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LIABILITIES MANAGEMENT

A

PROJECT REPORT ON

LIABILITY MANAGEMENT

BANKING AND INSURANCE

SEMESTER IV

2009-2010

UNDER THE GUIDANCE OF

Miss HEMANSHI

SUBMITTED BY

AUTE LOVE KISHOR

ROLL NO- 40

BIRLA COLLEGE OF ARTS, SCIENCE &

COMMERCE

MURBAD ROAD, KALYAN (W)

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DECLARATION

I,Aute Love Kishor, student of S.Y.B&I

semester IV (2009-2010)

Hereby declare that I have completed the project on

Liability Management. I further declare that the information

contained in this project report is genuine, true & the fair to

the best of my knowledge.

Signature

Roll no-40

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INDEX

Sr. no Contents Page no.

1.

2.

Preface

What is liability management?

01

02

3. Introduction of liability management 11

4. Need for liability management 13

5. Management of liability 16

6. Asset liability management 23

7. Conclusion 27

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PREFACE

I have selected the project Liability Management

for completing the curriculum of IVsemester of B.com

Banking and Insurance. For the past three semesters I have

been walking through various concepts of Banking and I

believe that Liability Management is one of the key factor to

make any bank successful and survive in difficult

circumstances. To broaden my ideas I have opted for thissubject.

It was not so easy for me to collect information and data

related to my project topic. I have seen various books related

to my topic but I have selected only that information which is

relevant to my project. I have also visited various websites for

project purpose but information which is website provided is

not so much relevant to my project. In that case the college

library and college faculty has helped me in getting true and

fair information relating to my project.

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1. WHAT IS BANKING?

The development of Banking is evolutionary in

nature. There is no single answer to the question of what isbanking? Because, a bank performs a multitude of functions

and services which can be comprehended into a single

definition. For a common man a bank means a store house of

money, for a business man it is an institution of finance and

for a worker it may be a depository for his savings.

It may be explained in brief as Banking is what abank does. But it is not clear enough to understand the

subject in full. The oxford Dictionary defines a bank as an

establishment for the custody of money which it plays out on

customers order.

According to section 5 (b) of the Banking

Regulation Act 1949,

Banking means, accepting for the purpose of lending or

investment of deposit of money from the public repayable on

demand or otherwise, and withdrawable by cheque, draft,

order or otherwise.

According to above definition, the main function of a

bank is to collect deposits from the public and use these funds

for lending and investment. For the deposits collected from

the public interest paid to the depositors. Similarly, interest is

earned on lending and investment.

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In this process, bank creates liabilities by way of deposits and

borrowing and assets by way of lending and investment. Foreach rupee collected in the form of deposit, equal asset is

created in the form of advances and investments or

cash/balance with banks.

Functions of Banks:-

Following are the functions perform by Bank:-

I) Primary Functions.

II) Agency Functions.

III) General Utility Functions.

IV) Foreign Trade Management.

V) Credit Creation.

I) Primary or Traditional Functions:-

These functions are classified into 2 categories,namely:-

1) Accepting Deposits.

2) Advancing of Loans.

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1) Accepting Deposits:-

The primary function of bank is acceptingdeposits and advancing of loans. Banks require money to

make loans and advances. Their share capital does not create

adequate funds for advancing loans. Hence they accept

deposits as interest. For the safety point people and

institutions deposit their money with the banks and they get

interest. For this purpose bank operate various types ofaccounts as given under:-

i) Fixed Deposits Account:-

It is also called time deposit account. In

such accounts money is deposited for a fixed period. After the

maturity of the account the bank repays the principal plus

interest for that given period. The interest on such accounts is

pre-decided. Generally, such accounts are having duration of

6 months to 10 years. The rate of interest varies as per the

duration of the account. Generally, the rate of interest is high

as such accounts as the bank is free to use the deposits for a

long period. Bank gives a receipt to the depositor. The receipt

is returned to the bank while getting the payment.

ii) Current Account:-

This account is generally open by traders,

businessman and industrialist. Customers have facility to

deposit and withdraw from such account as many times as

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they wish. The daily transactions of such account holders are

frequent and many. Hence they open such accounts in the

bank. There is uncertainty in the withdrawals from such

accounts and bank cannot use the deposits. No interest is paid

on such accounts. Customers are also given overdraft facility

as per their credit.

