banking

1. Review Notes
Banking Services
Dr. Lalit K Khurana
__________________________________________________________________
Definition:
As per Section 5(b) of the Banking Regulation Act, 1949, "banking" means the accepting, for the
purpose of lending or investment, of deposits of money from the public, repayable on demand or
otherwise, and withdrawable by cheque, draft, order or otherwise.
This is primary. Modern banking offers various financial services.
History: Banking in India, in the modern sense, originated in the last decades of the 18th century.
Among the first banks were the Bank of Hindustan, which was established in 1770 and liquidated
in 1829–32; and the General Bank of India, established in 1786 but failed in 1791. The largest
bank, and the oldest still in existence, is the State Bank of India (S.B.I). It originated as the Bank
of Calcutta in June 1806. In 1809, it was renamed as the Bank of Bengal.
This was one of the three banks funded by a presidency government; the other two were the Bank
of Bombay in 1840 and the Bank of Madras in 1843. The three banks were merged in 1921 to form
the Imperial Bank of India, which upon India's independence, became the State Bank of India in
1955. In 1960, the State Banks of India was given control of eight state-associated banks under the
State Bank of India (Subsidiary Banks) Act, 1959. These are now called its associate banks.In
1969 the Indian government nationalized 14 major private banks. In 1980, 6 more private banks
were nationalised. These nationalised banks are the majority of lenders in the Indian economy.
They dominate the banking sector because of their large size and widespread networks.
The Indian banking sector is broadly classified into scheduled banks and non-scheduled banks.
The scheduled banks are those included under the 2nd Schedule of the Reserve Bank of India Act,
1934.
Scheduled Commercial Banks in India are categorised into five different groups according to their
ownership and/or nature of operation:
 State Bank of India and its Associates
 Nationalised Banks
 Private Sector Banks
 Foreign Banks
 Regional Rural Banks.
Note : The term commercial banks refers to both scheduled and non-scheduled commercial banks
regulated under the Banking Regulation Act, 1949.

2. Commercial banks are important part of financial services
a) They offer deposit accounts with size and on maturity
b) Repackaging of funds received from deposits to provide loans of the clients
c) Commercial banks finance Industry and Trade, Agriculture and Consumer Activities
d) Help in Monetary Policy
Structure of Commercial Banks in India
Banking is a business of trust: Trust is created through
The business of banking involves the measuring, managing, and accepting of risk
Basic Exposures Banks face arise from:
 Credit Risk
 Interest-rate Risk
 Liquidity Risk
Role of Banks:
a) Intermediation (Risk Credit, Liquidity, Interest rate risk)
b) Payment System
c) Financial Service - Services: Collection, Deposit, Loan (retail and Business), Advisory,
Demat, Forex, Distribution (MF, Gold Coin, Shares)
Islamic banking
Liquidity
Safety
Service
Quality
Secrecy
Profitability

3. Islamic banking or Islamic finance or sharia-compliant finance is banking or financing activity that
complies with sharia (Islamic law) Islamic finance refers to the means by which corporations in
the Muslim world, including banks and other lending institutions, raise capital in accordance with
Sharia, or Islamic law. Islamic Finance is based on the Profit-Sharing principle. Thus, instead of
traditional accounts with given interest rates, Islamic banks provide accounts which offer
profit/loss. The bank in turn purchases assets with your money, which generate returns for the
bank.
Bank sources and uses of funds
A typical bank's assets consist of all forms of personal and commercial loans, mortgages and
securities. The liabilities are the customer deposits.
Sources
• Deposit accounts
• Bank capital
• Bonds issued by the bank
• Borrowed funds
• Time deposits
• Transaction deposits
Use of funds by the bank
• Bank loans
• Investment in securities
• Cash
• Fixed assets
• Repurchase agreements
Types of business loans
• Working capital loan – also called self liquidating loan – to support ongoing business
operations.
• Term loans – primarily to finance the purchase of fixed assets, it may range as long as 10
years. Subject to conditions referred to as protective covenants which specifies maximum
level of dividend, limits the additional debt, periodical interest payments, interest payment
+ loan payment = one lump sum also called balloon payment - this is known as bullet
loan.
• Direct lease loan: when avoiding more debt
• Line of credit – to borrow up to a specified amount within a specified period of time to
meet sudden requirement, used to avoid harming reputation of the company.
• Revolving credit loan – it normally charges a commitment fee on unused funds.
• Real estate loans: typically 15 to 30 years. Real estate is mortgaged. It can be with a
balloon payment.
Off-balance-sheet activities
Banks conduct many fee related activities that generate income for banks. Such activities are not
shown on the current balance sheet.

