Financial System& Commercial Banking 1&2 Set

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Q.1 Discuss the kinds of money market instruments, with emphasis on the prevailing yield from

investing in the instruments.

Ans. - Money Market: Money market means market where money or its equivalent can be traded.

Money is synonym of liquidity. Money market consists of financial institutions and dealers in

money or credit who wish to generate liquidity. It is better known as a place where large

institutions and government manage their short term cash needs. For generation of liquidity, short

term borrowing and lending is done by these financial institutions and dealers. Money Market is

part of financial market where instruments with high liquidity and very short term maturities are

traded. Due to highly liquid nature of securities and their short term maturities, money market is

treated as a safe place. Hence, money market is a market where short term obligations such as

treasury bills, commercial papers and bankers acceptances are bought and sold.

Following are the money market instruments

Treasury Bills (T-Bills): Treasury Bills, one of the safest money market instruments, are

short term borrowing instruments of the Central Government of the Country issued through

the Central Bank (RBI in India). They are zero risk instruments, and hence the returns are not

so attractive. It is available both in primary market as well as secondary market. It is a

promise to pay a said sum after a specified period. T-bills are short-term securities that

mature in one year or less from their issue date. They are issued with three-month, six-month

and one-year maturity periods. The Central Government issues T- Bills at a price less than

their face value (par value). They are issued with a promise to pay full face value on maturity.

So, when the T-Bills mature, the government pays the holder its face value. The difference

between the purchase price and the maturity value is the interest income earned by the

purchaser of the instrument.

Commercial Papers: Commercial paper is a low-cost alternative to bank loans. It is a short

term unsecured promissory note issued by corporates and financial institutions at a

discounted value on face value. They are usually issued with fixed maturity between one to

270 days and for financing of accounts receivables, inventories and meeting short term

liabilities. Say, for example, a company has receivables of Rs 1 lacs with credit period 6

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months. It will not be able to liquidate its receivables before 6 months. The company is in

need of funds. It can issue commercial papers in form of unsecured promissory notes at

discount of 10% on face value of Rs 1 lacs to be matured after 6 months. The company has

strong credit rating and finds buyers easily. The company is able to liquidate its receivables

immediately and the buyer is able to earn interest of Rs 10K over a period of 6 months. They

yield higher returns as compared to T-Bills as they are less secure in comparison to these

bills; however chances of default are almost negligible but are not zero risk instruments.

Commercial paper being an instrument not backed by any collateral, only firms with highquality

credit ratings will find buyers easily without offering any substantial discounts. They

are issued by corporates to impart flexibility in raising working capital resources at market

determined rates.

Certificate of Deposit: It is a short term borrowing more like a bank term deposit account. It

is a promissory note issued by a bank in form of a certificate entitling the bearer to receive

interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can

be issued in any denomination. They are stamped and transferred by endorsement. Its term

generally ranges from three months to five years and restricts the holders to withdraw funds

on demand. However, on payment of certain penalty the money can be withdrawn on demand

also. The returns on certificate of deposits are higher than T-Bills because it assumes higher

level of risk. While buying Certificate of Deposit, return method should be seen. Returns can

be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY,

interest earned is based on compounded interest calculation. However, in APR method,

simple interest calculation is done to generate the return. Accordingly, if the interest is paid

annually, equal return is generated by both APY and APR methods.

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Q.2 What are the financial services provided by a Merchant banker?

Ans. Merchant banking implies investment management. Companies raise capital by issuingsecurities in the market. Merchant bankers act as intermediaries between the issuers of capital and the

investors who purchase these securities. Merchant banking is the financial intermediation that matches

the entities that need capital and those that have capital for investment.

Following are the financial services provided by a Merchant banker

The services provided by merchant bankers includes management of mutual funds, public issues,

trusts, securities and international funds. It involves dealing with the corporate clients and advising

them on various issues like- mergers, acquisitions, public issues, etc.Functions of merchant bankers

include:

i) Management of debt and equity offerings. This forms the main function of the merchant banker. He

assists the companies in raising funds from the market. The undergoing tasks include instrument

designing, pricing the issue, registration of the offer document, underwriting support, marketing of the

issue, allotment and refund and listing on stock exchanges.

ii) Placement and Distribution. The merchant banker helps in distributing various securities like

equity shares, debt instruments, mutual funds, insurance products, and commercial paper, to name a

few. The distribution network of the merchant banker can be classified as institutional and retail in

nature. The institutional network consists of mutual funds, foreign institutional investors, private

equity funds pension funds, financial institutions, etc.

iii) Corporate advisory services. Merchant bankers offer customized solutions to their clients'

financial problems. Financial structuring includes determining the right debt-equity ratio and the

framing of appropriate capital structure theory.

iv) Project advisory services. Merchant bankers help their clients in various stages of the projectundertaken by the clients. They assist them in conceptualizing the project idea in the initial stage.

