance with the terms stated in the Letter of
dissatisfied, the buyer will have to provide
Credit.
guarantees in the form of assets (money deposits
and similar collateral) before the Issuing Bank is
F7. finally the Issuing Bank releases the documents
willing to issue the Letter of Credit. If this is not
and where these documents represent title to the
possible, the deal could be rejected.
goods, the buyer on presentation of these
documents to the carrier gains possession of the
3. The advising/confirming Bank then advises the
relevant goods.
seller that the Documentary Letter of Credit has
Amir Saif
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Banking Self
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TRADE FINANCE
Letter of Guarantee
A guarantee is a promise by the guarantor to be liable for the debt of
another person, the principal debtor, should the principal debtor fail to
perform an obligation, provided that the guarantor is notified of that fact by
the creditor. The guarantee is usually given after the bank has been suitably
furnished with collateral (e.g. customer deposits, title deeds to property).
In international trade, the provision by a bank of a guarantee can enable the
customer, who is perhaps new to a country, and may be unknown to local
banks and suppliers, but already has an established credit rating in another
country, to enjoy normal trading relationships. Income sources for the
guarantor bank are:
Commission over the period of guarantee.
In some cases, an interest-free or ‘cheap’ deposit as security from the
customer.
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Banking Self
Study Guide
TRADE FINANCE
Documentary letters of credit
Where international trade occurs and each counterparty is to be
satisfied as to the creditworthiness of the other, documentary letters
of credit are used. The buyer must be satisfied that the seller has
the capacity to produce, ship and deliver on time, and the seller
must be satisfied that the buyer can and will pay on time. However,
the seller may have little idea of the creditworthiness of the buyer.
T
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Banking Self
Study Guide
TRADE FINANCE
The advising/confirming Bank then advises the seller
that the Documentary Letter of Credit has been
Procedure
issued.
The buyer and seller conclude a sales contract
1. Once the seller has received a copy of the
providing for payment by way of a
Letter of Credit and is satisfied that he can
Documentary Letter of Credit.
meet its terms and conditions he is in a position
The buyer then approaches his own bank, \"the
to dispatch the goods to the buyer.
Issuing Bank\", and requests the bank to issue a
2. Having dispatched the goods and accumulated
Documentary Letter of Credit in favor of the
the required documents, the seller then sends
seller.
the documents stipulated in the Letter of Credit
Assuming the Issuing Bank is satisfied with the
to the advising/confirming Bank.
credit standing of the buyer, it will issue the
3. The advising/confirming Bank then checks the
Documentary Letter of Credit and request a
documents against the Letter of Credit.
bank in the seller's country to advise or confirm
Assuming the documents meet with the
the credit. However, if the Issuing Bank is
requirements of the Letter of Credit, the seller
dissatisfied, the buyer will have to provide
will receive payment in accordance with the
guarantees in the form of assets (money
terms stated in the Letter of Credit.
deposits and similar collateral) before the
4. Finally the Issuing Bank releases the
Issuing Bank is willing to issue the Letter of
documents and where these documents
Credit. If this is not possible, the deal could be
represent title to the goods, the buyer on
rejected.
presentation of these documents to the carrier
gains possession of the relevant goods.
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Banking Self
Study Guide
TRADE FINANCE
Letter of Guarantee
A guarantee is a promise by the guarantor to be liable for the debt of another
person, the principal debtor, should the principal debtor fail to perform an
obligation, provided that the guarantor is notified of that fact by the creditor.
The guarantee is usually given after the bank has been suitably furnished
with collateral (e.g.. customer deposits, title deeds to property).
In international trade, the provision by a bank of a guarantee can enable the
customer, who is perhaps new to a country, and may be unknown to local
banks and suppliers, but already has an established credit rating in another
country, to enjoy normal trading relationships. Income sources for the
guarantor bank are:
Commission over the period of guarantee.
In some cases, an interest-free or ‘cheap’ deposit as security from the
customer.
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Banking Self
Study Guide
TRADE FINANCE
Bills of exchange (Trade bills)
It is defined as an unconditional order in writing, addressed by one
person to another, signed by the person giving it, requiring the
person to whom it is addressed to pay on demand, or at a fixed or
determinable future time, a sum of money to, or to the order of, a
specified person or bearer.
