UNIT IV
Employment of funds by Commercial Banks
Source of bank funds:
A bank is a business company. Its main purpose is to make a profit. To achieve this goal, it serves its customers. This provides the general public with various interest-bearing obligations. These obligations are the source of funds for the bank and are shown on the debt side of the commercial bank's balance sheet. The main sources of funding for banks are:
1. Bank's own funds.
There are three main types of bank self-financing.
(A) Paid-in capital.
(B) Reserve.
(C) Part of undistributed profit.
(A) Bank's own funds.
1. Paid-in capital
The paid-in capital of the bank itself. The amount registered by the banking company is called nominal capital or authorized capital. The maximum amount of capital stated in the capital clause of the company's articles of incorporation. Capital is further divided into (i) paid-in capital and (ii) subscribed capital. Pakistani banks raise authorized capital by issuing common stock of Rs. Fully paid 10 each.
2. Reserve funds.
Reserves are another source of funding maintained by all commercial banks. At the time of dividend declaration, a part of the profit will be transferred to the reserve fund. This reserve belongs to shareholders and at the time of liquidation, shareholders are entitled to receive these reserves along with their capital.
The main purpose of securing some of the profits is to cover the unexpected costs of the bank. The Banking Company Ordinance requires all banking companies established in Pakistan to make reserves (binding).
3. Profit.
Profit is another source of business-oriented banks. Profit means the credit balance of an undistributed P & L account. The profits accumulated over the years increase the working capital of the bank and strengthen its financial position.
(B) Borrowing.
Borrowed capital is a major and important source of funding for all banking operations. It mainly comes from deposits that are accepted under different conditions in different accounts.
Bank borrowing is mainly in the form of deposits. Banks collect three types of deposits from their customers. (1) Current deposits or demand deposits (2) Savings deposits, and (3) Fixed deposits or time deposits. The more deposits you have in a bank, the more money you (use) to hire and the more profitable you are.
1. Borrowing from a central bank.
Emergency commercial banks borrow loans from the country's central bank. Central banks extend support when commercial banks need financial support.
2. Other sources of information.
Banks also raise funds by issuing bonds, corporate bonds, cash certificates and more. It's an uncommon, but reliable source of borrowing.
In finance, a bond is a debt security, and the authorized issuer owes the holder a debt and is obliged to pay the interest (coupon) to use and / or repay the principal, depending on the terms of the bond later called maturity. Bonds are formal contracts that repay the borrowed money with interest at regular intervals.
b. Debentures
A type of debt certificate that is not secured by physical assets or collateral. Bonds are only backed by the issuer's general creditworthiness and reputation. Both businesses and governments frequently issue this type of bond to secure capital. Like other types of bonds, corporate bonds are recorded in corporate bonds.
c. Cash certificate
Cash certificates and time deposits are similar types of bank investments. This term is most often used in connection with the services provided by Indian banks to their customers. These deposits are not directly related to the stock market or bond speculation, but provide a way for investors to earn interest on money in a safer environment.
3. Deposit. Public deposits are a powerful source of funding for banks. There are three types of bank deposits: (i) current deposits, (ii) ordinary deposits, and (iii) time deposits. Deposits in banks have increased significantly due to the spread of literacy, banking habits, and increased business operations.
In deposit terms, the term current deposit refers to a deposit in a bank account or financial institution that does not have a specified maturity date. These types of current deposit accounts typically earn only interest on demand deposits. Interest in checking deposits is very low.
ii. Deposit Savings:
A deposit account held by a bank or other financial institution that provides collateral for principal and reasonable interest rates. Depending on the type of savings account, the account holder may not be able to write a check from the account (without additional charges or costs) and the number of free transfers / transactions in the account may be limited. there is. Savings account funds are considered one of the most liquid investments other than demand accounts and cash. In contrast to savings accounts, checking accounts allow you to create checks and use electronic debit to access the funds in your account. Savings accounts are usually for money that you do not intend to spend on your daily expenses
iii. Time deposit:
Time deposits, also called time deposits, are time deposits at a banking institution and cannot be withdrawn for a certain "period" or for a certain period (unless a penalty is paid). At the end of the period, you can cancel or put it on hold for another period. Generally speaking, the longer the period, the better the yield of money. Certificate of deposit is a time deposit product
Factors determine the cost of raising bank funds:
1). Funding cost:
The cost of funds is the cost of obtaining funds from various sources in the form of equity capital, reserves, deposits, and borrowings.