iii) Saving Account:-

Such accounts are opened for the

convenience of middle and lower salaried or income groups.There is no restriction of the deposits but there is a restriction

on the withdrawals. A customer cannot withdraw more than

50 times during 6 months from the accounts. Bank pays rate

of interest, which is generally 4.5% per annum.

iv) Other Deposits Accounts:-

Bank also accepts deposits for the

accounts other than the above mentioned. Some of these

accounts are as under:-

a) Recurring deposit Account:-

Account holder deposits a given amountevery month and it is deposited for a given period. At the time

of maturity the principal and interest earned is paid to the

account holder. The rate of interest is higher than the saving

bank account and lower than fixed deposit account.

b) Daily Saving Deposit Scheme:-

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Under this scheme bank employee goes to

residence of account holder and daily is collected by him. It is

useful to daily wage earners and small shopkeepers.

c) Retirement scheme:-

Under this scheme saver saves a givenamount for a given period. After a given period the amount is

repaid in installments with the interest. It assists the

pensioners in their old age.

2) Advancing of Loans :-

Another important primary function of commercial

bank is advancing of loans. It is performed because banks

have to pay interest on various deposits. Thus bank charge

high rate of interest on advancing of loans and earn profit.

Banks collect small savings and are used for advancing of

loans for production purposes. Bank makes advancing of

loans to industrialist, traders, farmers, self-employed persons.

Generally commercial banks advance loans for the following

purposes:-

i) Cash Credit:-

Under this scheme bank advances the loans for a givenperiod on the security of shares, debentures and movable and

immovable properties. The loanee withdraws money from the

bank as per his requirements from time to time. Generally

bank charges interest on the amount which has been

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withdrawn by the account holder. Sometimes traders borrow

from banks on the security of goods. Borrower has the right to

get the dividend and interest on the securities pledged for

loan.

ii) Loans and Advances:-

Under it banks provide loans and advances to

its customer on adequate security. Such amount of loans and

advances are deposited in the account of the borrower and the

borrower can withdraw the amount as and when he requires.Such facility is given for a specific period. After the specific

periods the loans and advances are repaid to the bank.

iii) Overdraft:-

When a bank allows its customer having current

account to withdraw the amount more than the deposits in theaccount it is called overdraft. The overdraft depends on the

credit of the customers. Such facility is given for short term

and emergency purposes. Such facility is given on current

account only.

II) Agency Function:-

Commercial banks act as agent of their customers

and rendered services. Some charges levied by the banks on

such services. Some services rendered free of charges. The

following are the agency functions of commercial banks

provided to their customers:-

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1) Collection of payment of cheques, Bills of

Exchange and Other letters of credit:-

Bank collect payment of cheques, bills of exchange,and other letter of credit deposited by the customers in the

bank. Banks act as an agent on behalf of the customers and

collect deposit. The local collection is free of charge while

outstation collection of these instruments attracts charges.

2) payment of cheques, Bills of Exchange and

other letters of credit:-

Banks make payment on the basis of various instruments

written by the customers and the amount is debited. Many a

times, bank accepts a bill of exchange on behalf of customers

makes payment in time.

3) Receiving payments for customers:-

Banks also received rent, interest, installment of loan,

pension, dividend, etc. on behalf of their customers and the

amount is deposited in their accounts.

4) Payment on behalf of customers:-

Banks not only received payment on behalf of their

customers but also make payment on behalf of customers in

the form of rent, interest, dividend, installment of loan,

insurance premium, commission, etc, such amount written in

customers account and banks charge commission for these

functions.

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5) Transfer of money:-

Banks transfer money from one place to another as

directed by their customers. Bank draft, postal and telegraphictransfers are the methods through which such transfers take

place. Bank charges some commission for conducting these

functions.

6) Purchase and sale of shares securities:-Banks purchase and sale shares and securities

on behalf of their customers. Generally, banks have more

knowledge regarding such activities. Banks charges

commission for this purpose.

III) General Utility Function:-

Banks also carry on some utility functions, which areuseful to their customers. These functions are as under:-

1) Security of wealth and Assets:-

Lockers are provided by banks to their customers.