Once the idea is formed, they conduct feasibility studies to examine the viability of the proposed

project.

v) Loan Syndication. Merchant bankers arrange to tie up loans for their clients. This takes place in a

series of steps. Firstly, they analyze the pattern of the client's cash flows, based on which the terms of

the borrowings can be defined. Then the merchant banker prepares a detailed loan memorandum,

which is circulated to various banks and financial institutions and they are invited to participate in the

syndicate. The banks then negotiate the terms of lending on the basis of which the final allocation is

done.

vi) Providing venture capital financing. Merchant bankers help companies in obtaining venture capitalfinancing for financing their new and innovative strategies.

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Q.3 Discuss the quantitative tools of Monetary policy by the Reserve Bank of India to reduce

money supply in the economy.

Ans. There are two kinds of tools:

Quantitative toolscontrol the volume of credit and inflation, indirectly.

Qualitative toolsthey control the supply of money in selective sectors of the economy

1)Bank Rate

Bank Rate is the rate at which RBI allows finance to commercial banks. Bank Rate is a tool, which

RBI uses for short-term purposes. Any revision in Bank Rate by RBI is a signal to banks to revise

deposit rates as well as Prime Lending Rate.

Role of bank rate is limited in India because:

The structure of interest rates is administered by RBI

Commercial banks enjoy specific refinance facilities.

2)CRR

All scheduled commercial banks are required to maintain a fortnightly minimum average daily cash

reserve equivalent with RBI .The apex bank is empowered to vary this ratio between 3 and 15 per

cent. RBI uses CRReither to impound the excess liquidity or to release funds needed for the economy

from time to time.

3)SLR

Every bank is required to maintain at the close of business every day, a minimum proportion of their

Net Demand and Time Liabilities as liquid assets in the form of cash, gold etc, in addition to cash

reserve requirements. The ratio of liquid assets to demand and time liabilities is known as Statutory

Liquidity Ratio (SLR). Present SLR is 24%.

4)Repos and Reverse Repo

RBI is empowered to enter a transaction in which two parties agree to sell and repurchase the same

security. Under such an agreement the seller sells specified securities with an agreement to repurchase

the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities

with an agreement to resell the same to the seller on an agreed date in future at a predetermined price.

Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the

party acquiring fund) and Reverse Repo when described from the point of view of the supplier of

funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party

initiated the transaction.

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Q.4 What are the functions performed by NABARD?

Ans.Credit is a critical factor in development of agriculture and rural sector as it enables investment in

capital formation and technological upgradation. Hence strengthening of rural financial institutions,

which deliver credit to the sector, has been identified by NABARD as a thrust area. Various initiatives

have been taken to strengthen the cooperative credit structure and the regional rural banks, so that

adequate and timely credit is made available to the needy.

In order to reinforce the credit functions and to make credit more productive, NABARD has been

undertaking a number of developmental and promotional activities such as:-

i)Help cooperative banks and Regional Rural Banks to prepare development actionsplans for themselves

ii)Enter into MoU with state governments and cooperative banks specifying their respective obligations

to improve the affairs of the banks in a stipulated timeframe

iii)Help Regional Rural Banks and the sponsor banks to enter into MoUs specifying their respective

obligations to improve the affairs of the Regional Rural Banks in a stipulated timeframe

Monitor implementation of development action plans of banks and

fulfillment of obligations under MoUs

Provide financial assistance to cooperatives and Regional Rural Banks for

establishment of technical, monitoring and evaluations cells

Provide organisation development intervention (ODI) through reputed

training institutes like Bankers Institute of Rural Development (BIRD),

Lucknowwww.birdindia.org.in, National Bank Staff College,

Lucknow www.nbsc.in and College of Agriculture Banking, Pune, etc.

Provide financial support for the training institutes of cooperative banks

Provide training for senior and middle level executives of commercial banks,

Regional Rural Banks and cooperative banks

Create awareness among the borrowers on ethics of repayment through

Vikas Volunteer Vahini and Farmers clubs

Provide financial assistance to cooperative banks for building improved

management information system, computerisation of operations and

development of human resources

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Q.5 What do you understand by core banking ? Which banks in India offer core banking

solutions.

Core Banking is normally defined as the business conducted by a banking institution with its retail

and small business customers. Many banks treat the retail customers as their core banking customers,

and have a separate line of business to manage small businesses. Larger businesses are managed viathe corporate banking division of the institution. Core banking basically is depositing and lending of

money.

Nowadays, most banks use core banking applications to support their operations where CORE stands

for "centralized online real-time exchange". This basically means that all the bank's branches access

these services available across multiple channels likeATMs,Internet banking, and applications from

centralized datacenters. This means that the deposits made are reflected immediately on the bank's

servers and the customer can withdraw the deposited money from any of the bank's branches

throughout the world. These applications now also have the capability to address the needs of

corporate customers, providing a comprehensive banking solution.