Therefore, it generally refers to interest expense.
The lower the cost of capital, the more profitable it is.
2) Cost interest rate
Risk of loss thanks to fluctuations in interest rates. Interest rate risk is important for transactions like interest rate swaps. In such transactions, the parties receiving the floating exchange rate will receive less if the floating exchange rate goes down. Interest rate risk is also important for bonds. When interest rates go up, bond prices go down. This affects the bond secondary market. For example, if you buy a bond at a 3% interest rate and the prevailing interest rate rises to 5%, it will be difficult or impossible to resell the bond for profit. Finally, interest rate risk is also important and is a factor influencing the cost of raising bank funds.
2). Yield of funds;
Funds raised by banks through different sources are spread over different assets.
These assets generate income in the form of interest.
Therefore, the higher the interest rate, the higher the profitability, and the better the yield of the fund, the lower the cost of the fund.
3). Expand:
Spreads are defined as the difference between interest received (interest income) and interest paid (interest expense) in financing.
Higher spreads indicate more efficient financial intermediation and higher net income. Therefore, when interest income is high, the cost of capital is low and banks always raise funds to obtain a certain profit.
Therefore, higher spreads lead to higher profitability and reduce funding costs.
4) Technology level:
Upgraded technology typically lowers the cost of operating a bank and also impacts the cost of financing. This will improve the profitability of the bank.
5) Nature of deposit:
There are various types of deposit transactions with banks, such as time deposits, demand deposits, and short-term deposits. Larger demand deposits / short-term deposits also affected funding costs
All of these factors affect the direct or indirect funding costs of a bank, so funding costs are always calculated by a bank with all of the above factors in mind.
Analysis of Bank Funding Costs:
Costs are incurred at all sources of bank financing, but analysis shows that CRRs and SLRs also affect the cost of bank financing when borrowing from a central bank. High cost of borrowing and financing If a bank uses its own funds (capital paid, reserves, part of undistributed profit), the minimum funding cost will be very low, but the bank will always have its own. Funds are not available Borrowing funds from outside According to our analysis, public deposits are a powerful source of funding for nominal banks because of the cost of financing.
The lowest cost source of bank funds-
The primary source of funding for banks that accept deposits by the public is the best source of funding, and at a very low cost compared to all other sources of funding.
Key takeaways-
A security is a financial instrument, usually any financial asset that can be traded. The nature of what can and cannot be called securities usually depends on the jurisdiction in which the asset is traded. In the United States, the term broadly covers all financial assets traded and categorizes such assets into three major categories.
1. Equity securities:
Equity most often refers to the sharing of shares and ownership of a company (owned by shareholders). Equity securities typically bring regular benefits to shareholders in the form of dividends. However, stock securities fluctuate in value depending on the financial markets and the fate of the company.
2. Debt securities:
They include the sale of borrowed money and securities. They are issued by an individual, company, or government and are sold to other parties for a fixed amount, with a promise of repayment and interest. This includes a fixed amount (payment required), a specified interest rate, and a maturity date (the date on which the total amount of the security must be paid).
Bonds, bank notes (or promissory notes), and Treasury securities are all examples of debt securities. These are all agreements between the two parties regarding the amount of interest to borrow and repay at a preset time.
3. Derivatives:
Individuals who sell derivatives do not have to own the underlying asset entirely. The seller may simply repay the buyer with sufficient cash to purchase the underlying asset or by offering another derivative that meets the initial debt.
Derivatives often derive their value from commodities such as gas and precious metals such as gold and silver. Currencies, like interest rates, Treasury securities, bonds, and stocks, are another underlying asset that can make up a derivative.
Derivatives are most often traded by hedge funds to offset the risk from other investments. As mentioned above, the seller does not need to own the underlying asset and may require a relatively small down payment. This is an advantage because it makes trading easier.
Mode of Creating Charge
The different modes for creating bank bills are:
Pledge:
Pledges are said to be the relief of goods as collateral for the payment of debt or the fulfilment of promises. A pledge is a borrower who pledges property, and a pledgee is a person whose property has been pledged. Two important features of a pledge are the delivery and return of goods.