Their valuables namely important documents, ornaments,

gold, shares, debentures, deposit receipts, etc. are kept in these

lockers. Some annual charges are charged by the banks for the

purpose.

2) Financial Adviser:-

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Banks advise their customers on economic and

financial matters. It helps customers to take correct decision.

3) Personal Credit:-Banks provide customer loans to their customers

on the basis of personal credit. These loans are provided to

purchase consumers goods like car, scooter, refrigerator,

washing machine, air conditioner, etc. such loans are repaid in

installments.

4) Management of public debt:-

Commercial bank manages public debt on behalf

of central bank when central and state government raise loans

through debentures or bonds.

5) Share Market Function:-

Banks also settle the accounts on behalf of their

customers when they are purchasing and selling shares and

debentures in the share market.

IV) Financial and Managerial Arrangement forForeign Trade:-

Commercial banks have played a dominant role in the

expansion of foreign trade. Short term credit is provided for

foreign trade by banks. These banks accept and discount the

commercial bills, letter of credit. It facilitates in the

international transactions. Banks contract the importers and

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exporters and finalize the transactions between two parties.

It facilitates the international payment and increases the

international payments and increases the foreign trade.

v) Function of credit creation:-

Banks attract deposits from the public on thebasis of these deposits; they make loans and advances to the

public. Such amount of loan is deposited in the account of

loanee. Thus loans create deposits. On the basis of these

deposits loans are further granted. Thus loans from deposits

and deposits from loans are encouraged. This process is called

credit creation.

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2. INTRODUCTION OF LIABILITY

MANAGEMENT

In recent years, commercial banks have devotedincreased attention to the concept of liability management.

Liabilities management is concerned with the activities related

to the collection of funds from depositors and other creditors

and the determination of an appropriate mix of these funds.

Mobilization of deposits is become a challenging task for

banks in these days. Banks collect funds through differenttypes of deposits having different maturities. A bank invests

the funds raised from different creditors to earn income. These

activities involved some risk. Liabilities management stresses

that a bank should consider the cost and risk of different

sources of funds as well as the expected return on their

investments. In this way the inter relationship between assetsmanagement and liabilities management is the determining

factor in the context of profitability.

A commercial bank serves as a financial intermediary

between those having funds and those needing funds. While

raising and lending funds banks have to consider liquidity and

profitability factors. In this connection there is need for theuse of financial leverage to improve return on capital. In

recent years special attention is being paid to liabilities

management to improve the profitability of banks. Large

banks are stressing credit instead of assets conversion to meet

their liquidity needs, particularly since nationalization.

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The liability management involves:-

a) Choosing the source of financing to be used, i.e. choosing

between deposits finances and non- deposit financing.b) Determining the amount of funds needed and

c) Obtaining funds at lowest possible cost with the least risk

exposure.

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3. NEED FOR LIABILITY MANAGEMENT

The basic problem facing a bank manager is to have a

satisfactory trade off between liquidity and profitability- the

two principle but conflicting goals of a bank. A bank deals in

the money of the people. The success of the business of bank

depends partly on the efficiency with which it can provide

services to its depositors, but mainly on the confidence it

inspires among the depositors. It has been able to attract thedeposits of the people not only by promising some returns on

their money but also by committing itself to repayment on

demand. This is why the public accepts bank deposits as being

as good as cash.

The banker must, therefore, ensure an adequate

amount of liquidity in his assets so that he may be able to

meet any claims upon it in cash on demand. The perfectly

liquid asset is cash itself because it can fully satisfy the

depositors claims. The more cash a banker holds, the more

obviously he can, without difficulty of any kind, offer cash in

exchange for deposits. Further, the bankers with an adequate

amount of cash in hand meet the credit needs of thecommunity and can make speculative gains.

However, cash in a sterile asset which earns

bank is to make earnings on its business which are sufficient

to compensate it for the cost which it incurs on raising funds,

besides paying the wages of the staff and meeting other

expenses. If a banker holds a large portion of his fund in ready

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cash without earnings any income on it, his business will

result in losses, and sound the death-knell of the offer

sometime. He must, therefore, employ the bulk of the banks

resources in giving loans and advances, and in investing them

in high yielding securities. Such investment are, however,

subject to credit risk-the risk arising from default in repaying

money lent out and the money rate risk-the risk arising out of

fluctuations in the market role of interest. The banker will not

able to satisfy the cash requirements of the depositors on

demand with the funds deployed in the above investments.Once the depositors cheques are not honoured, the bank will

lose the confidence of the public, which will results in a mass

run on banks counter and jeopardize the liquidity position of

the bank. Ultimately, the very survival of the bank is

endangered.