A few decades ago it used to take at least a day for a transaction to reflect in the account because each

branch had their local servers, and the data from the server in each branch was sent in a batch to theservers in the datacenter only at the end of the day (EoD).

Normal core banking functions will include deposit accounts, loans, mortgages and payments. Banks

make branches.

Core banking solutions are banking applications on a platform enabling a phased, strategic approach

that is intended to allow banks to improve operations, reduce costs, and be prepared for growth.

Implementing a modular, component-based enterprise solution facilitates integration with a bank's

existing technologies. An overall service-oriented-architecture (SOA) helps banks reduce the risk that

can result from manual data entry and out-of-date information, increases management information and

review, and avoids the potential disruption to business caused by replacing entire systems.

Core banking solutions is new jargon frequently used in banking circles. The advancement in

technology, especially Internet and information technology has led to new ways of doing business in

banking. These technologies have cut down time, working simultaneously on different issues and

increasing efficiency. The platform where communication technology and information technology are

merged to suit core needs of banking is known as core banking solutions. Here, computer software is

developed to perform core operations of banking like recording of

transactions,passbookmaintenance, interest calculations onloansanddeposits, customer records,

balance of payments and withdrawal. This software is installed at different branches of bank and then

interconnected by means of communication lines liketelephones,satellite,internetetc. It allows the

user (customers) to operate accounts from any branch if it has installed core banking solutions. This

new platform has changed the way banks are working.Gartner defines a core banking system as a back-end system that processes daily banking transactions,

and posts updates to accounts and other financial records. Core banking systems typically include

deposit, loan and credit-processing capabilities, with interfaces to general ledger systems and

reporting tools. Strategic spending on these systems is based on a combination of service-oriented

architecture and supporting technologies that create extensible, agile architectures.

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Q.6 What is the advantage of giving loans via Self Help Groups.

Ans: Self help Group (SHGs) are small group of poor people. The members of an SHG face similarproblems. They help each other, to solve their problems. SHGs promote small saving among their

members. The savings are kept with the bank. This is common fund in the name of the SHG. The

SHG gives small loans to its members in the name of common fund.

A reasonably educated and helpful local person has to initially help the poor people to form groups.

He or She tells them about the benefits of thrift and advantages of forming groups. This person is

called as animator orfacilitator. Any of the following persons can be a successful animator:

Retired school teacher or a retired government servant, who is well known locally.

A health worker/ a field officer/ staff of a development agency or department of the State

Government.

YOU yourself! (The field officer or a staff member of a commercial bank/ regional rural bank or a

field staff from the local co-operative bank or society can also help the poor in forming groups.)

A field level functionary of an NGO.

An unemployed educated local person, having an inclination to help others. A member/participant in the Vikas Volunteer Vahini (VVV) Programme of NABARD.

Woman animators can play more effective role in organizing women SHGs.

The animator cannot organize the groups all alone. He or she will need guidance, training, reading

material, etc.

Usually, one of he following agencies help:

(i) A voluntary agency or Non Government Organisation (NGO).

(ii) The development department of the State Government.

(iii) The local branch of a bank.

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Assignmet Set 2

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Q.1 Discuss the three basic types of lease. What is the difference between lease and hire purchase.

Ans:A lease transaction is a commercial arrangement, whereby an equipment owner or manufacturerconveys to the equipment user the right to use the equipment in return for a rental. while Hire

purchase is a type of instalment credit under which the hire purchaser agrees to take the goods on hire

at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option topurchase. In lease financing no option is provided to the lessee (user) to purchase the goods. Where by

in Hire purchase option is provided to the hirer (user). Lease rentals paid by the lessee are entirely

revenue expenditure of the lessee. While in case of higher purchase only interest element included in

the HP instalments is revenue expenditure by nature. Components Lease rentals comprise of 2

elements (1) finance charge and (2) capital recovery. HP instalments comprise of 3 elements (1)

normal trading profit (2) finance chargeand (3) recovery of cost of goods/assets.

Types of leasing

There are different kinds of lease arrangement. It makes sense to consider them all to see which is best

suited to your business, your particular circumstances and the asset that you are acquiring.

The three main types of leasing are finance leasing, operating leasing and contract hire.

Finance leasing

A long-term lease over the expected life of the equipment, usually three years or more, after which

you pay a nominal rent or can sell or scrap the equipment - the leasing company will not want it

any more.

The leasing company recovers the full cost of the equipment, plus charges, over the period of the

lease.

Although you don't own the equipment, you are responsible for maintaining and insuring it.

You must show the leased asset on your balance sheet as a capital item, or an item that has been

bought by the company.

Leases of over seven years, and in some cases over five years, are known as 'long-funding leases'

under which you can claim capital allowances as if you had bought the asset outright.

Operating leasing

A good idea if you don't need the equipment for its entire working life.

The leasing company will take the asset back at the end of the lease.

The leasing company is responsible formaintenance and insurance.