4. – Loan commitments
– Standby letters of credit
– forward contracts
– Swap contracts
– Securitization
• Total OBSA - from 1.4 billion dollars in 1984 to 5.7 billion dollars in 1988. Such OBSA
represented 58% of total bank assets in 1984.
Types of Risk due to Off-balance-sheet activities (OBSA)
• Liquidity Risk (over-extension of obligations)
• Credit Risk (Underwritten guarantees)
• Interest Rate Risk ( A-L mismatch and interest rate swap)
• Informational Asymmetry- Market fails to recognize
Performance of a bank
To understand how well a bank is doing, we need to start by looking at a bank’s income statement,
the description of the sources of income and expenses that affect the bank’s profitability
• Return on assets
Net income gives us an idea of how well a bank is doing, but it suffers from one major drawback:
It does not adjust for the bank’s size, thus making it hard to compare how well one bank is doing
relative to another. A basic measure of bank profitability that corrects for the size of the bank is the
return on assets (ROA), which divides the net income of the bank by the amount of its assets. ROA
is a useful measure of how well a bank manager is doing on the job because it indicates how well a
bank’s assets are being used to generate profits.
• Return on equity
Although ROA provides useful information about bank profitability, but it is not what the bank’s
owners (equity holders) care about most. They are more concerned about how much the bank is
earning on their equity investment, an amount that is measured by the return on equity (ROE)
 Net interest margin
Another commonly watched measure of bank performance is called the net interest margin (NIM),
the difference between interest income and interest expenses as a percentage of total assets

5. Example
If Interest income = Rs. 150 crore
Interest expense = Rs. 80 crore
Interest-earning assets (at beginning of year) = Rs. 2,000 crore
Interest-earning assets (at end of year) = Rs. 2,500 crore
NIM = (150 - 80) / (2000 + 2500) / 2
NIM =70 / 2,250
NIM = 3.11%
These three measures - return on assets (ROA), return on equity (ROE), and the net interest margin
(NIM) remained fairly stable for measuring performance. ROA and ROE measures of bank
performance move closely together.
Other measures are:
 Non-current loans to total assets
 Asset growth rate
 Net operating income
 Asset Utilization
Camels rating
• It is a supervisory rating system originally developed in the U.S. to classify a bank's
overall condition.
(C)apital adequacy
(A)ssets
(M)anagement Capability
(E)arnings
(L)iquidity (also called asset liability management)
(S)ensitivity (sensitivity to market risk, especially interest rate risk)
Rating 1
Indicates strong performance and risk management practices that consistently provide for safe and
sound operations
Rating 5
Considered unsatisfactory performance that is critically deficient and in need of immediate
remedial attention.
Changing bank market structure
• Banks have been consolidating
– Acquisitions for economies of scale, revenue, and cost

6. • Competition from local banks
• Other types of financial service firms to diversify
Shadow Banking
Shadow banking institutions generally serve as intermediaries between investors and borrowers,
providing credit and capital for investors. Shadow banking institutions don't receive
traditional deposits like a depository bank; they escape most regulatory limits and laws imposed on
the traditional banking system.
One of the classic strategies employed by shadow institutions was borrowing via short-
term, liquid markets -- typically commercial paper markets -- and using these short-term funds to
invest in longer-term, less liquid assets like securitized mortgages.
“The shadow banking system is a term for the collection of non-bank financial intermediaries that
provide services similar to traditional commercial banks but outside normal financial regulations.”
The activity of borrowing short term and lending long term can also be replicated in the money
markets. Therefore, if a company were to set up a money market fund and sell short term securities
and use the proceeds to make long term loans, they would effectively be conducting banking. The
only thing missing would be a bank license.
Since there is no bank license, there would also not be any regulation. There would be no reserve
ratios or capital ratios to maintain and therefore no need to borrow from interbank markets.
The shadow banks will be able to perform every function of banking except accept deposits from
the public. Since most of the shadow banks have no interest in accepting deposits anyways, the
arrangement works perfectly fine.
Shadow banking system has come to play an increasingly significant role in
facilitating credit throughout the global financial system. Many believe the lack of government
regulatory oversight of the shadow banking system led to excesses precipitating in the global
financial meltdown and Great Recession
The Three Functions of Shadow Banks
 The shadow bank must issue short term securities and use the proceeds to buy longer term
assets.
 The shadow banking institution must be have liabilities which are liquid and assets which
are relatively illiquid
 The shadow bank must use further leverage while making investments. These investments
can be made by raising money from other institutions.
Advantages of Shadow Banking System
 No regulation: There is only one huge advantage to having the shadow banking system i.e.
no regulation. Since the banking industry is so regulated, this advantage is big enough to
offset hundreds of disadvantages on its own. No regulation on the money raised by selling
securities allows the shadow banks to take as much risk as they would like to without

7. defaulting on their obligations. Compliance procedures and reports which cost millions of
dollars as well as disruption of operations are no longer required.
Disadvantages of Shadow Banking System
 No Access to Cash: Shadow banks are not backed by the central bank. As a result, they do
not have any kind of backup that would save them from trouble if the depositors suddenly
wanted to withdraw their cash. It is true that commercial banks indirectly back these
shadow banking institutions. However, it is difficult for them to divert cash towards their
shadowy arm especially if a crisis is in progress. This creates a situation wherein shadow
banks not only face huge risks themselves but also pose systemic risk. This is because their
business creates the same amount of risk as that of banks. However, they do not have the
preventive regulations or the safety nets that banks have access to in case things start going
wrong.
 Distressed Sale:
Shadow banks buy long term assets and finance them by selling short term securities.
However, if investors become wary about a bank’s health, these long term assets have to be
liquidates with immediate effect. This creates a situation of distressed sales.
 Salvage Reputation:
The 2008 meltdown exposed a lot of links between the commercial banking system and the
shadow banking system. This is because when these shadowy banks started going bust,
they were often bailed out by commercial banks. Commercial banks would do so in order
to maintain their reputation in the money market so that they can continue their operations
in the future. However, as a result of the 2008 expose, very few banks are now willing to
indulge in shadow banking. Any bank seen as having exposure to shadow banks,
immediately witnesses a drop in its share prices as well as large cash withdrawals.
Nostro account refers to an account that a bank holds in a foreign currency in another bank.
Nostros, a term derived from the Latin word for "ours," are frequently used to facilitate foreign
exchange and trade transactions
Cheque truncation : It is the conversion of a physical cheque into a substitute electronic form for
transmission to the paying bank. Cheque truncation reduces or eliminates the physical movement
of cheques and reduces the time and cost of processing the cheque clearance system.
Core Banking Solution (CBS): It is networking of branches, which enables Customers to operate
their accounts, and avail banking services from any branch of the Bank on CBS network,
regardless of where he maintains his account. The customer is no more the customer of a Branch.
He becomes the Bank's Customer.
ALM (Asset Liability Management in context of Banking)
 Asset Liability Management in context of Banking is a continuous process of planning,
organizing and controlling of Asset Liability volume, maturity, interest rate and yield.

8.  Asset-liability management (ALM) as the coordinated management of a bank’s on- and
off-balance sheet activities driven by interest-rate risk and its two components: price risk
and reinvestment risk
Objectives of ALM: To protect/ enhance NII, NIM (Spread), MV of net worth of bank
• Net interest income (NII): Difference between the interest income a bank earns from its
lending activities and the interest it pays to depositors.
• Net interest margin (NIM) is a measure of the difference between the interest income
generated by banks and the amount of interest paid out to their lenders (for example,
deposits), relative to the amount of their (interest-earning) assets.
• Net Interest Margin is the ratio of net interest income to average interest-earning assets.
Average Interest-earning assets are loans / advances given to borrowers by banks. Average
of the beginning to end of the period is considered for prudent calculation
Strategies for Asset Liability Management:
a) Gap Management –
Gap is the difference between the duration of assets and liabilities held by a financial entity.
The duration imbalance or maturity imbalance is called “gap” in banks’ balance sheets in terms of
rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs).
Gap analysis is technique of asset liability management that can be used to assess interest rate risk
or liquidity risk. Gap analysis was widely adopted by financial institutions during the 1980's when
used to manage interest rate risk, it was used in duration analysis Gap analysis was one of the first
methods developed to measure a bank's interest rate risk exposure, and continues to be widely used
by banks.
 GAP is the difference between rate-sensitive assets (RSA) and rate-sensitive liabilities
(RSL).
 When RSA – RSL > 0, bank has positive maturity gap
 When RSA – RSL < 0, bank has negative maturity gap
The most familiar example of re-pricing assets is loans that are about to mature or are coming up
for renewal. If interest rate have risen since these loans were first make, the bank will renew them
only if it can get an expected yield that approximates the higher yields currently expected on other
financial instruments of comparable quality
Sensitivity can be described in terms of the effective time to repricing or duration
Reserves and other liquid assets reprice quickly while long-term, fixed-rate securities and loans do
not; since most deposits are short term, they reprice quickly

9. Gap management techniques require management to perform an analysis of the maturities and re-
prizing opportunities associated with the bank’s interest sensitive assets, deposits and money
market borrowings.
Example: GAP Analysis
A static measure of risk that is commonly associated with net interest income (margin) targeting
Traditional Static GAP Analysis
GAPt = RSAt -RSLt
 RSAt is Rate Sensitive Assets - Those assets that will mature or reprice in a given
time period (t)
 RSLt is Rate Sensitive Liabilities Those liabilities that will mature or reprice in a
given time period (t)
 What is the bank’s 1-year GAP with the auto loan?
 RSA1yr = $0
 RSL1yr = $10,000
 GAP1yr = $0 - $10,000 = -$10,000
 The bank’s one year funding GAP is -10,000
 If interest rates rise in 1 year, the bank’s margin will fall. The
opposite is also true that if rates fall, the margin will rise.
b) Spread Management
NIM can be viewed as the “spread” on earning assets, hence the term “spread management” and
“spread model”
NIM = Net Interest Income/Average Total Assets
Where NII = Interest Income – Interest Expense
NIM vary inversely with Bank Size because :-
 Competitiveness of the loan-and-deposit markets are a major factor
 Differences in the volumes, mixes, and pricing (interest rates) of the balance sheet
 Banks with more variable-rate loans will experience greater fluctuations in interest revenue
c) Earnings sensitivity analysis
 When a bank’s assets and liabilities do not reprice at the same time, the result is a change in
net interest income.
 The change in the value of assets and the change in the value of liabilities will also
differ, causing a change in the value of stockholder’s equity

10. Factors Affecting Net Interest Income
 Changes in the level of interest rates
 Changes in the composition of assets and liabilities
 Changes in the volume of earning assets and interest-bearing liabilities outstanding
 Changes in the relationship between the yields on earning assets and rates paid on interest-
bearing liabilities
 Earnings Sensitivity Analysis
 Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank
earnings due to changes in interest rates and balance sheet composition
 Example:
A bank makes a Rs.10,00,000 four-year car loan to a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one-year Rs.10,00, 000 CD at a cost of 4.5%. The bank’s initial
spread is 4%.
What is the bank’s risk?
*******
4 year Car Loan 8.50%
1 Year CD 4.50%
4.00%