Liquidity and profitability are, therefore, inimical to

each other. Cash has perfect liquidity but lacks yield. At the

other end are some loans and investments, which yield a high

rate of interest, but are hardly liquid at all. The conflict

between liquidity and income is not as sharp as it appears. In

order to ensure long-run earnings, the commercial bank must

retain public confidence in order to continue to survive andprovide for the liquidity needs of the bank.

The art of commercial banking lies in the resolution

of the conflicts between liquidity and profitability. It is an art

because science has not furnished inviolable rules; banks must

be managed with discrimination and good judgment. Rules

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and scientific procedures for doing the whole job cannot be

framed. A number of approaches, ways and means of

resolving the conflicts have been developed from time-to-

time.

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4. MANAGEMENT OF LIABILITIES

The management of liabilities is very difficult and

important job of a banker. For better liquidity and profitabilitythere is a need of liability management.

In liability management there are various liabilities

are involved, but management of capital and deposits are very

much important, because they are major liabilities in banks.

Management of Capital FundThe capital fund constitutes one of the sources of

funds for a commercial bank. It represents owned resources,

and includes the share capital subscribed by its shareholders

as well as reserve built up by the bank by ploughing back a

part of its business earnings. Success and survival of a bank

depend on its strength, which in turn, dispenses publicconfidence in it. Failure of individual banks, particularly large

ones, might erode public confidence in the banking system.

This is why regulators all over the world strive to minimize

the magnitude and scope of bank failures by clamping

minimum capital requirement for banks.

Management of capital funds entails risk returnstrade off. Increasing capital fund reduces the risk of bank

failure by acting as cushion against the losses. On the other

hand, it also reduces expected returns on equity, a measure

that the investors focus on increasingly as the basis for

valuing a banks share.

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Functions of Capital Fund in Commercial

Banks:-

Bank Capital Acts as Loss Absorber:-

Like other business, a commercial bank

needs capital to commence its operations, and to continue its

existence as a running business. Commercial and industrial

companies require capital initially to finance their operations

and secondly to provide a bailout for creditors or to cover

possible losses. From the standpoint of a bank, the reverse is

generally true. The primary role of bank capital is to act as

buffer. It provides a cushion to absorb possible losses so that

depositors may be fully protected at all times. Although the

capital fund is regarded as the absorber of losses arising from

the realization of assets and from other contingencies, yet this

function can be fulfilled only in the extreme case of theliquidation of the bank. The true nature of the protection

function of the capital fund is that it is ultimate of final

protection from the risk of insolvency. In the short run, a

major portion of the banks losses may be offset by its current

earnings, not by its capabilities. Even in the long run, the

capital fund may not fulfill the protective role because, if abank had poor earnings, losses internal control and a large

quantity of risk assets- symptoms of bank liquidation the bank

management would step in long before the capital funds were

severely impaired.

In a recent decision, it was held that the primary function

of the bank capital fund is to absorb the losses resulting from

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events that are managerial foresight cannot be reasonably

expected to anticipate. It should provide a margin of safety

that preferably would allow bank to continue operations

without loss of momentum and, at the least, would by time for

it in which may re-establish its operational momentum.

Normal risk- risks that cannot be anticipated should be cover

by gross earning and not by the capital fund.

Banks Capital Supplies Working Tools of Banks:-

The secondary function of the capital fund is toprovide the where withdrawal from the acquisition of such

fixed assets as buildings, equipments, furniture, etc. The

provision of the permanent assets is a continuous function of

the bank capital fund, mainly because depositors cannot be

expected to supply the funds for such assets, say a new branch

building. Under condition of expansion, therefore, the capitalbase must, of necessity, be strengthened in line with the

expansion of the bank.