You don't have to show the asset on your balance sheet.

Contract hire

Often used for company vehicles.

The leasing company takes some responsibility for management and maintenance, such

as repairs andservicing.

You don't have to show the asset on your balance sheet.

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Difference between lease and hire purchase

A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer

conveys to the equipment user the right to use the equipment in return for a rental. In other words,

lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to

use the asset during a specified period in return for a mutually agreed periodic payment (the leaserentals). The important feature of a lease contract is separation of the ownership of the asset from its

usage. Lease financing is based on the observation made by Donald B. Grant: "Why own a cow when

the milk is so cheap? All you really need is milk and not the cow."

Hire purchase is a type of instalment credit under which the hire purchaser, called the hirer, agrees to

take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as

interest, with an option to purchase. Under this transaction, the hire purchaser acquires the property

(goods) immediately on signing the hire purchase agreement but the ownership or title of the same is

transferred only when the last instalment is paid. The hire purchase system is regulated by the Hire

Purchase Act 1972. This Act defines a hire purchase as "an agreement under which goods are let on

hire and under which the hirer has an option to purchase them in accordance with the terms of theagreement and includes an agreement under which:

1) The owner delivers possession of goods thereof to a person on condition that such person pays the

agreed amount in periodic instalments

2) The property in the goods is to pass to such person on the payment of the last of such instalments,

and

3) Such person has a right to terminate the agreement at any time before the property so passes".

Hire purchase should be distinguished from instalment sale wherein property passes to the purchaser

with the payment of the first instalment. But in case of HP (ownership remains with the seller until the

last instalment is paid) buyer gets ownership after paying the last instalment. HP also differs formleasing.

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Q.2 Which are the main credit rating agencies in India and the functions performed by each.

Ans: A credit rating evaluates the credit worthiness of an issuer of specific types of debt,

specifically, debt issued by a business enterprise such as a corporation or a government. It is an

evaluation made by a credit rating agency of the debt issuers likelihood ofdefault.[1]

Credit ratings are

determined by credit ratings agencies. The credit rating represents the credit rating agency's

evaluation of qualitative and quantitative information for a company or government; including non-

public information obtained by the credit rating agencies analysts. Credit ratings are not based on

mathematical formulas. Instead, credit rating agencies use their judgment and experience in

determining what public and private information should be considered in giving a rating to a

particular company or government. The credit rating is used by individuals and entities that purchase

the bonds issued by companies and governments to determine the likelihood that the government will

pay its bond obligations.

Credit ratings are often confused with credit scores. Credit scores are the output of mathematical

algorithms that assign numerical values to information in an individual's credit report. The credit

report contains information regarding the financial history and current assets and liabilities of an

individual. A bank or credit card company will use the credit score to estimate the probability that the

individual will pay backloan or will pay back charges on a credit card. However, in recent years,credit scores have also been used to adjust insurance premiums, determine employment eligibility, as

a factor considered in obtaining security clearances and establish the amount of a utility or leasing

deposit.

A poor credit rating indicates a credit rating agency's opinion that the company or government has a

high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term

economic prospects. A poor credit score indicates that in the past, other individuals with similar credit

reports defaulted on loans at a high rate. The credit score does not take into account future prospects

or changed circumstances. For example, if an individual received a credit score of 400 on Monday

because he had a history of defaults, and then won the lottery on Tuesday, his credit score would

remain 400 on Tuesday because his credit report does not take into account his improved future

prospects.

1. Credit Rating Information Services of India Limited (CRISIL)

2. Investment Information and Credit Rating Agency of India (ICRA)

3. Credit Analysis & Research Limited (CARE)

4. Duff & Phelps Credit Rating India Private Ltd. (DCR India)

5. ONICRA Credit Rating Agency of India Ltd.

6. Back to Directory Index

7. IndiaOneStop Home

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Q.3 What are the functions of the Reserve Bank of India.

Ans: Functions of Reserve Bank of India

The Reserve Bank of India Act of 1934 entrust all the important functions of a central bank the

Reserve Bank of India.

Bank of issue

Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank notes of

all denominations. The distribution of one rupee notes and coins and small coins all over the country

is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank has a separate

Issue Department which is entrusted with the issue of currency notes. The assets and liabilities of the

Issue Department are kept separate from those of the Banking Department. Originally, the assets of

the Issue Department were to consist of not less than two-fifths of gold coin, gold bullion or sterling

securities provided the amount of gold was not less than Rs. 40 crores in value. The remaining three-

fifths of the assets might be held in rupee coins, Government of India rupee securities, eligible bills ofexchange and promissory notes payable in India. Due to the exigencies of the Second World War and

the post-was period, these provisions were considerably modified. Since 1957, the Reserve Bank of

India is required to maintain gold and foreign exchange reserves of Ra. 200 crores, of which at least

Rs. 115 crores should be in gold. The system as it exists today is known as the minimum reserve

system.