There are three types of bills normally encountered in banking:-
1 Trade bills
2 Treasury bills
3 Bank bills
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Banking Self
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TRADE FINANCE
Performance bonds
A performance bond is a form of guarantee issued normally in
connection with a long-term contract whereby the guarantor is liable
for a fixed sum, due if the customer fails to complete a contract.
The performance bond has recently become an important feature in
the international construction industry.
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Banking Self
Study Guide
INVESTMENTS
Securities (investments) usually represent a material, but relatively
small part of the total assets of a bank. It is not usual for banks to
deal actively in securities or to be long term holders of fixed interest
stocks or other bonds. The underlying reasons why are simply
because banks may find it difficult to switch from fixed term assets
such as loans to liquid assets in order to meet any unexpected
demand from its depositors. Consequently, banks hold such
securities as ‘reserves’ and these not only generate income, and
possibly capital appreciation, but are also readily convertible into
cash.
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Banking Self
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INVESTMENTS
Types of Investment
Banks may hold security both for dealing and for longer term
investment. Their characteristics are as follows:
1 Dealing - Transactions are made frequently with
the sole purpose of taking advantage of short-term
changes in market prices and yields.
2 Investment - These are held for the longer term,
usually to maturity. The bank's aim is to obtain
regular interest (or dividend yield) and possibly, in the long
term, capital appreciation.
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Banking Self
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INVESTMENTS
Specific types of securities
Securities held by banks (whether for investment or dealing
purposes) are usually described in their financial statements as
investments and include the following:
securities issued, or guaranteed by governments, which, in the case
of British Government securities, are often described as gilt-edged
and are usually dated;
liabilities of corporate bodies, which may take the form of shares,
debentures, loans stocks or bonds.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Gilt-edged securities
Gilt-edged securities, which are either issued or guaranteed by the
UK government, are usually listed and are considered absolutely
safe in terms of interest payments and repayment at maturity. They
present the investor with less risk but a potentially lower return than
an investment in equities. The market value of gilt-edged securities
is influenced by, among other factors, actual and prospective interest
rates and their value will not, therefore be necessarily more stable
than other securities. However, provided that they are dated, the
total yield to maturity is guaranteed at the time of purchase.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Treasury bills
These are issued weekly to fund the government's short-term
borrowing requirements and to control the money supply by
absorption of surplus funds from the money market.
Treasury bills do not carry any interest and therefore, when
potential buyers tender for such bills, the tender price will be set
at such a level that the difference between the offer price and the
face value, known as the discount, will represent a reasonable
rate of return in exchange to prevailing market conditions.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Equities
Equities (or ordinary shares) that are listed on a recognized stock
exchange are generally more marketable than those that are
unlisted. Although equities involve a higher degree of risk and
may, in a thin market, be difficult to realize, they offer the
opportunity to participate in a company's growth in both capital
and income terms. Banks may therefore choose to hold some
equities in order to provide a means to maintaining the value of
their capital base.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Preference shares
Preference shares entitle holders to dividends, usually at a fixed
annual rate, which are paid in priority to dividends on ordinary
shares. These dividends are often cumulative (that is to say, if a
preference dividend is passed because of an insufficiency of
profits, it must be made good before any dividend can be paid on
the ordinary shares in later years). Preference shareholders
normally do not have voting rights; in the event of a liquidation,
they rank before ordinary shareholders.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Bonds
A Bond is a document under seal requiring the payment of
principal and interest on due dates. Bearer bonds, so called
because they are payable to bearer, rather than registered in the
name of a holder, are negotiable instruments to which title can be
passed on transfer for value, in good faith and without notice of
any defect.
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Banking Self
Study Guide
INVESTMENTS
Specific types of securities
Eurobonds
A Eurobond is an instrument that evidences a long-term loan, often
denominated in US dollars but which may also be in other currencies
including sterling, issued by a large concern of international standing. It
may carry a fixed or variable rate of interest. There is a secondary market
for dealing in Eurobonds and prices vary with the quality of the borrower
and the prevailing rate of interest on Eurocurrency deposits. The market
in Eurobonds goes back many years, but developed significantly after the
Second World War when large amounts of US aid were given to
European countries during the reconstruction period. In recent years the
market has become very large indeed because of the calls made on
banks to recycle petrodollars, the absence of regulation in the market and
the levels of interest rates prevailing internationally.
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Banking Self
Study Guide
I hope this will help you a lot to
understand the banking procedure
Thank you,
Amir Saif
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