Banks Capital Acts as a Source of Loan Funds:-

Another important function of bank capital is

the assurance that the bank will be able to fulfill the credit

needs of the community and assume the risks inherent in its

safety. In other words, there are certain types of investments

for which borrowed funds may not be helpful; reliance is

placed on capital funds.

Bank capital represents the private ownership

of commercial banks, which distinguishes these institutions

from the mutual savings associations, co-operative banks, co-

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operative credits and thrift societies and post office savings,

banks, etc., which compete with commercial banks for

savings.

Management of Deposits:-

The survival of a commercial bank depends, on the

quantum of deposits held by it and the way deposits are

managed. Deposits in fact, constitute a vital source of funds in

a bank, which places an almost exclusive reliance on public

deposits for its operation, for the fact that equity capital

invested in a bank is very insignificant part of the total funds

of the bank. Lending and investment operations of a bank are

influenced essentially by the magnitude of deposits, their

composition and ownership. This is why a banker always

thinks of ways and means of increasing his deposits. It is true

that individual banks do not have complete control over the

level of the total deposits with the banking system and savings

of the community because a host of factors including the

monetary policy of the Central Bank determine it. However a

banker can influence, to some extent amount of deposits held

by it by adopting marketing approach.

In practical sense deposits are managed as given below:-

Suppose the borrower, Mr. X, pays a cheque of Rs. 800

to Mr. Y, who has an account in Bank of Baroda. Then Bank

of Baroda receives Rs.800 as primary deposits, which

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increases the liabilities of the bank by Rs. 800. It balance

sheet appears as follows:

BANK OF BARODA

Liabilities Assets

Demands deposits Rs. 800

( primary)

Cash received Rs. 800

Cash reserves Rs. 160

Excess reserves Rs. 640

As noted in the balance sheet of the

Bank of Baroda, the increased deposit liabilities of Rs. 800,

accompanied by equivalent in cash reserves of Rs. 800 have

resulted in excess reserves of Rs. 640, on account of the 20

percent cash reserves ratio. Thus, Bank of Baroda is now inposition to expand its loan and deposits by the amount of its

excess reserves. If Bank of Baroda expanded its loans and

deposits by the amount of its excess reserves, its balance sheet

would then change to:

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BANK OF BARODA

Liabilities Assets

Demand deposits Rs. 800

(Primary)


(Derivative)


Loans Rs. 640

Now, suppose the borrower, Mr. Z, passes on

the amount of (Rs. 640) to somebody (in meeting his business

obligations), who is turn may deposit it with the Canara Bank.

That increases the liabilities of the Canara Bank, by Rs. 640

and its balance sheet appears as:

CANARA BANK

Liabilities Assets


(Primary)



Excess reserves Rs. 512

The balance sheet shows that Canara Bank now has an

excess reserve of Rs. 512 which can be loaned out and which

in turn creates a derivative deposit of Rs. 512.

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It follows from this that, as the process continues,

every time- the liabilities with the banks go on increasing at

diminishing rate. This process will continue to operate until

all the original excess reserves of Rs. 800 with the first bank

have been parceled out among the various banks and have

become the required reserves. As a result, it may be found that

the aggregate of derivative deposits in the entire banking

system, over a period of time approximates five the initial

derivative deposit (credit).

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5. ASSET LIABILITY MANAGEMENT

Because the business of banking involves the

identifying, measuring, accepting managing the risk, the heart

of bank financial management is risk management. One of the

most important risk management functions in banking is Asset

Liability Management (ALM)

Asset and Liability Management has today

become the most typical subject of any financial institution. It

encompasses the analysis and development of goals and

objectives, the development of long term strategic plans,

periodic profit plans and rate sensitivity management. In one

way or another it has always been the function or

responsibility or Treasury and other financial/strategic

departments. However, of late Asset Liability Management

departments are being established and Asset and Liabilities

committees are being formed within financial institutions.

These committees are often given extraordinary powers

regarding the mix and match of Assets and Liabilities and

have large influence in winding up activities which do not fit

business strategy.

Asset Liability management is concerned with

strategic balance sheet management involving risk caused by

changes in interest rates, exchange rate, credit risk and the

liquidity position of the banks.