If the goods are pledged, no ownership of the goods is given, only ownership of the goods. The pledger remains the owner of the property. This method is said to be very popular and easy to secure the price of the property. The bank reserves the right to hold collateral only in the case of the specific debt in which the goods are pledged.
Hypothesis:
This is a mode in which you charge the goods or related documents without relinquishing ownership of the goods. This is a legal transaction that allows a product to be used as collateral for debt without transferring property or property to a lender. It is the borrower who maintains possession of the hypothesized goods. For the amount of debt, the same charge will be incurred for the item.
The hypothesis is the borrower who assumes the product, and the hypothesis is the lender. The borrower performs this method using a lender-friendly document called a hypothetical letter. The letter states that the goods or assets are in the lender's order and disposal until the debt is liquidated. This method is said to be dangerous and requires banks to perform regular inspections and physical verification of virtual products.
Mortgage:
That means that one person transfers interest in a particular property to another to ensure a prepayment of money. The mortgagee is the transferor and the mortgagee is the transferee. Mortgage certificates are said to be bean instruments with the help of mortgages being executed. Mortgage money means prepayment of the money on which the mortgage is made.
Ownership of real estate does not always have to be transferred to the mortgagee. Ownership remains in the mortgage. The mortgagee has the right to sell the property and collect the loan. Interest on the property is passed on to the mortgagee when the borrower repays the amount of the loan with interest.
There are many types of mortgages, including simple mortgages, regular mortgages, UK mortgages, conditional mortgages, anomalous mortgages, and fair mortgages.
Guarantee means giving something as security. A bank guarantee is when a bank provides guarantees and guarantees for various business obligations on behalf of its customers within certain regulatory limits. The lender provides a bank guarantee that acts as a promise to compensate the customer's loss in the event of the customer's default. If the customer is unable to do so, it is a guarantee to the beneficiary that the financial institution upholds the contract between the customer and the third party.
Meaning of Bank Guarantee:
The bank guarantees that the bank promises a third party to take payment risk on behalf of the customer. Bank guarantees are given for contractual obligations between a bank and its customers. Such guarantees are widely used in business and personal transactions to protect third parties from financial loss. This guarantee helps businesses buy things they wouldn't normally buy, helping them grow their business and drive entrepreneurial activity.
Similarly, major furniture manufacturers want to sign contracts with smaller wood shop vendors. Large manufacturers require small vendors to provide bank guarantees before signing a timber contract worth Rs 50. In this case, the major manufacturer will be the beneficiary and a guarantee will be required before the contract. If a small vendor cannot deliver the timber, a major furniture manufacturer can charge the bank for a loss.
Advantages and Disadvantages of Bank Guarantees-
Bank guarantees have their own strengths and weaknesses. The advantages are:
On the contrary, it has some drawbacks:
There are two main types of bank guarantees used in business:
Financial Guarantee:
These guarantees are usually issued in lieu of a security deposit. Some contracts may require a financial commitment from the purchaser, such as a security deposit. In such cases, instead of depositing money, the buyer can provide the seller with a financial bank guarantee, which the seller can indemnify in the event of a loss.
Performance Guarantee:
These guarantees are issued for the performance of contracts or obligations. In the event of default, default or short-term performance of the contract, the beneficiary's loss will be compensated by the bank.
For example, A signs a contract with B to complete a particular project, and that contract is support edited by Bank Guarantee. If A does not complete the project on time and does not compensate B for the loss, B can claim the loss to the bank using the bank guarantee provided.
Bank Guarantee (BG) Eligibility and Process:
Anyone with a financial track record is eligible to apply for BG. BG is applicable to his bank or other banking companies that provide such services. Before approving BG, the bank analyzes the applicant's previous banking history, creditworthiness, liquidity, CRISIL, and CIBIL ratings.
Banks also investigate the BG period, value, beneficiary details, and currency required for approval. In some cases, the bank requires the applicant to provide a guarantee to cover the BG value. Once the bank representative meets all the criteria, we will provide the necessary approvals for BG processing.
Bank Guarantee Fee:
In general, BG charges are based on the risk the bank takes on each transaction. For example, a financial BG is considered to take more risk than a performance BG. Therefore, the Treasury BG charges are higher than the Performance BG charges. Based on the type of BG, fees are typically charged quarterly based on the BG value of 0.75% or 0.50% for the lifetime of the BG.