Banker to Government

The second important function of the Reserve Bank of India is to act as Government banker, agent

and adviser. The Reserve Bank is agent of Central Government and of all State Governments in Indiaexcepting that of Jammu and Kashmir. The Reserve Bank has the obligation to transact Government

business, via. to keep the cash balances as deposits free of interest, to receive and to make payments

on behalf of the Government and to carry out their exchange remittances and other banking

operations. The Reserve Bank of India helps the Government - both the Union and the States to float

new loans and to manage public debt. The Bank makes ways and means advances to the Governments

for 90 days. It makes loans and advances to the States and local authorities. It acts as adviser to the

Government on all monetary and banking matters.

Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the provisions of the Banking

Companies Act of 1949, every scheduled bank was required to maintain with the Reserve Bank a cash

balance equivalent to 5% of its demand liabilites and 2 per cent of its time liabilities in India. By an

amendment of 1962, the distinction between demand and time liabilities was abolished and banks

have been asked to keep cash reserves equal to 3 per cent of their aggregate deposit liabilities. The

minimum cash requirements can be changed by the Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible securities or

get financial accommodation in times of need or stringency by rediscounting bills of exchange. Since

commercial banks can always expect the Reserve Bank of India to come to their help in times of

banking crisis the Reserve Bank becomes not only the banker's bank but also the lender of the last

resort.

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Controller of Credit

The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of

credit created by banks in India. It can do so through changing the Bank rate or through open market

operations. According to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any

particular bank or the whole banking system not to lend to particular groups or persons on the basis of

certain types of securities. Since 1956, selective controls of credit are increasingly being used by the

Reserve Bank.

The Reserve Bank of India is armed with many more powers to control the Indian money market.

Every bank has to get a licence from the Reserve Bank of India to do banking business within India,

the licence can be cancelled by the Reserve Bank of certain stipulated conditions are not fulfilled.

Every bank will have to get the permission of the Reserve Bank before it can open a new branch.

Each scheduled bank must send a weekly return to the Reserve Bank showing, in detail, its assets and

liabilities. This power of the Bank to call for information is also intended to give it effective control of

the credit system. The Reserve Bank has also the power to inspect the accounts of any commercial

bank.

As supereme banking authority in the country, the Reserve Bank of India, therefore, has the following

powers:

(a)It holds the cash reserves of all the scheduled banks.

(b) It controls the credit operations of banks through quantitative and qualitative controls.

(c) It controls the banking system through the system of licensing, inspection and calling for

information.

(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate of exchange. According

to the Reserve Bank of India Act of 1934, the Bank was required to buy and sell at fixed rates any

amount of sterling in lots of not less than Rs. 10,000. The rate of exchange fixed was Re. 1 = sh. 6d.

Since 1935 the Bank was able to maintain the exchange rate fixed at lsh.6d. though there were periods

of extreme pressure in favour of or against

the rupee. After India became a member of the International Monetary Fund in 1946, the Reserve

Bank has the responsibility of maintaining fixed exchange rates with all other member countries of the

I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the custodian of

India's reserve of international currencies. The vast sterling balances were acquired and managed by

the Bank. Further, the RBI has the responsibility of administering the exchange controls of the

country.

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Supervisory functions

In addition to its traditional central banking functions, the Reserve bank has certain non-monetary

functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve

Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI wide powers of

supervision and control over commercial and co-operative banks, relating to licensing and

establishments, branch expansion, liquidity of their assets, management and methods of working,

amalgamation, reconstruction, and liquidation. The RBI is authorised to carry out periodical

inspections of the banks and to call for returns and necessary information from them. The

nationalisation of 14 major Indian scheduled banks in July 1969 has imposed new responsibilities on

the RBI for directing the growth of banking and credit policies towards more rapid development of

the economy and realisation of certain desired social objectives. The supervisory functions of the RBI

have helped a great deal in improving the standard of banking in India to develop on sound lines and

to improve the methods of their operation.

Promotional functions

With economic growth assuming a new urgency since Independence, the range of the Reserve Bank's

functions has steadily widened. The Bank now performs a varietyof developmental and promotional

functions, which, at one time, were regarded as outside the normal scope of central banking. The

Reserve Bank was asked to promote banking habit, extend banking facilities to rural and semi-urban

areas, and establish and promote new specialised financing agencies. Accordingly, the Reserve Bank

has helped in the setting up of the IFCI and the SFC; it set up the Deposit Insurance Corporation in

1962, the Unit Trust of India in 1964, the Industrial Development Bank of India also in 1964, the

Agricultural Refinance Corporation of India in 1963 and the Industrial Reconstruction Corporation of

India in 1972. These institutions were set up directly or indirectly by the Reserve Bank to promotesaving habit and to mobilise savings, and to provide industrial finance as well as agricultural finance.

As far back as 1935, the Reserve Bank of India set up the Agricultural Credit Department to provide

agricultural credit. But only since 1951 the Bank's role in this field has become extremely important.

The Bank has developed the co-operative credit movement to encourage saving, to eliminate

moneylenders from the villages and to route its short term credit to agriculture. The RBI has set up the

Agricultural Refinance and Development Corporation to provide long-term finance to farmers.

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Q.4 How is asset liability management done in banks.

Ans: In banking institutions, asset and liability management is the practice of managing variousrisks that arise due to mismatches between the assets and liabilities (loans and advances) of the bank.

Banks face several risks such as the risks associated with assets,interest,currency exchange risks.

Asset Liability management (ALM) is at tool to manage interest rate risk and liquidity risk faced byvarious banks, other financial services companies .

Definition of ALM:

ALM is defined as, the process of decision making to control risks of existence, stability and

growth of a system through the dynamic balances of its assets and liabilities.

The text book definition of ALM :

It is a risk management technique designed to earn an adequate return while maintaining acomfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning

power and degree of willingness to take on debt. It is also called surplus- management.

International scenes:

Over the last few years the financial markets worldwide have witnessed wide ranging changes at fast

pace. Intense competition for business involving both the assets and liabilities, together with

increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought

pressure on the management of banks to maintain a good balance among spreads, profitability and

long-term viability.

These pressures call for structured and comprehensive measures and not just ad hoc action. The

Management of banks has to base their business decisions on a dynamic and integrated risk

management system and process, driven by corporate strategy. Banks are exposed to several major

risks in the course of their business credit risk, interest rate risk, foreign exchange risk, equity /

commodity price risk, liquidity risk and operational risks.

The ALM process rests on three pillars:

1) ALM information systems

2) Management Information System

3) Information availability, accuracy, adequacy and expediency

ALM involves identification of Risk parameters, Risk identification, Risk measurement and Risk

management and framing of Risk policies and tolerance levels.

ALM information systems;

Information is the key to the ALM process. Considering the large network of branches and the

lack of an adequate system to collect information required for ALM which analyses information

on the basis of residual maturity and behavioral pattern it will take time for banks in the present

state to get the requisite information.

Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a

banks ability to meet its liabilities as they become due, liquidity management can reduce theprobability of an adverse situation developing.

The importance of liquidity:

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It transcends individual institutions, as liquidity shortfall in one institution can have repercussions on

the entire system. Bank management should measure not only the liquidity positions of banks on an

ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios.

Experience shows that assets commonly considered as liquid like Government securities and

other money market instruments could also become illiquid when the market and players are

Unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches.

Various types of risks with assets:

Currency Risk;

Floating exchange rate arrangement has brought in its wake pronounced volatility adding a

new dimension to the risk profile of banks balance sheets. The increased capital flows across free

economies following deregulation have contributed to increase in the volume of transactions.

Large cross border flows together with the volatility has rendered the banks balance sheets

vulnerable to exchange rate movements.

Dealing in different currencies;

It brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the

same currency, then the currency mismatch can add value or erode value depending upon the currency

movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced

to zero or near zero.

Banks undertake operations in foreign exchange like accepting deposits, making loans and advances

and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not

be possible to eliminate currency mismatches altogether. Besides, some of the institutions may takeproprietary trading positions as a conscious business strategy. Managing Currency Risk is one more

dimension of Asset- Liability Management.

Mismatched currency position besides exposing the balance sheet to movements in exchange rate also

exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control Department)

introduced the concept of end of the day near square position in 1978, banks have been setting up

overnight limits and selectively undertaking active day time trading.

Interest Rate Risk (IRR);

The phased deregulation of interest rates and the operational flexibility given to banks in

pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.Interest rate risk is the risk where changes in market interest rates might adversely affect a banks

financial condition. Changes in interest rates affect both the current earnings (earnings

perspective) as also the net worth of the bank (economic value perspective). The risk from the

earnings perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest

Margin (NIM).

Problem with poor Management Information systems;

In the context of poor MIS, slow pace of computerisation in banks and the absence of total

deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest

Rate Risk. It is the intention of RBI to move over to modern techniques of Interest Rate Risk

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measurement like Duration Gap Analysis, Simulation and Value at Risk at a later date when banks

acquire sufficient expertise and sophistication in MIS.

The Gap or mismatch risk can be measured by calculating Gaps over different time intervals as at a

givendate. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive

assets(including off-balance sheet positions). An asset or liability is normally classified as rate

sensitive

if: The Gap Report should be generated by grouping rate sensitive liabilities, assets and off balance

sheet positions into time buckets according to residual maturity or next reprising period, whichever is

earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances,

deposits, borrowings, purchased funds etc. that mature/reprice within a specified timeframe are

interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank

expects to receive it within the time horizon. This includes final principal payment and interim

instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets

and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing.

While the interest rates on term deposits are fixed during their currency, the advances portfolio of the

banking system is basically floating. The interest rates on advances could be repriced any number of

occasions, corresponding to the changes in PLR.

Risks in ALM :

It is the risk of having a negative impact on a banks future earnings and on the market value of itsequity due to changes in interest rates. Liquidity Risk: It is the risk of having insufficient liquid assets

to meet the liabilities at a given time.

Forex Risk: It is the risk of having losses in foreign exchange assets and liabilities due to exchanges in

exchange rates among multi-currencies under consideration.

Conclusion; thus ALM is a continuous and day to day matter which has to be carefully managed and

preventive steps taken to mitigate the problems associated with it. It may cause irreparable damage to

the banks in terms of liquidity, profitability and solvency, if not monitored properly.

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Q.5 What are the internet banking facilities provided to corporates.

Ans: Corporate e - Banking

Finacle corporate e-banking is a comprehensive, corporate and small business banking solution

providing a single unified view of corporate banking relationships across asset and liability products,

limits, trade finance and cash management. It is designed to support multiple channels including the

Internet and mobile, and can be interfaced with disparate host systems and third-party applications.

The solution is built on new-generation industry standard technologies J2EE and .NET. This

empowers banks to provide their corporate customers anytime anywhere access to real-time

consolidated information. It also offers banks the flexibility to go to market with an innovative

product and service offerings portfolio. Finacle corporate e-banking solution is modular and enables

banks to hand-pick from its comprehensive set of features. Additionally, the infrastructure services

layer of the application provides a framework that aids in deploying new modules rapidly. The

solution is multi-currency enabled and offers multilingual support.

Key Modules

Accounts and Transfers

Electronic Invoice Presentment & Payment (EIPP)

Payments

Collections Management

Liquidity Management

Reconciliation Reporting

Trade Finance

Business Benefits

Aggregated Cross Border Service

The corporate e-banking solutions rich financial information portal provides corporate customers a

comprehensive facility to view critical information and monitor transactions across geographies

through a single interface. This plays a vital role in enabling the bank to provide all the global

financial solutions demanded by business houses expanding their footprint across geographies.

Business Agility

Built on industry standard platforms J2EE and .NET, the corporate e-banking solution provides the

bank tremendous flexibility to extend its product portfolio and customize the solution according to

requirements. The architecture of the solution enables the bank to write business rules once and

deploy them anywhere, add new rules, modify existing ones or integrate them with other applications

seamlessly. The solution also provides an additional layer that can be extended to interface with

multiple back office systems. All this enhances agility of operation, helping the bank identify new

opportunities and roll out new products.

Robust Security

The corporate e-banking solution offers extensive application security features and provides a robust

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framework to integrate with specialized security software. This enables the bank to confidently offer

products that are highly secure and geared to withstand the onslaught of security threats that abound

around Internet transactions.

Lower TCO

The deployment of Finacle enables a relatively cost-efficient channel through which to serve

customers. As the number of transactions completed on-line increases, the number of more expensive

branch transactions decreases. This is especially true of small business customers who tend to use the

branch as the primary channel. Greater automation and productivity, as well as reduced human error

lead to increased cost savings. The thin-client architecture over the Internet also reduces maintenance

costs associated with frequent upgrades and support.

Client Value

Finacle corporate e-banking solution enables subscription based alerts ensure that a customer receives

requisite information through the preferred channel. This leads to greater convenience and enables

better monitoring of banking transactions in real time.

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Q.6 What has been the philosophy behind reforms in the banking sector.

Ans: The last decade witnessed the maturity of India's financial markets. Since 1991, every

governments of India took major steps in reforming the financial sector of the country. The

important achievements in the following fields is discussed under serparate heads:

Financial markets

Regulators

The banking system

Non-banking finance companies

The capital market

Mutual funds

Overall approach to reforms

Deregulation of banking system

Capital market developments Consolidation imperative

Now let us discuss each segment seperately.

Financial Markets

In the last decade, Private Sector Institutions played an important role. They grew rapidly in

commercial banking and asset management business. With the openings in the insurance sector for

these institutions, they started making debt in the market.

Competition among financial intermediaries gradually helped the interest rates to decline.

Deregulation added to it. The real interest rate was maintained. The borrowers did not pay high price

while depositors had incentives to save. It was something between the nominal rate of interest and the

expected rate of inflation.

Regulators

The Finance Ministry continuously formulated major policies in the field of financial sector of the

country. The Government accepted the important role of regulators. The Reserve Bank of India (RBI)

has become more independant. Securities and Exchange Board of India (SEBI) and the Insurance

Regulatory and Development Authority (IRDA) became important institutions. Opinions are also

there that there should be a super-regulator for the financial services sector instead of multiplicity of

regulators.

The banking system

Almost 80% of the business are still controlled by Public Sector Banks (PSBs). PSBs are stilldominating the commercial banking system. Shares of the leading PSBs are already listed on the stock

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exchanges.

The RBI has given licences to new private sector banks as part of the liberalisation process. The RBI

has also been granting licences to industrial houses. Many banks are successfully running in the retail

and consumer segments but are yet to deliver services to industrial finance, retail trade, small business

and agricultural finance.

The PSBs will play an important role in the industry due to its number of branches and foreign banks

facing the constrait of limited number of branches. Hence, in order to achieve an efficient banking

system, the onus is on the Government to encourage the PSBs to be run on professional lines.

Development finance institutions

FIs's access to SLR funds reduced. Now they have to approach the capital market for debt and equity

funds.

Convertibility clause no longer obligatory for assistance to corporates sanctioned by term-lending

institutions.

Capital adequacy norms extended to financial institutions.

DFIs such as IDBI and ICICI have entered other segments of financial services such as commercial

banking, asset management and insurance through separate ventures. The move to universal banking

has started.

Non-banking finance companies

In the case of new NBFCs seeking registration with the RBI, the requirement of minimum net owned

funds, has been raised to Rs.2 crores.

Until recently, the money market in India was narrow and circumscribed by tight regulations over

interest rates and participants. The secondary market was underdeveloped and lacked liquidity.

Several measures have been initiated and include new money market instruments, strengthening of

existing instruments and setting up of the Discount and Finance House of India (DFHI).

The RBI conducts its sales of dated securities and treasury bills through its open market operations

(OMO) window. Primary dealers bid for these securities and also trade in them. The DFHI is the

principal agency for developing a secondary market for money market instruments and Government

of India treasury bills. The RBI has introduced a liquidity adjustment facility (LAF) in which liquidity

is injected through reverse repo auctions and liquidity is sucked out through repo auctions.

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On account of the substantial issue of government debt, the gilt- edged market occupies an important

position in the financial set- up. The Securities Trading Corporation of India (STCI), which started

operations in June 1994 has a mandate to develop the secondary market in government securities.

Long-term debt market: The development of a long-term debt market is crucial to the financing of

infrastructure. After bringing some order to the equity market, the SEBI has now decided to

concentrate on the development of the debt market. Stamp duty is being withdrawn at the time of

dematerialisation of debt instruments in order to encourage paperless trading.

The capital market

The number of shareholders in India is estimated at 25 million. However, only an estimated two lakh

persons actively trade in stocks. There has been a dramatic improvement in the country's stock market

trading infrastructure during the last few years. Expectations are that India will be an attractive

emerging market with tremendous potential. Unfortunately, during recent times the stock markets

have been constrained by some unsavoury developments, which has led to retail investors deserting

the stock markets.

Mutual funds

The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations, 1996 and

amendments thereto. With the issuance of SEBI guidelines, the industry had a framework for the

establishment of many more players, both Indian and foreign players.

The Unit Trust of India remains easily the biggest mutual fund controlling a corpus of nearly

Rs.70,000 crores, but its share is going down. The biggest shock to the mutual fund industry during

recent times was the insecurity generated in the minds of investors regarding the US 64 scheme. With

the growth in the securities markets and tax advantages granted for investment in mutual fund units,

mutual funds started becoming popular.

The foreign owned AMCs are the ones which are now setting the pace for the industry. They are

introducing new products, setting new standards of customer service, improving disclosure standards

and experimenting with new types of distribution.

The insurance industry is the latest to be thrown open to competition from the private sector including

foreign players. Foreign companies can only enter joint ventures with Indian companies, with

participation restricted to 26 per cent of equity. It is too early to conclude whether the erstwhile public

sector monopolies will successfully be able to face up to the competition posed by the new players,

but it can be expected that the customer will gain from improved service.

The new players will need to bring in innovative products as well as fresh ideas on marketing and

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distribution, in order to improve the low per capita insurance coverage. Good regulation will, of

course, be essential.

Overall approach to reforms

The last ten years have seen major improvements in the working of various financial market

participants. The government and the regulatory authorities have followed a step-by-step approach,

not a big bang one. The entry of foreign players has assisted in the introduction of international

practices and systems. Technology developments have improved customer service. Some gaps

however remain (for example: lack of an inter-bank interest rate benchmark, an active corporate debt

market and a developed derivatives market). On the whole, the cumulative effect of the developments

since 1991 has been quite encouraging. An indication of the strength of the reformed Indian financial

system can be seen from the way India was not affected by the Southeast Asian crisis.

However, financial liberalisation alone will not ensure stable economic growth. Some tough decisions

still need to be taken. Without fiscal control, financial stability cannot be ensured. The fate of the

Fiscal Responsibility Bill remains unknown and high fiscal deficits continue. In the case of financial

institutions, the political and legal structures hve to ensure that borrowers repay on time the loans they

have taken. The phenomenon of rich industrialists and bankrupt companies continues. Further, frauds

cannot be totally prevented, even with the best of regulation. However, punishment has to follow

crime, which is often not the case in India.