Asset Liability Management can hence be broadlydefined as coordinated management of a banks balance sheet

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to allow for an alternative interest rate, liquidity and pre-

payment summaries. It is a flexible methodology that allows

the banks to test the inter-relationships between the wide

variety of risk factors including market risks, liquidity risk,

management decisions, uncertain product cycles, etc.

Important of Asset Liability Management:-

Why do we need asset liability management?

In simple terms-a financial institution may have enough assets

to pay off its liabilities. But what if 50% of the liabilities arematuring within the same period? Though the financial

institution has enough assets, it may become temporarily

insolvent due to severe liquidity crisis.

Even if the assets and liability maturity is matched to

a large extent, the interest rates can change during the period

thereby affecting the interest income from assets and interestexpenses on liabilities. Depending upon the movement of

interest rates the net interest margin may increase or decrease

resulting in corresponding increase or decrease resulting in

profit during a certain period.

Some of the reasons for growing significance

of Asset Liability Management are:-

1. Volatility :-

Deregulation of financial system changed the

dynamics of financial markets. The vagaries of such free

economic environment are reflected in interest rate structure,

money supply and the overall credit position of market, the

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exchange rates and price levels. For a business, which

involves trading in money, rate fluctuations invariably affect

the market value of the bank and its Net Interest Income

(NII).

2. Product Innovation :-

The second reason for growing the importance of

ALM is rapid innovations take place in financial products of

the bank. While there were some innovations that came as

passing fads, others have received a tremendous response. Inseveral cases, the same product has been repeated with certain

differences and offered by various banks. What ever may be

features of the products, most of them have an impact on the

risk profile of the bank thereby enhancing the need for ALM.

For example, flexi-deposits facility.

3. Regulatory Environment:-

At the international level, the bank for international

settlements (BIS) provides a frame work for banks to tackle

the market risks that may arise due to rate of fluctuations and

excessive credit risk. Central Bank in various countries

(including R.B.I) has issued frameworks and guidelines for

banks to develop Asset Liability Management policies.

4. Management recognition :-

All the above mentioned aspects forced

bank managements to give a serious thought to effective

management of assets and liabilities. The management has

realized that it is just not sufficient to have a very good

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franchisee for credit disbursement, nor is it enough to have

just a very good retail deposit base. In addition to these, a

bank should be in a position to relate and link the asset side

with liability side. And this calls for efficient Asset Liability

Management.

This is increasing awareness in the top management

that banking is now a different game all together since all risk

of the game have since changed.

Objectives of Asset Liability Management:-

The basic objectives of ALM is to manage market risk

in such a way to minimize the impact of net interest income

fluctuations in the short run and protect the net income value

of the bank in the long run. Thus, the objectives of ALM are

as follows:-

1) To control liquidity risk.

2) To control the volatility of net interest income and net

economic value of a bank.

3) To control volatility in all targets accounts.

4) To ensure an acceptable balance between profitability

and growth rate.

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CONCLUSION

The proper management of liability is important for

every bank. Liability management is the activity related withthe collection of funds from depositors and other creditors and

these funds are invested and lent out, in these activities bank

earns some interest.

There are various liabilities of a bank, but capital

and deposits are major liabilities of a bank. Therefore there is

a need of proper management of capital and deposits.

The capital represents the owned fund and it

includes the share capital. If bank have to increase their funds

then there is a need to gain public confidence.

The deposits are real source of a bank. Without

deposits bank cannot do business effectively. Managements ofdeposits are also an important responsibility of a banker.

Management of liability is one of the

critical functions of a bank. It is easier said than done. Banks

normally devise policies for accepting or creating certain

liabilities. The simplest method used for encouraging

liabilities in a specific time zone is allotting incentives by wayof higher interest rate for a particular time zone and offer

lower rate in a time zone where the deposit liabilities are not

wanted by the bank. Each bank follows different practices

depending upon their need, Geographical spread and such

other relevant factors.

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BIBLIOGRAPHY

Sr. no Book Name Author

1. Banking and Finance C.M.Chaudhari

2. Management of India Financial

Institution

R.M.Srivastava

3. Practice and Law of Banking Jeevanandan

4. Banking Theory and Law Practice Sundharam &

varshney

5. Modern Banking K.P.M.Sundharam

6. Banking in India Khan Masood

Ahmad

7. Theory and Practice of Banking Reddy

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