Separately, banks may charge application processing fees, paperwork fees, and fees. In some cases, the bank will require the applicant for security. This is usually 100% of the BG value. In some cases, collateral or cash margin may also be accepted by the issuing bank.
Asset – liability management in commercial Banks. Basel norms:
From the 1970s to the early 1990s, there was no significant interest rate risk. This is because interest rates are set and recommended by the RBI. The spread between deposits and lending rates was very wide.
At that time, banks weren't processing their balance sheets themselves. The main reason behind this is that the balance sheet was controlled by regulatory and government prescriptions. Banks have been given more space and freedom to process their balance sheets due to interest rate deregulation. Therefore, it was important to put in place ALM guidelines to help banks stay safe from the large losses of ALM's widespread mismatch.
The Reserve Bank of India published its first ALM guidelines in February 1999. These guidelines came into effect on April 1, 1999. These guidelines included, among other things, interest rate and liquidity risk measurements, broadcast layouts, and soundness limits. Gap statements had to be made by scheduling all assets and liabilities according to the stated or expected repricing or maturity date.
At this stage, assets and liabilities were forced to be split into the following eight maturity buckets-
All liability records were investigated as outflows and asset records were investigated as inflows, based on the remaining interval to maturity, also known as maturity.
As a means of liquidity management, banks have accumulated internal mismatches across all time buckets of structural liquidity statements by building internal health limits with the consent of the Board of Directors / Management Committee. Was forced to manage.
According to the prescribed guidelines, on a regular course, the discrepancy, also known as the negative gap between the 1-14 day and 15–28-day time buckets, did not exceed 20% of the cash outflow with respect to the time bucket.
The RBI then mandated banks to establish an Asset Liability Commission as a committee of the Board of Directors to track, manage, monitor and report on ALCO, ALM.
This was in September 2007, with the aim of responding to international exercises, meeting the requirement to more sharply assess the effectiveness of liquidity management, and inspiring improvements in the term money market.
The RBI has fine-tuned these regulations to split the first-time buckets of days 1-14 currently stated in the Structural Liquidity Statement into three-time buckets for banks to measure liquidity risk. Guaranteed to accept more detailed strategies. The next day, 2-7 days, 8-14 days will be available. Therefore, banks were required to put mature assets and liabilities in 10-time buckets.
According to the RBI guidelines published in October 2007, banks have a total of 5%, 10% and 15 cumulative negative mismatches the next day, 2-7 days, 8-14 days, and 15-28 days. Recommended not to exceed%. 20% of each cumulative outflow to address the cumulative impact on liquidity.
Banks were also encouraged to attempt dynamic liquidity management and regularly design structural liquidity statements. In the absence of a fully networked environment, banks were initially allowed to put together a statement on the best current data coverage, but be careful to try to achieve 100% data coverage in a timely manner. Was advised.
Similarly, a statement of structural liquidity was to be presented to the RBI at regular intervals of one month, such as the third Wednesday of every month. The frequency of supervisory reporting on the status of structural liquidity has changed from April 1, 2008 to biweekly. The bank will approve the Structural Liquidity Statement to the Reserve Bank on the first and third Wednesdays of each month.
The bank's board of directors was assigned full risk management obligations, had to enter into risk management policies, and set limits on liquidity, interest rates, foreign exchange and stock price risk.
The Asset Liability Commission (ALCO) is one of the top committees that has missed the implementation of the ALM system. This committee is led by CMD / ED. ALCO also accepts product prices for deposits and down payments. Manage and monitor the risk level of the bank, as well as the expected maturity profile of incremental assets and liabilities. Banks need to require a view of current interest rates and make decisions on future business strategies based on this view.
The ALM process is based on three pillars:
The key to the ALM process is information. Due to the lack of a large network of branches and the appropriate systems to collect the information needed for ALM, current banks get the information they need to investigate information based on residual maturity and behavioural patterns. It takes time to do.
Measuring and processing liquidity requirements is an important practice of commercial banks. Liquidity management can minimize the potential for adverse situations by persuading the bank's ability to meet its obligations when it is due.
Past experience has shown that assets that are generally assumed to be liquid, such as government securities and other money market tools, can also become illiquid if the market and players are one-way. Therefore, liquidity should be tracked through maturity or cash flow mismatches.
Key takeaways:
References:
