You are on page 1of 165

UNIT 1

OVERVIEW OF FINANCIAL INSTITUTION


LESSON 1:
INTRODUCTION TO INDIAN FINANCIAL
SYSTEM

MANAGEMENT OF FINANCIAL INSTITUTION


Learning Objectives financial enterprises manufacture products (e.g., cars, steel,
After reading this lesson, you will understand computers) and/or provide non-financial services (e.g.,
transportation, utilities, computer programming). Financial
• Significance and definition of financial system
enterprises, more popularly referred to as financial
• Importance Of Financial Institutions institutions, provide services related to one or more of the
• Role Of Financial Intermediaries following: let us see what are those.

al
• Financial System – Various Types Of Classification • Transforming financial assets acquired through the market
• Functions Of Financial Institution and constitution them into a different, and more widely

i
preferable, type of asset-which becomes their liability. This is
Dear students, today is our first lecture on Management of

com Tr
the function performed by financial intermediaries, the
Financial Institution. Before we get deep into the subject, the
most important type of financial institution.
primary basic thing for us to understand is the significance, role,
importance and function of financial institution. • Exchanging of financial assets on behalf of customers.
• Exchanging of financial assets for their own accounts.
What is the Significance and Definition of Financial

rd. F
• Assisting in the creation of financial assets for their
System? customers, and then selling those financial assets to other
We all know that the growth of output in any economy market participants.

iza D
depends on the increase in the proportion of savings/
investment to a nation’s output of goods and services. So the
financial system and financial institutions help in the diversion
• Providing investment advice to other market participants.
• Managing the portfolios of other market participants.
dfw P
of rising current income into savings/investments. So now you are aware that financial intermediaries include
We can define financial system as a set of institutions, depository institutions (commercial banks, savings and loan
instruments and markets, which foster savings and channels associates, savings banks, and credit unions), which acquire the
w.p m

them to their most efficient use. The system consists of bulk of their funds by offering their liabilities to the public
individuals (savers), intermediaries, markets and users of mostly in the form of deposits: insurance companies (life and
savings. Economic activity and growth are greatly facilitated by property and casualty companies); pension funds; and finance
ww Co

the existence of a financial system developed in terms of the companies.


efficiency of the market in mobilising savings and allocating What are the Role of Financial Intermediaries?
them among competing users. Financial intermediaries obtain funds by issuing financial claims
Well-developed financial markets are required for creating a against themselves to market participants, and then investing
balanced financial system in which both financial markets and those funds; the investments made by financial intermediaries-
cu

financial institutions play important roles. Deep and liquid their assets- can be in loans and/or securities. These
markets provide liquidity to meet any surge in demand for investments are referred to as direct investments. Market
liquidity in times of financial crisis. Such markets are also participants who hold the financial claims issued by financial
necessary to derive appropriate reference rates for pricing intermediaries are said to have made indirect investments.
Do

financial assets. We can elaborate this further by understanding that financial


This lesson introduces the financial intermediary. Intermediaries institutions are business organisations that act as mobilisers
include commercial banks, savings and loan associations, and depositories of savings, and as purveyors of credit or
investment companies, insurance companies, and pension finance. They also provide various financial services to the
funds. The most important contribution of intermediaries is a community. They differ from non-financial (industrial and
steady and relatively inexpensive flow of funds from savers to commercial) business organisations in respect of their dealings,
final users or investors. Every modern economy has i.e., while the former deal in financial assets such as deposits,
intermediaries, which perform key financial functions for loans, securities, and so on, the latter deal in real assets such as
individuals, households, corporations, small and new machinery, equipment, stocks of goods, real estate, and so on.
businesses, and governments. You should not think that the distinction between the financial
What is the Importance of Financial Institutions? sector and the “real sector” is something ephemeral or
Now coming to the importance of Financial Institution that i.e. unproductive about finance. At the same time, it means that the
why is financial intermediaries so important in any country or role of financial sector should not be overemphasised. The
for that matter in any economy. The answer is simple. Business activities of different financial institutions may be either
entities include non-financial and financial enterprises. Non- specialised or they may overlap; quite often they overlap. Yet you

© Copy Right: Rai University


11.621.6 1
need to classify financial institutions and this is done on the interlinked by the laws, contracts, covenants and
MANAGEMENT OF FINANCIAL INSTITUTION

basis of their primary activity or the degree of their communication networks.


specialisation with relation to savers or borrowers with whom Financial markets are sometimes classified as primary (direct)
they customarily deal or the manner of their creation. In other and secondary (indirect) markets. You all must be well aware
words, the functional, geographic, sectoral scope of activity or that primary markets deal in the new financial claims or new
the types of ownership are some of the criteria, which are often securities and, therefore, they are also known as new issue
used to classify a large markets. On the other hand, secondary markets deal in securities
Financial System – Various Types of Classification already issued or existing or outstanding. The primary markets
We can classify financial institutions into banking and non- mobilise savings and supply fresh or additional capital to
banking institutions. You know that the banking institutions business units. Although secondary markets do not contribute
have quite a few things in common with the non-banking ones, directly to the supply of additional capital, they do so indirectly
but their distinguishing character lies in the fact that, unlike by rendering securities issued on the primary markets liquid.
other institutions, they participate in the economy’s payments Stock markets have both primary and secondary market

al
mechanism, i.e., they provide transactions services, their deposit segments.
liabilities constitute a major part of the national money supply, Very often financial markets are classified as money markets
and they can, as a whole, create deposits or credit, which is and capital markets, although there is no essential difference

i
money. Banks, subject to legal reserve requirements, can advance between the two as both perform the same function of

com Tr
credit by creating claims against themselves, while other transferring resources to the producers. This conventional
institutions can lend only out of resources put at their disposal distinction is based on the differences in the period of maturity
by the savers, and the latter as mere “purveyors” of credit. of financial assets issued in these markets. While money
While the banking system in India comprises the commercial markets deal in the short-term claims (with a period of maturity

rd. F
banks and co-operative banks, the examples of non-banking of one year or less), capital markets do so in the long-term
financial institutions are Life Insurance Corporation (LIC), Unit (maturity period above one year) claims. Contrary to popular
Trust of India (UTI), and Industrial Development Bank of usage, the capital market is not only co-extensive with the stock

iza D
India (IDBI). We shall discuss this in detail later.
There are also few other ways to classify financial institution.
market; but it is also much wider than the stock market.
Similarly, it is not always possible to include a given participant
in either of the two (money and capital) markets alone.
dfw P
Like they can be classified as intermediaries and non-
Commercial banks, for example, belong to both. While treasury
intermediaries. As we have seen earlier, intermediaries
bills market, call money market, and commercial bills market are
intermediate between savers and investors; they lend money as
examples of money market; stock market and government
well as mobilise savings; their liabilities are towards the ultimate
w.p m

bonds market are examples of capital market.


savers, while their assets are from the investors or borrowers.
Non--intermediary institutions do the loan business but their The above classification can be tabulated in the table format as
resources are not directly obtained from the savers. All banking given below:
ww Co

institutions are intermediaries. Many non-banking institutions Table 1


also act as intermediaries and when they do so they are known
as Non-Banking Financial Intermediaries (NBFI). UTI, Classification by nature of claim:
Debt Market
LIC, General Insurance Corporation (GIC) is some of the Equity Market
NBFIs in India. Non-intermediary institutions like IDBI,
cu

Classification by maturity of claim:


Industrial Finance Corporation (IFC), and National Bank for Money Market
Capital Market
Agriculture and Rural Development (NABARD) have come Classification by seasoning of claim :
into existence because of governmental efforts to provide Primary Market
Secondary Market
assistance for specific purposes, sectors, and regions. Their
Do

Classification by immediate delivery or future delivery:


creation as a matter of policy has been motivated by the Cash or spot Market
Derivative Market
philosophy that the credit needs of certain borrowers might not Classification by organizational structure:
be otherwise adequately met by the usual private institutions. Auction Market
Over -the-counter Market
Since they have been set up by the government, we can call them Intermediated Market

Non-Banking Statutory Financial Organisations (NBSFO).


Let us now shift our focus to financial markets. Financial
markets are the centers or arrangements that provide facilities What are the points of difference related to financial
for buying and selling of financial claims and services. The instruments? These instruments differ from each other in
corporations, financial institutions, individuals and respect of their investment characteristics, which of course, are
governments trade in financial products in these markets either interdependent and interrelated. Among the investment
directly or through brokers and dealers on organised exchanges characteristics of financial assets or financial products, the
or off--exchanges. The participants on the demand and supply following are important: (i) liquidity, (ii) marketability, (iii)
sides of these markets are financial institutions, agents, brokers, reversibility, (iv) transferability, (v) transactions costs, (vi) risk of
dealers, borrowers, lenders, savers, and others who are default or the degree of capital and income uncertainty, and a
wide array of other risks, (vii) maturity period, (viii) tax status,

© Copy Right: Rai University


2 11.621.6
(ix) options such as call-back or buy-back option, (x) volatility

MANAGEMENT OF FINANCIAL INSTITUTION


of prices, and (xi) the rate of return-nominal, effective, and real.
What are the Functions of Financial Institution?
After a detailed discussion on financial institution it becomes
easy for us to determine the functions of financial institution.
Financial institutions or intermediaries offer various types of
transformation services. They issue claims to their customers
that have characteristics different from those of their own
assets. For example, banks accept deposits as liability and
convert them into assets such as loans. This is known as
“liability-asset transformation” function. Similarly they
choose and manage portfolios whose risk and return they alter
by applying resources to acquire better information and to

al
reduce or overcome transaction costs. They are able to do so
through economies of scale in lending and borrowing. They
provide large volumes of finance on the basis of small deposits

i
or unit capital. This is called “size-transformation” function.

com Tr
Further, they distribute risk through diversification and thereby
reduce it for savers as in the case of mutual funds. This is called
“risk-transformation” function. Finally they offer savers
alternate forms of deposits according to their liquidity
preferences, and provide borrowers with loans of requisite

rd. F
maturities. This is known as “maturity-transformation”
function.

iza D
A financial system also ensures that transactions are effected
safely and swiftly on an on-going basis. It is important that
dfw P
both buyers and sellers of goods and services should have the
confidence that instruments used to make payments will be
accepted and honoured by all parties. The financial system
ensures the efficient functioning of the payment mechanism.
w.p m

In a nutshell, financial markets can be said to perform


proximate functions such as
1. Enabling economic units to exercise their time preference,
ww Co

2. Separation, distribution, diversification, and reduction of


risk,
3. Efficient operation of the payment mechanism,
4. Transmutation or transformation of financial claims so as to
cu

suit the preferences of both savers and borrowers,


5. Enhancing liquidity of financial claims through securities
trading, and
Do

6. Portfolio management.
Questions to Discuss
1. What is the Significance And Definition of Financial System?
2. What is the Importance Of Financial Institutions?
3. What is the Role Of Financial Intermediaries?
4. What are the various classifications of Financial Institutions?
5. What are the functions of Financial Institutions?
Notes:

© Copy Right: Rai University


11.621.6 3
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 2:
INTRODUCTION TO INDIAN FINANCIAL SYSTEM

Learning Objectives This economic function of financial intermediaries-


After reading this lesson, you will understand transforming more risky assets into less risky ones- is called
diversification. Although individual investors can do it on their
• Maturity Intermediation
own, they may not be able to do it as cost-effectively as a
• Reducing Risk Via Diversification financial intermediary, depending on the amount of funds they
• Reducing The Costs Of Contracting And Information have to invest. Attaining cost-effective diversification in order to
Processing deduce risk by purchasing the financial assets of a financial

al
• Providing A Payments Mechanism intermediary is an important economic benefit for financial
markets.
• Asset/ Liability Management Of The Financial Institutions
Reducing the Costs of Contracting and Information

i
• Nature Of Liabilities

com Tr
• Liquidity Concerns Processing
• Brokerage and asset transformation
You can also reduce the cost of contracting and information
processing. Suppose you are an investor purchasing financial
• Advantages of financial institutions
assets. You should take the time to develop skills necessary to
• Criteria To Evaluate Financial Institutions understand how to evaluate an investment. Once these skills are

rd. F
After getting aware of the characteristics of financial institution, developed you should apply them to the analysis of specific
let us understand some other related concepts. financial assets that are candidates for purchase (or subsequent

iza D
What do you Mean by Maturity Intermediation?
The commercial bank by issuing its own financial claims in
sale). If you as an investor wants to make a loan to a consumer
or business you will need to write the loan contract.
dfw P
essence transforms a longer-term asset into a shorter-term one Although there are some people who enjoy devoting leisure
by giving the borrower a loan for the length of time sought and time to their task, most prefer to use that time for just that-
the investor/depositor a financial asset for the desired leisure. Most of us find that leisure time is in short supply, so
investment horizon. This function of a financial intermediary is to sacrifice it, we have to be compensated; the form of
w.p m

called maturity intermediation. compensation could be a higher return that we obtain from an
investment.
You should understand that maturity intermediation has two
implications for financial markets. First, it provides investors In addition to the opportunity cost of the time to process the
ww Co

with more choices concerning maturity for their investments; information about the financial asset and its issuer, there is the
borrowers have more choices for the length of their debt cost of acquiring that information. All these costs are called
obligations. Second, because investors are naturally reluctant to information processing costs. The costs of writing loan
commit funds for a long period of time, they will require that contracts are referred to as contracts are referred to as contracting
long-term borrowers pay a higher interest rate than on short- costs. There is also another dimension to contracting costs, the
cu

term borrowing. A financial intermediary is willing to make cost of enforcing the terms of the loan agreement.
longer-term loans, and at a lower cost to the borrower than an With this in mind, consider the two examples of financial
individual investor would, by counting on successive deposits intermediaries- the commercial bank and the investment
providing the funds until maturity. Thus, the second company. People who work for these intermediaries include
Do

implication is that the cost of longer-term borrowing is likely to investment professionals who are trained to analyse financial
be reduced. assets and manage them. In the case of loan agreements, either
standardised contracts can be prepared, or legal counsel can be
What is Reducing Risk Via Diversification?
part of the professional staff that writes contracts involving
Next shall discuss the way to reduce the risk through
more complex transactions. The investment professional can
diversification. Consider the example of the investor who places
monitor compliance with the terms of the loan agreement and
funds in an investment company. Suppose that the investment
take any necessary action to protect the interests of the financial
company invests the funds received in the stock of a large
intermediary. The employment of such professionals is cost-
number of companies. By doing so, the investment company
effective for financial intermediaries because investing funds is
has diversified and reduced its risk. Investors who have a small
their normal business.
sum to invest would find it difficult to achieve the same degree
of diversification because they do not have sufficient funds to In other words, there are economies of scale in contracting and
buy shares of a large number of companies. Yet by investing in processing information about financial assets because of the
the investment company for the same sum of money, investors amount of funds managed by financial intermediaries. The
can accomplish this diversification, thereby reducing risk. lower costs accrue to the benefit of the investor who purchases

© Copy Right: Rai University


4 11.621.6
a financial claim of the financial intermediary and to the issuers investment company that agrees to repurchase shares at any

MANAGEMENT OF FINANCIAL INSTITUTION


of financial assets, who benefit from a lower borrowing cost. time.
Providing a Payments Mechanism Nature of Liabilities
You have seen that most transactions made today are not done By the liabilities of the financial institution we mean the
with cash. Instead, payments are made using cheques, credit amount and timing of the cash outlays that must be made to
cards, and electronic transfers of funds. These methods for satisfy the contractual terms of the obligations issued. The
making payments are provided by certain financial liabilities of any financial institution can be categorized
intermediaries. according to four typed as shown in the below table. The
At one time, non-cash payments were restricted to cheques categorisation in the table assumes that the entity that must be
written against non-interest-bearing accounts at commercial paid the obligation will not cancel the financial institution’s
banks. Similar check writing privileges were provided later by obligation prior to any actual or projected payout date.
savings and loan associations and saving banks, and by certain The descriptions of cash outlays as either known or uncertain
types of investment companies. Payment by credit card was also are undoubtedly broad. When you refer to a cash outlay as

al
one time the exclusive domain of commercial banks, but now being uncertain, you do not mean that it cannot be predicted.
other depository institutions offer this service. Debit cards are There are some liabilities where the “law of large numbers”
offered by various financial intermediaries. I am sure all of us makes it easier to predict the timing and/or amount of cash

i
present over here must be having at least one debit card apart outlays. This is the work typically done by actuaries, but of

com Tr
from credit cards. And you all must also be aware that a debit course even actuaries cannot predict natural catastrophes such as
card differs from a credit card in that, in the latter case, a bill is floods and earthquakes.
sent to the credit card holder periodically (usually once a month) Table 2
requesting payment for transactions made in the past. In the

rd. F
case of a debit card, funds are immediately withdrawn (that is, Nature of Liabilities of Financial Institutions

debited) from the purchaser’s account at the time the transaction Liability type Amount of Cash Outlay Timing of Cash Outlay

takes place

iza D
The ability to make payments without the use of cash is critical
for the functioning of a financial market. In short, depository
Type I
Type II
Type III
Type IV
Known
Known
Uncertain
Uncertain
Known
Uncertain
Known
Uncertain
dfw P
institutions transform assets that cannot be used to make
payments into other assets that offer that property.
Let us illustrate each one of them
Asset/ Liability Management of the Financial
Type I Liabilities
w.p m

Institutions Both the amount and the timing of the liabilities are known
To understand the reasons mangers of financial institutions with certainty. A liability requiring a financial institution to pay
invest in particular types of financial assets and the types of Rs.50, 000 six months from now would be an example. For
ww Co

investment strategies they employ, it is necessary that you have a example, depository institutions know the amount that they are
general understanding of the asset/ liability problem faced. committed to pay (principal plus interest) on the maturity date
The nature of the liabilities dictates the investment strategy a of a fixed-rate deposit, assuming that the depositor does not
financial institution will pursue. For example, depository withdraw funds prior to the maturity date.
institutions seek to generate income by the spread between the
cu

Type I Liabilities
return that they earn on assets and the cost of their funds. That
however, are not limited to depository institutions. A major
is, they buy money and sell money. They buy money by
product sold by life insurance companies is a guaranteed
borrowing from depositors or other sources of funds. They sell
investment contract, popularly referred to as a GIC. The
money when they lend it to businesses or individuals. In
Do

obligation of the life insurance company under this contract is


essence, they are spread businesses. Their objective is to sell
that, for a sum of money (called a premium), it will guarantee
money for more than it costs to buy money. The cost of the
an interest rate up to some specifies maturity date. For example,
funds and the return on the funds sold is expressed in terms of
suppose a life insurance company for a premium of Rs.10
an interest rate per unit of time. Consequently, the objective of
million issues a five-year GIC agreement to pay 10%
a depository institution is to earn a positive spread between the
compounded annually. The life insurance company knows that
assets it invests in (what it has sold the money for) and the
it must pay Rs16.11 million to the GIC policyholder in five
costs of its funds (what it has purchased the money for).
years.
Life insurance companies- and, to a certain extent, property and
casualty insurance companies- are in a spread business. Pension Type II Liabilities
funds are not in the spread business in that they do not raise The amount of cash outlay is known, but the timing of the
funds themselves in the market. They seek to cover the cost of cash outlay is uncertain. The most obvious example of a Type
pension obligations at a minimum cost that is borne by the II liability is a life insurance policy. There are many types of life
sponsor of the pension plan. Investment companies face no insurance policies but the most basic type is that, for an annual
explicit costs for the funds they acquire and must satisfy no premium, a life insurance company agrees to make a specified
specific liability obligations; one exception is a particular type of

© Copy Right: Rai University


11.621.6 5
dollar payment to policy beneficiaries upon the death of the certain types of investment companies, it means not being able
MANAGEMENT OF FINANCIAL INSTITUTION

insured. to find new buyers for shares.


Type III Liabilities Brokerage and Asset Transformation
With this type of liability, the timing of the cash outlay is Now let us move ahead to discuss the services. Intermediary
known, but the amount is uncertain. An example is where a services are of two kinds, brokerage function and asset
financial institution has issued an obligation in which the transformation activity. Brokerage function as represented by
interest rate adjusts periodically according to some interest rate the activities of brokers and market operators, processing and
benchmark. Depository institutions, for example, issue supplying information is a part and parcel of all intermediation
accounts called certificates of deposit, which have a stated by all institutions. Brokerage function brings together lenders
maturity, the interest rate paid need not be fixed over the life of and borrowers and reduces market imperfections such as search,
he deposit but may fluctuate. If a depository institution issues information and transaction costs. The asset transformation
a three-year floating-rate certificate of deposit that adjusts every activity is provided by institutions issuing claims against
three months and the interest rate paid is the three-month themselves, which differ, from the assets they acquire. Mutual

al
Treasury bill rate plus one percentage point, the depository funds, insurance companies, banks and depositors with a share
institution knows it has a liability that must be paid off in three of a large asset or issuing debt type liabilities against equity type
years, but the dollar amount of the liability is not known. It assets. While providing asset transformation, financial firms

i
will depend on three-month Treasury bill rates over the three differ in the nature of transformation undertaken and in the

com Tr
years. nature of protection or guarantees, which are offered. Banks
Type IV Liabilities and depository institutions offer liquidity, insurance against
There are numerous insurance products and pension contingent losses to assets and mutual funds against loss in
obligations that present uncertainty as to both the amount and value of assets.

rd. F
the timing of the cash outlay. Probably the most obvious Through their intermediary activities banks provide a package of
examples are automobile and home insurance policies issued by information and risk sharing services to their customers. While
doing so they take on part of heir risk. Banks have to manage

iza D
property and casualty insurance companies. When, and if, a
payment will have to be made to the policyholder is uncertain.
Whenever damage is done to an insured asset, the amount of
the risks through appropriate structuring of their activities and
hedge risks through derivative contracts to maximize their
dfw P
the payment that must be made is uncertain. profitability.
What are the Liquidity Concerns? Financial institutions provide three transformation services.
By liquidity concerns what do you understand? Because of the Firstly, liability, asset and size transformation consisting of
mobilization of funds and their allocation (provision of large
w.p m

uncertainty about the timing and/ or the amount of the cash


outlays, a financial institution must be prepared to have loans on the basis of numerous small deposits). Secondly,
sufficient cash to satisfy its obligations. Here it has been maturity transformation by offering the savers the relatively
assumed that the entity that holds the obligation against the short- term claim or liquid deposit they prefer and providing
ww Co

financial institution may have the right to change the nature of borrowers long-term loans which are better matched to the cash
the obligation, perhaps incurring some penalty. For example, in flows generated by their investment. Finally, risk transformation
the case of a certificate of deposit, you as a depositor may by transforming and reducing the risk involved in direct lending
request the withdrawal of funds prior to the maturity date; by acquiring more diversified portfolios than individual savers
can. The expansion of the financial network or an increase in
cu

typically, the deposit-accepting institution will grant this request


but assess an early withdrawal penalty. In the case of certain financial intermediation as denoted by the ration of financial
types of investment companies, shareholders have the right to assets of all kinds of gross national product accompanies
redeem their shares at any time. growth. To a certain extent, growth of savings is facilitated by
the increase in the range of financial instruments and expansion
Do

Some life insurance products have a cash-surrender value. This


of markets.
means that, at specified dated, the policyholder can exchange the
policy for a lump-sum payment. Typically, the lump-sum Finally What are the Advantages of Financial
payment will penalize the policyholder for turning in the policy. Institutions?
There are some life insurance products that have a loan value, After discussing the financial institution now tell me students
which means that the policyholder has the right to borrow that is there any advantage of financial institution at all. I am
against the cash value of the policy. sure you all will have the same answer YES. Benefits provided
In addition to uncertainty about the timing and amount of the by financial intermediaries consist of reduction of information
cash outlays, and the potential for the depositor of policyholder and transaction costs, grant long-term loans, and provide liquid
to withdraw cash early or borrow against a policy, a financial claims and pool risks. Financial intermediaries economise costs
institution has to be concerned with possible reduction in cash of borrowers and lenders. Banks are set up to mobilize savings
inflows. In the case of a depository institution, this means the of many small depositors, which are insured. While lending,
inability to obtain deposits. For insurance companies, it means the bank makes a single expert investigation of the credit
reduced premiums because of the cancellation of policies. For standing of the borrower saving on several investigations of
amateurs.

© Copy Right: Rai University


6 11.621.6
Financial intermediaries make it possible for borrowers to • Financial reforms are not merely a question of “credit

MANAGEMENT OF FINANCIAL INSTITUTION


obtain long-term loans even though the ultimate lenders are limits”; they encompass issues involved in “limits of credit”.
making only short-term loans. Borrowers who wish to acquire • State intervention is not the best way to achieve a fair
fixed assets do not want to finance them with short-term loans. distribution of credit.
Although the bank has used depositors funds to make long-
• Financial institutions must evolve from below rather than be
term loans it still promises its depositors that they can
imposed from above. Financial development ought to take
withdraw their deposits at any time on the assumption that the
place at a slow and steady pace rather than in spurts and in a
law of large numbers will hold. Bank deposits are highly liquid
programmed or (time) encapsulated manner.
and one can withdraw the deposit any time, though on some
kinds of deposits the interest previously earned on it has to be • There should be a replacement of large-scale by small-scale,
foregone. Finally, banks by pooling the funds of depositors wholesale by retail, and class by mass banking.
reduce the riskness of lending. Indirect finance in some reduces • The sufficing principle rather than the maximising one
the information and transaction costs of lenders and should power the financial system. The functioning of
different financial institutions must be on the basis of a

al
borrowers, renders deposits liquid and reduces the risk of
lending. communitarian spirit, not competition and profit motive.
The ability of the financial intermediaries to ensure the most • The financing of investment which results in the

i
efficient transformation of mobilized funds into real capital has displacement or retrenchment of labour should be

com Tr
not, however, received the attention it deserves. Institutional discouraged.
mechanisms to ensure end use of funds have not been efficient • The scope for financing various sectors is ultimately
in their functioning, leaving the investor unprotected. Efficient constrained by domestic saving. The substantial increase in
financial intermediation involves reduction of the transaction the total saving in India is unlikely to take place now.
cost of transferring funds from original sabers to financial

rd. F
• The working of the Indian financial system should not be
investors. The total coat of intermediation is influenced by
corporate-sector-centric.
financial layering, which makes the individual institution’s costs

iza D
additive in the total cost of intermediating between savers and
ultimate borrowers. The aggregate cost of financial
intermediation from the original saver to ultimate investor is
• There are limits to the overall and industrial growth, and,
therefore, a “ceiling” on the targeted rate of growth has to be
imposed.
dfw P
much higher in developing countries than in developed • The only legitimate role of the financial markets is
countries. infrastructural, hence they should not exist to provide
opportunities to make quick, disproportionate pecuniary
Criteria to Evaluate Financial Institutions
w.p m

gains.
Given the controversy regarding the contribution of financial
sector, it is necessary to have a framework to evaluate the • It is the primary markets activity of supporting new,
performance of the country’s financial sector. Let us first look at economically and socially productive real investment, trade,
ww Co

the criteria formulated, in the form of questions, by Richard D. and flows of goods and services, which is of foremost
Erb, the former Deputy Managing Director of the International importance. The enthusiasm, hyperactivity, and
Monetary Fund: (i) Do institutions find the most productive preoccupation with the secondary markets ought to be
investments? (ii) Do institutions revalue their assets and avoided.
liabilities in response to changed circumstances? (iii) Do Summary
cu

investors and financial institutions expect to be bailed out of Financial institutions provide various types of financial services.
mistakes and at what price? (iv) Do institutions facilitate the Financial intermediaries are a special group of financial
management of risk by making available the means to insure, institutions that obtain funds by issuing claims to market
hedge, and diversify risks? (v) Do institutions effectively participants and use these funds to purchase financial assets.
Do

monitor the performance of their users, and discipline those Intermediaries transform funds they acquire into assets that are
not making proper and effective use of their resources? (vi) more attractive to the public. By doing so, financial
How effective is the legal, regulatory, supervisory, and judicial intermediaries do one or more of the following: (1) provide
structure? (vii) Do financial institutions publish consistent and maturity intermediation; (2) provide risk reduction via
transparent information? diversification at lower cost; (3) reduce the cost of contracting
These criteria, useful as they are, do not encompass social and and information processing; or (4) provide a payments
ethical aspects of finance which ought to be regarded as mechanism.
important as economic aspects. Therefore, the relevant The nature of their liabilities determines the investment strategy
normative criteria, organising principles, and value premises pursued by all financial institutions. The liabilities of all
which should guide the functioning of the financial system are: financial institution will generally fall into one of the four types
• Finance is not the most critical factor in development. shown in Table 2.
• The use of finance must be imbued with the virtues of
austerity, self--limit, and minimisation.

© Copy Right: Rai University


11.621.6 7
We shall discuss the classifications, roles, functions and
MANAGEMENT OF FINANCIAL INSTITUTION

advantages of the financial institutions in detail in our later


lectures.
Questions to Discuss:
1. What do you mean by Maturity Intermediation?
2. What is Reducing Risk Via Diversification?
3. What is the nature Of Liabilities?
4. What are the Liquidity Concerns?
5. What are the Advantages of financial institutions?
6. What are the criteria To Evaluate Financial Institutions?
Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


8 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 3:
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT

Learning objectives human and physical capital are its important sources and any
After reading this lesson, you will understand increase in them requires higher saving and investment, which
the financial system helps to achieve. Second, the financial
• Effects of financial system on saving and investment
system contributes to growth not only via technical progress
• Relationship between financial system and economic but also in its own right. Economic development greatly
development depends on the rate of capital formation. The relationship
• A cautionary approach- between capital and output is strong, direct, and monotonic

al
• The process of financial development (the position which is sometimes referred to as “capital
fundamentalism”). Now, the capital formation depends on
• Criteria to evaluate financial sector
whether finance is made available in time, in adequate quantity,

i
Students, today in the class let us discuss the correlation of and on favourable terms-all of which a good financial system

com Tr
financial system and the economic development. The role of achieves. Third, it also enlarges markets over space and time; it
financial system in economic development has been a much- enhances the efficiency of the function of medium of exchange
discussed topic among economists. Is it possible to influence and thereby helps in economic development.
the level of national income, employment, standard of living,
We can conclude from the above that in order to understand the
and social welfare through variations in the supply of finance?

rd. F
importance of the financial system in economic development,
In what way financial development is affected by economic
we need to know its impact on the saving and investment
development?
processes. The following theories have analyzed this impact: (a)

iza D
There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe
The Classical Prior Saving Theory, (b) Credit Creation or Forced
Saving or Inflationary Financing Theory, (c) Financial Repression
dfw P
Theory, (d) Financial Liberalisation Theory.
the relationship between finance and economic development.
The Prior Saving Theory regards saving as a prerequisite of
The importance of finance in development depends upon the
investment, and stresses the need for policies to mobilise saving
desired nature of development. In the environment-friendly,
voluntarily for investment and growth. The financial system has
w.p m

appropriate-technology-based, decentralised Alternative


both the scale and structure effect on saving and investment. It
Development Model, finance is not a factor of crucial
increases the rate of growth (volume) of saving and
importance. But even in a conventional model of modem
investment, and makes their composition, allocation, and
ww Co

industrialism, the perceptions in this regard vary a great deal.


utilisation more optimal and efficient. It activises saving or
One view holds that finance is not important at all. The
reduces idle saving; it also reduces unfructified investment and
opposite view regards it to be very important. The third school
the cost of transferring saving to investment.
takes a cautionary view. It may be pointed out that there is a
considerable weight of thinking and evidence in favour of the How is this achieved? In any economy, in a given period of
cu

third view also. Let us briefly explain these viewpoints one by time, there are some people whose current expenditures is less
one. than their current incomes, while there are others whose current
expenditures exceed their current incomes. In well-known
In his model of economic growth, Solow has argued that
terminology, the former are called the ultimate savers or
growth results predominantly from technical progress, which is
surplus--spending-units, and the latter are called the ultimate
Do

exogenous, and not from the increase in labour and capital.


investors or the deficit-spending-units.
Therefore, money and finance and the policies about them
cannot contribute to the growth process. Modern economies are characterized (a) by the ever-expanding
nature of business organisations such as joint-stock companies
You All Tell Me What are your Opinions Regarding or corporations, (b) by the ever-increasing scale of production,
this? (c) by the separation of savers and investors, and (d) by the
differences in the attitudes of savers (cautious, conservative, and
Effects of Financial System on Saving and Investment
usually averse to taking risks) and investors (dynamic and risk-
It has been argued that men, materials, and money are crucial
takers). In these conditions, which Samuelson calls the
inputs in production activities. The human capital and physical
dichotomy of saving and investment, it is necessary to connect
capital can be bought and developed with money. In a sense,
the savers with the investors. Otherwise, savings would be
therefore, money, credit, and finance are the lifeblood of the
wasted or hoarded for want of investment opportunities, and
economic system. Given the real resources and suitable
investment plans will have to be abandoned for want of
attitudes, a well--developed financial system can contribute
savings. The function of a financial system is to establish a
significantly to the acceleration of economic development
bridge between the savers and investors and thereby help the
through three routes. First, technical progress is endogenous;
mobilisation of savings to enable the fructification of

© Copy Right: Rai University


11.621.6 9
investment ideas into realities. Figure below reflects this role of providing insurance services and hedging opportunities, and by
MANAGEMENT OF FINANCIAL INSTITUTION

the financial system in economic development. making financial services such as remittance, discounting,
acceptance and guarantees available. Finally, it not only
Relationship Between Financial System and
encourages greater investment but also raises the level of
Economic Development resource allocational efficiency among different investment
channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business
units or borrowers through more systematic and expert project
appraisal, feasibility studies, monitoring, and by generally
Economic Development
keeping a watch over the execution and management of
projects.
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands

al
of thought in this regard. According to the first one, as
Savings & Investment or
Capital Formation emphasized by Kalecki and Schumpeter, financial system plays a
positive and catalytic role by creating and providing finance or

i
credit in anticipation of savings. This, to a certain extent,

com Tr
ensures the independence of investment from saving in a given
Surplus Spending Deficit Spending period of time. The investment financed through created credit
Economic Units Economic Units generates the appropriate level of income. This in turn leads to
an amount of savings, which is equal to the investment already
undertaken. The First Five Year Plan in India echoed this view

rd. F
Income Minus Income Minus when it stated that judicious credit creation in production and
(Consumption + (Consumption + availability of genuine savings has also a part to play in the
Own investment)

iza D Investment)
process of economic development. It is assumed here that the
investment out of created credit results in prompt income
generation. Otherwise, there will be sustained inflation rather
dfw P
Surplus or Saving Deficit or Negative
Saving than sustained growth.
The second strand of thought propounded by Keynes and
Tobin argues that investment, and not saving, is the constraint
w.p m

Financial System on growth, and that investment determines saving and not the
other way round. The monetary expansion and the repressive
policies result in a number of saving and growth promoting
ww Co

forces: (a) if resources are unemployed, they increase aggregate


demand, output, and saving; (b) if resources are fully
employed, they generate inflation which lowers the real rate of
A financial system helps to increase output by moving the
return on financial investments. This in turn, induces portfolio
economic system towards the existing production frontier. This
shifts in such a manner that wealth holders now invest more in
is done by transforming a given total amount of wealth into
cu

real, physical capital, thereby increasing output and saving; (c)


more productive forms. It induces people to hold less savings
inflation changes income distribution in favour of profit
in the form of precious metals, real estate land, consumer
earners (who have a high propensity to save) rather than wage
durables, and currency, and to replace these assets by bonds,
earners (who have a low propensity to save), and thereby
shares, units, etc. It also directly helps to increase the volume
Do

increases saving; and (d) inflation imposes tax on real money


and rate of saving by supplying diversified portfolio of such
balances and thereby transfers resources to the government for
financial instruments, and by offering an array of inducements
financing investment.
and choices to woo the prospective saver. The growth of
“banking habit” helps to activise saving and undertake fresh The extent of contribution of the financial sector to saving,
saving. The saving is said to be “institution-elastic” i.e., easy investment, and growth is said to depend upon its being free or
access, nearness, better return, and other favourable features repressed (regulated). One school of thought argues that
offered by a well-developed financial system lead to increased financial repression and the low/ negative real interest rates
saving. which go along with it encourage people (i) to hold their saving
in unproductive real assets, (ii) to be rent -seekers because of
A financial system helps to increase the volume of investment
non-market allocation of investible funds, (iii) to be indulgent
also. It becomes possible for the deficit spending units to
which lowers the rate of saving, (iv) to misallocate resources and
undertake more investment because it would enable them to
attain inefficient investment profile, and (v) to promote capital-
command more capital. As Schumpeter has said, without the
intensive industrial structure inconsistent with the
transfer of purchasing power to an entrepreneur, he cannot
factor-endowment of developing countries. Financial
become the entrepreneur. Further, it encourages investment
liberalisation or deregulation corrects these ill effects and leads to
activity by reducing the cost of finance and risk. This is done by

© Copy Right: Rai University


10 11.621.6
financial as well as economic development. However, as Second, it has been pointed out that the roles of capital

MANAGEMENT OF FINANCIAL INSTITUTION


indicated earlier, some economists believe that financial formation and finance in development have been unduly or
repression is beneficial. The most recent thinking on this subject disproportionately stressed; that capital shortage is not the
says that the empirical foundations of financial liberalisation are single most important barrier to development. Empirically, it
not robust enough, and that mild, moderate, small repression has been very often found that the rate of capital formation
is more growth promoting than either large-scale repression or increased without raising the growth rate; and the relation
complete laissez-faire. between capital and growth has been one of correlation rather
than causation. It is estimated that in industrialized countries,
capital accumulation could account for at most one--fourth of
the rate of economic growth in the 19th and 20th centuries.
Increase in capital without suitable social, economic, political
conditions cannot cause growth; and, on the other hand,
favourable developments in the conditions just mentioned can

al
achieve much growth with minimum of capital. The
conventional thinking has always stressed the need for
substitution of capital for other factors but the scope and

i
possibilities for this kind of substitution, particularly in the

com Tr
light of factor endowments, have never been really explored.
For growth, much additional capital, and, therefore, much
finance, is not always required; through depreciation allowances,
better composition of capital, appropriate technology, and
higher productivity, a lot of growth can be achieved. The

rd. F
methodology used for estimating the financial resource
requirements (incremental capital-output ratio) is also riddled

iza D with many valuations, measurement, and other problems.


The thrust and message of the above analysis are clearly
expressed in the following statements:
dfw P
• Real growth cannot be bought with money alone (Chandler).
• By and large, it seems to be the case that where enterprise
leads, finance follows (Joan Robinson). Societies in which
w.p m

Financial Sector and Economic Development: a other conditions of growth were favourable were usually
capable of devising adequate financial institutions
Cautionary Approach
(Habakkuk).
Many economists have taken a cautionary view of the role of
ww Co

financial markets in development. The capital market • The role of finance in development is a subsidiary one
enthusiasm and optimism implicit in certain theories of (Newlyn).
finance, viz., Capital Asset Pricing Model and Efficient Market The Process of Financial Development
Hypothesis with their multiple unrealistic, restrictive How does financial development occur? Is it influenced by
cu

assumptions, have been questioned in different ways. economic development? Does the former always precede the
First, it has been argued that the financial sector can perform the latter? The literature talks about “supply leading” and “demand
developmental role if it functions efficiently, but in practice, it is following” financial development. Under the former, financial
not efficient. Tobin’s analysis in this respect is highly instructive. development occurs first and stimulates economic growth.
Do

With logic and examples, he has explained how the prices in Under the latter, as trade, commerce and industry expand, the
financial markets rarely reflect intrinsic values; how very little of financial institutions, instruments, and services needed by them
the work done by the securities industry has to do with also expand as a matter of response. The financial development
financing real investment; how the allocation of funds by is said to be “active” in the first case, and “passive” in the
financial markets is hardly optimal; and that the services of second one.
financial system do not come cheap. According to him, financial Such a characterisation of the process of financial development
system serves us all right. But its functioning does not merit is not very apt. It is difficult to establish precisely the sequence
complacency. Financial activities generate high private reward of real and financial sector developments; the cause and effect
disproportionate to their social productivity. The ‘casino effect’ relationship between them is difficult to disentangle. It will be
of financial markets cannot be forgotten. The speculation in more correct to say that their growths are intertwined,
financial markets is a negative-sum game for the general public. symbiotic, and mutually reinforcing. While financial markets
More recently, through the application of chaos and fractal accelerate development, they, in turn, grow with economic
analyses to financial markets, it has been shown that they are development. In the words of Schumpeter, “the money market
characterized by asymmetry, turbulence, discontinuity, is always the headquarters of the capitalist system, from which
stampedes, non-periodicity, and inefficiency. orders go out to its individual divisions, and that which is

© Copy Right: Rai University


11.621.6 11
debated and decided there is always in essence the settlement of corporate-sector-centric. (k) There are limits to the overall and
MANAGEMENT OF FINANCIAL INSTITUTION

plans for further development. All kinds of credit requirements industrial growth, and, therefore, a “ceiling” on the targeted rate
come to this market; all kinds of economic project are first of growth has to be imposed. (l) The only legitimate role of
brought into relation with each other and contend for their the financial markets is infrastructural, hence they should not
realization in it; all kinds of purchasing power flows to it to be exist to provide opportunities to make quick, disproportionate
sold. This gives rise to a number of arbitrage operations and pecuniary gains. (m) It is the primary markets activity of
intermediate manoeuvres, which may easily veil the supporting new, economically and socially productive real
fundamental thing. Thus, the main function of the money or investment, trade, and flows of goods and services, which is of
capital market is trading in credit for the purpose of financial foremost importance. The enthusiasm, hyperactivity, and
development. Development creates and nourishes this market. preoccupation with the secondary markets ought to be avoided.
In the course of development, it becomes the market for
Questions to Discuss:
sources of income themselves.”
1. What are the effects of Financial System on saving and
Criteria To Evaluate Financial Sector Investment?

al
At the end of the discussion let us evaluate financial sector
2. Discuss the relationship Between Financial System and
critically. Given the controversy regarding the contribution of
Economic Development?
financial sector, it is necessary to have a framework to evaluate

i
the performance of the country’s financial sector. Let us first 3. Discuss a cautionary approach on Financial Sector and

com Tr
look at the criteria formulated, in the form of questions, by Economic Development?
Richard D. Erb, the former Deputy Managing Director of the 4. What are the criteria To Evaluate Financial Sector?
International Monetary Fund: (i) Do institutions find the most Notes:
productive investments? (ii) Do institutions revalue their assets
and liabilities in response to changed circumstances? (iii) Do

rd. F
investors and financial institutions expect to be bailed out of
mistakes and at what price? (iv) Do institutions facilitate the

iza D
management of risk by making available the means to insure,
hedge, and diversify risks? (v) Do institutions effectively
monitor the performance of their users, and discipline those
dfw P
not making proper and effective use of their resources? (vi)
How effective is the legal, regulatory, supervisory, and judicial
structure? (vii) Do financial institutions publish consistent and
w.p m

transparent information?
These criteria, useful as they are, do not encompass social and
ethical aspects of finance, which ought to be regarded as
ww Co

important as economic aspects. Therefore, the relevant


normative criteria, organizing principles, and value premises
which should guide the functioning of the financial system are:
(a) Finance is not the most critical factor in development. (b)
The use of finance must be imbued with the virtues of
cu

austerity, self--limit, and minimization. (c) Financial reforms are


not merely a question of “credit limits”; they encompass issues
involved in “limits of credit”. (d) State intervention is not the
best way to achieve a fair distribution of credit. (e) Financial
Do

institutions must evolve from below rather than be imposed


from above. Financial development ought to take place at a
slow and steady pace rather than in spurts and in a programmed
or (time) encapsulated manner. (f) There should be a
replacement of large-scale by small-scale, wholesale by retail, and
class by mass banking. (g) The sufficing principle rather than the
maximising one should power the financial system. The
functioning of different financial institutions must be on the
basis of a communitarian spirit, not competition and profit
motive. (h) The financing of investment, which results in the
displacement or retrenchment of labour, should be
discouraged. (i) The scope for financing various sectors is
ultimately constrained by domestic saving. The substantial
increase in the total saving in India is unlikely to take place now.
(j) The working of the Indian financial system should not be

© Copy Right: Rai University


12 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 4:
FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT

Learning objectives Allocational Efficiency


After reading this lesson, you will understand When financial markets channelise resources into those
investment projects and other uses where marginal efficiency of
• Financial development: some concepts
capital adjusted for risk differences is the highest, they are said to
• Reforms model for economic growth have achieved allocational efficiency.
Today we shall discuss some important concepts most
Innovations
frequently used in financial world..
Financial innovation can be variously defined as the

al
Financial Development: Some Concepts introduction of a new financial instrument or service or practice,
In this section we discuss a few concepts, which describe the or introducing new uses for funds, or finding out new sources
phenomenon of change and development in a financial system.

i
of funds, or introducing new processes or techniques to handle

com Tr
All these concepts are closely inter-related, and at present they are day-to-day operations, or establishing a new organisation-all
widely referred to in the discussions on financial markets. these changes being on the part of existing financial
Efficiency institutions. In addition, the emergence and spectacular growth
What do you mean by efficiency? The ultimate focus of the of new financial institutions and markets is also a part of
efficiency in financial markets is on the nonwastefulness of financial innovation. The word “new” here means not only the

rd. F
factor use and the allocation of factors to the socially most coming into being of what did not exist till then but also the
productive purposes. The following five concepts are useful in new way of using existing instruments, practices, technology,

iza D
judging the efficiency of a financial system.
Information Arbitrage Efficiency
and so on. Similarly, the use or adoption of an already existing
financial instrument, by financial institution(s), which
previously did not do, so is also regarded as an innovation. The
dfw P
This is the degree of gain possible by the use of commonly marked transformation in the roles of financial institutions and
available information. If one can make large gains by using the departure from the conventional notions regarding their
commonly available information, financial markets are said to functions also constitute financial innovation. As per one
be inefficient. Thus, the efficiency is inversely related to this type definition, financial innovations are “unforecastable
w.p m

of gain. Under conditions of perfect market, the possibilities of improvements” in the array of available financial products and
such a gain are nil because the prices in such a market already processes.
reflect fully and immediately all relevant and ascertainable
Financial innovations bring about wide ranging changes as well
ww Co

available information, and no one would know anything that is


as effects in the financial system. They lead to the broadening,
not already known and therefore not reflected in market prices.
deepening, diversification, structural transformation,
Fundamental Valuation Efficiency internationalization and sophistication of the financial system.
When the market price of a security is equal to its intrinsic value They result in the financialisation of the economy whereby
or investment value, the market is said to be efficient. The financial assets to total assets ratio tends to increase. This
cu

intrinsic value of an asset is the present value of the future financialisation may occur with the growth of
stream of cash flows associated with the investment in that institutionalisation or intermediation and securitisation
asset, when the cash flows are discounted at an appropriate rate simultaneously, or it may occur with the growth of one at the
of discount. This again would happen when markets are cost of other.
Do

perfectly competitive. The process of financial innovation has been characterised


Full Insurance Efficiency differently by different authors. These innovations are regarded
This indicates the extent of hedging against possible future as responses to regulatory and tax regimes, financial constraints,
contingencies. The greater the possibilities of hedging and and so on. The literature on the subject suggests the following
reducing risk, the higher the market efficiency. groups of factors as being responsible for financial innovations:
(i) tax asymmetries that can be exploited to produce tax savings;
Functional or Operational Efficiency
(ii) transaction costs; (iii) agency costs; (iv) opportunities to
The market which minimizes administrative and transaction
reduce or reallocate risk; (v) opportunities to increase asset-
costs, and which provides maximum convenience (or minimum
liquidity; (vi) regulatory or legislative change; (vii) level and
inconvenience) to borrowers and lenders while performing the
volatility of interest rates and prices; and (viii) technological
function of transmission of resources, and yet provides a fair
advances.
return to financial intermediaries for their services, is said to be
operationally or functionally efficient.

© Copy Right: Rai University


11.621.6 13
Financial Engineering intermediaries may occur when they are subject to interest rate
MANAGEMENT OF FINANCIAL INSTITUTION

This is perhaps the latest terminological addition to the world ceilings while the open market rates of return are rising.
of finance, which, incidentally, is a new example of the invasion The terms securitisation and disintermediation are often used
of social thinking by technology. After innovations, industrial interchangeably. Although these terms are very closely related,
engineering and social engineering, we now have financial one should be careful in using them interchangeably. A decline
engineering. It basically means financial innovations; the two in the share of only a particular type of financial intermediary,
terms have often been used interchangeably. The dictionary say commercial banks, does not necessarily mean
meanings of innovation and engineering perhaps give a clue to disintermediation. Similarly, securitisation in the second sense
the possible difference between financial innovations and does not involve disintermediation.
financial engineering. To innovate means to introduce new
methods, new ideas, and make changes. To engineer means to Broad, Wide, Deep and Shallow Markets
arrange, contrive, to bring about artfully or skilfully. All these are closely related terms. The broad and wide financial
market attracts funds in greater volume and from all types of
Financial engineering thus connotes development of new
national and international investors. In such a market, financial

al
financial technology to cope with financial changes. It involves
institutions offer, even globally, 24-hour sales and trading
construction, designing, deconstruction, and implementation
capability in debt and equity instruments. The deep market is
of innovative financial institutions, processes, and instruments.
one where there are always sufficient orders for buying and

i
It means the formulation of creative solutions to problems in
selling at fine quotations both below and above the market

com Tr
finance. The development and use of skills, means, techniques,
price, and where there are good opportunities for swap deals. A
tools for changing and managing cash flows and investment
swap deal is a medium-term or long-term arrangement between
features of financial instruments form a part of financial
two parties in which each party commits to service the debt of
engineering. In today’s highly volatile markets, it seeks to limit
the other. In other words, a swap is the exchange of future
financial risk by creating financial instruments for hedging,

rd. F
streams of payment between two or more parties. The shallow
speculation, arbitraging, and by fine-tuning portfolio
market, on the other hand, means an underdeveloped market,
adjustments. It also seeks to maximise profits quickly. The
its underdevelopment being the result of financial repression

iza D
creation of financial derivatives and securitisation are its two
examples. Computer power and human insight are combined
to spot arbitrage opportunities, measure risk, and to react to
or administered finance.
Financial Repression
dfw P
news very fast in financial engineering. It represents economic conditions in which the government’s
regulatory and discretionary policies distort financial prices or
Financial Revolution interest rates (i.e., the real interest rates are kept low or negative),
Some people believe that a veritable financial revolution has discourage saving, reduce investment, and misallocate financial
w.p m

taken place in the world of finance in the recent past. The resources. The government-directed credit program, and direct
concept of financial revolution is an extension of the concepts rather than indirect credit controls predominate in a repressed
of financial innovations and engineering. It is meant to convey system. As indicated above, it is also known as the system of
ww Co

that, of late, the magnitude, speed, and spread of changes in administered interest rates and finance.
the financial sector the world over has been simply tremendous,
prodigious, phenomenal; that it has undergone a “future Financial Reforms, Financial Liberalisation, and
shock”. It indicates that life in the world of finance is no longer Deregulation
easy and that financial markets now work 24 hours a day. The Financial reforms involve instituting policies, which will increase
cu

innovations in computers and satellite communications, and the allocative efficiency of available saving, promote the growth
the linking up of the two have completely changed the of real sector, and enhance the health, stability, profitability, and
production, marketing, and delivery of financial products. And viability of the financial institutions. In theory, they need not
as with every revolution, not all changes have been for the best, necessarily increase the market -orientation of the system, but in
Do

and there have been unexpected consequences. practice at present, they have come to mean greater market
Diversification orientation. Therefore, liberalisation, deregulation, and reforms
In one sense, diversification means the existence or the mean the same thing currently. They refer to the policy of
development of a very wide variety of financial institutions, reducing or removing completely the legal restrictions, physical
markets, instruments, services, and practices in the financial or administrative or direct controls, ceilings on interest rates,
system. In another but related sense, it refers to the presence of restrictions on the flow of funds, official directives regarding
opportunities for investors to purchase a large mix or portfolio sectoral and other allocations of funds, restrictions on the scope
of varieties of financial instruments. With the diversified of activities of banks and other financial institutions, and so
portfolio, investors can minimise the risk for a given rate of on, which exist under the administered finance. It is obvious
return, or they can maximise the return for a given risk. that liberalisation is the process in which the intervention or
interference of the government in financial markets is reduced
Disintermediation
and the markets are allowed, as far as possible, to function on
It refers to the phenomenon of decline in the share of financial
the basis of free market or competitive principles.
intermediaries in the aggregate financial assets in an economy
because people “switch out of’ their liabilities into direct
securities in the open market. Such a flow of funds out of these

© Copy Right: Rai University


14 11.621.6
Privatisation Securitisation

MANAGEMENT OF FINANCIAL INSTITUTION


It is regarded as a necessary part of financial reforms. It means The term “securitisation” is used in financial literature in two
increasing the ownership, management, and control of the senses. First, it means the faster growth of direct (primary)
financial sector by individuals and private incorporated and financial markets and financial instruments than that of
unincorporated bodies. This may be achieved partly by financial intermediaries. In other words, it refers to the growing
denationalisation, disinvestments by the state, allowing private ability and practice of firms to tap the bond, commercial paper,
sector entry, and abstaining from new ownership by the state. and share markets as alternatives to institutional financing.
Second, it refers to the process by which the existing assets of
Prudential Regulation
the lending financial institutions are “sold” or “removed” from
This is another major element of financial sector reforms. It
their balance sheets through their funding by other investors. In
means regulation without suppression, and supervision and
this process, investors are sold securities, which evidence their
control without constriction. It implies that the authorities have
interest in the underlying assets without recourse to the original
not abdicated the role of and responsibility for evolving a
lender. The redemption of these securities does not become the
healthy, strong, sound, safe, stable, and viable financial system.

al
obligation of the original lender. The payments to the investors
It aims to impart greater transparency and accountability in
are made to the extent of cash flows realised from the
operation, and to restore credibility and confidence in the
underlying assets. What happens is that a number of assets of
financial system. It relates to income recognition, assets

i
a given lender having similar characteristics are pooled together,
classification, provisioning for bad and doubtful debts, and

com Tr
and undivided interests in this pool are sold in the form of
capital adequacy. The prudential regulation is the policy of the
what are called Pass Through Certificates (PTC). The tenor
State with regard to macro and micro prudential concerns.
(maturity) of the PTC generally matches the average maturity of
1ntegration the pooled assets. The cash flows from the underlying assets are
It refers to the establishment of close connections or effective passed through, after retaining management fees, to the holders

rd. F
linkages between different constituents or parts, and between of PTC in the form of periodic (monthly) payments of interest
different sub-parts of the financial system. As a result, there are and principal. The redemption of securities is made only to the

iza D
substantial flows of funds between them, and there is a greater
correspondence between interest rates in different parts of the
financial system. Financial integration is the opposite of the
extend of the cash flows realised from the underlying assets.
The securitisation essentially involves the “collateralised
financing” rather than the “sale of assets”. The ever-increasing
dfw P
maturitywise, geographical, institutional, seasonal, instrumental, resource requirements and the desire to maintain high levels of
segmentation or partitioning or compartmentalisation of the disbursements while keeping the overall size of assets within
financial markets. certain limits have led financial institutions to innovate in the
form of securitisation. The deal between ICICI and Citibank to
w.p m

Internationalisation and Globalisation


These terms indicate the extension of activities of a financial securitise ICICI’s Sellers Line of Credit Bills of Exchange, had
system beyond the national boundaries. The extension may marked the first securitisation deal in India.
take place in the form of borrowing as well as lending, and it
ww Co

Indian Financial Markets and Banking System-


may take place through official or private or commercial channel.
Reforms Model for Economic Growth
In the process of internationalisation, the domestic financial
Cross-country evidence suggests that economic growth is
institutions participate in foreign financial markets, and the
positively related to financial development. Recent economic
foreign institutions participate in domestic markets to a
research studies by leading global investment bankers indicate
cu

significant extent. In other words, the domestic and foreign


that, over the next few decades, the growth generated by the
financial markets get integrated and interlinked, and the supply
large developing countries, particularly the BRICs (Brazil,
and demand curves of funds assume a different character.
Russia, India and China) could become a much larger force in
When globalisation occurs, financial instruments may be
the world economy than it is now. For India, the multi-
denominated in several currencies, and there would be a
Do

dimensional reforms model adopted for our financial sector a


convergence of interest rates in different national markets,
decade ago is now bringing in a robust picture of the financial
because interest rate changes originating in one financial centre
system and our economy.
would be quickly transmitted to other centres.
The pre-reforms phase of pre-emption of resources and micro-
Sometimes, a distinction is made between internationalisation
management by Government, interest rate regulation, “a licence
and globalisation. While the former term is used to indicate the
Raj” and a closed economy gave way to a unique reforms model
absence of regulation or control of any national authority on
with multiple dimensions for all-round development of the
financial markets, the latter is said to refer to the establishment
financial sector. The financial sector reforms followed the
of interlinkages among national markets as a result of the
traditional “pancha sutra” approach of cautious and proper
progressive liberalisation and the removal of exchange controls.
sequencing; mutually reinforcing measures; complementarity
This distinction is not really convincing; it is based on the
between reforms in the banking sector and changes in fiscal,
ideology-induced narrowing down of the meaning of the term
external and monetary policies; developing financial
“internationalisation”.
infrastructure; and developing financial markets.
The reforms have covered key segments of the Indian financial
markets: capital markets, the money and Government securities

© Copy Right: Rai University


11.621.6 15
markets and the forex markets. With prudential strengthening developing unique credit risk models for risk-rating and pricing
MANAGEMENT OF FINANCIAL INSTITUTION

of the banking system coupled with real sector reforms, there and real-time credit monitoring. The risk management
has been a gradual transformation of the Indian economy. framework for market risk using internal models is being
The capital markets have demonstrated improved market developed by Indian banks. Use of derivatives for market risk
efficiency and transparency. The institutionalisation of SEBI, management is on the increase. Banks are now moving towards
the incorporation of NSE, the enactment of Depositories Act, the Basel II framework for capital allocation and risk
screen-based trading, entry of FIIs and mutual funds, access to management. Banks are actively considering measures to contain
international capital markets through ADRs, GDRs, FCCBs etc. impact of operational risks to manageable limits.
have all contributed to this transformation. Inspite of the The challenges for the banks in the times to come would be to
Monday mayhem on our bourses following the election results, counter increased competition, meeting the demanding
the following week’s figures indicated that there were net standards of customers, stepping up of income and to move
inflows through the FII route. Our systems for managing towards becoming “one-stop financial hyper-markets”. The key
market volatility in the Stock Exchanges also clicked into place as for this would be in technological advances, going in for risk-

al
was evident with the “circuit breakers” for sudden market bundling and rebundling through new financial products,
swings getting into operation. sound risk management architecture and enhancing share-
The money markets have now gradually become a conduit for holder value.

i
providing an equilibrating mechanism for evening out short- Our reforms model would dynamically incorporate measures

com Tr
term surpluses and deficits in the financial system. Measures are for risk management, adequate capital allocation, sound
being taken to have a pure inter- bank call/ notice money regulatory and supervisory practices. These would provide
market. Collateralised borrowing and lending obligation necessary conditions for a long-term growth path towards our
(CBLO) has been operationalised as a money market country becoming one of the largest economies.

rd. F
instrument through the Clearing Corporation of India Ltd.
Summary
(CCIL).
The ultimate goal of the financial system is to accelerate the rate
The G-sec market has seen significant liquidity and depth post-

iza D
1990. The initial reforms of moving to an auction based system
for issuing Government debt, terminating the system of
of economic development. While financial markets may
accelerate development, they themselves, in turn, develop with
economic development. The relationship between economic
dfw P
automatic monetisation of fiscal deficit were complementary to development and financial development is thus symbiotic.
interest rate deregulation in the banking sector. Primary Dealers Efficient financial markets are characterised by the absence of
were institutionalized. FIIs were allowed to invest in G- information-based gain, by correct evaluation of assets, by
securities and T-bills in primary and secondary markets subject maximisation of convenience and minimisation of transactions
w.p m

to certain ceilings. Other measures included issuance of uniform costs, and by maximisation of marginal efficiency of capital. In
accounting norms for repo and reverse repo transactions, facility reality, the contribution of the financial system to growth is
for anonymous screen-based order-driven trading system for G- highly constrained because it does not work efficiently and
ww Co

secs on stock exchanges, introduction of exchange-traded capital is not the most important barrier to growth. The role of
interest rate derivatives on the National Stock Exchange (NSE), finance in development is believed to be secondary by many
relaxation in regulation relating to sale of securities by experts. A framework to evaluate the working of any financial
permitting sale against an existing purchase contract, facilitating sector must include economic, commercial as well as social and
the roll over of repos and switch over to the DVP III mode of ethical criteria. Financial innovations refer to wide-ranging
cu

settlement. Market Stabilisation Scheme (MSS) has been changes in the financial system. The introduction of new
introduced to differentiate the liquidity absorption of a more financial institutions, markets, instruments, services,
enduring nature by way of sterilisation from the day-to-day technology, organisation, and so on are parts of financial
normal liquidity management operations. innovations. Financial engineering connotes skilful
Do

Our Forex policies are in line with global best practices. Forex development and use of new financial technology, creative
reserves of over $118 billion are now a buffer for crisis solutions, and tools to cope with financial changes. It involves
prevention, providing confidence to the markets and protection construction, designing, deconstruction of innovative financial
against exchange rate volatility. Substantial delegation of powers instruments, institutions and processes to reduce risk and to
to the banking system in the area of international trade, maximise profits quickly. Financial revolution means that the
remittances, borrowings and investments has helped bring magnitude, speed, and spread of changes in the financial sector
about greater openness and reassured the global market players are simply phenomenal. The markets, which attract funds in
of our inherent strengths. large volume and from all types of investors, are known as
The impact of reforms on the banking industry has been broad financial markets. The markets, which provide
substantial. There has been an increase in operational efficiency opportunities for sufficient orders at fine rates below and above
and profitability. NPA levels are coming down. There is greater the market price, are called deep financial markets. Markets that
use of technology for transaction processing and information are underdeveloped due to governmental regulations and
management using computer and communication devices. Our controls are termed as shallow financial markets. Financial
banks have now a greater awareness of credit risk management. repression exists when the regulatory policies of the
Further progress on this front would have to be taken up by government distort interest rates, discourage saving, reduce

© Copy Right: Rai University


16 11.621.6
investment, and misallocate resources. Financial reforms or

MANAGEMENT OF FINANCIAL INSTITUTION


liberalisation aim at creating a market-oriented, competitive
financial system by removing physical, administrative, and direct
controls. Financial integration refers to the establishment of
close and effective interlinkages between various parts and sub-
parts of the financial system so that interest rates differentials in
the system are minimised. Securitisation refers to a fast growth
of direct (primary) financial instruments, and to a collateralized
financing through the “sale” of existing assets of financial
institutions. Disintermediation refers to the “switch out of’ the
liabilities of financial intermediaries by the investors.
Internationalisation or globalisation of financial markets occurs
when national and foreign markets become integrated.

al
Questions to Discuss:
1. What do you mean by efficiency? Discuss five concepts are
useful in judging the efficiency of a financial system.

com Tr
i
2. What do you understand by innovations, privatization and
securitisation?
3. Discuss the Indian Financial Markets & Banking System-
Reforms Model for Economic Growth.

rd. F
Notes:

iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 17
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 5:
THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING

Learning Objective government, collected revenue on behalf of the government,


After reading this lesson, you will understand managed the transfer of funds from one centre to another, and
some of them had the monopoly as mint-masters and money
• Evaluation of various constituents of Indian Financial
changers. In later years, their direct contacts with the
system prior to 1950.
government as financiers declined. They continue to perform
• Evaluation of currency and money supply other functions, albeit in a declining proportion. The financial
The Indian financial system has covered a long journey. It has instrument they have popularised is hundi. A notable feature

al
and always will hold an important position in our economy. Let of this institution is that it functions with a personal touch that
us understand how? is often lacking in a modern banking system.
Currency and Money Supply Structure and Growth of Modern Banks

com Tr
i
Currency and exchange form an essential part of any financial You know that the growth of the modern banking business in
system. Prior to Independence, the Indian currency had not India was negligible till the beginning of the present century.
been standardised. For about 60 years till 1893, it had remained During the second half of the 18th century, agency houses used
on the silver standard and subsequently on the gold exchange to perform banking business as an adjunct to their main
standard. During this period (with the exception of the war business. The foundation of modern banking was laid during

rd. F
years), even though gold could be procured through import the early part of the nineteenth century with the establishment
without any restrictions, the system did not fulfill the other of three Presidency Banks, namely the Bank of Bengal (1806),

iza D
essential requirements of the gold standard. First, gold coins
were not very much in circulation. Second, the currency authority
did not accept the responsibility of selling gold without limit. It
Bank of Bombay (1840), and the Bank of Madras (1846).
During the second half of the 19th century, some exchange
banks and Indian joint stock banks also were set up. In 1900,
dfw P
had acquired legally the option of offering gold or sterling there were nine Indian joint-stock banks, eight exchange banks,
against rupees. As sterling was on the gold standard, the rupee and three Presidency Banks. In the total private deposits of Rs
can be said to have been on the gold exchange standard. With 3146 lakh in 1900, the shares of each of these types of banks
the abandonment of the gold standard by England in were respectively 25.68 per cent, 33.38 per cent and 40.94 per
w.p m

September 1931, the sterling exchange standard came to be cent. The slow rate of growth of the banking business till the
established in India. beginning of the present century was due to (a) a high rate of
Paper currency has been used in India since the beginning of the failure of banks, because most of them had been created in a
ww Co

19th century. Currency notes were issued by the commercial speculative rush; (b) stagnant economic conditions during this
banks and their use was extremely limited. In 1861, the period; (c) a decline in prices; and (d) the passing of the
government acquired the monopoly of issuing notes. An idea Currency Act, 1861 which took away the power of banks to
of the progress of monetisation can be obtained from the issue notes.
volume of notes issued and their circulation. While the volume During the first half of the present century, the banking system
cu

increased from Rs 11 crore in 1874 to Rs 1199 crore in 1948, the progressed rapidly. The deposits in banks increased from Rs 82
circulation increased from Rs 10 crore to Rs 1188 crore during crore in 1910 to Rs 957 crore in 1948. Except during the
the same period. If we take the total money supply (currency depression of the 1930s, the rate of economic progress was
and demand deposits), it increased from Rs 285 crore in 1935 quite high in this period. The World Wars contributed to raising
Do

and to Rs 384 crore in 1939, and to Rs 2052 crore in 1945. the level of economic activity and the monetary resources in the
Thereafter, it declined to Rs 1970 crore in 1948, and to Rs 1833 economy. In 1921, the three Presidency Banks were
crore in 1950.3 Thus the major increase in the volume of amalgamated to form the Imperial Bank of India (IBI).
money in India occurred during the Second World War. Although the IBI functioned as a quasi-central bank, the money
Currency constituted a major portion of the money supply. The market was without a proper central bank until 1935 when the
percentage of currency to total money supply increased from Reserve Bank of India (RBI) was established. After the
57.22 per cent in 1935 to 65.61 per cent in 1950 and 66.68 per establishment of the RBI, the IBI used to act as the agent of
cent in 1952. the RBI in places where the RBI did not have any offices of its
Banking Sector own. Similarly, even after 1935, the IBI continued to act as a
The two most important constituents of the money market in banker for other banks (to a very limited extent). It used to
India are the modern banks and the indigenous bankers. discount hundis and grant demand loans against government
Modern banking became an effective force only after 1910. securities. All these functions are now performed by the State
Before that the indigenous bankers dominated the scene. Until Bank of India (SBI), and the special position of SBI in the
1860, they financed trade, acted as bankers to the company banking system today stems from these historical antecedents.

© Copy Right: Rai University


18 11.621.6
Around 1950, the banking system in India comprised the RBI, Banking Portfolios

MANAGEMENT OF FINANCIAL INSTITUTION


IBI, cooperative banks, exchange banks, and Indian joint-stock Comparable data on the liabilities and assets of various groups
banks. Indian joint-stock banks were divided into four classes, of banks over a sufficiently long period of time is not available
according to the amount of paid-up capital and reserves held by to evaluate in precise terms the trends in portfolio management.
them. Class A had Rs 5 lakh and over; Class B (Rs 1 lakh and The preferences of different categories of banks in respect of
over but less than Rs 5 lakh); Class C (Rs 50,000 and over but various items in the portfolio were not similar. For example,
less than 1 lakh); and Class D (less than Rs 50,000). After the class Al banks used to invest less in government securities than
creation of the RBI, banks were divided into scheduled and did the IBI. Consequently, the credit/deposit ratio of the
non-scheduled banks. Class A banks, which became scheduled former used to be usually higher than that of the latter. Subject
banks were known as Class A1 banks; while others came to be to these limitations, certain broad features of portfolio
known as Class A2 banks. The relative importance of different behaviour in the banking system are discussed below. The
types of banks in 1950 is indicated in Table1. analysis is based mainly on certain important banking ratios of
the IBI.

al
Table 1 Structure of Commercial Banking in 1950
Category of Banks No. of Banks Deposits
Deposits are the mainstay of any bank. The proportion of
1 All banks 1205
(Rs lakh)
130428
fixed deposits with the banks appears to have declined
(8) (1251) significantly over the period 1921-1950. Before the First World

i
2 Commercial banks 605 100217
(8) (1249) War, fixed deposits of the five big banks were as high as 70 per

com Tr
3 Indian joint-stock banks 584 82770
(5) (1197) cent or more, of the total deposits. Later there was a decline in
4. Imperial Bank 1
(3)
23164
(1183)
this ratio. It was around 60 to 65 per cent till 1925, 45 percent in
5. (a) Class A 1 banks
(b) Class A2 banks
74
73
52270
4659
1935, and 32 per cent in 1950. The most common maturity
(c) Class B banks
(d) Class C banks
189
123
2176
370
period of fixed deposits then was one year. The major factors
(e) Class D banks 124 131 behind this marked decline in fixed deposits were: (a) inflation

rd. F
6. Exchange banks 15 17039
(3) (52) during the war years; (b) competition from post office savings
accounts and life insurance companies; (c) growing opportunity

iza D
Note: Figures in brackets relate to the year 1870.
Source: RBI, Banking and Monetary Statistics in India, Bombay,
and increasing preference for investment in industrial securities;
and (d) decline in interest rates on fixed deposits.
Table 2 presents some important banking ratios over the period
dfw P
1954. 1921-1950. It will be observed that generally the credit/deposit
Although the number of commercial banks in 1950 was small, ratio was pretty low. The most popular form of bank credit was
they accounted for 77 per cent of deposits of the entire banking cash credit/ overdraft, followed by loans. The practice of bill
w.p m

system. The share of Indian joint-stock banks, and the Imperial financing declined sharply over this period. Except at the end of
Bank in total deposits was 63.46 per cent and 13.06 per cent the Second World War, the call money market was not active.
respectively. During 1910-50, Indian joint stock banks expanded Inactivity of bill and call markets meant that various
ww Co

rapidly at the expense of both the IBI and the exchange banks. constituents of the organised money market were very loosely
Within the joint-stock banking sector, scheduled banks linked and virtually functioned in isolation. As a result, the
accounted for 63 per cent of deposits in that sector. Within the money market was characterised by sharp imbalances between
class Al banks, the top 5 to 7 banks’ accounted for the major the supply and demand for funds, both regionally and
portion of deposits. On the basis of the available evidence, the seasonally. The spread of interest rates between regions and
cu

following conclusions emerge with respect to the banking seasons, therefore, varied sharply. As expected, unless compelled
system in India. (a) There was a high degree of concentration by circumstances, banks did not invest heavily in government
in-the banking business. The top seven6 joint-stock banks and securities. In 1935 and 1945, the ratios of investment in
the ill I accounted for most of the banking business. (b) The government securities were high for different reasons. In 1935,
Do

degree of concentration increased till 1935 and declined the lack of alternative investment opportunities due to a slack in
thereafter. (c) The smaller banks were responsible for providing business must have led banks to utilise funds for holding
banking facilities in about two-thirds of the places on the government securities. In 1945, the compulsions of war finance
banking map of India. It was these banks that mobilised. must have forced them to invest in government securities. As
savings from sources which the big banks would not tap, and it soon as the war was over, the ratio declined significantly.
was they that catered to the financial needs of such borrowers From the other available information, it would appear that
who would have been shunned by the big banks. Thus, there was a tendency to invest more in short--term government
qualitatively, the services of smaller banks were of much securities (less than five years maturity) than in long-term
importance. (Bank of India, Central Bank of India, Allahabad securities. While the share of the former increased from 21 per
Bank, Punjab National Bank, Bank of Baroda, Bank of Mysore, cent in 1945 to 29 per cent in 1950, that of the latter declined
and Indian Bank of Madras) from 31 per cent to 17 per cent during the same years. The
banks did not invest in industrial securities to any significant
extent. The ratio of their investment in industrial securities to
total investments was around 4 per cent in 1949 and 1950.

© Copy Right: Rai University


11.621.6 19
A study of the sectoral distribution of advances shows that the
MANAGEMENT OF FINANCIAL INSTITUTION

shares in 1948 of commerce, industry, and agriculture were


about 46 per cent, 31 per cent, and 2 per cent respectively. The
major part of advances to the commercial sector was given to
wholesale trade (46 per cent). About 86 per cent of bank
advances were on a secured basis.

Table 2 Some Banking Ratios of the Imperial Bank of India (1921 to 1950) (Percentage)
Ratio 1921 1935 1939 1945 1950
1. Credit/Deposit 60.65 33.67 42.58 26.40 43.09
(50.95)* (55.93) (40.82) (51.22)
2. Loans/total advances 36.22 23.99 25.05 28.50 93.79
3. Cash credits overdrafts/ Total advances 43.70 66.31 63.77 64.42 -
4. Bills discounted and purchased/total
20.07 9.70 11.18 7.00 6.21
advances
(21.89)
5. Total advances/tota1 assets 53.98 21.16 37.25 25.00 39.97
(43.48) (46.28) (34.14) (39.77)

al
6. Government Securities/ Total assets 13.05 47.18 44.72 56.02 38.80
(34.33)* (32.19) (43.0) (31.0)
7. Money at call/tota1 advances 0.63 0.56 0.52 8.58 2.98
Notes: (i) Figures in brackets are for Class A1 banks.

i
(ii)* Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India, Bombay, 1954.

com Tr
Notes
(i) Figures in brackets are for Class A1 banks.

rd. F
(ii) Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
iza D
An important aspect of the growth of commercial banking,
which serves as an indicator of the progress of the banking
dfw P
habit, volume of transactions, and the velocity of deposits i.e.,
the number of times each deposit is used to settle transactions
in a given period of time is the volume of cheque clearances. By
1947, there were 29 clearing houses in the country of which
w.p m

those at Bombay, Calcutta, Delhi, Kanpur, Madras were the


major ones. The volume of cheques (in terms of amount)
cleared at the clearing houses increased from Rs 212 crore in
ww Co

1900 to Rs 2185 crore in 1939, and to Rs 6461 crore in 1947. The


number of cheques cleared increased from 153 lakh in 1939 to
246 lakh in 1947.
Questions to Discuss:
cu

What do you understand by money supply?


Discuss the structure and growth of modern banks.
Notes:
Do

© Copy Right: Rai University


20 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 6:
THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING

Learning Objective
After reading this lesson, you will understand Table Growth of Cooperative Banking (1916 to 1950) (Amount in Rs Lakh)

• Evaluation of banking system Land


State Cooperative Central Cooperative Primary Agricultural
Item Mortgage
• Evaluation of insurance Funds Banks Banks Societies
Bank

• Evaluation of stock funds 1916 1935 1950 1916 1935 1950 1916 1935 1950 1938 1950
1. Number 6 11 14 239 615 498 14509 76045 116534 202 288
• Evaluation of Government securities

al
2. Total Working 77 1163 3045 323 2940 4987 375 2492 3522 411 1273
Capital
Let us evaluate some of the securities in today’s lecture. We shall 3.
Loans and
deposits
56 573 1625 220 1713 2397 40 185 393 375 1159
discuss them in brief here and later on have a detailed held from
individuals

i
discussion on each of the banks. 4. Loans due '58 498 1412 288 2040 2892 402 2342 2496 370 1046

com Tr
Commercial Banks
Commercial banks provided mainly short-term credit to the
Notes
industrial sector. Further, they provided credits mainly to the
large-scale units. Thus, before 1950 there were two important 1. Data on primary agricultural credit societies separately was
gaps in the field of industrial finance-the lack of supply of not available for the years 1935, but was available for the year

rd. F
long-term funds to all industrial units, and the lack of supply 1950. Assuming the ratio in 1950 to be applicable for other
of any form of capital to small-scale industrial units. Attempts years, the figures have been calculated for those years.

iza D
were made to bridge these gaps by setting up certain industrial
banks in the private sector. In 1923, there were about eight
industrial banks, of which four were liquidated by 1935. In the
2. Loans and deposits in case of primary agricultural credit
societies are from both members and non members.
dfw P
3. Data on land mortgage banks is for both primary and central
intervening period, other banks came up with the result that land mortgage banks.
there were about seven such banks working in 1936-37. These
Source: RBI, Banking and Monetary Statistics of India,
banks used to accept some deposits from the public. The
Bombay, 1954.
w.p m

volume of their operations was quite limited. The lack of


institutional arrangements to supply adequate long-term Small Savings
industrial finance remained, till the beginning of the planning Small savings have been one of the oldest media for
community savings. In India, with its huge population and
ww Co

period, a persistent and important gap in the financial structure


in India. varying low income levels of different groups of people, the
importance of this method was recognised by the company
Co-operative Banks government. It encouraged wage earners, small and medium
Apart from the inadequate supply of long-term finance to farmers, and the middle class to save through government-run
industry, another serious gap in the financial system in India savings banks. These banks were attached either to the
cu

that persisted till the end of the period under discussion was Presidency Banks or district treasuries, or post offices. The Post
the inadequate supply of short--term as well as long-term Office Savings Banks (POSB) took over the savings bank
funds to the agricultural sector. In order to supplant money business of district treasuries in 1886, and that of Presidency
lenders and indigenous bankers, efforts were being made since Banks in 1896. Thus by 1896, the POSBs had monopolised the
Do

the second decade of the present century to organise co- small savings business.
operative credit institutions. In the forty years since their
inception, cooperative banks made very little progress in Apart from the POSB deposits, the Postal Department did not
absolute terms; their progress was particularly negligible in offer any other financial asset to the, investors till 1915.
relation to the demand for funds in the agricultural sector. The Subsequently, it offered various certificates of different
setting up of the RBI in 1935 and its efforts to channelise more maturities at different periods of time. The Government also
funds to this sector did help the cooperative movement, but introduced, between April 1941 and April 1947, the Post Office
not to the desired extent. The total working capital, deposits Defence Saving Deposits. Among these assets, deposits
from individuals, and loans due to state, central, and primary remained, during the entire period under discussion, the major
cooperative banks were, in 1950, only Rs 115 crore, Rs 44 crore financial asset issued by small savings organisations. In
and Rs 68 crore, respectively. In the same year Land Mortgage comparison with the period after 1950, the diversity in schemes
Banks (LMBs) had working capital, deposits, and loans of Rs offered was very limited.
13 crore, Rs 12 crore, and Rs 10 crore, respectively. The POSB deposit receipts increased from Rs 366 lakh in 1896
to Rs 9875 lakh in 1950. The outstanding deposits in these two
years were Rs 904 lakh, and Rs 16,866 lakh. The amount of

© Copy Right: Rai University


11.621.6 21
outstanding certificates increased from Rs 57 lakh in 1939 to Rs sanctioned, but not for the actual capital issues. The per year
MANAGEMENT OF FINANCIAL INSTITUTION

2,8211akh in 1950. Thus, the total volume of small savings was average amount of capital issues applied for and sanctioned
Rs 17,687 1akh in 1950. The number of small savings banks during 1945 to 1952, was Rs 193 crore and Rs 141 crore
had increased from 6,343 to 9,256 between 1896 and 1950. respectively. Understandably, there were marked ups and downs
in the new issue activity. The three years following each of. the
Insurance Funds
two World Wars were characterised by an unusually high
The life insurance business in India began on sound lines with
amount of capital issues. The annual average amount of capital
the enactment of the Indian Life Insurance Companies Act,
issues was Rs 183 crore during 1918 to 1920; while during 1945-
1912. It was carried on by Indian and foreign life insurance
47 this figure was Rs 255 crore. In both cases, the boom was
companies, provident societies, and the Post and Telegraph
followed by a steep fall in capital issues in the subsequent 4-5
department. In addition, certain provinces transacted insurance
years. As expected, during the depression years, there was a
business for their own employees. Indian and foreign
marked slack in the new issue activity.
companies conducted general insurance business also for
emergencies such as fire, marine and miscellaneous. A major proportion of capital was raised by the issuance of

al
ordinary shares. In contrast with the period after 1960,
Over time, the volume of general insurance business declined
debentures were not very popular in India during the period
relatively to that of life insurance. As far as the business of life
before 1950. It has been pointed out by Muranjan that the
insurance is concerned, the foreign companies’ share in it

i
unpopularity of debentures was due to the following reasons-
declined significantly, and Indian companies’ share increased. Of

com Tr
unfamiliarity of the general public with this form of
the total premium of all life insurance companies, the latter’s
investment, the preference of rich classes for speculative scrips,
share was 50 per cent in 1928 and 83 per cent in 1950. The
heavy stamp duties on purchases and transfers of debentures,
volume of business of provident societies, and of the Post and
and the avoidance of debentures by insurance and other
Telegraph department has always been negligible.
financial institutions with large investible resources.

rd. F
The size and growth of the insurance business in India is
The security prices also reflect the tenor of the working of stock
shown in Table below.
markets. The available data on index numbers of security prices

Category
1. Life insurance business in force
iza D
Table Insurance Funds in India in 1928, 1948 and 1950 (Rs lakh)
1928 1948 1950
for the period 1927 to 1949 help us to draw some important
conclusions. First, unlike the later period, prices of government
securities and fixed-yield industrial securities showed marked
dfw P
(a) Number of companies 70 275 244
(b) Sum insured 13502 73505 82545
(c) Premium Income 670 3607 4150 fluctuations. The index number of government security prices
2. Non-Life Insurance
(a) Number of companies 128 157 174 varied in the range of 82 to123. It should, however, be noted
(b) Premium income 354 1507 1663
that these fluctuations occurred before the establishment of the
w.p m

RBI. After 1935, the prices of government securities remained


Source: RBI, Banking and Monetary Statistics of India, quite stable. There is no doubt that this must have been due to
Bombay, 1954. the RBI’s policy because in the post-1935 period the prices of
ww Co

other securities increased phenomenally. Debenture prices


Stock Market
fluctuated in the range of 95 to 196; the level of these prices was
The private sector as well as the government raises large
higher than the level of prices of ordinary shares during 1927 to
amounts of funds on the stock market. The first Stock
1942. It was only after 1942 that the latter exceeded the former.
Exchange in India was established at Bombay in 1887. The
Third, there was an economic depression between 1927 and
volume of funds raised on the stock market by the private
cu

1933. There was a boom between 1934 and 1946 (except 1938
sector industrial units and the government increased
and 1939); prices again declined substantially during 1947-49.
significantly during the first half of the 20th century. The
The ordinary share prices reached their nadir in 1932 (index was
increased pace of industrialisation during this period which was
64.4), and their zenith in 1946 (index was 264.9).
caused by the two World Wars, protection to domestic
Do

industries, and other fiscal measures adopted by the Public Deposits


government, led to the growth of active new issue markets and It is appropriate here to draw attention to the then prevalent
stock exchanges. The expansion of government activity for practice which later assumed such significant dimensions as to
developmental purposes and the demands made by the two cause serious concern to the monetary authorities, namely, the
wars also meant an increase in the amount of government financing of fixed assets by companies with deposits from the
securities issued. public. These deposits were for a fixed period of one to seven
The growth of the private sector is reflected in the increased years. Unlike in the later period, these deposits were then much
number and paid-up capital of joint-stock companies. The more local; they used to be offered on the basis of the
paid-up capital increased from a mere Rs 24 crore in 1890 to Rs reputation for business integrity, or social and caste affiliations
570 crore in 1948. We do not have very reliable figures on the of the concerned management. Around 1930, these deposits
actual capital issues by the corporate sector for this period. It accounted for about 11 per cent and 39 per cent of the total
can, however, be stated that on an average, the capital issues of finance of the Bombay and Ahmedabad mills respectively. It is
joint-stock companies amounted to Rs 70 crore per year during interesting to note that in some cases, the interest rates on these
the period 1918 to 1939. For the years 1945 to 1952, we have deposits were equal to or lower than the average lending rates
figures for the amount of capital issues applied for and of commercial banks of the time.

© Copy Right: Rai University


22 11.621.6
Government Securities and Treasury Bills A rough consolidated picture about the relative sizes and

MANAGEMENT OF FINANCIAL INSTITUTION


The markets of government securities and treasury bills also growth or different financial resources is presented in Table
expanded phenomenally during this period. The amount of below:
gross issues of central and provincial government securities
increased from a meagre Rs 2 crore in 1890 to Rs 382 crore in Table Financial Structure in India, 1890 -1948 (Rs Crore)

1947. By the 1940s, the gilt-edged market had become fairly Year Private Small saving Total capital of Paid-up. Premium. Gross issues State
deposits of deposits and all co-op capital of income of of Provident
wide and active. Banks, life insurance companies, princes and all banks certificates
(outstanding)
societies. joint-stock Insurance Government Fund
cos cos securities
princely state governments, and private trusts, took an interest
in this market. Securities of different maturities were being 1890 25 6 -- 24 0.11 2.0 0.49
1900 31 10 -- 36 0.52 - 1.37
issued, and innovative steps like giving attractive names to these 1910 82 16 3 63 2.0 2.50 3.59
1920 220 27 36 164 8.0 21.35 19.71
issues were undertaken to make them popular. During the 1930 221 75 91 282 25.0 37.25 58.24
1939 261 135 109 290 - 28.42 72.46
Second World War, to ensure their sale, many issues were made 1941 364 95 112 302 59.0 147.36 75.03
1943 719 118 132 339 - 146.53 83.96
on a tap basis rather than by prescribing a specific subscription 1945 109 221 146 389 - 221.79 93.02

al
period. The foundation of the policy of maintaining stability in 1947
1948
799
957
268
247
164
--
479
570
47.7
47.5
382.37
-
97.55
79.36
the gilt-edged market was laid down during the Second World
War when a large amount of funds was needed by the

i
government. In subsequent years, although the reasons for a Note: If there is any discrepancy in figures in this Table and

com Tr
large amount of funds changed, the policy of maintaining figures quoted earlier on any item, it is not an error, it may be
stability continued. The setting up of the RBI in 1935 facilitated due to differences in sources, definition of item and coverage,
the pursuit of such a policy. Earlier the IBI used to buy and sell etc. Figures for 1947 and later are for the Indian Union. Source:
securities depending on the position of its own resources. It Muranjan, S.K., op. cit., p. 32; and RBI, Banking and Monetary
rarely operated in the market out of consideration for market Statistics of India, Bombay, 1954.

rd. F
stability.
Interest Rates
Treasury bills (TBs) were first issued in India in October 1917. A detailed study or the level and structure or interest rates

iza D
Originally, these bills were of different maturities-of three, six,
nine, and twelve months. On a few occasions, bills of maturity
of four and eight months were also issued. On several
before 1950 is too big a topic to be attempted here. We would
like to point out here only three important features or the
interest rates during this period.
dfw P
occasions, joint issues of more than one maturity were also
First, the interest rates on the same type or deposits and
made. Since 1933-34, only bills of three months’ duration have
advances differed for different banks. While the IBI did not pay
been in vogue. Treasury bills used to be sold by tender and on
any interest on current deposits, exchange banks and Indian
w.p m

tap; the latter method was adopted generally for the purpose of
joint-stock banks offered interest on them. The average rate of
provincial governments, semi--government institutions, and
interest on current deposits by one or the leading commercial
some foreign holders. During the pre-war years, these bills were
banks in India was 2.56 per cent in 1921, 1.29 per cent in 1935
often issued to induce an inflow of foreign funds. During the
ww Co

and 0.26 per cent in 1943. Similarly, the interest rates on fixed
war years, the consideration changed to one of providing liquid
and savings deposits varied from one type of bank to another.
assets to the banks. Although the RBI offered the facility of
On advances also, these rates varied a great deal. In short, from
discounting TBs to banks, they did not have a wide appeal
the point or view or interest rates, the banking system was not
among banks and other institutions. The IBI was the main
homogeneous. This aspect of interest rates has certainly
cu

supporter of this market. Provincial governments also used to


undergone a definite change in the planning era during which it
issue TBs, but they were not preferred by any institution
has become much less heterogeneous.
including the RBI. This was reflected in the fact that the
discount rate on provincial TBs was higher than that on TBs of Second, there was much variation in interest rates in different
the central government. The practice of issuing ad hoc TBs had regions. They were the highest in Chennai and South India; and
Do

started during this period. The amount of TBs sold by tender also quite high in the Indus and Gangetic plains. In Mumbai,
was Rs 87 crore in 1919 and Rs 85 crore in 1948. There was a Ahmedabad, and Kolkata, which were the areas or
substantial decline in this amount in the intervening years (Rs manufacturing, finance, and business, the rates were relatively
51 crore in 1947, for instance). low. Such geographical differentials in the interest rates were
dependent on such factors as: (a) the degree or closeness or links
between the Central Bank and the concerned locality; (b) the size
of capital supply in general, and deposits in particular, in the
locality; (c) whether funds can be attracted and transferred to
different places; (d) whether the major activity in the area is
agriculture, manufacturing or commerce. With the progress
towards integration in the banking system, growth of branch
banking, increase in the spread of offices of the RBI,
improvement in remittance facilities, growth in transport and
communication and the resultant facilities for the quick transfer
of funds, geographical differentials in the interest rates have

© Copy Right: Rai University


11.621.6 23
greatly diminished since 1950, although they have not
MANAGEMENT OF FINANCIAL INSTITUTION

completely disappeared.
Third, the level of interest rates even in the organised sector
during the major part of this period was quite high. This needs
to be emphasised because during the planning period, a case has
been made in certain circles for a cheap money policy on the plea
that, historically, borrowers and lenders in India have been used
to a low cost of finance. A plea such as this is based on the
experience of a very brief period in the economic history of
India. The yield of 3.5 per cent government securities ruled
between 4 to 7 per cent during 1870--1949 except for the
periods, 1891-1915, and 1936-1949 when it varied between 3 to
4 per cent. The average interest rate charged by banks for lending

al
was 6 to 7 per cent during this period except for 1932-1949. The
rate of interest of the Bank of Bombay varied between 6.2 to
9.8 per cent during 1890 to 1899. Further, in the first decade of

i
the 19th century, agency houses charged 10 to 12 per cent on

com Tr
their loans. Around the same time, investments in
governments fetched the high yield of 8 to 9 per cent, and
commercial bills were discounted at a rate between 6 and 12 per
cent. Similarly, even in the slack season, commercial banks
charged 10 to 11 per cent against wheat pits in the 1920s. On

rd. F
current deposits, the Central Bank of India paid an interest rate
between 2 and 2.5 per cent till 1931. It is only after 1933 that

iza D
interest rates declined steeply; they have been maintained at a
low level since the beginning of the planning period.
Summary
dfw P
On the whole, the Indian Financial system was fairly developed
even on the eve of planning. Though banking business was
concentrated in the hands of few large banks, yet the services of
w.p m

smaller banks were of great importance. At that time banks did


not invest much in government securities, hence the major
beneficiaries of bank credit were commerce followed by
ww Co

industry.
Questions to Discuss:
1. Evaluate the banking system.
2. Evaluate the insurance Funds.
cu

3. Evaluate the stock funds.


4. Evaluate the Government securities.
Notes:
Do

© Copy Right: Rai University


24 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 7:
TUTORIAL-1

Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 25
UNIT 2
REGULATORY FRAMEWORK AND
LESSON 8: PROMOTIONAL INSTITUTIONS
THE RESERVE BANK OF INDIA
MANAGEMENT OF FINANCIAL INSTITUTION

Learning Objective these, the RBI and SEBI have special role and responsibility. We
After reading this lesson, you will understand shall first discuss the functioning of the RBI followed by the
SEBI.
• Organisation and management of RBI
• Function and Roles of RBI What is the Organisation and Management of RBI
The Reserve Bank of India was established on April 1,1935,
• Treasury Bills

al
under the Reserve Bank of India Act, 1934. The main functions
Today we shall discuss one of the most important aspects of of the Bank are to act as the note-issuing authority. Banker’s
Financial Institution in India. Bank, Banker to the government and to promote the growth

i
Introduction of the economy within the framework of the general economic

com Tr
A study of financial institutions in India can appropriately policy of the government, consistent with the need to maintain
begin with a brief discussion of the regulatory framework of price stability. The Bank also performs a wide range of
the country. Since the financial markets are characterised by promotional functions to support the pace of economic
various degrees of imperfections, the need for regulation- development. The Reserve Bank is the controller of foreign
prudential or otherwise-even in a liberalised framework cannot exchange. It is the watchdog of the entire financial system. The

rd. F
be denied. The financial system deals in other people’s money Bank is the sponsor bank of a wide variety of top-ranking
and, therefore, their confidence, trust and faith in it is crucially banks and institutions such as SBI, IDBI, NABARD and NHB.

iza D
important for its smooth functioning. Financial regulation is
necessary to generate, maintain and promote this trust. One
reason why the public trust may be lost is that some of the
The Bank sits on the board of all banks and it counsels the
Central and State Government and all public sector institutions
on monetary and money matters. No central bank, even in the
dfw P
savers or investors or intermediaries may imprudently take too developed world, is saddled with such onerous responsibilities
much risk, which could engender defaults, bankruptcies, and and functions.
insolvencies. Thus a regulation is needed to check imprudence The RBI, as the central bank of the country, is the centre of the
w.p m

in the system. Indian Financial and Monetary System. As the apex institution,
The task of efficient regulation is rendered difficult by the very it has been guiding, monitoring, regulating, controlling, and
nature of financial assets, which are mobile, easily transferable or promoting the destiny of the IFS since its inception. It is quite
ww Co

negotiable; and also by the nature of financial markets which are young compared with such central banks as the Bank of
prone to a systemic risk. The modern trading technology and England, Riksbank of Sweden, and the Federal Reserve Board
the possibility of high leveraging enable market participants to of the US. However, it is perhaps the oldest among the central
take large stakes, which are disproportionate with their own banks in the developing countries. It started functioning from
investments. There are also frequent instances of dishonest, April1, 1935 on the terms of the Reserve Bank of India Act,
cu

unfair, fraudulent, and unethical practices or activities of the 1934. It was a private shareholders’ institution till January 1949,
market intermediaries or agencies such as brokers, merchant after which it became a state-owned institution under the
bankers, custodians, trustees, etc. The regulation becomes Reserve Bank (Transfer to Public Ownership) of India Act,
necessary to ensure that the investors are protected; that 1948. This act empowers the central government, in
Do

disclosure and access to information are adequate, timely, and consultation with the Governor of the Bank, to issue such
equal; that the participants measure up to the rules of the directions to it, as they might consider necessary in the public
market place; and that the markets are both fair and efficient. In interest. Further, the Governor and all the Deputy Governors
this context, it is said that fairness and efficiency are two sides of of the Bank are appointed by the Central Government.
the same coin; if the market is unfair, in the end, it is also The Bank is managed by a Central Board of Directors, four
inefficient. Local Boards of Directors, and a committee of the Central
The regulatory framework or apparatus for the financial sector in Board of Directors. The functions of the Local Boards are to
India broadly consists of the Ministry of Finance of the advise the Central Board on matters referred to them; they are
Government of India which administers the Companies Act, also required to perform duties as are delegated to them. The
1956, and the Securities Contracts (Regulation) Act, 1956; the final control of the Bank vests in the Central Board, which
Reserve Bank of India and the Board of Financial Supervision comprises the Governor, four Deputy Governors, and fifteen
(BFS) under its aegis; the Securities and Exchange Board of Directors nominated by the central government. The committee
India (SEBI), Insurance Regulatory Authority; the Governing of the Central Board consists of the Governor, the Deputy
Boards of various stock exchanges and the apex financial Governors, and such other Directors as may be present at a
institutions such as the IDBI, SIDBI, NHB and NCB. Among given meeting. The internal organisational set-up of the Bank

© Copy Right: Rai University


26 11.621.6
has been modified and expanded from time to time in order to • To regulate the overall volume of money and credit in the

MANAGEMENT OF FINANCIAL INSTITUTION


cope with the increasing volume and range of the Bank’s economy with a view to ensure a reasonable degree of price
activities. The underlying principle of the internal organisation stability.
is functional specialisation with adequate coordination. In order
Role of the Bank
to perform its various functions, the Bank has been divided and
In view of the Bank’s close contacts and intimate knowledge of
sub-divided into a large number of departments.
the financial markets, it is in a position to advise the Central and
The pattern of central banking in India was initially based on State Governments on the Quantum, timing and terms of
the Bank of England. England had a highly developed banking issue of new loans. While formulating the borrowing program
system in which the functioning of the central bank as a for the year, the Government and the Bank take into account a
banker’s bank and their regulation of money supply set the number of considerations such as the amount of Central and
pattern. The central bank’s function as ‘a lender of last resort’ State loans maturing for redemption during the year, the
was on the condition that the banks maintain stable cash ratios estimate of available resources (based on the estimated growth
as prescribed from time to time. The effective functioning of in deposits with the banks, premium income of insurance

al
the British model depends on an active securities market where companies and accretions to provident funds) and the
open market operations can be conducted at the discount rate. absorptive capacity of the market.
The effectiveness of open market operations however depends
In India, banks, insurance companies and provident funds are

i
on the member banks’ dependence on the central bank and the
statutorily required to invest a portion of their liabilities,

com Tr
influence it wields on interest rates. Later models, especially
premium income or accretions, as the case may be, in
those in developing countries showed that central banks play an
Government and other approved securities, which ensures a
advisory role and render technical services in the field of foreign
captive market for these securities, facilitating the easy
exchange, foster the growth of a sound financial system and act
absorption of new issues. The Bank tries to ensure that over a
as a banker to government.

rd. F
reasonably long period it will be neither a net purchaser of
What are the Functions and Roles of RBI securities from the market nor a net seller so that the loans
raised are absorbed by the market outside the Bank to the
Functions of the Bank
iza D
The RBI functions within the framework of a mixed economic
system. With regard to framing various policies, it is necessary
maximum extent.
The Bank actively operates in the gilt-edged market to ensure
dfw P
to maintain close and continuous collaboration between the the success of Government loan operations. For instance, the
government and the RBI. In the event of a difference of Bank grooms the market by acquiring securities nearing maturity
opinion or conflict, the government view or position can always to facilitate redemption. If maturing stocks are held by
be expected to prevail. investors to the last, conditions in the money market are likely
w.p m

The Preamble of the RBI Act, 1934 states that “Whereas it is to be disturbed as most of the cash paid out seeks avenues of
expedient to constitute a Reserve Bank for India to regulate the reinvestment, but, in practice, all the investors are not equally
issue of bank notes and the keeping of reserves with a view to eager to wait for cash repayment on the redemption date and
ww Co

securing monetary stability in (India) and generally to operate then undertake reinvestment, as they can reinvest the proceeds
the currency and credit system of the country to its advantage”. at times of their own choosing if these were realized earlier, the
To elaborate, the main functions of the RBI are: Bank, therefore, stands ready as the stock approaches maturity
to buy all the stocks offered for sale at these terms. Thus, in
• To maintain monetary stability so that the business and
carrying out the loan operations of the Government the Bank
cu

economic life can deliver welfare gains of a properly endeavours on the one hand to minimize the effects of such
functioning mixed economy. operations on the money market and Government securities
• To maintain financial stability and ensure sound financial market, and on the other to obtain the best possible terms for
institution so that monetary stability can be safely pursued the Government concerned. The close involvement in the
Do

and economic units can conduct their business with market by its continuous presence and the willingness to deal in
confidence. the securities at process determined by it give the Bank a good
• To maintain stable payments system so that financial degree of flexibility when it is seeking occasions for
transactions can be safely and efficiently executed. implementing a shift in policy on prices.
• To promote the development of financial infrastructure of The timing of the issue of new loans is normally left to the
markets and systems, and to enable it to operate efficiently Reserve Bank. The Central Government and the state
i.e., to play a leading role in developing a sound financial Governments float market loans separately, but through the
system so that it can discharge its regulatory function Reserve Bank. For the management of the public debt of the
efficiently. Government, the Bank charges a commission. In addition, the
• To ensure that credit allocation by the financial system
Reserve Bank also charges for all new issues both by Central and
broadly reflects the national economic priorities and societal State Government loans, besides recovering brokerage and
concerns. expenses incurred by the Bank on account of printing of loan
notifications, telegrams, advertisements, etc.

© Copy Right: Rai University


11.621.6 27
Treasury Bills
MANAGEMENT OF FINANCIAL INSTITUTION

You must be well aware that Treasury Bills are the main
instrument of short-term borrowing by the Government, and
serve as a convenient gilt-edged security for the money market.
The qualities of high liquidity, absence of risk of default, and
negligible capital depreciation in case of sale before maturity
make them an ideal form of short-term investment for banks
and other financial institutions.
In certain countries, unlike in India, Treasury Bills are an
important tool for the central bank for influencing the level of
liquidity in the money market through open market operations.
Sale of Treasury Bills helps to absorb any excess liquidity in the
money market and, conversely, their purchase by the central

al
bank has the effect of relieving stringency. Since neither the
Government nor the money market wishes to hold surplus
cash, the central bank steps in and restores the equilibrium by

i
selling to or purchasing from the money market Treasury Bills

com Tr
(and similar other securities) accordingly as the Government
payments are larger than its receipts or vice versa. In this way, the
Government is able to borrow cheaply to meet its immediate
needs and to use its temporary surplus to by back before
maturity some of its outstanding debt.

rd. F
The Reserve Bank, as the agent of the Government, issues
Treasury Bills at a ‘discount’. These are negotiable securities and

iza D
can be rediscounted with the Bank at any time before maturity
upon terms and conditions determined by it from time to time.
dfw P
Questions to Discuss:
1. Discuss the Organisation and Management of RBI.
2. What are the Functions of RBI?
w.p m

3. What are the roles of RBI?


Notes:
ww Co
cu
Do

© Copy Right: Rai University


28 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 9:
THE RESERVE BANK OF INDIA

Learning Objective The fiscal operations of the Government exercise a direct and
After reading this lesson, you will understand significant impact on the monetary and credit system, which the
Bank is required to regulate. It follows that monetary and credit
• The Reserve Bank as Banker and advisor to Government
policies can be implemented more effectively if there is
• Authorities invested with RBI coordination between them and the economic policies of the
• Autonomy for Central Bank Government. Hence, the Bank takes an active interest in the
In today’s lesson, we shall discuss the management the advisory formulation of fiscal and other policies of the Government and

al
and promotional aspects of RBI, Treasury Bills, and finally the tenders advice calculated to promoter the attainment of the
autonomy of the Central Bank. national economic goals.
Daily operations in the gilt-edged and foreign exchange markets

i
The Reserve Bank as Banker to Government
and close contacts with the commercial banks and other financial

com Tr
You have been studying since childhood that The Reserve Bank
is the Central Bank of India. It is the banker to the Central institutions and with the business world in general have
Government statutorily and to the State Governments by virtue equipped the Reserve Bank with the technical knowledge of,
of agreements entered into with them. The Bank provides a full and practical experience in, these spheres which contribute
range of banking services for these Governments such as greatly to the Bank’s competence to give financial advice to

rd. F
acceptance of moneys on deposit, withdrawal of funds by Government. Like all central banks, the Bank acts as adviser to
cheques, receipt and collection of payments to Government and the Government not only on policies concerning banking and
financial matters but also on a wide range of economic issues

iza D
transfer of funds by various means throughout India. The
Governments’ main accounts are held in the Bank. A large
number of branches of agency banks, sub-agency banks and
including those in the field of planning and resource
mobilisation. It has of course a special responsibility in respect
dfw P
Treasury agencies also undertake Government business because of policies and measures concerning new loans, agricultural
the Bank has branches/offices mainly in the State capitals and a finance, co-operative organisaton, industrial finance and
few big cities in the country. The Government revenue collected legislation affecting banking and credit.
through the agency banks is remitted to the Government The Bank’s advice is sought on certain aspects of formulation
w.p m

revenue collected through the agency banks are remitted to the of the country’s Five Year Plans, such as the financial pattern,
Government accounts at the Bank in due course. mobilisation of resources and institutional arrangements with
regard to banking and credit matters. As the agency for
ww Co

Before the establishment of the Bank, the more important


current financial transactions of the Indian Government were administration of exchange control, the Bank’s intimate
handled by the then Imperial Bank of India; the administration knowledge of the exchange markets, trade and balance of
of the public debt was the direct responsibility of the payments position places it in a vantage position to offer sound
Government although the Public Debt Offices were being technical advice to Government in evolving policies on
international finance and regulations regarding foreign trade and
cu

managed by the Imperial Bank. Both these responsibilities in


regard to Government finance were centralised in the Reserve exchange. For the effective discharge of this advisory role, the
Bank on its formation. Further, the Bank acts as the banker not Bank has built up a research and statistical organisation.
only to the Government of India, but in view of the federal The Bank is the main channel of communication between the
Government on the one hand and the banks and financial
Do

character of the constitution of India, also to the Governments


of the States. institution on the other. The Bank, we now know, keeps the
Government informed of the developments in the financial
Adviser to Government
markets from time to time. Thus RBI being the banker to the
The Bank has ordinary banking relationship with the
central and state governments provides to the governments all
Government, performing deposit and lending functions. It
banking services such as acceptance of deposits, withdrawal of
manages the public debt on behalf of the Government.
funds by cheques, making payments as well as receipts and
Besides, the Bank is entrusted with a wide range of statutory
collection of payments on behalf of the government, transfer
functions such as buying and selling of foreign exchange,
of funds, and management of public debt.
administration of exchange control and provision of rural
credit, the performance of which is attuned to the policies of The Bank receives government deposits free of interest, and it is
the Government in the relevant areas. It maintains close not entitled to any remuneration for the conduct of the
coordination with the Government at all levels, especially with ordinary banking business of the Government. The deficit or
the Ministry of Finance, both in the day-to-day affairs and surplus in the central government account with the RBI is
through participation in the official committees. managed by the creation and cancellation of treasury bills
(known as ad hoc treasury bills).

© Copy Right: Rai University


11.621.6 29
As a banker to the government, the Bank can make “ways and the Bank issues notes in the following denominations: Rs 5, 10,
MANAGEMENT OF FINANCIAL INSTITUTION

means advances” (i.e., temporary advances made in order to 20, 50, 100, 500 and 1000. The responsibility of the Bank is not
bridge the temporary gap between receipts and payments) to only to put currency into or withdraw it from circulation but
both the central and state governments. The maximum also to exchange notes and coins of one denomination into
maturity period of these advances is- three months. However, those of other denominations as demanded by the public. All
in practice, the gap between receipts and payments in respect of affairs of the Bank relating to note issue are conducted through
the central government used to be met by the issue of ad hoc its Issue Department. In order to discharge its currency
treasury bills, while the one in respect of the state governments functions, the Bank has 15 full-fledged issue offices and 2 sub-
is met by the ways and means advances. The arrangements in offices, and 4127 currency chests in which the stock of new and
this regard have been changed in the recent past. The ways and re-issuable notes, and rupee coins are stored. Of these, 17 chests
means advances to the state governments are subject to some were with the RBI, 2877 with the SBI and associate banks, 791
limits. These advances are of the following types: (a) normal or with nationalised banks, 423 with treasuries, and 19 with private
clean advances i.e., advances without any collateral security; (b) sector banks (these numbers are not fixed and can be varied as

al
secured advances, i.e., those which are secured against the pledge per the requirement).
of central government securities; and (c) special advances, i.e., The Bank can issue notes against the security of gold coins and
those granted by the Bank at its discretion. The interest rate gold bullion, foreign securities, rupee coins, Government of

i
charged by the Bank on these advances did not, till May 1976, India securities, and such bills of exchange and promissory

com Tr
exceed the Bank rate. Thereafter, the Bank has been operating a notes as are eligible for purchase by the Bank. The RBI notes
graduated scale of interest based on the duration of the have a cent per cent backing or cover in these approved assets.
advance. Earlier i.e., till 1956, not less than 40% of these assets were to
Apart from the ways and means advances, the state consist of gold coin and bullion and sterling/foreign securities.
governments have made heavy use of overdrafts from the RBI. In other words, the proportional reserve system of note issue

rd. F
An overdraft refers to drawals of credit by the state existed in India till 1956. Thereafter, this system was abandoned
governments from the RBI in excess of the credit (ways and and a minimum value of gold coin and bullion and foreign

iza D
means advances) limits granted by the RBI. In other words,
overdrafts are unauthorised ways and means advances drawn by
the state governments on the RBI. The management of the
securities as a part of total approved assets came to be adopted
as a cover for note issue.
dfw P
Supervising Authority
states’ overdrafts has gradually become one of the major
The RBI has vast powers to supervise and control commercial
responsibilities of the RBI on account of the persistence of
and co-operative banks with a view to developing an adequate
large proportions of those overdrafts.
and sound banking system in the country. It has, in this field,
w.p m

The issue, management and administration of the public the following powers: (a) to issue licenses for the establishment
(central and state governments) debt are among the major of new banks; (b) to issue licenses for the setting up of bank
functions of the RBI as the banker to the government. The branches; (c) to prescribe minimum requirements regarding
ww Co

Bank charges a commission from the governments for paid-up capital and reserves, transfer to reserve fund, and
rendering this service. maintenance of cash reserves and other liquid assets; (d) to
inspect the working of banks in India as well as abroad in
respect of their organisational set-up, branch expansion,
mobilisation of deposits, investments, and credit portfolio
cu

management, credit appraisal, region-wise performance, profit


planning, manpower planning and training, and so on; (e) to
conduct ad hoc investigations, from time to time, into
complaints, irregularities, and frauds in respect of banks; (f) to
Do

control methods of operations of banks so that they do not


fritter away funds in improper investments and injudicious
advances, (g) to control appointment, re-appointment,
termination of appointment of the Chairman and chief
executive officers of private sector banks; and (h) to approve or
force amalgamations.
Note Issuing Authority In keeping with the recommendations of Narasimham
The RBI has, since its inception, the sole right or authority or Committee (1991), the RBI function of bank supervision was
monopoly of issuing currency notes other than one rupee notes separated from its traditional central banking function by the
and coins, and coins of smaller denominations. The issue of creation of a separate Department of Supervision (DOS) from
currency notes is one of its basic functions. Although one rupee 22 November 1993. Similarly, following the securities scam
coins and notes, and coins of smaller denominations are issued which showed the glaring weaknesses in the system for
by the Government of India, they are put into circulation only monitoring the financial sector, the Board of Financial
through the RBI. The currency notes issued by the Bank are Supervision (BFS) was set up on 16 November 1994 under the
legal tender everywhere in India without any limit. At present, aegis of the RBI to oversee the IPS. The DOS initially took over

© Copy Right: Rai University


30 11.621.6
the inspection of commercial banks from the Department of rate of the rupee was being fixed in terms of the ‘basket of

MANAGEMENT OF FINANCIAL INSTITUTION


Banking Operations and Development (DBOD) of the RBI. currencies’ till early 1990s.
Since April 1995, it has been taking steps to extend its area of The RBI is the custodian of the country’s foreign exchange
supervision over the all-India financial institutions also. In July reserves, and it is vested with the responsibility of managing
1995, it took over the supervision of non-banking financial the investment and utilisation of the reserves in the most
companies (NBFCs), and in November 1995 the registration of advantageous manner. The RBI achieves this through buying
these companies, from the Department of Financial Companies and selling of foreign exchange from and to scheduled banks,
(DFCs). The BFS has a full-time vice chairman and six other which are the authorised dealers in the Indian foreign exchange
members; the RBI Governor is its chairman. It has powers to market. The Bank also manages the investment of reserves in
supervise and inspect banks, financial institutions, and NBFCs. gold accounts abroad and the shares and securities issued by
There is five-member Advisory Council to render advice to it. foreign governments and international banks or financial
The DOS assists the BFS. institutions.
Exchange Control Authority The role of the RBI as a participant in the foreign exchange

al
One of the essential functions of the RBI is to maintain the market, and as the stabilizer of that market and the rupee
stability of the external value of the rupee. It pursues this exchange rate has become all the more important with the
objective through its domestic policies and the regulation of the introduction of the floating exchange rate system and the rupee

i
foreign exchange market. As far as the external sector is convertibility on trade, current and capital accounts (the last one

com Tr
concerned, the task of the RBI has the following dimensions: to take place in the near future). In the recent past, it has
(a) to administer the Foreign Exchange Control; (b) to choose intervened significantly to achieve exchange rate stability
the exchange rate system and fix or manage the exchange rate
Promoter of the Financial System
between the rupee and other currencies; (c) to manage exchange
Apart from performing the functions already mentioned, the
reserves; and (d) to interact or negotiate with the monetary

rd. F
RBI has been rendering ‘developmental’ or ‘promotional’
authorities of the Sterling Area, Asian Clearing Union, and
services, which have strengthened the country’s banking and
other countries, and with international financial institutions

iza D
such as the IMF, World Bank, and Asian Development Bank.
The RBI administers the Exchange Control in terms of the
financial structure. This has helped in mobilising savings and
directing credit flows to desired channels, thereby helping to
achieve the objective of economic development with social
dfw P
Foreign Exchange Regulation Act (FERA), 1947 which has been justice. It has helped in deepening and widening the financial
replaced by a more comprehensive Foreign Exchange system. As a part of its promotional role, the Bank has been
Regulation Act, 1973. The FERA is now replaced by the pre-empting credit for certain sectors at concessional rates.
Foreign Exchange Management Act (FEMA), which is
w.p m

In the money market, the RBI has continuously worked for the
consistent with full capital account convertibility and the
integration of its unorganised and organised sectors by trying
objective of progressively liberalising capital account
to bring indigenous bankers into the mainstream of the
transactions. The objective of exchange control is primarily to
banking business. In order to improve the quality of finance
ww Co

regulate the demand for foreign exchange within the limits set
provided by the money market, it introduced two Bill Market
by the available supply. This is sought to be achieved by
Schemes, one in 1952, and the other in 1970. With a view to
conserving foreign exchange, by using it in accordance with the
increasing the strength and viability of the banking system, it
plan priorities, and by controlling flows of foreign capital. In
carried out a program of amalgamations and mergers of weak
India, during most of the years since 1957, foreign exchange
banks with the strong ones. When the social control of banks
cu

earnings have been far less than the demand for foreign
was introduced in 1968, it was the responsibility of the RBI to
exchange, with the result that the latter had to be rationed in
administer it in the country for achieving the desired objectives.
order to maintain exchange stability. This is done through
After the nationalisation of banks, the RBI’s responsibility to
exchange control, which is imposed both on receipts and
develop banking system on the desired lines increased. It has
Do

payments of foreign exchange on trade, invisible, and capital


been acting as a leader in sponsoring and implementing the
accounts. The problem of foreign exchange shortage has been
‘Lead Bank’ scheme. With the help of a statutory provision for
so persistent and acute that the scope of exchange control in
licensing the branch expansion of banks, the RBI has been
India has steadily widened and the regulations have become
trying to bring about an appropriate geographical distribution
progressively more elaborate over the years. The Bank
of bank branches. In order to ensure the security of deposits
administers the control through authorised foreign exchange
with banks, the RBI took the initiative in 1962 to create the
dealers.
Deposits Insurance Corporation.
FEMA lays down that the exchange rates used for the conduct
The RBI has rendered service in directing and increasing the
of foreign exchange business must be those, which are fixed by
flow of credit to the agricultural sector. It has been entrusted
the RBI. The arrangements or the system under which exchange
with the task of providing agricultural credit in terms of the
rate is fixed by the RBI has undergone many changes over the
Reserve Bank of India Act. 1934. The importance with which
years. Till about 1971, as a member of the IMF, India had an
the RBI takes this function is reflected in the fact that since 1955,
exchange rate system of “managed flexibility”. This
it has appointed a separate Deputy Governor in charge of rural
arrangement changed during the 1970s as a result of
credit. It has undertaken systematic studies on the problem of
international monetary crisis in 1971. Since 1975, the exchange
rural credit and has generated basic data and information in this

© Copy Right: Rai University


11.621.6 31
area. This was first done in 1954 by conducting an All-India overseeing the safety and soundness of the banking and
MANAGEMENT OF FINANCIAL INSTITUTION

Rural Credit Survey. And that was followed by studies of the financial systems. It plays an important role in building up and
All-India Rural Credit Review Committee in 1968, the maintaining confidence in the underlying stability of the IFS. In
Committee to Review Arrangements for Institutional Credit for short, the RBI helps to create and maintain a stable, efficient,
Agriculture and Rural Development in 1978, and the and well-functioning financial system in India.
Agricultural Credit Review Committee in 1986.
Autonomy for Central Bank
As a part of its efforts to increase the supply of agricultural Autonomy for Central Bank is a crucial issue. The Reserve Bank
credit, the Bank has been working to strengthen co-operative of India Act does not assure autonomy to the bank. It is true
banking structure through the provision of finance, that the Central Bank can only be independent within the
supervision, and inspection. It provides to co-operative banks government but not from the government. In US there are
(through state co-operative banks), short-term finance at a adequate safeguards to ensure that the Federal Reserve is not
concessional rate for seasonal agricultural operations and compelled to act against its own judgement. In India there have
marketing of crops. It subscribes to the debentures of Land been historic accords limiting this access of government to RBI

al
Development Banks. It operates the National Agricultural but they are breached in practice, RBI should not be involved in
Credit (long-term operations) Fund, and the National underwriting government securities. It acts as a principal and as
Agricultural Credit (Stabilisation) Funds through which it an agent in the securities market. The dual role of RBI as an

i
provides long-term and medium-term finance to co-operative issuer and regulator of debt gives rise to conflict of policies of

com Tr
institutions. It established the Agricultural Refinance debt management and monetary policy. The advisory group on
Cooperation (now known as NABARD) in July 1963 for monetary and financial policies headed by M. Narsimham
providing medium-term and long -term finance for agriculture. suggested (September, 2000) the separation of debt
It also helped in establishing an Agricultural Finance management and monetary policy functions and the setting up
Corporation. of an independent debt management office by the

rd. F
The role of the Bank in diversifying the institutional structure Government.
for providing industrial finance has been equally important. All Further the fiscal profligacy of the government is abetted by the

iza D
the Special Development Institutions at the central and state
levels and many other financial institutions mentioned earlier
were either created by the Bank on its own or it advised and
system of pre-emption of large portion on net accrual of banks
deposits through the prescription of statutory liquidity ratio.
dfw P
The Indian banking system was operating for a long time with
rendered help in setting up these institutions. The UTI, for a high level of reserve requirements in the form of Statutory
example, was originally an associate institution of the RBI. A Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). SLR and
number of institutions providing financial and other services CRR keeps in changing form time to time as the need be. As of
w.p m

such as guarantees, technical consultancy, and so on have come date the SLR is 25% and CRR is 4-4.5%. Reduction in statutory
into being on account of the efforts of the RBI. pre-emption is constrained as long as fiscal deficit remains high.
Through these institutions, the RBI has been providing short- The Report of the Committee on the Financial System, 1991
ww Co

term and long-term funds to the agricultural and rural sectors, has pointed out that SLR should not be used to mobilise
to small-scale industries, to medium and large industries, and resources for financing budgetary deficits but as a prudential
to the export sector. It has helped to develop guarantee services measure. It has also stated that CRR should be used for
in respect of loans to agriculture, small industry, exports and pursuing monetary policy objectives.
sick units. It also co-ordinates the efforts of banks, financial In the context of globalisation of the financial system Reserve
cu

institutions and government agencies to rehabilitate sick units. Bank needs autonomy to define benchmarks or anchors such as
The Bank has evolved and put into practice the consortium, co- inflation and money supply to guide policy and use its
operative, and participatory approach to lending among banks judgement to assess the impact of the ever changing financial
and other financial institutions. By developing the practice of environment on the design and implementation of policy.
Do

inter-institutional participation, of expertise pooling, and of Reform of the banning system is not complete unless it
geographical presence, it has helped to upgrade credit delivery includes the Central Bank. The emphasis on market as a source
and service capability of the financial system. By issuing of financial discipline required an autonomous Central Bank,
appropriate guidelines, in 1977, regarding the transfer of loans which can strike right balance with the operation of market
accounts by borrowers, it has evolved a mutually acceptable forces. The responses would be quick and effective only if the
system of lending, so that the banking business grows in a Central Bank is autonomous.
healthy manner and without cut-throat competition. Central banks, which mandated to pursue monetary and
To preserve and enhance the stability of the banking and financial stability should enjoy autonomy in the execution of
financial system is an important part of the “promotional” role policy and be accountable for the achievement of the objective.
of the RBI. In fact, financial stability has now assumed relatively There is consensus that the monetary authority’s primary
greater importance as one of the tasks of the RBI. This is objective should be price stability, that the central bank should
evident in its work to formulate prudential norms for banks have sufficient independence to vary its operational instrument
and financial institutions, its intervention in the foreign and its main instrument is its control over short-term interest
exchange market, and its participation in the operation of rates. The profound transformation of the financial
“safety nets” i.e., the legal and organisational structure for environment had a major effect both on the relationship

© Copy Right: Rai University


32 11.621.6
between the monetary policies across countries and their design Notes:

MANAGEMENT OF FINANCIAL INSTITUTION


within the countries. Central banks while defining benchmarks
or anchors to guide policy to achieve monetary and financial
stability have to take into account the increasing constraints that
result from the growing power of markets to arbitrage across
currencies, instruments and institutions as well as across legal,
regulatory and tax jurisdictions. The increasing power of
markets put a premium on transparency to guide market
expectations, market incentives and credibility of policies. The
market orientation of the framework has to be strengthened by,
• Enlisting and upgrading the markets disciplinary mechanism
• Enlarging the domain and improving the quality of public
disclosure

al
• Designing regulatory constraints such as capital standards so
as to make them less vulnerable to financial arbitrage

i
• Limiting the impact of those forms of intervention that

com Tr
provide perfection without commensurate over sight which
reduce the incentive to prudent behavior
Central bank’s incentive for stability requires supporting policies
in terms of sustainable fiscal positions and greater flexibility in
labour market. Further the effectiveness of market forces

rd. F
depends on fostering ownership structures through
privatisation, which are more responsive to market, and

iza D
removing obstacles to the adjustment of capital and labour.
The systemic orientation has to be sharpened by upgrading
payment and settlement systems to contain the knock on effects
dfw P
of failures of institutions. A right balance between the market
and the central bank as a source of financial discipline has to be
struck.
w.p m

Summary
Regulation of the financial system and its various component
sectors occurs in almost all countries. A useful way to organise
ww Co

the many instances of regulation is to see it as having four


general forms: (1) enforcing the disclosure of relevant
information; (2) regulating the level of financial activity through
control of the money supply as well as trading in financial
markets; (3) restricting the activities of financial institutions and
cu

their management of assets and liabilities; and (4) constraining


the freedom of foreign investors and securities firms in
domestic markets.
The most important players in financial markets throughout
Do

the world are central banks, the Government authorities in


charge of monetary policy. Central banks’ actions affect interest
rates, the amount of credit, and the money supply, all of which
have direct impacts not only on financial markets but also on
aggregate output and inflation. To understand the role that
central banks play in financial markets and the overall economy,
we need to understand how these organizations work. Who
controls central banks and determines their actions? What
motivates their behavior? Who hold the rein of power?
Questions to Discuss:
• Discuss the advisory role of RBI.
• Discuss the authorities invested with RBI.
• Discuss the autonomy for Central Bank.

© Copy Right: Rai University


11.621.6 33
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 10:
MONETARY POLICY OF RBI

Learning Objectives of banking, and the filling in of gaps in the financial structure
After reading this lesson, you will understand become necessary.
• Monetary policy of RBI Objectives of Monetary Policy
• Objectives of monetary policy In the present day, it is generally accepted that the main objective
of monetary policy is the promotion of economic growth with
• Scope of monetary and fiscal policies
price stability, to elaborate, monetary policy has to be directed
• Monetary management towards attaining a high rate of growth, while maintaining

al
• Banks and credit creation reasonable stability of the internal purchasing power of money.
• Instruments of monetary control The central bank attempts to ensure an adequate level of

i
liquidity to support the rate of economic growth envisaged and
• Money supply

com Tr
to assist in the fullest possible utilization of resources without
After the overview of the whole financial institutions let us generating inflationary pressures. However, it is difficult to say
now get to the functioning of the financial system. with any degree of precision as to what is adequate under a
Monetary Policy of RBI given situation. But, as a working rule, the rate of increase in
You must know that the monetary policy is regarded as an money supply has to be somewhat higher than the projected

rd. F
indispensable tool of economic management. Monetary policy rate of growth of real national income to meet the demand for
refers to the use of official instruments under the control of the money likely to arise as income grows and correspondingly the

iza D
central bank to regulate the availability, cost and use of money
and credit with the aim of achieving optimum levels of output
and employment, price stability, balance of payments
savings component, after taking into account the degree of
monetisation in the economy, an excessive growth in liquidity
relative to the requirements of real output would result in the
dfw P
equilibrium or any other goals set by the State, an appropriate build-up of inflationary pressures.
monetary policy by adjusting money supply to the needs of A central bank has necessarily to function within the ambit of
growth, directing the flow of funds in keeping with the overall the current economic milieu of the country. If the dominant
economic priorities, and providing institutional facilities for
w.p m

emphasis is on planned development, as in a country like India,


credit in specific areas of economic activity, created a favourable monetary policy has in addition to take care of promotional
environment for economic growth. The central bank exercises aspects such as monetary integration of the country, directing
its influence on the availability and cost of credit primarily by credit flow according to policy priorities, assisting in
ww Co

affecting the reserves position of commercial banks. mobilization of the savings of the community, and promotion
The efficacy of monetary policy depends on the prevailing of capital formation and, above all, extend support to the
economic situation and structural factors like the proportion of authorities in the task of allocation of resources by assisting in
currency in money supply, size of public debt, non-monetised the maintenance of an appropriate structure of relative prices.
cu

sector in the economy and presence of active sub-markets. Scope of Monetary and Fiscal Policies
Again, the manner in which monetary policy is operated hinges Monetary policy is but one aspect of the broader economic
on the particular needs of the situation, such as the degree of policy of a country, the other important component being fiscal
imbalance in the overall supply-demand situation, trends in policy. Both monetary and fiscal policies have repercussions on
Do

agricultural and industrial production and the general price level, the whole economy, affecting the price level, level of economic
and the balance of payments situation. Since these conditions activity, employment and balance of payments. While monetary
are constantly changing, the authorities have to adapt to the policy influences economic trends through the cost and
circumstances the choice and mix of various techniques, putting availability of credit, fiscal policy is a more important
emphasis as required on controlling the sources of money determinant of aggregate demand in as much as it directly
supply or interest rates policy. affects the financial resources and purchasing power in the
Monetary policy also encompasses institutional changes in the hands of the public.
banking and credit structure. While the level of savings is In the developing countries the central banks have been called
basically a function of the level of income, the absence or upon to play a positive and energetic role in administering
underdeveloped state of financial institutions inhibits the monetary policy to achieve the desired economic goals. In these
effective mobilization of savings for purposes of development, countries, fiscal policy is necessarily expansionary which means
the institutionalization of savings provides the potential saver that the central bank has to provide large funds to the
with a choice of financial assets with varying degrees of safety, Government in the form of loans and advances for purposes
liquidity and yield, in this context, wider geographical and of economic growth. Resort to central bank credit for meeting
functional coverage of institutional credit facilities, especially that budgetary deficits results in an expansion of money supply and

© Copy Right: Rai University


34 11.621.6
therefore in the cash reserves of banks. With the expansion of Monetary policy refers to the use of these instruments of

MANAGEMENT OF FINANCIAL INSTITUTION


bank reserves, the ability of the banking system to expand control to regulate money supply and credit with a view to
credit also increased. In such a situation, monetary policy has to influence the level of aggregate demand for goods and services.
be such as to moderate the secondary expansion that will occur
as a result of the increase in bank reserves, while at the same
time ensuring that sufficient credit facilities are made available
for meeting the genuine needs of agriculture, industry,
commerce and other productive activities. Thus, on the one
hand, the credit policy has to be evolved to meet the credit
needs of the growing economy, and, on the other, it has to be
restrictive in order to keep in check inflationary forces. Moreover,
while making any change in the structure of interest rates, public
debt policy considerations will have to be kept in view.

al
Therefore, the monetary and fiscal policies need to be properly
coordinated to be really effective.
Monetary Management

i
In recent years, the objective of monetary policy in India has

com Tr
been twofold. It has to facilitate the flow of an adequate
volume of bank credit to industry, agriculture and trade to meet
their genuine needs and provide selective encouragement to
sectors which stand in need of special assistance such as the
weaker sections of the community and the neglected sectors and

rd. F
areas in the country. Al the same time, to keep inflationary
pressures under check it has to restrain under credit expansion

iza D
and also ensure that credit is not diverted for undesirable
purposes. As the central monetary authority, the Reserves
Bank’s chief function is to ensure the availability of credit to the
dfw P
extent that is appropriate to sustain the tempo of development Banks and Credit Creation
and promote the maintenance of internal price stability. Deposits with banks may originate in two ways- through either
‘passive’ creation or ‘active’ creation. The former occurs when
The focus of monetary policy had to be adjusted from time to
w.p m

banks open deposit accounts for customers against receipt of


time so as to soften the impact of created money on the
value either in cash or by cheques drawn on other banks. The
economy and at the same time to achieve the objectives of
immediate effect is that there is no addition to the quantum of
planned development. The first decade of the Plan era saw the
money though its distribution may undergo a change; but
ww Co

revival of the traditional weapons of monetary control; during


ultimately it serves as the base for banks to extend credit and
the second half of that decade the regulatory functions were
would thus lead to an increase in money supply. Active creation
developed. In the sixties, the problems of stabilization were
of deposits takes place through the process of lending when
replaced by a greater concern for economic growth and control
the money lent out by banks re-enters the system as deposits.
over the accompanying increases in money supply. By the 1970s
cu

The capacity of banks to provide credit depends on their cash


and through 1980, the twin objectives of provision of credit for
reserves, comprising cash in hand and balances with the central
attaining faster economic growth and price stabilization
bank. (The amount of cash to be kept by banks will be
assumed importance. This policy has come to be known as
determined both by the legal requirements and the pattern of
‘controlled expansion’.
the inflow and outflow of cash in a bank.) When a bank
Do

Instruments of Monetary Control extends credit, either the whole of it or a part, depending upon
One of the most important functions of a central bank is the extent of banking habit would eventually find its way to the
monetary management-regulation of the quantity of money deposit stream, either with itself or with other banking
and the supply and availability of credit for industry, business institutions. Under the fractional reserve system, banks can
and trade. The monetary or credit management activities of the create deposits by a multiple of the reserves since the payments
bank are two types: general monetary and credit management made with the proceeds of bank loans are eventually
functions- total supply of money and credit and the general redeposited with banks leading to additional reserve funds.
level of interest rates. The central bank relies on two types of
Even in the countries with a widespread banking habit, there is
instruments, the direct and the indirect, the direct instruments
a limit to the ability of banks to generate deposits, which is set
of monetary control are reserve requirements, administered
by various economic and institutional factors. In developing
interest rates and credit controls; and the indirect instrument of
countries, the scope for credit creation by banks is much less
control is open market operations.
than in countries with a well-developed banking system. While
the Reserve Bank can regulate the amount of money creation by
banks through control of their cash reserves, in practice, the
regulation of money supply is not wholly under the Bank’s

© Copy Right: Rai University


11.621.6 35
control. It is considerably affected by the budgetary operations Treasury Bills and Government securities and the Bank’s loans
MANAGEMENT OF FINANCIAL INSTITUTION

of the Government over which the Bank has no control, and advances to the State Governments. However, it should be
although the Bank ahs opportunities of tendering advice to noted that the concept of net bank credit to the Central
Government on this matter. If the Government meets its Government is not the same as the Central Government’s
budgetary deficits by borrowing from the Reserve Bank, there budgetary deficit, especially since all term borrowings, including
will be an increase in money supply, both in currency and bank the increase in the banks’ holdings of Central Government
deposits; it may be relevant to note that there is no statutory securities, are treated in the budget as resources of the
limit on the extension of credit by the Bank to Government, Government while all holding of short-term paper (Treasury
another source of variations in money supply over which the bills) including the holding of non-bank institutions enter the
Banks, influence is restricted is the country’s external payments budgetary deficit.
position. Bank credit to the commercial sector, including that
Money Supply extended to public sector commercial undertakings, represents
The total expansion of money supply depends on the creation the gross commercial and co-operative banks’ credit and

al
of high-powered money (reserve base) and the multiplier action investments in the commercial sector’s shares, bonds and
upon it, the components of the reserve money are currency debentures, and the Reserve Bank’s credit to the commercial
with the public, other deposits with the RBI, and bankers’ sector, viz., loans and advances to financial institutions, internal

i
deposits with the RBI. Money multiplier is the mean value of bills purchased and discounted, holding of capital and bonds

com Tr
the ratio of money supply or aggregate monetary resources to of financial institutions, and investments in debentures.
reserve money. It is the interacting variable between these two The net foreign exchange assets of the Reserve Bank and the
monetary aggregates. Reserve requirements consist of cash foreign exchange assets of banks together constitute the net
reserve ratio and statutory liquidity ratio. The impact of any foreign exchange assets of the banking sector. In the former are
variation in the ratio is direct, precise and certain. Reserve

rd. F
included the Bank’s holdings of foreign securities, gold coin
requirements bear on the volume of credit by affecting the credit and bullion and balances held abroad; from the total is
base of bank reserves. Altering the ratios will affect the credit- deducted the balance in IMF Account excluding the amount of

iza D
creating capacity of banks, volume of credit and therefore of
money supply. The impact of any change in reserve ratios on
money supply depends, besides the extent of multiple credit
quota subscription in rupees, the effect of the external sector on
money supply is measured by the movement in net foreign
exchange assets. Whenever there is an increase in net foreign
dfw P
creation by banks, on the ratio of bank reserves to total assets this is an expansionary factor even as a decrease is a
reserves, which is defined as the currency with the public and contractionary factor.
bank reserves. Net bank credit to Government is determined by the
w.p m

Government’s budgetary policies, including the size of the


budgetary deficit which again depends on the actual behaviour
of revenue and expenditure during the year, as the Reserve
ww Co

Bank is not able to influence the size of the budgetary deficit, it


has to formulate its credit policy within this overall constraint.
The banking system constitutes the major source of
institutional credit. Bank credit to the commercial sector can be
influenced by the RBI’s credit policies via the capacity of banks
cu

to create credit and thereby influence a part of aggregate demand


in the economy. As a general rule, to control the growth of
liquidity in the economy caused mainly by the Government’s
budgetary deficits, the Reserve Bank acts primarily on bank
Do

credit to the commercial sector.


Questions to Discuss:
The three important factors affecting money supply in India are 1. What do you understand by Monetary Policy?
the net bank credit to Government, bank credit to the 2. What are the objectives of monetary policy?
commercial sector and net foreign exchange assets of the
3. Discuss the scope of monetary and fiscal policies.
banking sector.
4. What is Monetary Management?
Net bank credit to Government is composed of net Reserve
Bank credit to the Government and the holdings of 5. Discuss Money Supply in detail.
Government securities by commercial and co-operative banks.
The Reserve Bank’s net credit to Government is the sum of the
Reserve Bank’s net credit to the Central Government and net
credit to the State Governments and is arrived at after deducting
deposits of the Central and State Governments with the
Reserve Bank from the sum total of the Bank’s investments in

© Copy Right: Rai University


36 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 11:
TOOLS OF MONETARY POLICY

Learning Objectives institution by the approved brokers. In a triangular switch


After reading this lesson, you will understand operation, the selling bank’s quota (fixed on the basis of time
and demand deposit liabilities) is debited (the Reserve Bank
• Tools of monetary policy
being the purchaser). The objective behind fixing a quota for
• Instruments of general credit control switch deals is to prevent the excessive unloading of low
• Goals of monetary policy yielding securities on to the Reserve Bank. The Bank maintains
• Recent policy developments separate lists for purchase and sale transactions with reference to

al
its stock of securities and the dates of maturity of the different
After discussing the monetary policy in our last lesson let us
loans.
now discuss the tools of monetary policy.
REPO auction was allowed since 1992-93. Since November

i
What are Open Market Operations? 1999 REPOs are offered on a daily fixed rate basis to provide

com Tr
Open market operations can be continuous and flexible in signals to money market rates and impart stability to short-term
influencing bank reserves. Effects depend on the medium of interest rates by setting a floor to call rates.
operation, short bills like Treasury Bills or long-term securities,
till the initiation of several measures to promote primary and REPOs and Reverse REPOS
secondary markets in Government securities since 1992-93, the In order to activate the REPOs market so that it serves as an

rd. F
market was quite narrow. There was no choice of amount. The equilibrating force between the money market and the securities
amount was determined by the budgetary requirements and the market, REPO and reverse REPO transactions among select

iza D
interest rate by the need to keep the cost of borrowing low. As
the corollary to the financial liberalization measures, the
automatic monetisation of the fiscal deficit was limited to Ways
institutions have been allowed since April 1997 in respect of all
dated Central Government securities besides Treasury Bills of
all maturities, a system of announcing a calendar of REPO
dfw P
and Means Advances at market related interest rates form April auctions to enable better treasury management by participants
1,1997 and development of money market and securities was introduced in January 1997.
market by way of introduction of new instruments, auction Reverse REPOs ease undue pressure on overnight call money
w.p m

system for Government securities (including repos/reverse rates. PDs are allowed liquidity support in the form of reverse
repos) and instituting a network of primary and satellite dealers REPO facility.
with a view to enabling the emergence of open market Reverse REPO transactions can be entered into by non-bank
ww Co

operations as the principal instrument of liquidity entities who are holders of SGL accounts with the Reserve
management. Bank with banks, primary dealers in Treasury Bills of all
REPOs maturities and all dated central government securities. The first
REPO and reverse REPO operated by RBI in dated step if the transaction by non-bank entites should be by way of
government securities and Treasury Bills (except 14 days) help purchase of securities eligible for REPOs from banks/primary
cu

banks to manage their liquidity as well as undertake switch to dealers and the second step will be by way of selling back
maximize the return. REPOs are also used to signal changes in securities to banks/primary dealers. Non-bank entities are
interest rates. REPOs bridge securities and banking business. however not allowed to enter into REPO transactions with
A REPO is the purchase of one loan against the sale of banks/primary dealers. The transactions have to be effected at
Do

another. They involve the sale of securities against cash with a Mumbai.
future buy back agreement. There are no restrictions on tenor of Interbank REPOs
REPOs. They are well established in US and spread to Euro Commercial banks and select entities can conduct REPO
market in the second half of 1980s to meet the trading demand transactions in PSU bonds and private corporate debt securities.
from dealers and smaller commercial banks with limited access These transactions provide liquidity support to the debt market
to international interbank funding. REPOs are a substitute for Delivery Versus Payment (DVP) was introduced in April 1999
traditional interbank credit. as a regulatory safeguard.
REPOs are part of open market operations undertaken to In July 1999 non-bank participants in the money market were
influence short-term liquidity. With a view to maintain an allowed to access short-term liquidity through REPOs on par
orderly pattern of yields and to cater to the varying requirements with banks.
of investors with respect to maturity distribution policy or to It may be noted that according to the international accounting
enable them to improve the yields on their investment in practices, the funds advanced by the purchaser of a security
securities, RBI engages extensively in switch operations. In a under a firm repurchase agreement are generally treated as
triangular switch, one institution’s sale/purchase of security is
matched against the purchase/sale transaction of another

© Copy Right: Rai University


11.621.6 37
collaterised loan and the underlying security is maintained on operations, which can also be used for carrying out changes on
MANAGEMENT OF FINANCIAL INSTITUTION

the balance sheet of the seller even the smallest scale. Changes in reserve requirements operate
directly and immediately by affecting the quantum of loanable
What do you Understand by Discount Policy?
resources with banks: an increase reduces the banks capacity to
Discount loans are loans from the central bank to depository
lend and a reduction in effect places funds with them. The
institution and that the discount rate is the interest rate charged
effects of changing reserve requirements are similar in some
on these loans. Discount policy, which primarily involves
respects to but different in others from those of open market
changes in the discount rate, affects reserves in the banking
operations. They are similar in that they both change instantly
system because when a discount loan is extended, the central
the reserve position of banks and set in motion secondary
bank increases a bank’s reserves by an equal amount.
forces leading to multiple expansion or contraction of credit.
In addition to its use as a tool to influence reserves in the The two instruments differ in that changes in reserve
banking system and the money supply, discounting is requirements are much more effective than open market
important in preventing financial panics. An important role of operations (and also discount rate) in situations where the
RBI is intended to be as the lender of last resort; it was to

al
banks have a volume of reserves far in excess of the legal
provide reserves to banks when no one else would in order to requirements or where a large expansion of credit is desired, to
prevent bank failures from spinning out of control, thereby elaborate, where large-scale and widespread liquidity exists, a rise
preventing bank and financial panics. Discounting is a

i
in reserve requirements will be more useful in eliminating the
particularly effective way to provide reserves to the banking

com Tr
excess reserves. Once this is done, open market operations are
system during a banking crisis because reserves are immediately more suitable as a flexible instrument to tighten or ease credit
channeled to the banks that need them most. operations, as it is selective in its application and can also be
What is the Reserve Requirement? used on a day-to-day basis. Conversely, the reserve requirements
Changes in reserve requirements affect the demand for reserves: can be lowered to bring about an increase in general liquidity in

rd. F
A rise in reserve requirements means that banks must hold the banking system, and thereafter through open market
more reserves, and a reduction means that they are required to operations the liquidity can be maintained at the desired level.

iza D
hold less. All depository institutions, including commercial
banks, savings and loan associations, mutual savings banks,
and credit unions, are all subject to reserve requirements.
Unlike the Bank rate whose effectiveness depends, among other
things, upon the attitude of the commercial banks and the
borrowers, open market operations can be so regulated that
dfw P
Reserve requirements have been rarely used as a monetary policy bank reserves change to the level desired by the central bank. In
tool because raising them can cause immediate liquidity the final analysis, however, the use of one instrument rather
problems for banks with low excess reserves. Continually than another at any point of time is determined by the nature
of the situation and the range of influence it is desired to wield
w.p m

fluctuating reserve requirements would also create more


uncertainty for banks and make their liquidity management as well as the rapidity with which the change is required to be
more difficult, brought about. Rather, it has come it be recognized that in the
majority of circumstances, no single instrument is adequate to
ww Co

Instruments of General Credit Control meet the task; instead, all three need to be employed in
Instruments of credit control are of two types: general of appropriate combination.
quantitative and selective of qualitative. The instruments of
In India, the statutory basis for the regulation of the credit
general credit control are the Bank rate, also known as the
system by the Bank is embodied in the Reserve Bank of India
discount rate, reserve requirements and open market
cu

Act and the Banking Regulation Act. The former confers on the
operations. All the three methods by affecting the lendable
Bank the usual powers available to central banks generally, while
resources of the commercial banks affect the total volume of
the latter provides special powers of direct regulation of the
credit and hence total money supply. In the case of selective
operations of the commercial and co-operative banks.
credit controls the impact is not so much on the total amount
Do

of credit as on the direction of credit, i.e., on the amount that is Goals of Monetary Policy
put to use in a particular sector of the economy, and they bring Reserve Bank of India focuses on the following main six basic
to bear a restraining influence on the borrowers. goals of monetary policy:
The three instruments are designed to affect the liquidity in the • High employment
economy by acting on the quantum of bank reserves. Open • Economic growth
market operations and reserve requirements directly affect the • Price stability
reserve base while the Bank rate produces its impact indirectly
• Interest-rate stability
through variations in the cost of acquiring the reserves. The
effects of Bank rate changes are not confined to the banking • Stability of financial markets
system and the money market; they produce wider • Stability in foreign exchange markets
repercussions on the economy as a whole. However, its action is
High Employment
indirect, its influence on money and credit being through
Promoting high employment consistent with a stable price level
primary changes in short-term money rates and secondary
is a worthy goal for two main reasons: (1) the alternative
repercussions on long-term interest rates or yields; i9t is not
situation, high unemployment, causes much human misery,
also as flexible for day-to-day adjustments as open market

© Copy Right: Rai University


38 11.621.6
with families suffering financial distress, lass of personal self- hamper economic growth. For example, the information

MANAGEMENT OF FINANCIAL INSTITUTION


respect, and increase in crime (though this last conclusion is conveyed by the prices of goods and services is harder to
highly controversial), and (2) when unemployment is high, the interpret when the overall level of process is changing, which
economy has not only idle workers but also idle resources complicates decision making for consumers, businesses, and
(closed factories and unused equipment), resulting in a loss of government, not only do public opinion surveys indicate that
output (lower GDP) the public is very hostile to inflation, but also a growing body
Although it is clear that high employment is desirable, how of evidence suggests that inflation leads to lower economic
high should it be? At what point can we say that the economy is growth. The most extreme example of unstable prices is
at full employment? At first, it might seem that full hyperinflation, such as Argentina, Brazil, and Russia have
employment is the point at which no worker is out of job, that experienced in the past. Many economists attribute the slower
is, when unemployment is zero. But this definition ignores the growth that these countries have experienced to their problems
fact that some unemployment, called frictional with hyperinflation. Further, inflation may strain a country’s
unemployment, which involves searches by workers and firms social fabric: Conflict may result because each group in the

al
to fund suitable matchups, is beneficial to the economy. For society may compete with other groups to make sure that its
example, a worker who decides to look for a better job might be income keeps up with the rising level of prices.
unemployed for a while during the job search. Workers often Interest-Rate Stability

i
decide to leave work temporarily to pursue other activities Interest-Rate stability is desirable because fluctuations in interest

com Tr
(raising a family, travel, returning to school), and when they rates can create uncertainty in the economy and make it harder to
decide to reenter the job market, it may take some time for plan for the future, fluctuations in interest rates that affect
them to fund the right fob. The benefit of having some consumers’ willingness to buy houses, for example, make it
unemployment is similar to the benefit of having a nonzero more difficult for consumers to decide when to purchase a
vacancy rate in the market for rental apartments. house and for construction firms to plan how many houses to

rd. F
Another reason that unemployment is not zero when the build. Upward movements in interest rates generate hostility
economy is at full employment is due to what is called toward central banks like RBI and lead to demands that their

iza D
structural unemployment, a mismatch between job
requirements and the skills or availability of local workers.
Clearly, this kind of unemployment is undesirable.
power be curtailed.
Stability of Financial Markets
dfw P
Financial crises can interfere with the ability of financial markets
Nonetheless, it is something that monetary policy can do little to channel funds to people with productive investment
about. opportunities, thereby leading to a sharp contraction in
The goal for high employment should therefore not seek an economic activity. The promotion of a more stable financial
w.p m

unemployment level of zero but rather a level above zero system in which financial crises are avoided is thus an important
consistent with full employment at which the demand for labor goal for a central bank.
equals the supply of labor. This level is called the natural rate The stability of financial markets is also fostered by interest-rate
ww Co

of unemployment. stability because fluctuations in interest rates create great


Economic Growth uncertainty for financial institutions. An increase in interest rates
The goal of steady economic growth is closely related to the produces large capital losses on long-term bonds and
high-employment goal because businesses are more likely to mortgages, losses that can cause the failure of the financial
invest in capital equipment to increase productivity and institutions holding them. In recent years, more pronounced
cu

economic growth when unemployment is low. Conversely, if interest-rate fluctuations have been a particularly severe problem
unemployment is high and factories are idle, it does not pay for for savings and loan associations and mutual savings banks.
a firm to invest in additional plants and equipment. Although Stability in Foreign Exchange Markets
the two goals are closely related, policies can be specifically aimed
Do

With the increasing importance of international trade to the


at promoting economic growth by directly encouraging people Indian economy, the value of the rupees relative to other
to save, which provides more funds for firms to invest, in fact, currencies has become a major consideration for the RBI. A rise
this is the stated purpose of so-called supply-side economics in the value of the rupee makes Indian industries less
policies, which are intended to spur economic growth by competitive with those abroad, and declines in the value of the
providing tax incentives for businesses to invest in factories and rupee stimulate inflation in India. In addition, preventing large
equipment and for taxpayers to save more, there is also an active changes in the value of the rupee makes it easier for firms and
debate over what growth role monetary policy can play in individuals purchasing or selling goods abroad to plan ahead.
boosting growth. Stabilizing extreme movements in the value of the rupee in
Price Stability foreign exchange markets is thus viewed as a worthy goal of
Over the past few decades, policymakers in India have become monetary policy,
more aware of the social and economic costs of inflation and Conflict Among Goals
more concerned with a stable price level as a goal of economic Although many of the goals mentioned are consistent with
policy. The price stability is desirable because a rising price level each other-high employment with economic growth, interest-
(inflation) creates uncertainty in the economy, and that may rate stability with financial market stability-this is not always the

© Copy Right: Rai University


11.621.6 39
case. The goal of price stability often conflicts with the goals of • Fiscal-monetary relationship has been reformed in a major
MANAGEMENT OF FINANCIAL INSTITUTION

interest-rate stability and high employment in the short run way by abolishing the system of automatic monetisation of
(but probably not in the long run). For example, when the fiscal deficit, which was taking place through the issuance of
economy is expanding and unemployment is falling, both ad hoc treasury bills. This has been achieved through the
inflation and interest rates may start to rise, if the central bank signing of two agreements between the GOI and the RBI.
tries to prevent a rise in interest rates, this may cause the • Interest rates structure has been simplified and deregulated.
economy to overheat and stimulate inflation. But is a central
• Far-reaching changes in the external sector of the economy
bank raises interest rates to prevent inflation, in the short run
have been effected. Substantial elimination of imports and
unemployment may rise, the conflict among goals may thus
exchange controls, introduction of market-determined
present central banks like RBI with some hard choices.
exchange rate system, rupee convertibility, encouragement to
FDI, and greater access to external capital markets are some
of these changes.
Summary

al
The goals of monetary policy include a stable price level,
economic growth, high employment, stable interest rates, and
predictable and steady currency exchange rates. Unfortunately,

com Tr
i
monetary policies involve difficult trade-offs, and policies that
help to achieve one goal may make another less attainable.
The conduct of monetary policy involves actions that affect the
RBI’s balance sheet. Open market purchases lead to an
expansion of reserves and deposits in the banking system and

rd. F
hence to an expansion of the monetary base and the money
supply. An increase in discount loans leads to an expansion of

iza D reserves, thereby causing an expansion of the monetary base


and the money supply. The three basic tools of monetary policy
are open market operations, discount policy, and reserve
dfw P
Recent Policy Developments requirements. Open market operations are the primary tool.
Although the above-given account of the long-term evolution
of monetary policy has referred to certain recent changes, a brief Because predicting the Reserve Bank’s actions can help managers
critical update of the RBI policy will be useful for purposes of of financial institution predict the course of future interest
w.p m

study. rates, which has a major impact on the financial institutions’


profitability, such managers value the services of RBI watchers,
Major Changes experts on Central Bank behavior.
ww Co

• The recent monetary policy, particularly the one announced in


Questions to Discuss:
April 1997 and October 1997 can be said to have ushered in
the following changes: 1. What are Open Market Operations?

• It has encouraged greater market orientation in the financial


2. What are the instruments of general credit control?
sector by empowering banks with greater operational 3. Discuss the goals of monetary policy.
cu

flexibility. Although the RBI will continue to prescribe 4. Discuss the recent policy developments.
prudential guidelines, it has now moved out of
microregulation.
• The borrowers also have been empowered to reinforce
Do

marketisation, and this is bound to change the relationship


between borrowers and bankers.
• The interest rates are now sought to be emphasised as
potential instruments for influencing the liquidity in the
system. The Bank rate is being made an important signal and
reference rate to define determine the stance of monetary
policy and the cost of funds ill the economy.
• The policy is directed to integrate further the money market,
the government securities market, and the forex markets.
• The government securities market is being made an active
segment of the IPS so that the conduct of monetary policy
could be rendered effective.

© Copy Right: Rai University


40 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 12:
TUTORIAL-2

Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 41
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 13:
THE SECURITIES AND EXCHANGE BOARD OF INDIA

Learning objectives The SEBI was established on April 12, 1988 through an
After reading this lesson, you will understand administrative order, but it became a statutory and really
powerful organisation only since 1992. The CICA was repealed
• Securities contracts (regulation) act, 1956
and the office of the CCI was abolished in 1992, and the SEBI
• Securities and exchange board of India was set up on 21 February 1992 through an ordinance issued on
• Objectives and regulatory approach 30 January 1992. The ordinance was replaced by the SEBI Act
• Powers, scope, and functions on 4 April 1992. Certain powers under certain sections of SCRA

al
and CA have been delegated to the SEBl. The regulatory powers
Discussion on SEBI is important for our discussion. It is one
of the SEBI were increased through the Securities Laws
of most important regulatory authority in India. It is gaining
(Amendment) Ordinance of January 1995, which was

i
more importance day by day with new issues cropping up.
subsequently replaced by an Act of Parliament. The SEBI is

com Tr
Securities Contracts (Regulation) Act, 1956 under the overall control of the Ministry of Finance, and has its
The objective of the Securities Contracts (Regulation) Act head office at Mumbai. It has now become a very important
(SCRA) is to regulate the working of stock exchanges or constituent of the financial regulatory framework in India.
secondary market with a view to prevent undesirable The philosophy underlying the creation of the SEBI is that
transactions or speculation in securities, and thereby to build up

rd. F
multiple regulatory bodies for securities industry mean that the
a healthy and strong investment market in which public could regulatory system gets divided, causing confusion among
invest with confidence. It empowers the GOI to recognise and market participants as to who is really in command. In a

iza D
derecognise the stock exchanges, to stipulate laws and by-laws
for their functioning, and to make the listing of securities on
stock exchanges by Public Limited Companies (PULCOs)
multiple regulatory structure, there is also an overlap of
functions of different regulatory bodies. Through the SEBI,
dfw P
the regulation model which is sought to be put in place in India
mandatory. It prohibits securities transactions outside the is one in which every aspect of securities market regulation is
recognised stock exchanges. It lays down that all contracts in entrusted to a single highly visible and independent
securities except spot delivery contracts can be entered into only organisation, which is backed by a statute, and which is
w.p m

between and through the members of recognised stock accountable to the Parliament and in which investors can have
exchanges. It prescribes conditions or requirements for listing trust.
of securities on the recognised stock exchanges. It empowers
Constitution and Organisation
ww Co

the GOI to supercede the governing bodies of stock exchanges,


to suspend business on recognised stock exchanges, to declare The SEBI is a body of six members comprising the Chairman,
certain contracts illegal and void under certain circumstances, to two members from amongst the officials of the ministries of
prohibit contracts in certain cases, to license the security dealers, the central government dealing with finance and law, two
and to lay down penalties for contravention of the provisions members who are professionals and have experience or special
knowledge relating to securities market, and one member from
cu

of the Act. It is administered by the Ministry of Finance,


Department of Economic Affairs, GOI. the RBI. All members, except the RBI member, are appointed
by the government, who also lays down their terms of office,
Securities and Exchange Board of India tenure, and conditions of service, and who can also remove any
Genesis member from office under certain circumstances. The central
Do

The year 1991 witnessed a big push being given to liberalisation government is empowered to supersede the SEBI in public
and reforms in the Indian financial sector. For sometime interest, or if, on account of grave emergency, it is unable to
thereafter, the volume of business in the primary and secondary discharge its functions or duties, or if it persistently defaults in
securities markets increased significantly. As a part of the same complying with any direction issued by the government, or if
reform process, the globalisation or internationalisation of the its financial position and administration deteriorates.
Indian financial system made it vulnerable to external shocks. The work of the SEBI has been organised into five operational
The multi-crore securities scam rocked the IFS in 1992. All these departments each of which is headed by an executive director
developments impressed on the authorities the need to have in who reports to the Chairman. Besides, there is a legal
place a vigilant regulatory body or an effective and efficient department and the investigation department. The departments
watchdog. It was felt that the then existing regulatory have been divided into divisions. The various departments and
framework was fragmented, ill coordinated, and inadequate and the scope of their activities are as follows:
that there was a need for an autonomous, statutory, integrated
(i) The Primary Market Policy, Intermediaries, Self-Regulatory
organisation to ensure the smooth functioning of the IFS. The
Organisations (SROs), and Investor Grievance and Guidance
SEBI came into being as a response to these requirements.
Department. It looks after all policy matters and regulatory

© Copy Right: Rai University


42 11.621.6
issues in respect of primary market, registration, merchant Table 1: Details of Intermediaries Registered

MANAGEMENT OF FINANCIAL INSTITUTION


bankers, portfolio management services, investment
advisers, debenture trustees, underwriters, SROs and
investor grievance, guidance, education, and association.
(ii) The Issue Management and Intermediaries Department: It
is responsible for vetting of all prospectuses and letters of
offer for public and right issues, for coordinating with the
primary market policy, for registration, regulation and
monitoring of issue-related intermediaries.
(iii) The Secondary Market Policy, Operations and Exchange
Administration, New Investment Products and Insider
Trading Department: It is responsible for all policy and
regulatory issues for secondary market and new investment Objectives and Regulatory Approach

al
products, registration and monitoring of members of stock The overall objective of the SEBI, as enshrined in the Preamble
exchanges, administration of some of the stock exchanges, of the SEBI Act, 1992 is “to protect the interests of investors
market surveillance and monitoring of price movements and in securities and to promote the development of, and to

i
insider trading and EDP and SEBI’s data base. regulate the securities market and for matters connected

com Tr
therewith or incidental thereto”. To elaborate, the SEBI
(iv) The Secondary Market Exchange Administration,
regulates stock exchanges and securities industry to promote
Inspection and Non-member Intermediaries Department: It
their orderly functioning. It protects the rights and interests of
looks after the smaller stock exchanges of Guwahati,
investors, particularly individual investors, and guides/educates
Magadh, Indore, Mangalore, Hyderabad, Bhubaneshwar,
them. It prevents trading malpractices and aims at achieving a

rd. F
Kanpur, Ludhiana and Cochin. It is also responsible for
balance between self-regulation by securities industry and its
inspection of all stock exchanges, and registration, regulation
statutory regulation.
and monitoring of non-member intermediaries such as sub-
brokers.
iza D
(v) Institutional Investment (Mutual Funds and Foreign
Having regard to the emerging nature of the securities markets
in India, the SEBI necessarily has the twin task of regulation
dfw P
Institutional Investment), Mergers and Acquisitions, and development. Its regulatory measures are always meant to
Research and Publications, and International Relations and be subservient to the needs of the market development.
IOSCO Department: It looks after policy, registration, Underlying those measures is the logic that rapid and healthy
regulation and monitoring of Foreign Institutional market development is the outcome of well-regulated
w.p m

Investors (FIls), domestic mutual funds, mergers and structures. In this spirit, the SEBI endeavours to create an
substantial acquisitions of shares, and IOSCO (International effective surveillance mechanism and encourage responsible and
Organisation of Securities Commissions) membership, accountable autonomy on the part of all players in the market,
ww Co

international relations, and research, publication and Annual who are expected and required to discipline themselves and
Report of SEBI. observe the rules of the market. The self-regulation and
regulation by exception are thus the comer stones of its
(vi) Legal Department looks after all legal matters under the regulatory framework. The SEBI believes that self-regulation
supervision of the General Counsel. can work only if there is an effective regulatory body overseeing
cu

(vii) Investigation Department carries out inspection and the activities of self-regulatory organisations.
investigation under the supervision of the Chief of The SEBI also aims at facilitating an efficient mobilisation and
Investigation: allocation of resources through the securities markets,
The SEBI has regional offices at Kolkata, Chennai and Delhi. It stimulating competition, and encouraging innovations. Its
Do

has also formed two non-statutory advisory committees regulation is expected to be flexible, cost -effective and
namely, the Primary Market Advisory Committee and Secondary confidence- inspiring. To investors, the SEBI provides a high
Market Advisory Committee with members from market degree of protection of their rights and interests through
players, recognised investor associations, and other eminent adequate, accurate, and authentic information and disclosure of
persons. such information on a continuous basis. To issuers, it provides
SEBI is a member of IOSCO, an international body a market place in which they can confidently raise all the finance
comprising of security regulators from over 100 countries. It they need in an easy, fair, and efficient manner. To the market
participates in the Development Committee of IOSCO, which intermediaries, it offers a competitive, professionalised and
provides a platform for regulators from emerging markets to expanding market with adequate and efficient infrastructure so
share their views and experiences. that they can render better and more responsible service to the
investors and issuers.

© Copy Right: Rai University


11.621.6 43
Table 2: Exchange wise Brokers Registered with SEBI As said earlier, with the repeal of the ClCA, all matters related to
MANAGEMENT OF FINANCIAL INSTITUTION

the issue of capital are now governed by the guidelines issued


by the SEBI. Similarly, as a result of the delegation of certain
powers under the SCRA to the SEBl, the latter can conduct
inquiries into the working of the stock exchanges which have to
-submit their annual reports to the SEBl and seek its approval
for amending their rules and bye-laws; it can direct them to
amend their bye-laws and rules including reconstitution of their
governing boards/councils; and it is empowered to license
security dealers operating outside their jurisdiction.
Consequent on the amendments to the SEBl Act in 1995, the
regulatory powers over corporate in the issuance of capital,
transfer of securities and other related matters are now vested in

al
the SEBI. The amendments also provide for the deletion of
the existing provision relating to disqualification of a member
of the SEBl Board on his being appointed as a director of a

i
company. The SEBl has also been empowered to demand

com Tr
explanations, to summon the attendance and call for
documents from all categories of market intermediaries in order
to enable it to investigate irregularities, impose penalties, and
initiate prosecution. The SEBl has also been empowered now
to notify its regulations and file complaints in courts without

rd. F
the prior approval of the GOI.
However, in the exercise of its powers and in performing its
Powers, Scope, and Functions
iza D
The scope of operations of the SEBI is very wide; it can frame
functions, the SEBl is bound by such directions on questions
of policy as the GOl may give in writing from time to time.
Although it has the opportunity to express its views before any
dfw P
or issue rules, regulations, directives, guidelines, norms in
respect of both the primary and secondary markets, direction is given, the decision of the GOI is final in every case.
intermediaries operating in these markets, and certain financial Questions to Discuss:
institutions. It has powers to regulate (i) depositories and
w.p m

1. Discuss the constitution and organization of SEBI.


participants, (ii) custodians, (iii) debenture trustees, and trust
deeds, (iv) FIls, (v) insider trading, (vi) merchant bankers, (vii) 2. Discuss the objectives and regulatory approach of SEBI
mutual funds, (viii) portfolio managers, and investment 3. What are the powers, scope, and functions of SEBI?
ww Co

advisers, (ix) registrars to issue and share transfer agents, (x)


Notes:
stock brokers and sub-brokers, (xi) substantial acquisition of
shares and takeovers, (xii) underwriters, (xiii) venture capital
funds, and (xiv) bankers to issues. The SEBl can issue
guidelines in respect of (a) information disclosure, operational
cu

transparency, and investor protection, (b) development of


financial institutions, (c) pricing of issues, (d) bonus issues, (e)
preferential issues, (f) financial instruments, (g) firm allotment
and transfer of shares among promoters.
Do

The SEBl is empowered to register any agency or intermediary


who may be associated with the securities market and none of
them shall buy, sell or deal in securities except under and in
accordance with the conditions of a certificate of registration
issued by the SEBI. However, the GOI is empowered to
exempt any person or class of persons from registration with
the SEBI. The SEBl can suspend or cancel a certificate of
registration issued by it to anyone, after giving him a reasonable
opportunity of being heard. The SEBl Act lays down the civil
and criminal penalties for contravention of the Act; anyone who
contravenes or attempts to contravene or abets contravention
of the provisions of the Act or of any rules or regulations
made thereunder, is punishable with imprisonment or fine or
both.

© Copy Right: Rai University


44 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 14:
THE SECURITIES AND EXCHANGE BOARD OF INDIA

Learning objectives • Bankers to an issue and portfolio managers have to be


After reading this lesson, you will understand registered with the SEBI. There were 77 bankers to issue
who were thus registered as of 31, March 1996. Similarly,
• Highlights of SEBI’s performance
there were 13 registered and 100 permitted portfolio
• Appraisal of SEBI’s work managers at the end of March 1996.
Let us move ahead with our discussion on SEBI. Let us now
Secondary Market and Intermediaries
discuss highlights and appraisal of SEBI’s work.

al
• The governing boards and various committees of stock
Highlights of Sebi’s Performance exchanges (SEs) have been recognised, restructured and
Since the enactment of the SEBl Act in 1992, financial broad-based.
institutions, agencies, and market intermediaries mentioned

i
• Inspection of all 22 SEs has been carried out to determine,

com Tr
above are now being governed by the guidelines, rules, and
inter alia, the extent of compliance with the directives of the
regulations notified by the SEBI from time to time. Due to lack
SEBI.
of space, it is not possible to present their exhaustive list here.
We give below only the major policy measures and reforms • Computerised 0r screen-based trading has been achieved on
introduced by the SEBl during 1992 to 1996. almost all exchanges except some of the smaller ones.

rd. F
• Corporate membership of SEs is now allowed, encouraged,
Primary Securities Market
and preferred. The Articles of Association of SEs have been
• The issues of capital by companies no longer require any

pricing it. iza D


consent from any authority either for making the issue or for
amended so as to increase their membership. All the SEs
have been directed to establish either a clearing house or a
clearing corporation.
dfw P
• Efforts have been made to raise the standards of disclosure • The Bombay Stock Exchange (BSE) has been asked to reduce
in public issues and enhance their transparency. The SEBI trading period or settlement cycle from 14 to 7 days for B
has accepted and implemented almost all the group shares.
recommendations of Malegam Committee appointed by it
w.p m

• A process through which investor grievances against brokers


in 1994-95 in this connection.
may find redressal through a complaint to the SEBI has
• The offer document is now made public even at the draft been put in place.
stage.
ww Co

• All the recommendations of the Dave Committee for


• Companies making their first public issue are eligible to do improving the working of the OTCEI have been accepted.
so only if they have three years of dividend-paying track
• The SEs have been instructed to set up independent market
record preceding an issue. Those not meeting this
surveillance departments. The SEBI has strengthened its
requirement can still make an issue if their projects are
own investigation and enforcement machinery.
cu

appraised by banks or FIs with minimum 10 per cent


participation in the equity capital of the issuer, or if their • In accordance with the recommendations of G.S. Patel
securities are listed on the OTCEI (Over-the-Counter Committee, BSE has been allowed to introduce a revised
Exchange of India). carry forward system (CFS) of trading. Other SEs can
introduce forward trading only with the prior permission of
Do

• For issues above Rs 100 crore, book-building requirement


the SEBI. Transactions are not allowed to be carried forward
has been introduced.
for more than 90 days now. The shares received by financiers
• The pricing of preferential allotment has to be at market funding carry forward transactions have to be deposited and
related levels, and there is a five-year lock- in period for such kept in the safe custody of the clearing house of the stock
allotments. exchange or its authorised agent. Every member is required
• In case of proportionate allotment scheme, a minimum of to keep books and records of the source of finance with the
50 per cent of the net offer to the public is to be reserved for sub accounts being maintained in the clearing house. The
individual investors applying for securities not exceeding scrip-wise carry forward position has to be disclosed to the
1000 securities, and the remaining part can be allotted market. The SEs are required to introduce the ‘twin track’
to applications for more than 1000 securities. system which will segregate transactions into carry forward
• Initially, the underwriting of issues to public was made and cash transactions, and each one of the former will be
mandatory, but now this stipulation has been removed. identified with a transaction identification number till its
During 1995-96, the SEBI granted registration to four final settlement.
underwriters, bringing their total number to 40. • The brokers are required to ensure segregation of client
account and own account.

© Copy Right: Rai University


11.621.6 45
• The capital adequacy norms of 3 per cent for individual schemes are required to be kept with an independent custodian.
MANAGEMENT OF FINANCIAL INSTITUTION

brokers and 6 per cent for corporate brokers introduced. ‘I’here has to be an arms-length relationship between the
• Both the brokers and sub-brokers have been brought within trustees, the asset management company, and the custodian.
the regulatory fold for the first time now; and the concept of The SEBI (Mutual Funds) Regulations, 1993 were revised to
the dual registration of stock brokers with the SEBI and the provide for portfolio disclosure, standardisation of accounting
SEs has been introduced. The total number of registered policies, valuation norms for determining net asset value and
brokers and sub-brokers was 8,746 at the end of March pricing.
1996, of which 1917 were corporate members. The UTI has been organised under the UTI Act, 1963, and it
• Penal action can now be taken directly by the SEBI against has evolved as a distinct institution. Therefore, certain special
any member of a stock exchange for violation of any dispensations have been provided to it under the SEBI
provision of the SEBI Act. regulatory framework. Subject to this, the UTI also has been
brought under the SEBI since July 1994. As a result, new
• It has been made mandatory for the stock” brokers to
schemes of the UTI also now fall under the jurisdiction of the
disclose the transaction price and brokerage separately in the

al
SEBI.
contract notes issued by them to their clients.
• The daily margin and additional margin for volatile scrips are Miscellaneous

i
now levied on a weekly and marked-- to-market basis. • FIls are also required to be registered with the SEBI. The

com Tr
• The SEs have amended their Listing Agreements such that total number of them so registered were 367 as of 31 March
the issuers have now to provide shareholders with cash flow 1996.
statements in a prescribed format, along with the complete • It is required that the capital of companies to be registered as
balance sheet and profit and loss statement. depositories must be Rs 100 crore. Similarly custodians are
• The trading hours in almost all the SEs have now been required to have a net worth of Rs 50 crore, and they are to

rd. F
increased from 21/2 hours to 3 hours per day. get their systems and procedures evaluated externally.
• Compulsory audit of the brokers’ books and filing of the • Venture capital funds (VCFs) allowed to invest in unlisted

iza D
audit reports with the SEBI has now been made mandatory.
• A system of market making in less liquid scrips on selected
companies, to finance turnaround companies, and to provide
loans.
dfw P
SEs has been introduced. • As per the approved modified takeover code recommended
by the Bhagawati Committee, the minimum public offer of
• Insider trading has been prohibited and such trading has
20 per cent purchase, when the threshold limit of 10 per cent
been made a criminal offence punishable in accordance with
equity is crossed, is made mandatory. Those in control are
w.p m

the provisions of the SEBI Act.


permitted to 2 per cent of shares per annum upto a
• Registrars to Issues (RI) and Share Transfer Agents (STA) maximum of 51 per cent. The acquirers have to deposit a
have now been classified into two categories: Category I with certain value of cash and assets in an escrow account. The
ww Co

a minimum net worth requirement of Rs 6 lakh who can escrow deposits have to be higher for conditional public
carry on the activities both as RI and STA, and category II offers unless the acquirer agrees to buy a minimum of 20 per
with a minimum net\worth requirement of Rs 3 lakh who cent.
can carry on anyone of these activities. There were 209 RI and
STA in Category I and 125 in Category II at the end of Investor Protection Measures
The SEBI has introduced an automated complaints handling
cu

March 1996.
system to deal with investor complaints. To create an awareness
• Till end-August 1997, merchant bankers (MBs) were
among the issuers and intermediaries of the need to redress
classified into four categories, each with different investor grievances quickly, the SEBI has been issuing
responsibilities and commensurate with capital requirements. fortnightly press releases publishing the names of the
Do

With effect from September 1997, such a classification has companies against whom maximum number of complaints
been abolished and there will be only one entity now, have been received. To help investors in respect of delay in
namely, merchant bankers. A system of penalty points for receiving refund orders in case of oversubscribed issues, a facility
MBs for defaults committed by them has been introduced. It in the form of stockinvest has been introduced. To ensure that
is provided that they can be suspended or deauthorised after no malpractice takes place in the allotment of shares, a
a maximum of 8 penalty points. The MBs have to fulfill representative of the SEBI supervises the allotment process. It
capital adequacy requirements also. During 1995-96, 231 MBs has also accorded recognition to several genuine, active investor
were granted registration, while registration of nine MBs was associations. It issues advertisements from time to time to
cancelled. The number of MBs was 1,012 in 1995-96 and 790 guide and enlighten investors on various issues related to the
in 1994-95. securities market and of their rights and remedies.
Mutual Funds
As on 31 March 1996, 26 mutual funds (MFs) excluding the
UTI were registered with the SEBI. MFs are required to have a
board of trustees or trustee company separate from the asset
management company, and securities belonging to the various

© Copy Right: Rai University


46 11.621.6
The complaints received by the SEBI are categorised in five There are many examples of this. The SEBI’s rejection of the

MANAGEMENT OF FINANCIAL INSTITUTION


types: Malegam Committee’s recommendation that new companies
• Type I: Non-receipt of refund orders/allotment letters/ should never be allowed to get listed on stock exchanges is one
stockinvests. such example. Its dispensing with the requirement of the
vetting of public and rights issues is another example. The
• Type II: Non-receipt of dividend.
dispensing with the requirements of minimum promoters’
• Type III: Non-receipt of share certificates/bonus shares. contribution and lock-in in the case of a company whose shares
• Type IV: Non-receipt of debenture certificates/interest on are listed on a stock exchange for at least three years is yet
debentures/redemption amount of debentures/ interest on another example. The appointment of another panel (J.R.
delayed payment of interest. Verma panel) by the SEBI on the carry forward system within a
• Type V: Non-receipt of annual reports, rights issue forms/ matter of one year of the presentation of the report by the G.S.
interest on delayed receipt of refund orders/ dividends. Patel Committee on the same subject, because of the
recalcitrance and pressures imposed by the stockbrokers, best
Appraisal of Sebi’s Work

al
reflects the fallibility, weaknesses, and the failure of SEBI. The
How has the SEBI performed so far? Has it been effective? The Verma panel reversed the recommendations of the Patel
SEBI’s task is no doubt challenging, complex and difficult, and Committee and recommended the production of virtually the
it needs to be fully supported in its efforts. But there are certain

i
old carry forward or badla system of trading. There have been
aspects of its working which need improvement and correction.

com Tr
instances of issues and other market activities, which the SEBI
1) The SEBI’s Annual Report, 1995-96 claims an increasing and ought not to have allowed but did, although it knew about the
a very high success rate in resolving investor complaints. But malpractices involved in them. The allotment of shares by
the reality is different. The market surveys conducted by L.C. Sterling Tea, and making of a right issue by New World Medical
Gupta revealed that 90 per cent of the respondent-investors India Ltd. are recent instances.

rd. F
felt that the system of dealing with investor complaints was 4) The regulatory ineffectiveness of the SEBI in certain cases
not effective; 85 per cent of shareholders felt that they were has been due to its concentration on symptoms rather than

iza D
not adequately protected; and 70 per cent of investors
indicated that they had actually suffered because of weak
investor protection. Price rigging, a serious menace to the
the root causes. The present settlement or delivery system is
highly conducive for manipulative operations and unhealthy
speculation. The SEBI has kept on tinkering with the trading
dfw P
investors, has, in fact, become more common in recent years. laws instead of doing away with such an outdated delivery
2) On reading the rules, regulations, guidelines, directions and system.
norms issued by the SEBI, one doubts whether one is living The SEBI’s failure appears to be partly deliberate also. There is a
in the “liberalised” or “prudential regulation as opposed to
w.p m

feeling among market watchers that, as in many other countries,


statistic control” environment at all. It is difficult to believe the SEBI as a regulator has been rather soft and unduly
that “self-regulation” and “regulation by exception” are really favourable to the securities industry; it has been more corporate-
the corner-stones of the SEBI’s regulatory philosophy. The
ww Co

friendly than investor-friendly.


number of rules, etc. prescribed by the SEBI has become too
large; it has been adding to, and changing them too often 5) It is imperative that the SEBI should become more effective,
and in a back and forth fashion. This has created a veritable efficient, socially accountable, and small-investor-friendly. It
maze of a plethora of regulations. This has led to a very has often complained of having insufficient authority and
high level of uncertainty and confusion. As L.C. Gupta has powers.
cu

rightly said, guidelines have grown by successive additions of Summary


clarifications and further clarifications to clarifications. In the Before the SEBI became a statutory body, the framework for
process, the guidelines have become incomprehensible. regulating the securities market or industry comprised of
According to some, they are so chaotic and confusing that it Companies Act, 1956, Securities Contracts (Regulation) Act,
Do

is difficult for anybody to determine what rules are currently 1956, and Capital Issues (Control) Act, 1947 .The SEBI was set
in force. As a result, SEBI officials may wield undue power up in 1988 through an administrative order, and it became a
by providing their own interpretation of the rules. statutory body in 1992. The SEBI is governed by a six-member
3) There is a widespread feeling in the financial markets that the Board of Governors appointed by the GOI and RBI.
SEBI is not really serious about reforming the system and Operationally, it is divided into seven departments. Its head
protecting the individual and small investors. It has quite office is at Mumbai and regional offices are at Delhi, Kolkata
often failed to penalise the people responsible for causing and Chennai.
abnormal price fluctuations on the stock market. There has Its objectives are to protect the investors, and to regulate the
been a lack of will, dithering and hesitancy on the part of financial system in order to bring about its healthy
SEBI to strike against the wrong doers. Even certain well-- development. Self-regulation and regulation by exception are
publicised market manipulations have gone unpunished. said to be the cornerstones of its policies. It seeks to increase
the efficiency of mobilisation and allocation of resources
through the securities market.

© Copy Right: Rai University


11.621.6 47
It has wide powers to issue rules, regulations, and guidelines in
MANAGEMENT OF FINANCIAL INSTITUTION

respect of both the primary and secondary securities markets, a


wide variety of intermediaries operating in these markets, viz.,
brokers, merchant bankers, underwriters, bankers to issues, etc.,
and certain financial institutions such as mutual funds.
Questions to Discuss:
1. Discuss the highlights of SEBI’s performance.
2. Appraise the work of SEBI.
Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


48 11.621.6
UNIT 3
COMMERCIAL BANK
LESSON 15:
COMMERCIAL BANKS

MANAGEMENT OF FINANCIAL INSTITUTION


Learning objectives Theoretical Basis of Banking Operations
After reading this lesson, you will understand Commercial banks ordinarily are simple business or commercial
concerns which provide various types of financial services to
• Introduction
customers in return for payments in one form or another, such
• Theoretical basis of banking operations as interest, discounts, fees, commission, and so on. Their
• Functions of the commercial banks and the services rendered objective is to make profits. However, what distinguishes them

al
by them from other business concerns (financial as well as
• General structure and methods of commercial banking manufacturing) is the degree to which they have to balance the
principle of profit maximisation with certain other principles.

i
• Employment of funds by commercial bankers
In India especially, banks are required to modify their

com Tr
Commercial banks are the oldest, biggest, and fastest growing performance in profit making if that clashes with their
financial intermediaries in India. They are also the most obligations in such areas as social welfare, social justice, and
important depositories of public saving and the most promotion of regional balance in development. In any case,
important disbursers of finance. Commercial banking in India compared to other business concerns, banks in general have to
is a unique system, the like of which exists nowhere in the

rd. F
pay much more attention to balancing profitability with
world. The truth of this statement becomes clear as one studies liquidity. It is true that all business concerns face liquidity
the philosophy and approaches that have contributed to the constraint in various areas of their decision-making and,

iza D
evolution of the banking policy, programmes and operations in
India. This however is too big a subject to be discussed here in
detail. We will therefore confine ourselves to presenting only an
therefore, they have to devote considerable attention to liquidity
management. But with banks, the need for maintenance of
dfw P
liquidity is much greater because of the nature of their liabilities.
outline of the said philosophy and approaches, and discussing Banks deal in other people’s money, a substantial part of which
the actual working of banks in detail. is repayable on demand. That is why for banks, unlike other
Commercial banks are organised on a joint stock company business concerns, liquidity management is as important as
w.p m

system, primarily for the purpose of earning a profit. They can profitability management.
be either of the branch banking type, as we see in most of the This is reflected in the management and control of reserves of
countries, with a large, network of branches, or of the unit commercial banks. They are expected to hold voluntarily a part
ww Co

banking type, as we see in the United States, where a bank’s of their deposits in the form of ready cash, which is known as
operations are confined to a single office or to a few branches cash reserves; and the ratio of cash reserves to deposits is
within a strictly limited area. Although the commercial banks known as the (cash) reserve ratio. As banks are likely to be
attract deposits of all kinds-Current, Savings and Fixed-their tempted not to hold adequate amounts of reserves if they are
resources are chiefly drawn from current deposits, which are left to guide themselves on this point, and since the temptation
cu

repayable on demand. So they attach much importance to the ‘may have extremely destabilizing effect on the economy in
liquidity of their investments and as such they specialise in general, the Central Bank in every country is empowered to
satisfying the short-term credit needs of business other than prescribe the reserve ratio that all banks must maintain. The
the long-term. Central Bank also undertakes, as the lender of last resort, to
Do

The banking system in India works under the constraints that supply reserves to banks in times of genuine difficulties. It
go with social control and public ownership. The public should be clear that the function of the legal reserve
ownership of banks has been achieved in three stages: 1955, requirements is two-fold: to make deposits safe and liquid, and
July 1969, and April 1980. Not only the public sector banks but to enable the Central Bank to control the amount of checking
also the private sector and foreign banks are required to meet deposits or bank money which the banks can create. Since the
targets in respect of sectoral deployment of credit, regional banks are required to maintain a fraction of their deposit
distribution of branches, and regional credit-deposit ratios. The liabilities as reserves, the modem banking system is also known
operations of banks have been determined by Lead Bank as the “fractional reserve banking”.
Scheme, Differential Rate of Interest Scheme, Credit Another distinguishing feature of banks is that while they can
Authorization Scheme, inventory norms and lending systems create as well as transfer money (funds), other financial
prescribed by the authorities, the formulation of the credit institutions can only transfer funds. In other words, unlike
plans, and Service Area Approach. other financial institutions, banks are not merely financial
intermediaries. This aspect of bank operations has been
variously expressed. Banks are said to create deposits or credit or
money, or it can be said that every loan given by banks creates a

© Copy Right: Rai University


11.621.6 49
deposit. This has given rise to the important concept of deposit There may also be leakages in the form of cash holding when
MANAGEMENT OF FINANCIAL INSTITUTION

multiplier or credit multiplier or money multiplier. The import the banks make loans. The process moves rather slowly and
of this is that banks add to the money supply in the economy, with jerks, and not as promptly and smoothly as implied.
and since money supply is an important determinant of prices, Subject to such qualifications, there is no doubt that modem
nominal national income, and other macro-economic variables, banks can create money in the process of their working.
banks become responsible in a major way for changes in
Functions of the Commercial Banks and the Services
economic activity. Further, as indicated in chapter one, since
banks can create credit, they can encourage investment for some Rendered by Them
time without prior increase in saving. The two essential functions of commercial banks may best be
summarized as the borrowing and lending of money. They
Let us briefly discuss the basis and process of creation of
borrow money by taking all kinds of deposits. Deposits may be
money by banks. In modem economies, almost all exchanges
received on current account whereby the banker incurs the
are affected by money. Money is said to be a medium of
obligation of paying legal tender on demand, or on fixed
exchange, a store of value, a unit of account. There is much
deposit account whereby the banker incurs the obligation of

al
controversy as to what, in practice in a given year, is the measure
paying legal tender after the expiry of a fixed period, or on
of supply of money in any economy. We do not need to go
deposit account hereby the banker undertakes to pay the
into that controversy here. Suffice it to say that every one agrees
customer an agreed rate of interest on it in return for the right

i
that currency and demand deposits with banks are definitely to

com Tr
to demand from him an agreed period of notice for
be included in any measure of money supply. Thus, apart from
withdrawals. Thus a commercial banker whether it is through
the currency issued by the government and the Central Bank,
current account or fixed deposit account, mobilizes the savings
the demand or current or checkable deposits with banks are
of the society. Then he provides this money to those who are in
accepted by the public as money. Therefore, since the loan
need of it by granting overdrafts or fixed loans or by
operations of banks lead to the creation of checkable deposits,

rd. F
discounting bills of exchange or promissory notes. Thus the
they add to the supply of money in the economy. To
primary function or a com-mercial banker is that of a broker
recapitulate, the money-creating power of banks stems from the

iza D
fact that modem banking is a fractional reserve banking, and
that certain liabilities of banks are accepted (used) by the public
as money.
and a dealer in money. By discharging this function efficiently, a
commercial banker renders very valuable service to the
community by increasing the productive capacity of the country
dfw P
and thereby accelerating the pace of economic development. He
The process of money creation works as follows. Assume that gathers the small savings of the people, thus reducing to the
the legally required reserve ratio is 10 per cent and that banks are lowest limits idle money. Then he combines these
maintaining just that ratio. Assume further that a bank in the smallholdings in amounts large enough to be profitably
w.p m

economy receives a brand new input of Rs. 1,000 of reserves employed in those enterprises where they are most called for
either as a deposit or as proceeds of a sale of government bond and most needed. Here, he makes capital effective and gives
to the Central Bank or in some other form. There is thus a industry the benefits of capital, both of which rise would have
ww Co

creation of Rs. 1,000 of bank money, but there is yet no remained idle. Take for instance, the practice of discounting
multiple expansion of money. If banks were required to keep bills. By converting future claims into present money, the
100 per cent cash reserve balances, no bank would be in a commercial banker bridges the time element between the sale
position to create extra money out of a new deposit of Rs.l,000 and the actual payment of money. This will enable the seller to
with it. catty on his business without any hindrance and the buyer will
cu

But since a bank is required to hold only 10 per cent of its get enough time to realise the money.
deposits as cash reserves, it now has Rs. 900 as excess reserves, Thus we have seen that a banker receives deposits, which he has
which it can utilise to invest or to give a loan. Assume that the to repay according to his promise, and makes them affordable
bank gives a loan of Rs. 900, and the borrower who takes the to those people who are really in need of them. He is actually
Do

loan in cash or cheque deposits it either with the same bank or distributing his deposits between the borrowers and his own
with some other bank. Either way, there has been a creation of vaults. Herein lies the most delicate of the functions of
money and the total amount of bank money created at this commercial bankers.
stage is Rs. 1,000 + Rs. 900 = Rs. 1,900. This process of
Besides these two main functions a commercial banker
creation can continue till no bank anywhere in the system has
performs a variety of other functions, which may be grouped
reserves in excess of the required 10 per cent reserve, and the
under two main heads viz., the agency services and the general
total money supply created in the economy is Rs. 10,000. The
utility services.
ratio of new deposits to the original increase in reserves is called
the money multiplier or credit multiplier or deposit multiplier. Agency Services
This multiplier will be equal to the reciprocal of the required A commercial bank provides a range of investment services.
reserve ratio. Customers can arrange for dividends to be sent to their bank
The process of creation of bank money does not work in and paid directly into their bank accounts, or for the bank to
practice to the full capacity or to the full potential as has been detach coupons from bearer bonds and present them for
described above. Banks may have a reserve ratio, which is higher payment and to act upon announce-ments in the Press of
than the required reserve ratio. drawn bonds, coupons payable, etc. Orders for the purchase or

© Copy Right: Rai University


50 11.621.6
sale of stock exchange securities are executed through the banks’ General Utility Services

MANAGEMENT OF FINANCIAL INSTITUTION


brokers who will also give their opinions on securities or lists These services are those in which the banker’s position is not
of securities. Similarly, banks will make applications on behalf that of an agent for his customer; They include the issue of
of their customers for allotments arising from new capital credit instruments like letters of credit and travellers’ cheques,
issues, pay calls as they fall due (that is, subscriptions to capital the acceptance of bills of exchange, the safe custody of
issues made over a period), and ultimately obtain the share valuables and documents, the transaction of foreign exchange
certificate or other documents of title. On certain agreed terms business, acting as a referee as to the respectability and financial
the banks will allow their names to appear on ap-proved standing of customers and providing specialised advisory
prospectuses or other documents as bankers for the issue of service to customers.
new capital; they will receive applications and catty out other By selling drafts or orders and by issuing letters of credit,
instructions. circular notes, travellers’ cheques, etc., a commercial banker is
A commercial bank undertakes the payment of subscriptions discharging a very important function. A banker’s draft is an
premia, rents and collection of cheques, bills, promissory notes order, addressed by one office of a bank to any other of its

al
etc., on behalf of its customers. It also acts as a correspondent branches or by anyone bank to another, to pay a specified sum
or representative of its customers, other banks and financial to the person concerned. A letter of credit is a document issued
corporations. by a banker, authorizing some other banker to whom it is

i
Most of the commercial banks have an executor and trustee addressed, to honour the cheques of a person named in the

com Tr
depart-ment; some may have affiliated companies to deal with document, to the extent of a stated amount in the letter and to
this branch of their business. They aim to provide, therefore, a charge the same to the account of the grantor of the letter of
complete range of trustee, executor or advisory services for a credit. A letter of credit includes a promise by the issuing banker
small charge. The business of banks acting as trustees, to accept all bills to the limits of credit. When the promise to
accept is conditional on the receipt of the documents of title to

rd. F
executors, administrators, etc., has continuously expanded with
considerable usefulness to their customers. By appointing a goods, it is called a documentary letter of credit. Where the
bank as an executor or trustee of his Will the customer secures promise is unconditional it is called a clean letter of credit.

iza D
the advantage of continuity, and avoids having to make
changes; impartiality in dealing with beneficiaries and in the
exercise of discretions; and the legal and specialised knowledge
Letters of credit may again be classified as revocable and
irrevocable. A revocable letter of credit is one, which can be
cancelled at any time by the issuing banker. But the banker will
dfw P
pertaining to executor and trustee services. When a person dies still be liable for bills negotiated before cancellation. An
without making a Will the next-of-kin can employ the bank to irrevocable letter of credit is, one, which cannot be cancelled
act as administrator and to deal with the estate in accordance before the expiry of the period of its currency. ‘Circular letter of
w.p m

with the rules relating to intestacies. Alternatively, if a testa-tor Credit’ is generally intended for travellers who may require
makes a Will but fails to appoint an executor, or if an executor money in different countries. They may be divided into
is unable or unwilling to act, the bank can usually undertake the traveller’s letters of credit and guarantee letters pf credit. A
travellers letter of credit carries the instruction of the issuing
ww Co

adminis-tration with the consent of the persons who are


immediately concerned. Banks will act solely or jointly with bank to its foreign agents to honour the beneficiary’s drafts,
others in these matters, as also in the case of trustee for stocks, cheques, etc., to a stated amount, which it under-takes to meet
shares, funds, properties or other investments. Under a on presentation. While issuing a guarantee letters of credit, the
declaration of trust, a bank undertakes the supervision of banker secures a guarantee for reimbursement at an agreed rate
cu

invest-ments and distribution of income; a customer’s of interest or he may insist on sufficient security for the grant
investments can be trans-ferred into the bank’s name or control, of the credit. There is yet another type which is known as
thus enabling it to act immediate-ly upon a notice of rights ‘Revolving Credit’. Here the letter is so worded that the amount
issue, allotment letters, etc. Alternatively, where it is not desired of credit available automatically reverts to the original amount
after the bills negotiated under them are duly honoured.
Do

to appoint the bank as nominee, these services may still be


carried out by appointing the bank as attorney. Where business Circular Notes are cheques on the issuing banker for certain
is included in an estate or trust, a bank will provide for its round sums in his own currency. On the reverse side of the
management for a limited period, pending its sale to the best circular note is a letter addressed to the agents specifying the
advantage as a going concern or transfer to a beneficiary. name of the holder and referring to a letter indication in his
Private companies wishing to set up pension funds may hands, containing a specimen signature of the holder. The note
appoint a bank as custodian trustee and investment adviser, will not be honoured unless the letter of indication is
while retaining the administration of the scheme in the hands presented. Travellers’ cheques are documents similar to circular
of the management of the fund. notes with the exception that they are not accompanied by any
letter of indication. Circular cheques are issued by banks in
Most banks will undertake on behalf of their customers the
certain Coun-tries to their agents abroad. These agents sell them
prepara-tion of income tax returns and claims for the recovery
to intending visitors to the country of the issuing bank.
of overpaid tax. They also assist the customers in checking of
assessments. In addition, to the usual claims involving personal Another important service rendered by a modern commercial
allowances and relief’s, claims are prepared on behalf of bank is that of keeping in safe custody valuables such as
residents abroad, minors, charities, etc. negotiable securities, jewellery, documents of title, wills, deed-

© Copy Right: Rai University


11.621.6 51
boxes, etc. Some branches are also equipped with specially All these money transmission services have particular regard to
MANAGEMENT OF FINANCIAL INSTITUTION

constructed strong rooms, each containing a large number of the developments in computerised book-keeping, which the
private steel safes of various sizes. These may be used by non- banks in some countries have already introduced. Some banks
customers for a small fee as well as by regular customers. Each are reported to be experi-menting with the use of electronic
licensee is provided with the key of an individual safe and thus machines, which will scan cheques and dispense notes or coins,
not only obtains protection for his valuables, but also retains thus saving time at the counter.
full personal control over them, The safes are accessible at any
Overseas Trading Services
time during banking hours and often longer.
Recognition of overseas trade has led modem commercial
For shopkeepers and other customers who handle large sums banks to set up branches specializing in the finance of foreign
of mon-ey after banking hours, ‘night safes’ are available at trade and some banks in some countries have taken interest in
many banks. Night safes take the form of a small metal door in export houses and factor-ing organisations. Assisted by banks
the outside wall of the bank, accessible from the street, behind affiliated to them in overseas territo-ries, they are able to provide
which there is a chute connecting with the bank’s strong room. a comprehensive network of services for foreign banking

al
Customers who require this service are provided with a leather business, and many transactions can be carried through from
wallet, which they lock before placing in the chute. The wallet is start to finish by a home bank or its subsidiary. In places where
opened by the customer when he calls at the bank the next day banks are not directly represented by such affiliated

i
to credit the contents into his account. undertakings, they have working arrangements with

com Tr
Another function of great value, both to bankers and to correspondents so that the banks are in a position to undertake
businessmen, is that of a referee as to the respectability and foreign banking business in any part of the world.
financial status of the customer. The banks provide more than just a means for the settlement
Among the services introduced by modern commercial banks of debts between traders both at home and abroad for the

rd. F
during the quarter of a century or so, the bank giro and credit goods they buy and sell; they are also providers of credit and
cards deceive special mention. The bank giro is a system by enable the company to release the capital which would otherwise
which a bank customer with many payments to make, instead be tied up in the goods exported. The following is an outline

iza D
of drawing a cheque for each item, may simply instruct his bank
to transfer to the bank accounts of his creditors the sum due
of some of the services provided by banks for overseas traders.
For centuries past the bill of exchange has been one of the chief
dfw P
from him, and he writes one cheque debiting his account with means of settlement in trade. Its function is to enable a seller or
the total amount. Credit advices containing the name of each exporter of goods to obtain cash as soon as possible after the
creditor with the name of his bank and branch will be cleared dispatch of goods, and yet enable the buyer or importer to
through the ‘credit clearing’ of the clearing house, which defer payment until the goods reach him, or later.
w.p m

operates in a similar way as for the clearing of cheques.


There are many ways in which trade may be financed with bills.
Even non-customers of a bank for a small charge may make use Two common ways are:
of this facility. A direct debiting service is also operated by some
ww Co

1. The exporter will draw a bill on the importer, or, by


banks. This service is designed to assist organisations, which
arrangement between the parties, on the importer’s bank, for
receive large num-ber of payments on a regular basis. A creditor
the amount of the export-er’s invoice for the goods, and to
is thereby enabled with the prior approval of the debtor, to
the bill attach the shipping documents which will convey title
claim any money due to him direct from the debtor’s bank
to the goods (usually an invoice, marine insur-ance policy,
account. To some organisations, for example, insur-ance
cu

and the ship owner’s receipt for the goods for the carriage,
companies, which receive, say, six equal sums on six dates in a
called a bill of lading). The exporter will sell (negotiate) the
year, the scheme is only an extension of the standing order
bill with the documents to local bankers, who with the
facility; but for the public utilities and traders which send out
documents and thus, in effect, the goods in their possession,
invoices for valuable amounts at differing times, the scheme is
Do

will be willing to pay the exporter practi-cally the full amount


an entirely new one.
of his invoice and bill; they will immediately forward the bill
Credit cards are introduced for the use of credit-worthy and documents to their banking correspondents or agents in
customers. Users are issued with a card on production of which the importer’s country, to be presented to the importer, or
their signature is accepted on bills in shops and establishments the import-er’s bank as the case may be, for payment if the
participating in the scheme. The banks thereby guarantee to bill is payable on demand, or for acceptance if the bill is a
meet the bill and recover from the cardholder through a single term bill.
account presented periodically. In some cases users are required 2. The importer’s bank, at his request, will arrange for its
to pay a regular subscription for the use of the service as well. banking correspondents or agents in the exporter’s country
An extension of the scheme allows the repayment of large to accept a term bill drawn on them by the exporter, and to
sums (subject to a maximum) over a period at interest. be accompanied by specified shipping documents mentioned
Some banks are opening budget accounts for credit worthy in the first example. (Such an arrange-ment is an example of
custom-ers. The bank guarantees to pay, for a specific charge, ‘opening credit’, which is mentioned below). When the bill is
certain types of annual bills (for example, fuel bills, rates etc.) accepted, it will be returned to the exporter, who can either
promptly as they become due, whilst repayments are spread keep it until the period of the bill expires and then claim
over a 12-monthly period from the customer’s current account.

© Copy Right: Rai University


52 11.621.6
payment from the accepting bank, or, as is more likely in In case where it is not possible to arrange a documentary credit

MANAGEMENT OF FINANCIAL INSTITUTION


practice, sell the bill to his own or other The accepting bank, and the arrangement is for payment to be made only when the
upon accepting the bill will detach the shipping docu-ments goods have been sold, a bank can usually undertake the dispatch
and send them to the importer’s bank. of the shipping documents and arrange the goods to be
If a bill is payable on demand, the importer, or his bank on his warehoused and insured in the name of a correspondent bank,
behalf if the bill is drawn on them, has to pay the whole sum pending delivery of the goods in part or in whole to the
when the bill is presented. exporter’s agent against payment. The correspondent bank will
then remit proceeds of sales as and when they are made by the
If the bill is drawn payable at a later date, for example, three
agent. Exporters who are dealing With first-class agents may be
months after presentation, it is, upon presentation, accepted by
prepared to ship their goods on open account. In such cases,
the importer if it is drawn on him, or by his bankers on his
the exporter usually sends the documents directly by air mail to
behalf if it is drawn on them by special arrangements. But the
the consignee, who acts as his agent for tile sale of the goods.
importer is not called upon to pay until the three months are
Remittances, in order to avoid the inconveniences of collection,
up.

al
may be by a cheque on an Indian bank or by a telegraphic
Usually the arrangement between the buyer and seller of the transfer.
goods will be that the shipping documents which accompany
the bill are to be detached upon payment or acceptance of the Information and other Services

i
bill, by whoever pays or accepts it namely, the importer or a As part of their comprehensive banking services, many banks

com Tr
bank on his behalf. The documents thus become available to act as a major source of information on overseas trade in all
the buyer, so that he can take delivery of the goods when the aspects. Some banks produce regular bulletin on trade and
ship arrives, re-sell them in the ordinary way, and from the economic conditions at home and abroad, and special reports
proceeds recoup himself or his bank, or make funds available to on commodities and markets. In some cases they invite
enquiries for those wishing to extend their foreign trade, and are

rd. F
meet the bill when it matures.
able through their correspondents to furnish the names of
An overseas buyer may arrange through his bank in the home
reputa-ble and interested dealers of goods and commodities

iza D
coun-try to open a documentary credit in favour of the seller.
This is an undertaking that the bank will honour drafts drawn
in accordance with the terms of credit, if accompanied by
and to advise on the appointment of suitable agents. For
businessmen travelling abroad letters of introduction,
indicating the purpose of journey taken, can be issued
dfw P
stipulated shipping documents, insurance policies, etc. and
addressed to banking correspondents in the various centres it is
presented not later than the date of expiry of the credit. The
proposed to visit. In this way it is often possible to establish
terms usually cover the nature, price and quantity of the goods,
new avenues of business. On request, banks obtain for
the methods of shipment, the documents to be attached and
w.p m

customers, for business purposes, confidential opinions on the


the date by which shipment must be effected. The credit or may
financial standing of companies, firms or individuals at home
undertake payment of a sight draft or acceptance of a term draft
or overseas.
and it may be expressed either in home currency or in foreign
ww Co

currency, this depending on the condition of sale. It may be Commercial bank furnish advice and information outside the
either revocable or irrevocable. The former may be cancelled at scope merely of trade. If it is desired to set up a subsidiary or
any time, but the latter cannot be cancelled without the consent branch overseas (or for an overseas company to set up in the
of both parties, and therefore provides much greater protection home country) they provide detailed information on local legal
to the exporter. requirements on company formation, tax requirements,
cu

exchange control and insurance, and they help to estab-lish


If, say, a foreign importer has no account with an Indian bank,
contact with local banking organisations.
he will open the credit with his local bank. The exporter may,
however, prefer to receive a corresponding advice that the credit To sum up, the service rendered by a modem commercial bank
is opened from an Indian bank. Consequently, it is usual for the is of inestimable value. It mobilizes the scattered savings of the
Do

foreign bank to instruct its Indian banking correspondent to community and redistributes them into more useful channels.
advise the credit to the exporter. As an additional safeguard, an It enables large pay-ments to be made over long distances with
Indian exporter may require his bank not only to advise but minimum expenses. It consti-tutes the very life blood of an
also to undertake responsibility by adding its confirmation. advanced economic society. In the words of Walter Leaf: “The
This is known as a ‘confirmed credit’. Having received the banker is the universal arbiter of the world’s econo-my,”
advice, on shipment of the goods, the exporter must lodge the General Structure and Methods of Commercial
documents within the time allowed by the credit. If the
Banking
documents are in order as stipulated in the credit, the exporter
will then receive immediate payment if it pro-vides for sight Certain Sound Commercial Banking Principles
payment; if it calls for a bill drawn payable after sight, the bank Just as in the case of any other commercial enterprise, the
will accept the bill, which will then be available for discount. If commer-cial banks also strive to earn a profit. But is profitability
for any reason the exporter in unable to present the document everything, which a banker should pay attention to? Can a
he must request the importer to instruct bank to extend or commercial banker employ his funds in a risky manner in
amend the credit. anticipation of wild fall profits? The answer is definitely in the
negative. He is a custodian of other’s surplus funds. Therefore

© Copy Right: Rai University


11.621.6 53
while earning a profit he should never forget the fact that he is a via media between liquidity and profitability while selecting his
MANAGEMENT OF FINANCIAL INSTITUTION

doing business with others funds, which he acquires be-cause assets.


of his credit. We have seen that these deposits are either
Employment of Funds by Commercial Bankers
repayable on demand or after the expiry of a fixed period. In
Generally, the following are the important items seen on the
either case he must be ready to meet the liabilities as and when
asset side of the Balance Sheet of a bank.
necessary and, as such, he has many outstanding contracts for
the future delivery of money. • Cash in hand.
• Money at call and short notice.
In case of failure, he will suffer in his credit on which the very
foundation of his business stands. Not only will he feel the • Bills discounted.
shock of such a failure, but also it will be transmitted to the • Investments.
other links of the banking organisation, thereby precipitating • Advances to customers.
nation-wide bank failures. So banker should always bear in
mind that he is guardian of a very delicate mecha-nism, which These items are given in the order of liquidity.

al
paves the way for future economic development and. which, if The first item appearing on the asset side of bank’s balance
disturbed, will create monetary disequilibria with all the evil sheet is cash in hand, including cash reserve at the central bank
effects incidental thereto. Obviously, a banker should take the and demand deposits with other banks. This is the most liquid

i
necessary precautions 10 keep his assets as ‘liquid’ as possible. of all assets. From the point of view of profitability, a banker is

com Tr
But what is meant by liquidity? tempted to minimise his cash holdings; while from the point
By liquidity we mean the capacity to produce cash on demand. of view of liquidity, he is tempted to maximise his cash
No doubt the most liquid asset is cash in the vaults of a bank. holdings. To maintain more resolves than what is necessary is
It is necessary for a banker to keep a certain percentage of the to impair the profits. The English bankers usually maintain a
cash ratio of 8 per cent while, in India, a higher cash ratio is

rd. F
deposits in the form of liquid cash as reserve, either in his own
vault or with his bank, generally the central bank. But such desirable owing to the undeveloped and unpredictable nature
liquid cash does not earn anything and it is purely idle money, of the money market.

iza D
intended to provide the necessary liquidity by meeting the
immediate withdrawals of deposits. As a rule, successful
banking is dependent on the capacity of these reserves to meet
A banker is generally guided by experience in deciding what
propor-tion of his deposits in cash will enable him readily to
meet all demands. In addition to the minimum requirements
dfw P
the immediate requirements. When liquidity is provided by indicated by experience, a good banker must necessarily allow
liquid cash, a banker should invest his excess money in. some for unpredictable needs. In this con-nection certain important
assets, which are liquid in nature and at the same time, which considerations influencing the cash resolves of a banker may be
w.p m

earn an income. pointed out.


Briefly, we may explain the liquid assets as those, which can be In the first place, if the customers are highly banking minded,
turned into, cash quickly and without loss, to meet the the need for liquid cash will be small because in that case
ww Co

customer’s claims. But if an asset is to be turned into cash depositors will seldom demand the payment of legal tender
quickly, it must be shift able in nature, i.e. the liquidity of an currency and will content themselves by the transfer of rights
asset depends on the question of shifting it to the central bank which the bank can do by mere book entries. Secondly the
or to others willing to supply cash. For instance if a blinker habits of the customers, and the business conditions of the
holds a first class bill of exchange, among his other assets, locality have an important bearing of the cash reserves. Certain
cu

which satisfies the eligibility rules of the central bank, it can be businesses carried on by the depositors may make heavy
rediscounted with the central bank, when the banker is short of occasional de-mands which the banker will have to meet with
funds. A government security satisfies the quality of an idle adequate provision of liquid cash. Thirdly, it is also dependent
asset, viz. shift ability because it is in great demand in the stock on the resolves kept by other banks of the locality. If certain
Do

exchange. But liquidity implies not only shift ability but also banks are keeping higher amounts of resolves, other banks will
shift ability without loss. To take an example, the ordinary be compelled to increase their cash ratio in their bid for
shares of an industrial concern may be shift able but only at a popularity. Further the nature of accounts and the size of
discount. Here shiftability is possible only at a loss and hence average deposits also influence the resolves. For instance, if the
the asset cannot be considered as a sound banking asset. accounts are of a fluctuating nature, a higher cash resolve may be
The conclusion that we arrive at from the above discussion is required. So also the resolves of a bank having only a few large
that commercial bankers, while employing their funds, should deposits will be generally large because of the chance of heavy
pay regard both for profitability and liquidity. And liquidity in demands. On the other hand, if the bank has a large number
its turn is dependent on shiftability without loss. It is a point of small sized deposits, the danger of large withdrawals by any
to be remembered always that liquidity should not be sacrificed individual customer will be less and hence it need not keep a
at the alter of profitability. At the same time no less important large amount of liquid cash. Again, the presence of a bankers’
is it to remember that to maintain excessive liquidity is to clearing house greatly reduces the need of liquid cash to be kept
sacrifice earnings, without which banking operations cannot be by a bank because he has only to provide for the difference
carried on successfully. A good banker would, therefore, follow between the cheques drawn by him on other banks. Lastly, the

© Copy Right: Rai University


54 11.621.6
banker has to take into account probable receipts of cash by the

MANAGEMENT OF FINANCIAL INSTITUTION


bank and probable demands upon it, in the near future.
Thus the ratio of liquid cash to deposits, which a banker
should maintain is dependent upon a number of
considerations. It varies from place to place and from banker to
banker. Therefore, no hard and fast rule can be laid down as to
the exact cash ratio, which a banker should maintain. He has to
give due consideration to the various factors dis-cussed above
and has to decide himself the amount of liquid cash which he
should maintain. In this connection, it may be pointed out that
commercial bankers, in most countries, are required to maintain
a minimum reserve of liquid cash, through legislation.
Questions to Discuss:

al
1. What is the theoretical basis of banking operations?
2. Discuss the functions of the commercial banks and the

i
services rendered by them.

com Tr
3. Discuss the general structure and methods of commercial
banking.
4. Discuss the employment of funds by commercial bankers.
Notes:

rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 55
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 16:
LENDING FUNCTION

Learning objectives Need for Credit


After reading this lesson, you will understand Just as there are two reasons for the banks to extend the credit
function, there are also two reasons for the demand for credit.
• Need for lending
Firstly, on the demand side of the economy are the consumers
• Need for credit of goods and services who require funds basically for acquiring
• Types of credit certain assets like consumer durables. And secondly, on the
• Nature of Credit supply side, the need for credit arises from the corporate in the

al
manufacturing, trading and services sectors. These corporate
• Security Offered for Loans
basically require funds for long-term investment as well as for
• Purpose of Loan day-to-day operations. Thus the need for credit arises from the

i
Need for Lending supply side as well as the demand side of the economy. Thus,

com Tr
Having raised the funds the banks will have to ensure that the at any point of time, in the credit market, there will always be
same will be deployed into proper avenues so that they sustain some players to extend credit and a few others who will be
profitably. The two major applications of banking funds are seeking credit. However, to ensure that the borrowing and
credit accommodation and investments in securities. Of these, lending takes place in the credit market, the needs of the

rd. F
the former has evolved as the prime function of the banks both borrower should be met by the lender. In order to facilitate this,
due to the regulatory prescriptions as well as for profitable different types of credit facilities have originated in the credit
sustenance. market.

iza D
According to Section 6 of the Banking Regulation Act, 1949, the
business of banking is defined as follows:
Types of Credit
Most of the credit facilities that are offered in the credit market
dfw P
“Banking means accepting for the purpose of lending or are in the form of loans. A loan is a broad term used to explain
investment of deposits of money from the public, repayable the different types of short/medium and long-term credit
on demand or otherwise, and withdrawable by cheque, draft, facilities extended in the credit market. Irrespective of their
order or otherwise.” nature, all loans are contractual agreements entered into by the
w.p m

borrower of the funds with the lender of the funds. The


Thus, as per the statute, all banking firms will have to
agreement states the terms and conditions such as loan
necessarily perform the role of a lending organisation. While
amount, repayment period, rate of interest, terms of
ww Co

other financial institutions and NBFCs also share the corporate


repayment, nature of security, penal provisions for breach of
finance activity along with banks, there is, however, a marked
contract, etc.
difference in the credit facilities offered by each type of these
intermediaries. Depending on their need for credit, the borrower will select the
type of credit facility that suits their cash flow requirement and
The other major reason of the lending function is to add value
that which is a low cost option. To meet the varied
cu

to the bank. By lending the funds mobilized by it, a bank will


requirements of the borrower, banks have also developed a
be in a position to earn spreads to sustain profitably.
variety of credit facilities. The development of these credit
Profitability through lending will be obtained if the bank is in a
facilities essentially depends on three parameters: Purpose of
position to take and manage credit risk that arises on account of
credit, Nature of credit and Security offered.
Do

the quality of the borrower and liquidity risk that may arise by
borrowing short and lending long in order to attain greater As mentioned earlier, the credit requirement arises from both
spreads. Further, the spreads earned in this activity will also be the demand and the supply side of the economy. The loans
exposed to risks arising both from interest rates and the that are extended to the supply side can be classified, as
exchange rates. commercial loans while the demand side loans will be
individual loans. Commercial loans are extended for two
Thus, while lending, the bank should essentially try to balance
purposes: Firstly, to acquire fixed assets and secondly, for the
its spreads and the risk levels. The significance of the lending
purpose of maintaining/running the business. Likewise, there
activity to the banking business can further be explained by the
are broadly three purposes for the individual loans:
fact that a shrinkage in the credit asset portfolio leads to greater
consumption, acquisition of durables and housing finance.
impact on the NII of the bank when compared to the
This classification of the credit facilities into commercial and
shrinkage in any other asset in its portfolio.
individual credit facilities is simple and broad but it does not
The need for lending thus arises both due to the regulatory help understand the critical aspects of the lending activity. To
prescriptions as well as for profitability purpose. Having enable such understanding, we shall examine the loans as
understood the need for lending, let us also look into the need described by the banks in their annual reports. Banks present
for credit. their entire advances in three different ways based on the nature

© Copy Right: Rai University


56 11.621.6
of credit, the type of security and the purpose of the loan. normally seen in trading concerns and manufacturing concerns,

MANAGEMENT OF FINANCIAL INSTITUTION


Using these parameters, there will be further classification of the which may have a retail outlet, which is more an exception. This,
banks’ advances, which are examined here. however, is not possible in the normal course and may happen
when there is a geographical distance existing between the seller
Nature of Credit
and the buyer. In such circumstances, there will be a time lag
On considering the nature of the loan, the advances of banks
before the buyer actually receives the goods, thereby leading to a
can be further classified into the following three types:
time gap between the time goods are dispatched and the
• Installment Credit payment is received. Thus, it can be observed that even a cash
• Operating Credit sale will result in receivables for the seller. Funding of these
• Receivable Finance receivables through internal sources by the company may not be
feasible, especially due to the volume of funds required for
Installment Credit:
extending such credit.
In this type of finance, once the credit amount is decided, the
bank will disburse the amount either at one go or in stages All receivables, created either due to cash or credit transactions,

al
depending on how a project gets implemented. The repayment will lock the funds of the firm. Banks offer receivable finance
process, which is generally on installment basis, will commence facility, which imparts liquidity to these receivables. When there
after the entire credit amount is disbursed. The installments can is a payment lag due to the geographical consideration, the bank

i
be monthly, quarterly, half-yearly or annual payments. The acts as an intermediary, collecting funds from the buyer on

com Tr
frequency of the installment depends on the cash flow stream behalf of the seller. Such facility will be fee-based since the bank
of the borrower. Based on this repayment schedule, the tenor does not actually extend any credit and only enables the
of the credit facility is decided. This forms the base for the collection of funds. This does not result in extending credit.
classification of the loans into short, medium or long-term When bank extends credit, it will instead of collecting funds
from the buyer and passing it over to the seller, will actually

rd. F
loans. When the tenor is less than three years, it is a short-term
loan. Such loans are generally extended to households for the provide credit for the sale and will collect the funds from the
purchase of consumer durables. When the tenor ranges from 3- buyer at a later point of time. This is the fund based receivables

iza D
5 years, it is a medium-term loan’ which is generally required by
the small and medium-sized firms for acquiring fixed assets.
financing facility offered by the bank.
When receivable finance is extended either for cash sales or credit
sales, there will be a few essential documents for bill financing
dfw P
And in cases where the repayment period exceeds 5 years then a
long-term loan facility that is extended to large corporate/ viz. bill of exchange document of title to goods (lorry/rail way
projects for the acquisition of fixed assets during project receipt, airway bill), invoice, etc.
implementation stage. Bill of Exchange (B/E)
w.p m

Operating Credit: In most of the cases, when credit is sought through receivable
Unlike the installment credit, the operating credit is for meeting finance, a B/E will be created. A B/E is a negotiable
the financial requirements of the daily operations. Since the firm instrument. In terms of Section 5 of the Negotiable
ww Co

cannot know its exact requirements on any given day, the bank Instruments Act, 1881, a B/E is an instrument in writing
provides an operating account (current account) after deciding containing an unconditional order, signed by the maker (in this
on the credit limit. The firm can withdraw from this account case the seller), directing a certain person (in this case the buyer)
using a cheque facility as and when it requires the funds. The to pay a certain amount of money only to, or to the order of, a
repayment mechanism for such credit facility is also different certain person (in this case a bank) or to the bearer of the
cu

from the installment credit. The firm will repay into the same instrument.
current account as and when it has surplus cash. Generally, this Lorry Receipt (LR)/Railway Receipt (RR)/Airway Bill
credit is extended for a period of 1-2 years, but since the firms These documents are evidences of dispatch of goods and
are going concerns, this credit facility may actually be rolled over
Do

holders of these documents are entitled to take delivery of the


every year. This makes the operating credit a permanent credit underlying goods. These are also sometimes known as quasi-
facility. The forms of credit that can be categorised here are the negotiable instruments.
cash credit facility and the overdraft facility. The major
distinction between these two credit facilities is that the cash Invoice
credit facility is sanctioned against inventory while the overdraft The invoice that has been raised for the sale transaction indicates
facility is generally against any other security. the value of the underlying goods.

Receivable Finance: The requirement or non-requirement of each of the above


The other type of credit is receivable finance where the firm gets mentioned documents depend on the type of receivable finance
credit in the form of bill finance. Sale transactions of a firm are that is being offered. Further, depending on the key documents
generally either in cash or credit form. In credit sales, as it is involved in bill finance, the bills can be classified into two types
observed, payment will be made at a predetermined time after — Demand Bills and Usance Bills. When there is a demand
the sale has actually taken place. This results in the creation of bill, it means payment is to be made on demand. When the sale
receivables for the selling firm. In cash sales, it is, however, is on a credit basis, the amount is payable on a specified due
considered that the payment will be made immediately as in the date, it will usually involve a Usance Bill. If the specified due
case of an over-the-counter sale. Such sale transactions are date is after the bill date (every bill will be dated), the terms of

© Copy Right: Rai University


11.621.6 57
payment is known as “Days After Date” and if the specified guarantee of a bank/government are categorised as “Advances
MANAGEMENT OF FINANCIAL INSTITUTION

date is after the bill is presented to the buyer, then the terms of covered by Bank/Government Guarantees” and hence are not
payment will be known as “Days After Sight”. Within this reported under unsecured loans category.
broad classification, depending on the mode of financing, bills
Secured Advances:
can be further categorized as:
Secured advances on the other hand, have impersonal security
• Clean Bills i.e. the security has to be a tangible asset against which the loan
• Documentary Bills is to be granted. Primary Security is an asset against which the
• Supply Bills loan is given and Collateral Security is a security, which is given
in addition to the existing primary security. These primary and
Clean Bills: collateral securities can be movable or immovable assets and
In transactions where the seller would have already delivered the depending on the same the charge created on the security may
goods and the documents to the buyer, the seller can avail the vary.
receivables finance facility using the Clean Bill. The seller can avail Charge on the movable properties can be created in the

al
this facility without any supporting documents. Since the following five different ways:
delivery of goods and documents has already taken place, it
• Pledge
implies that the transaction would have been on credit basis.

i
Hence, a Clean Demand B/E can be raised in this case. • Hypothecation

com Tr
• Assignment
Documentary Bill:
In certain cases, the seller would have only dispatched the goods • Banker’s Lien
without transferring the document of title for goods and/or • Set-Off
invoice, etc. In such cases, the seller can avail the bill finance A brief discussion on each of these methods of creating a

rd. F
facility through the Documentary Bill. To suit the cash and charge on security is followed hereunder.
credit sales, a Documentary B/E can be either a Documentary
Pledge:

iza D
Demand Bill or a Documentary Usance Bill. When the
transaction is a cash sale, the Documentary Demand Bill is used
in which case the buyer has to pay the bank the amount and
According to Section 172 of the Indian Contract Act, 1872,
pledge is defined as: “Pledge is a contract whereunder deposit
dfw P
collect the documents. In the case of a credit sale, using the of goods is made a security for a debt and the right to property
Documentary Usance Bill, the buyer collects the documents first vests in the pawnee so far as it is necessary to secure the debt.”
without payment by accepting the bill. On the due date of the In other words, a pledge arises when the lender or the pledgee
bill, the buyer has to pay to the bank the bill amount. In both takes possession of the goods or bearer securities for extending
w.p m

the cases the seller avails the finance from the bank. a credit facility to the borrower or the pledgor. The pledgee can
retain the possession of the goods until the pledgor repays the
Supply Bill: entire debt amount and in case of a default, the pledgee has the
A Supply Bill is used in a buyers market i.e. when the buyer is a
ww Co

right to sell the goods in his possession and adjust its proceeds
large corporation or a government body; the seller has to first towards the amount due.
deliver the goods without raising the B/E. After the buyer is
The delivery of goods in a pledge can be either by actual delivery
satisfied with the quality of the goods, then the invoice has to
or constructive delivery. In the former case, the pledgor will
be raised. The documents like B/E and LR/RR will not be
handover the physical possession of the goods to the pledgee.
cu

available in this case. In the absence of such supporting


Such type of lending is done by the pawn broker. In the case of
documents, the seller can avail the receivable finance facility by
constructive delivery, there is symbolic delivery of goods, i.e. for
providing the evidence of the delivery of the goods.
example, the pledgee may be given possession of the key to the
The classification discussed above is based on the nature of store in which the pledged goods are present or there may be a
Do

loan. The second parameter that is used for classifying the loans transfer of the bill of lading. Such type of lending is usually
is the security of the loan. Security for the loans can be personal considered by a bank.
or impersonal. Based on the type of security, all advances made
While lending against pledge, the bank always maintains a
by the banks to any type of borrower can be classified into
margin between the value of the goods and the amount of
unsecured or secured advances.
credit allowed. For instance, if the bank is extending a credit of
Security Offered for Loans Rs.l lakh against the pledge of goods, then the value of the
Loans are generally c1assified into secured or unsecured loans. goods pledged should be more than Rs.l lakh. Further, in a
The features of these two types of loans are discussed below: pledge transaction, the underlying goods are usually either the
Unsecured Advances: raw material or the work-in-process or the finished goods.
When the advance given by the bank has a personal security of These would be required by the borrower in the regular course
any individual or the borrower with or without a guarantor, it of business. In such a case the borrower needs to take prior
will be c1assified as an unsecured advance. In the absence of any approval from the bank to withdraw any goods that are pledged
tangible security, though personal security is given by an with the bank since the goods will be in the custody of the
individual by way of an obligation for repayment, the loans are bank. In addition to this, the borrower will also have to submit
treated as unsecured. However, all those loans that have the

© Copy Right: Rai University


58 11.621.6
statements to the bank for additions or withdrawals made to Thus, a bank has the right to retain all forms of securities or

MANAGEMENT OF FINANCIAL INSTITUTION


these goods that represent the pledge transactions. negotiable instruments deposited by or on behalf of the
debtor in the ordinary course of its banking business and use
Hypothecation:
the proceeds of the same towards adjusting the debt obligation
Hypothecation is also a way of creating a charge against the
of the borrower.
security of movable assets much similar to pledge. However,
pledge is a charge, which is defined by law whereas Set-off:
hypothecation is not. In case of pledge, the assets are in the Set-off can be treated as the right of lien, the only distinction
custody of the lender, real or constructive, whereas in case of being that lien relates to goods or any other property on which
hypothecation the assets are in the custody of the borrower. the bank as a creditor has a right, while a set-off is a lien on any
Hypothecation is to be registered under Section 125 of the amount of the debtor that is due from the bank. Simply put,
Indian Companies Act, 1956 when the hypothecator is a set-off is a legal right by which the bank as a creditor is allowed
company, while no such provision exists in case of charges by to use its own debt obligation (i.e. amount that the bank is
way of pledge. In case of Hypothecation, the goods are not allowed to set-off against the repayment of the credit facility it

al
kept under the lock and key of the banker. The borrower, had offered to the debtor). Such right exists when the amount
however, will have to submit a statement on the goods of the debts are certain, when the parties are the same and when
indicating the additions and withdrawals of the same to the there is no contract, express or implied to the contrary.

i
bank. All the above mentioned methods of offering security are

com Tr
In addition to the fact that the bank does not have the related to movable assets. However, apart from movable assets,
possession of the goods under Hypothecation, it is also a fact there can also be immovable properties that are offered as
that there is no statutory status given to a Hypothecation security. The process of offering immovable, as security is
transaction. In this regard, it is, however, to be noted that known as Mortgage.

rd. F
Hypothecation has a close link to floating charge. While there is Mortgage
no law governing the Hypothecation of goods, Section According to Section 58 of the Transfer of Property Act, 1882, a
125(4)(f) of the Companies Act, 1956 that refers to the Floating

iza D
Charge on undertaking or any property, may be related to
Hypothecation. As per this Section, floating charge, creates an
mortgage is defined as follows: “Mortgage is the transfer of an
interest in specific immovable property for the purpose of
securing the existing or future debt, or the performance of an
dfw P
immediate charge on the property charged but however, allows engagement which may give rise to pecuniary liability.” Thus
the borrower to use the property for its business just as in the through a mortgage, the interest and the rights on the
case of Hypothecation. This makes the charge in Hypothecation mortgaged property are transferred from the mortgagor
transaction similar to the type of floating charge. (borrower) in favor of the mortgagee (bank). The principal and
w.p m

Assignment: the interest amount that has been secured for is known as
Assignment is a charge in case of an “Actionable Claim” which mortgage-money. There are essentially, six ways of
is defined under Section 3 of the Transfer of Property Act, 1882 mortgaging:
ww Co

as follows: • Simple Mortgage


“Actionable claim means a claim to any debt, other than a debt • Mortgage by Conditional Sale
secured by mortgage of immovable property or by
• Usufructory Mortgage
Hypothecation or pledge of movable property, or to any
• English Mortgage
cu

beneficial interest in movable property not in the possession,


either actual or constructive, of the claimant, which the civil • Equitable Mortgage
courts recognise as affording grounds for relief, whether such • Anomalous Mortgage
debt or beneficial interest be existent, accruing, conditional or
Of the different types of mortgages mentioned above, simple
Do

contingent. “
mortgage and equitable mortgage are the most important.
Assignment is a charge created on assets such as receivables,
A simple mortgage takes place without delivering possession of
debtors, etc. For example, policyholders can take a loan against
the mortgaged property. This type of mortgage binds the
the Life Insurance policy from a bank. In such cases, the LIC
mortgagor to pay the mortgage-money expressly or impliedly,
policy is assigned by the policyholder to the bank. If a bank
and in case of any failure to repay the amount, the mortgagee
finances a firm against book debts, then such book debts are
has the right to sell the mortgaged property and use the
assigned to the bank.
proceeds of the same towards the payment of the mortgage-
Lien: money. Such a mortgage is created through a document known
Banker’s Lien is a general lien and is defined under section 171 as “Deed of Mortgage” and is usually registered with the
of the Indian Contract Act, 1872 as follows: “Bankers, factors, Registrar of Assurances.
wharfingers, attorneys and policy-brokers, may, in the absence An equitable mortgage arises when a mortgagor delivers to the
of contract to the contrary, retain as a security for a general creditor the documents of title to immovable property, in order
balance of account, any goods bailed to them; but no other to create a security on the same at certain places, which are
persons have a right as a security for such a balance, goods notified, in the official gazette. It will be necessary to deliver the
bailed to them, unless there is an express contract to that effect.” documents at these specified places by the borrower to the

© Copy Right: Rai University


11.621.6 59
creditor irrespective of location of the property and residential For the above mentioned sectors, the RBI has issued guidelines
MANAGEMENT OF FINANCIAL INSTITUTION

status of the borrower or lender. Equitable mortgage is also for the amount of financing that have to be done for various
known as mortgage by deposit of title-deeds. sectors. Apart from such guidelines, RBI has identified the
Having discussed the classification of loans based on the sectors where the financing facility offered is much less than
security offered, we now proceed towards the last type of what is required and set targets for the banks to meet while
classification of advances as given in a bank’s balance sheet financing these sectors. While there were many neglected sectors,
which is based on the purpose of the loan. it was primarily the agricultural and the SSI sector that were of
major concern. India being an agrarian economy and with most
Purpose of Loan of its population living in the rural and semi-urban areas, the
There are basically three purposes for which the banks extend development of the agricultural and the SSI sectors was crucial
their loans and based on these purposes the sectorial for the economic development of the nation. Considering this,
classification of banks’ advances are made. Ever since the RBI has set targets as follows:
nationalisation, the banks have been providing financial
• Agricultural Sector: The advances given to the agricultural
assistance to the neglected sectors of the economy. Accordingly,

al
sector are classified into direct and indirect advances and the
the RBI has laid down specific guidelines to direct funding for
combined target for these two types of advances was set at
these sectors. Apart from this, advances are also made to the
18 percent.
public sector units. Based on such advances, the sectorial

i
classification of loans has accordingly been made as under: • SSI Sector: While there is no target set for the advances to

com Tr
be made for the SSI sector as a whole, there is a sub-target of
• Priority Sector
40 percent set for the advances made to the cottage
• Public Sector
industries, khadi and village industries, artisans, tiny
• Banking Sector industries (plant and machinery outlay up to Rs.25 lakh) or

rd. F
• Others other SSI units availing credit up to Rs25 lakh.
Priority Sector Advances The other guidelines issued by the RBI that govern the priority
sector lending to various sectors are given below.

iza D
In order to channelise the flow of credit to certain key sectors of
the economy, the RBI, in the credit policy for 1967-68, has
identified the priority sectors. Initially, the priority sector
Agriculture
As mentioned above, the advances made to the agriculture
dfw P
comprised of agriculture, exports and small-scale industries sector are of two types -direct and indirect. Direct loans include
(SSI). Following this, banks were given a target of one-third of both short-term and medium-term loans. For the short-term,
the outstanding credit to the priority sector by the end of farmers are given credit against Pledge/Hypothecation of
March, 1979. Subsequently, in 1985, the floor for the priority agricultural produce (including warehouse receipts) for a period
w.p m

sector advances was set at 40 percent and within this target, a not exceeding 6 months. The credit amount involved, for such
sub-target of 10 percent is set for the weaker sections. The RBI’s crop loans is Rs.1 lakh. The medium-term loans are extended
definitions for the priority sector and the weaker sections within for the purpose of the purchase of agricultural implements and
ww Co

this priority sectors are given below: machinery, development of irrigation potential, reclamation and
• Priority Sector - Agriculture., Small-Scale Industries SSI), land development schemes, construction of farm buildings and
Transport, Retail trade, Small Business, Professional and structures, etc., construction and running of storage facilities,
Self-Employed persons, Education, Housing and production of irrigation charges, etc.
cu

Consumption. Other types of direct advances made to the farmers include the
Within this classification, the RBI has also defined the weaker following:
sections as follows: • Short-term advances made to cultivators of traditional
• Small and marginal farmers with land holding of 5 acres or plantations (tea, coffee, rubber and spices) irrespective of the
Do

less, landless laborers, tenant farmers and share croppers; size of holdings would be treated as direct agricultural
• Artisans or small industrial activity viz. manufacturing,
advances under priority sector.
processing and servicing in villages and small towns with a • Advances granted for development of sericulture and for
population not exceeding 50000 involving utilisation of grainages under sericulture.
locally available natural resources and/or human skills. • Advances up to Rs.5 lakhs granted for financing distribution
Individual credit requirement should not exceed Rs.25000 to of input such as cattle feed, poultry feed, etc.
be considered as part of the weaker sections; Apart from the above mentioned direct loans, the RBI has also
• Scheduled Castes and Scheduled Tribes; specified certain indirect loans that are to be categorized as
• Beneficiaries of Differential Interest Rate (DRI) scheme; priority sector. The indirect advances in agriculture have,
• Self-Employment Program for Urban Poor (SEPUP);
however, been restricted to 4.5 percent of the overall target of
18 percent set for the agricultural sector. Within this upper limit
• Beneficiaries of Integrated Rural Development Program
of 4.5 percent, the banks can give indirect agri-loans to
(IRDP). organisations/boards/individuals providing fertilizers,
electricity, spraying operations, etc. In addition to this, indirect
finance includes loans given to co-operative marketing societies,

© Copy Right: Rai University


60 11.621.6
co-operative banks lending for such societies, agri-industries exclusively for financing of housing irrespective of the loan size

MANAGEMENT OF FINANCIAL INSTITUTION


corporations, agricultural finance corporations, etc. per dwelling unit will be reckoned for inclusion under private
sector advances. Loans up to Rs.50, 000 for repairing of houses.
Small-Scale Industries
All firms, which have a total outlay for the plant and machinery RRBs
not exceeding Rs.3 crore, and Rs.25 lakh fall into the category of The net funds provided by the bank to the RRBs will also be
SSI and Tiny sector respectively. Apart from the target considered as a priority sector advance.
mentioned above for the related activities of the SSI sector, the Investments
indirect credit in this sector will be given to agencies assisting in Bank’s investments in special bonds issued by certain specified
the supply of inputs and marketing of outputs of artisans, institutions such as SFCs/SIDCs, REC, NABARD and NHB
village and cottage industries and to government sponsored would be reckoned as a part of priority sector advances under
corporations/organisations providing funds to the weaker the appropriate sub-head subject to certain conditions.
sections.
Finance extended to state electricity boards for systems
Retail Trade

al
improvement scheme in the rural areas under special project
Advances granted to (i) private retail traders dealing in essential agriculture (SI-SPA) was classified as indirect finance to
commodities (fair price shops) and consumer cooperative stores agriculture under priority sector.
and (ii) other private retail traders with credit limits not

i
During February 1999, RBI had introduced the advances made

com Tr
exceeding Rs.5 lakh.
to food and agro-processing industries and investments in
Services (small Business venture capital into the priority sector lending.
The advances made to the firms providing services (other than Loans to the software industries (having credit limit not
professional services) will be covered here. The original cost exceeding Rs.1 crore from the banking system).
price of the equipment used and the working capital limits of

rd. F
The above mentioned guidelines give the priority sector
such firms should not exceed more than Rs.10 lakh and Rs.5
advances that arc to be made by the scheduled commercial banks
lakh respectively. Further, the aggregate of these shall not exceed
more than Rs.1 lakh.
Transport iza D (SCBs) only. The RBI has issued separate guidelines for the
priority sector advances of foreign banks. From July 1993,
foreign banks are required to make 32 percent of their net bank
dfw P
Advances given to the road transport operators coming under credit to the priority sectors. The definition of priority sector to
this category will be given to the extent of financing ten vehicles. foreign banks also includes the export credit. Within the overall
Bank credit to NBFCs for the purpose of on-lending to small target set for the priority sector, a sub-target of 10 percent is set
road and water transport operators (fleet of vehicles. not more for SSI and export credit. The shortfall, if any, in meeting the 10
w.p m

than 10) is also considered as priority sector. This implies that if percent target will have to be made by depositing the same with
a company XYZ Travels Ltd. has a fleet of nine vehicles and the Small Industries Development Bank of India (SIDBI).
takes credit for its 10th vehicle from a bank, then the credit
Public Sector/Banking Sector/Other Sectors
ww Co

extended by the bank for financing this vehicle will be


The other sectorial classifications are based on the constitution
considered as a priority sector advance for the bank. Having
of the borrowers and these include the loans extended to the
purchased this 10th vehicle, XYZ Travels Ltd. has taken credit
public sector, the banking sector and others. The residual of the
from the bank for the purchase of yet another vehicle. The
advances, after lending to priority, public and banking sectors
credit advancement made by the bank for this vehicle will,
cu

will appear in the category of others. Thus, advances that are


however, not be a priority sector advance since XYZ Travels Ltd.
extended to individuals, private corporates and all other
already has a fleet of 10 vehicles and the finance is taken for the
institutions will be classified here.
11th vehicle.
By classifying the total advances in the above mentioned ways
Professional and Self-Employed Individuals
Do

i.e. based on the nature, security and purpose, the bank will be
In the individual category, the total advances given to
in a better position to analyze its loan profile from various
professionals and self-employed, whose borrowing limits do
angles. This kind of classification helps the reader of a balance
not exceed Rs. 5 lakh of which not more than Rs. l lakh for
sheet to understand the bank better.
working capital purpose are covered. However, in case of
professionally qualified medical practitioners (setting up practice Having decided on the type of credit it will be offering, the bank
in rural and semi-urban areas), the borrowing limit shall not will then have to take crucial decisions regarding the loan
exceed Rs.l0 lakh, of which, the working capital should not be appraisal and disbursal, loan pricing and other loan
more than Rs.2 lakh. Within the above ceiling, the medical components. Once the bank decides on the type of credit
practitioner will also be given an advance for the purchase of advances it will be making, the loan appraisal and disbursal
one motor vehicle. follows. We shall now try to get an insight into these aspects of
lending.
Housing
Direct housing loans only up to Rs.5 lakh in rural/semi-urban
areas and up to Rs.l0 lakh in urban and Metropolitan areas, are
treated as priority sector advances. All investments in bonds
issued, by NHB/Housing and Urban Development Authority

© Copy Right: Rai University


11.621.6 61
Loan Appraisal and Disbursal While the total working capital requirement of the borrower is
MANAGEMENT OF FINANCIAL INSTITUTION

All the types of advances that are made by the bank, which are Rs.55 lakh, there will be the margin amount which is to be
discussed above, will be debt finances. And prior to the brought-in by the borrower. To arrive at this margin money, the
disbursal of any amount as advances, the bank should be well bank will have to first arrive at Maximum Permissible Bank
aware of the cash requirements of the borrower and the type of Finance (MPBF).
advance it should make in order to suit such requirement of the The three methods that can be used to assess the credit amount
borrower. This type of appraisal differs greatly from the initial are
appraisal that the bank conducts while deciding on the approval
of the loan. The initial appraisal basically involves an analysis of Turnover Method
the market, technological, financial, managerial analysis and Based on the forecasts made for the turnover of the firm, a
suggests the bank the feasibility of making any advances with percentage of the same will be taken as the amount to be
such analysis. Once the bank decides to sanction the loan financed for the working capital.
proposal, the other critical issues that need to be catered to are Earlier, banks were to assess the credit requirements of

al
the decisions relating to the way of financing, i.e. which mode borrowers with fund based working capital up to Rs.l crore
of funding will suit the clients cash requirements and the from the banking system in a simplified method of fixing a
manner in which the amount has to be disbursed. limit of minimum of 20 percent of the assessed turnover with

i
Firms basically need bank funds as project finance or as working a minimum margin of 5 percent to be brought in by the

com Tr
capital. Project finance is generally used for financing, long-term borrowers. Now the method can be adopted for fund based
assets of the firm. Consider the following illustration: working capital liability of Rs.5 crore.
Cash Budget Method
Project details of LLG Steels Ltd.: (Rs. lakh)
Land 125.00 This method assesses the requirement of the funds by the firm

rd. F
Site Development
Building
15.00
75.00
at various periods and then decides on the MPBF. This method
Plant and Machinery 25.00 suits the seasonal industries. Based on the seasonality, banks
Pre-operative Expenses 5.00
can set the peak and non-peak limits for the bank finance.
245.00
iza D
The above figures show the total financial requirement for the
Tandon Committee Method
Tandon gave three methods of assessing the MPBF, which are
dfw P
project, which the firm submits, to the bank. In any type of as follows:
lending activity, banks do not fund the entire amount required
by the borrower. They require the borrower to bring in some Method I 0.75 (CA - CL)
w.p m

amount as the margin money. In case of the financing, of the Method II 0.75 (CA) - CL
long-term assets, this margin will be normally 25 percent of the
Method III 0.75 (CA - CCA) – CL
total amount for each type of asset that the bank is willing to
finance. Thus in the above illustration, as the bank will be
ww Co

financing, land, site development, building and plant and Core current assets are to be financed by the long-term sources
machinery, the margin money will be Rs.60 lakh (240 x 0.25). of the borrowers.
The balance of the amount i.e. Rs.180 lakh will be provided by CA and CL are Current Assets and Current Liabilities
the bank as a term loan and/or lease finance. Having decided on respectively and CCA are the Core Current Assets.
cu

the loan amount, the same will be disbursed in lumpsum on


Till the recent past, banks were required by the RBI to use the
an installment basis depending on the project requirement.
Tondon Committee’s method II for assessing the MPBF.
Similar type of appraisal is also conducted by banks while However, banks are now free to adopt their own policy to
deciding on the amount of the working capital. The borrower assess the MPBF. Hence, banks can use any of the above three
Do

will make projections of the market demand, etc. and arrive at approaches depending on tile nature of the business and the
the amount of working capital it requires at a particular level of size of the firm and assess the MPBF.
production. Consider the working capital requirement of LLG
Assuming that the current liabilities of LLG Steels Ltd. are
Steels Ltd.:
Rs.25 lakh the MPBF using the Tandon Committee’s method
Rs. lakh
II will be as follows:

Inventory 20.00
Debtors 8.00 The Current Assets = Rs.55 lakh
Receivables 5.00
Cash 10.00
Others 12.00
The Current Liabilities = Rs.25 lakh
55.00 MPBF = 0.75(CA) - CL = 0.75(55) - 25
= 16.25
The decision relating to the amount to be financed will be
followed by the method of financing, the same. Financing, of
the working capital will be through cash credit (CC), working
capital demand loan (WCDL) and/or bill financing,

© Copy Right: Rai University


62 11.621.6
mechanisms. In a CC approach, there will be a lot of uncertainty

MANAGEMENT OF FINANCIAL INSTITUTION


for the bank about the cash inflows and outflows and so will be
the case with the interest income. To avoid this and to gain,
better control over the flow of credit, RBI had, in April 1995,
introduced the loan system of delivery of credit for borrowers
with working capital (fund based) limit of Rs.l0 crore. Since it is
a short-term loan, which has a minimum repayment/maturity
period of 15 days, it is also known as the Working Capital
Demand Loan (WCDL). The bifurcation of the working capital
finance into CC and Loan component will be in the ratio of
20:80.
Questions to Discuss:
1. What is the need for lending and need for credit?

al
2. What are the types of credit?
3. Discuss the nature of credit?

i
4. What is the security offered for Loans?

com Tr
5. Discuss the purpose of Loan.
6. Systems Hardware Ltd. Has submitted its project report for
getting credit facility from the Dhan Bank Ltd. The following
are the details relating to project finance and working capital

rd. F
requirements of the firm:
Rs in Lakh
Land
Site development
Building
Plant and machinery
Pre-operative expenses
iza D
75.00
5.00
55.00
125.00
10.00
dfw P
Total 270.00

The working capital requirement of the Company is as given


below:
w.p m

Rs in Lakh
Inventory 45.00
Debtors 15.00
Receivables 10.00
Cash 10.00
ww Co

Others 8.00
Total 78.00

1. Assess the margin amount that the company has to bring in


for its project and the amount of bank finance for the same.
cu

2. Assess the Maximum Permissible Bank Finance (MPBF)


using the second method of Tandon Committee (current
liabilities are Rs. 30 lakh).
3. Give the details of the means of finance for the working
Do

capital, if the actual bill finance required is Rs. 5 lakh.


Notes:

© Copy Right: Rai University


11.621.6 63
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 17:
LOAN POLICY

Learning Goals: multifarious objectives like profitability, liquidity, volume of


After reading this lesson, you will be understand business, risk levels, etc. there will be prioritization of objectives
while drafting the policy. But due to certain conflicting
• Need for a Loan Policy
situations, reconciliation/trade-off between different objectives
• Components of a Loan Policy. may become necessary. Further, in the case of certain objectives,
Lending is a crucial activity for a bank as it enables it to sustain there will be regulatory prescriptions like the capital adequacy
profitably. But to sustain profitably, prudent decisions need to’ norms. Thus, while setting the loan objectives in. the policy,

al
be taken both prior to and after sanctioning the credit. These adherence to the regulatory prescriptions will also be an
decisions generally relate to the amount of credit to be extended important consideration. By stating the related regulatory
during a financial year, the industries to focus on, the aspects in the policy, the loan officers will be fully aware of the

i
geographical spread, the type of credit to offer, the type of importance of the policy measures. .

com Tr
proposals to finance, the disbursal mechanism, the collateral
Volume and Mix of Loans
value, the method of pricing, the repayment schedule, the
The policy should specify the targeted composition of the loan
monitoring process, etc. These macro and micro level
portfolio, such composition being in terms of industry/
considerations of the lending activity contribute to the
location/size/ interest rate/security. Decisions regarding the

rd. F
achievement of the bank’s objectives. The bank’s management
loan portfolio will depend on the size of the bank, the credit
should thus, ensure that lending decisions fall in line to
requirements in its operational areas and the expertise available
subserve the bank’s overall objectives.
Need for a Loan Policy
iza D
While lending decisions are crucial for the bank, it is neither
with the bank. In an agrarian type of economy most of the
loan demands may come from the farmers. Likewise, if the
bank size is small, it may have to put a limit to individual loan
dfw P
feasible nor desirable for the top management to review and proposals to be in proportion to its total loan portfolio.
clear every single loan proposal that the -bank receives. This Generally, exposure levels, which the banks can have for the
arises not only due to the process involved in such an activity various types of borrowers, are given by the apex regulatory
but also due to the numbers. Furthermore, for most of the body. While fulfilling the, regulatory prescription it is desirable
w.p m

loan proposals, whichever industry they may belong to, the to develop more detailed limits within the bank.
modus operandi remains the same - analyzing, selecting,
Geographical Spread
sanctioning and monitoring. Hence, the, top management
There will be various locations from where a bank conducts its
ww Co

needs to set the standards. Standards relating to the exposure


operations. Of these locations, some may be weak credit
limits for individual / company / industry, credit quality of the
demand areas with a considerably high deposit potential and
borrowers, lending rate, risk level, etc. enable decentralized
vice versa. While operating in any area, the bank should have the
decision-making by the lending officers.
requisite funds and expertise to meet the credit demands. The
To enable such decision-making, there should actually be a
cu

policy should thus, state the key trade areas of the bank for
policy document that carefully specifies the dos and don’ts while extending credit. Further, within the trade areas, there may be
sanctioning the loan proposals. As loan proposals differ widely certain areas with a primary focus and a few others, which may
from each other, there cannot be a strict methodology for be given the secondary focus. Such a classification may also
accepting or rejecting the proposals. Instead, guidelines can be
Do

enable the bank to switch on to the secondary trade areas when


given within the loan policy for the decision makers to enable the chief trade areas are not active.
them to screen out loans, which can be outrightly rejected, loans
that can be sanctioned without any involvement of the top Loan Evaluation Procedures
management and proposals that require a certain amount of The policy document shall specify a process for eva1uation of
top level decision-making. Discussed below are a few loan proposals, which will enable uniform evaluation across
considerations that the loan policy may address. areas/people. Evaluation involves a careful selection of the
borrowers by understanding their creditworthiness. While
Components of a Loan Policy evaluating the proposal, banks should not only assess the
When a bank is developing its loan policy, there will be certain ability of the client to payback the loan but also their willingness
significant issues, which it needs to incorporate in the policy. to repay. Banks need to consider the following variables while
Discussed below are a few considerations that the loan policy evaluating a loan proposal:
may address.
Industry Prospects
Loan Objectives To study the prospects of the industry, an industry level credit
The first step to framing a loan policy is formulating the analysis needs to be performed which most importantly
objectives of the lending activity. Due to the presence of includes a study of the following:

© Copy Right: Rai University


64 11.621.6
• Industry cycles limits, which are generally set, based on the responsibility and

MANAGEMENT OF FINANCIAL INSTITUTION


• Threat from substitutes the experience of the loan officer should be done diligently. Too
Iowa limit will lead to a situation where a major part of the
• Shifts in consumer demands
senior management’s time is spent on smaller quantum of
• Regulatory environment loans. In contrast to this situation, the risk of the bank may
Operational Efficiency increase when loan sanction powers are too high. Inexperienced
The company level credit rating is conducted to assess the officers may commit the bank to undesirable loans.
operational efficiency of the client company. The critical aspects Credit Files
that are to be evaluated in this process fall into the following The details regarding the borrower are not only essential during
categories: the loan appraisal time but they are also required throughout
• Operating margins the tenor of the loan. This is essential especially since there may
• Stability and growth of market share always be a probability of default or a change in the risk-return
profile of the customer. Continuous evaluation is possible with
• Access to key raw materials

al
the help of a credit file, which keeps track of the historical record
• Benefit from economies of scale of the borrower. In this context, the loan policy can specifically
Financial Efficiency mention the inputs required for maintaining the credit files for

i
Repayment of the loan by the clients depends greatly on their varying types of loans. The credit file maintained for a borrower

com Tr
financial soundness. Hence, financial analysis becomes an should reveal all the parameters considered while accepting the
imperative part of credit risk analysis. It includes an analysis of proposal. It is useful to keep a record of any specific events/
the following: experiences which indicate whether the decision taken for
• Financial leverage granting such a loan was sound or not. The contents of the
credit file should include all details of the borrower including

rd. F
• Coverage ratios
detailed financial statements and analysis, collateral provided
• Cost of capital and the value of the same, details of compensating balances,
• Ability to raise funds
• Working capital management iza D etc. Moreover, since most of the customers are not one time
borrowers, it will be all the more necessary for the bank to
maintain such credit files of the customers.
dfw P
• Interest rate risk management
Lending Rates
Management Evaluation
The interest charged should reflect the credit risk present in the
While the above mentioned factors assess the ability of the
credit disbursal. The major issue will thus be to adjust the rate
w.p m

client to repay, the management evaluation to a certain extent,


charged to the risk perception. For this, the loans can be
throws light on the willingness of the client to repay. Thus,
classified into different risk groups based on the risk involved.
evaluation of management includes a study on the performance
Having done this, the policy should then state the returns a
ww Co

of the promoter, top management and also the performance of


particular loan should be giving at a particular level of risk. The
group companies under the same management.
policy should also state the risk level at which no credit can be
Fundamental Analysis extended. In addition to this, the policy should also give
Here, the fundamental factors that influence the working of the guidelines for selecting a floating or a fixed rate of interest.
client company are analyzed. These factors are listed below: A loan policy will actually be a function of the size of the bank.
cu

• Capital structure Hence, apart from the above mentioned considerations,


• Asset/liability position. Asset quality depending on the bank’s own requirements, there may be
several other issues/parameters that may be included in its loan
• Profitability
policy. Given below are some of the other issues/parameters
Do

• Sensitivity to interest rate structures, tax policies, etc. that the loan policy may contain:
Above is the broad classification of the various parameters used
to evaluate a loan proposal. The parameters used for evaluating
• Type and extent of collaterals
will vary depending on the type of the borrower, the nature of
the project and the purpose of funds. The list provided above • Compensating balances 2 / margin.
is not an exhaustive one and depending on the loan proposal, • Statutory limits for different types of loans
the bank will select the evaluating variables. Once a broad list of • Monitoring mechanism
such parameters is identified, the loan policy may also specify
• Loan-Deposit ratio
benchmarks so that uniform evaluation can be ensured.
• Incentive schemes for the loan officers.
Loan Administration
• Loan repayment pattern
Efficient administration is the key to the success of the lending
policy. And for improving its efficiency, the authority of the • Communication practices
loan executives should be clearly stated as also their • Extension of renewals of past-due installment loans
responsibilities. The loan policy should state the sanctioning (rescheduling the loan)
powers of the loan officers regarding the credit limits. The credit

© Copy Right: Rai University


11.621.6 65
• Loan-loss reserves
MANAGEMENT OF FINANCIAL INSTITUTION

• Consumer laws and regulations


• Role of credit department
• Role of recovery department
Having drafted the loan policy, adequate measures should also
be taken to ensure that the policy is being effectively used in the
lending activity. For this, there need to be loan committees,
which review the loan policy from time to time and also, assess
the performance of the credit departments. These committees
should meet frequently to assess the loan policy, to assess the
loan proposals beyond a threshold limit and also those loan
proposals that do not comply with ‘the normal credit

al
standards. It will have to suggest measures to cope with certain
grey areas and find a solution to the critical questions relating to
a bad loan before it drifts into an undesirable and

i
uncontrollable situation

com Tr
Summary
By listing the lending parameters, defining responsibilities and
having in place a proper system of checks and balances, the loan
policy does provide a framework for bank lending. In addition
to this, a good loan policy should have two other features -

rd. F
firstly, it has to establish the credit culture for the bank and
secondly, it has to be contemporary. If a loan policy is able to

iza D
establish a credit culture for the bank, then it will also enable a
new entrant into the organization to understand the procedures
of the bank easily. And due to the dynamic operating
dfw P
environment, there may be certain changes in the bank
objectives, the pricing methodologies practiced, the exposure
levels, etc. and all these require a revision in the loan policy.
w.p m

Hence, the loan policy needs to be contemporary so as to suit


the changing lending environment.
Questions to Discuss:
ww Co

1. What is the need for a Loan Policy?


2. Discuss the components of a Loan Policy.
Notes:
cu
Do

© Copy Right: Rai University


66 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 18:
LOAN PRICING

Learning Goals: However, one issue that arises during such computation is
After reading this lesson, you will be understand whether to use the average cost of funds or the marginal cost
of funds. This becomes a fairly simple issue if the liabilities and
• Objectives of loan pricing
the assets of the bank are examined. If we consider a bank’s
• Cost plus loan pricing model balance sheet, the liabilities of the bank will be deployed into
Being the purveyors of credit, primary activity of banks is various assets including advances and investments. In certain
lending. Apart from ensuring proper application of the surplus situations when the bank does not have suitable deployment

al
funds mobilized, lending also enables these banks to maintain opportunity by way of loans or investments, it will temporarily
profitability. Deployment of funds should be at a rate that deploy the same into the money market and will utilize the
covers the cost of funds and leaves a margin to the lender after same for the future credit proposals. Along with these funds,

i
meeting the expenses. This margin should on one hand cover incremental deposits will also be used for offering credit. When

com Tr
the risks a bank is exposed to due to their lending activity and the funds deployed in the money market are used for extending
on the other hand provide certain income. Pricing thus has an the credit, then it is desirable for the bank to consider the
implication on the profitability and the sustenance of the bank. average costs of funds while pricing the loans. This is basically
While a bank can adopt a pricing policy for greater margins, it due to the fact that various sources of funds would have been

rd. F
may, however, have an adverse affect on their business volume. used for the deployment into the money market. An average
A bank needs to thus, adopt a pricing policy that ensures cost of funds will be essential since in a declining interest rate
profitability while increasing the business volumes. Arriving at scenario, by considering only the marginal cost of funds, the

iza D
such a price level is difficult for the simple reason that there are a
number of factors, both internal and external to the bank that
influences such a decision. The aspects related to loan pricing
higher interest rates on the banks funds will eat into the
profitability of the bank.
dfw P
Alternatively, if the bank does not have any surplus funds
that are discussed in this lesson can be broadly categorised into deployed into the money market, then the future credit
the following: requirements will have to be funded using the incremental
• Determinants of loan pricing deposits only. Under such circumstances the incremental or the
w.p m

• Methodologies of loan pricing marginal cost of funds can be used while assessing the loan
price. Thus, in loan pricing, the use of the average cost of funds
Objectives of Loan Pricing and the marginal cost of funds will depend on the composition
ww Co

Prior to deciding the price of any product, it is essential to first of asset-liability position.
identify the objective the price of the product should attain for
the firm i.e. should it ensure high returns, higher business or Risk-Reward
should it just enable a break even. Similar is the case when the The relation between risks and returns will have to be
bank decides to fix its loan price. Banks generally have three considered taking three different loan attributes- the tenor of
the loan, the credit risk of the customer and the size of the
cu

major objectives in loan pricing-


loan. Form the theories of interest rates, it can be understood
• Maintain margins
that the interest rates increase with the increase in the tenor of
• Balance risk-reward profile the loan. Thus, loans with longer maturity are charged a higher
• Ensure market rates interest rate when compared to the loans maturing in the short-
Do

Margins ensure profitability, the balanced risk-reward profile term. This is due to the fact that the risk involved in lending foe
ensures sustenance, and the market rate ensures the presence of longer periods is greater when compared to the lending for
the bank in the market. While all the three objectives are shorter periods. Considering this, if a bank would like to earn
important and interrelated, prioritizing them, however, will be a greater returns, it would have to lend for longer periods. But for
policy decision to be taken by the bank. this, the bank should also have funds with marching maturity.
However, the sources of funds for a bank do not generally
Margins:
include long-term funds. In such cases, the bank may borrow
To ensure margins, the bank should have surplus income after
short and lend long, which may lead to an enhanced level of
having met its cost of funds and cost of servicing. For this
risk. Due to the presence of this risk, the bank should decide on
purpose, the bank can ascertain the cost of its funds, add the
a level of risk-reward that it is prepared to accept and then
overall cost of servicing to which it can add the necessary
decide on the maximum tenor of its loans.
margins it would like to maintain for taking the risk and to earn
a profit. The total of this will give the rate at which the loan has The second major attribute that influences the risk, reward
to be priced. proportion of the bank is the credit risk involved in the lending
function. All loans have a certain element of risk involved in
them due to the probability of default. The level of risk,

© Copy Right: Rai University


11.621.6 67
however, varies for each borrower, moving upwards from Market Rates:
MANAGEMENT OF FINANCIAL INSTITUTION

sovereign debt to corporate debt. Due to the presence of this The last factor that affects the loan pricing decision is the market
risk, the returns will also vary, with greater returns being rate. If the rates charged by the bank are higher than the market
attached to higher risk levels. This linkage between the credit risk rates, then it will lose its business to those offering cheaper
and the returns highlights the need for the bank to first decide rates. On the other hand, if it lowers its rates below the market
on the level of risk-reward it would prefer to maintain. Having rates, then though the volume of the business may increase,
laid down the tolerable risk level and the approximate returns but the lower returns will reduce its profitability. To prevent loss
for the same, the bank can accept or reject the loan proposals of business and lower profits, thee bank should ensure that
based on the risk they are exposed to. loan prices remain close to the prevailing interest rate structure
Apart from the above mentioned attributes, the size of the in the market.
loan also influences the risk-reward ratio. While the affect of Considering the various factors influencing the loan pricing
term to maturity and the credit risk on the risk-reward ratio decision of the bank and the alternatives in pricing, the bank
could be clearly observed, the same may not be possible in the will next have to develop loan pricing model. If the objective of

al
case of the size of the loan. The key issues to be considered the bank is to earn spreads, then the pricing model will first
here will be the relationship, the servicing costs and the risk focus on the cost analysis of the bank and then ensure that the
involved have with the size of the loan. price charged covers its costs and leaves a margin. Similarly,

i
Considering the servicing costs, as the size of the loan increases, when the risk-reward objective is set as the top priority, the

com Tr
these costs come down as it will be cheaper to service a single customer evaluation and a price that reflects the risk involved by
loan account of Rs. 10 lakh each. Loans which are made in small extending such credit becomes essential. And finally, if the
denominations and which involve greater clerical and bank’s chief objective is market presence, then it will ensure that
management time, carry high cost per rupee of loan extended its rates move in tandem with the rates of the other players in
the market. However, this cannot be pursued irrespective of its

rd. F
and vice versa. Example of this can be a credit card facility where
the time involved for management is greater than the tem loan. ability to sustain.
Compensation for this high service costs are the high interest However, prudence lies in actually integrating these three

iza D
rates charged for the credit card facility. On the other hand, loan
of larger denominations will take comparatively lesser time for
management and may be a useful proposition. However, the
objectives and emerging with a price that not only covers the
banks’ lending costs and gives a return on it, but also ensures
that the bank is able to sustain the risk level taken and at the
dfw P
greater exposure to one client will result in higher risk. To same time keeps itself close to the prevailing market rates.
understand this, consider the Capital Structure theories. It can Discussed below is a pricing model that uses various
be recalled form the traditional approach of capital structure that approaches to build in these three objectives. The basic model
w.p m

the gains on account of increased leverage will be higher than of the cost plus pricing is used to arrive at the loan price. Within
the increased cost of equity thus having a positive impact on the this, various methods of assessing the risk premium and the
value of the firm up to a particular level of leverage. Thus the required profit margin are discussed. Following this approach,
ww Co

ratio of debt to equity, which does not adversely affect the value the bank can build in a pricing methodology that ensures a
of the firm, will be safe for the creditor/bank. The bank can price, which covers the costs and the risks and leaves a profit
lend to a single customer as long as this degree of leverage is margin.
maintained. However, if the debt amount goes beyond this
level for the firm, then the credit risk for the bank will rise. The Cost Plus Loan Pricing Model
This model basically focuses on arriving at a loan price that
cu

rise in the credit risk will again lead to a rise in the servicing
costs, which have actually been falling due to the size of loan. ensures a certain margin after covering the cost of the funds,
This is basically due to the fact that with the size of the loan operations costs, cost of servicing. The process involved in
being large and the credit risk increasing, the bank will have to arriving at a contractual rate based on this model consists of the
following steps:
Do

mare closely monitor such loans. Thus, the higher returns


which are expected due to the fall in the servicing costs will be • Arrive at cost of funds
off-set by the ruse in the credit risk, thus, the impact of the size • Assess the servicing costs
of the loan on the risk-reward ratio of the bank will have to be • Quantify the credit risk and set premium
examined both from the point of view of the company (capital
• Assess the profit margin that ensures the targeted ROE
structure) and the bank.
• Relate the rate to a reference rate (Prime Rate)
Thus, the bank’s risk-reward ratio, as discussed above, depends
on the term to maturity of the loan, the credit risk of the loan • Ensure market presence.
and the size of the loan. The returns and the risks of the bank The word margin, however, connotes differently depending on
will undergo a change due to the changes that take place in these how the bank can segregate its costs and other risks. And
three attributes of the loan. This requires the bank to have a depending on what the word margin means to the bank the
continuous monitoring on the risk level and the returns in pricing methodology varies slightly. The basic relationship,
order to remain within the prescribed framework. however, is given as follows:

© Copy Right: Rai University


68 11.621.6
Loan Price = Cost of funds + Margin………(1) Operating and Servicing Costs

MANAGEMENT OF FINANCIAL INSTITUTION


These costs represent the other expenses that represent the
Cost of Funds:
burden for the bank and comprise of the costs incurred while
While assessing the cost of funds apart from deciding on the
servicing deposits, extending loans and other services. These
average cost of funds and the marginal cost of funds, the bank
vary depending on the nature of the loan, the cash flow pattern,
will also have to assess the same considering the average cost of
and the maturity. All the administration cost incurred by the
funds vs. the cost of pooled funds (funds having the same
bank while the loan is still live viz., salaries, costs incurred in
interest rate). This decision depends on the ability of the bank
creating and perfecting a security interest in collateral, costs
to identify the liabilities that are deployed into a particular asset.
incurred on documentation for security interest in collateral,
In other words, if the bank is not in a position to identify the
costs in establishing and managing the records, collection costs,
source from which the funds are used to extend a particular
etc. will be considered here. Similar servicing costs are involved
credit facility, then the average cost of funds will be the suitable
both for deposits and other services. While the servicing costs
option. However, if the bank can clearly segregate its liabilities,
for other services maybe recovered from the fee income received
then it can pool funds with similar maturities and fund a credit

al
from such services, the servicing costs of deposits will also have
proposal with a similar maturity. The cost of funds will thus be
to be met from the interest income.
the average cost of pooled funds and not the average cost of
total funds. This approach to assessing the cost of funds will Risk Premium

i
enable price matching as well as maturity matching. However it Risk margin will be set after considering the different types of

com Tr
may not be possible to adopt a pooled funds approach in risks the loan is exposed to. For a proper assessment of this,
respect of all sources of funds. It is, therefore, desirable to risk unbundling becomes essential. Provisions are generally
adopt this pooled funds approach at least in respect of high made to tackle the risk element in the assets.
cost funds so that the price decided on the basis of average Profit Margin
funds does not result in reduction of spreads. Further, in the

rd. F
After considering all the costs involved with the lending activity
case of average cost of funds, the bank cannot use the same rate as well as adjusting for the risk the bank will then look towards
for loans of differing tenors.

iza D
While the price arrived based on the average cost of funds
results in a flat yield curve, it is not always seen in the market
including a profit margin. This margin would depend on the
returns it would like to earn from the lending activity.
Having considered the various components that the bank’s
dfw P
and it will not be in tune with the concept of upward sloping margin can comprise of; it can be observed that the margin
yield curve. Therefore, it is possible to change margins at mentioned in Eq.(1) is set to meet the other expenses
different rates to address this problem. (operating ,and the servicing costs), the provisions for risk and a
Thus, it can be observed that in the pooled cost of funds residue which forms the profit margin. Since the cost of funds
w.p m

approach the margins are fixed. However, when the average cost represent the interest expenses, the margin will not require to
of funds is considered, the margins for loans with higher meet them. Thus, when a bank is unable to segregate its other
maturities will be less while the margins for the loans of lower expenses and quantify its risks, this type of loan pricing can be
ww Co

maturities will be higher. To avoid such fluctuations in the adopted. Based on the type of security, the nature of the loan
actual margins when the average cost of funds is considered, the and the purpose for which the funds are borrowed, the bank
bank will have to set margins based on the tenor of the loan can set a range for the margins to be included in pricing. The
instead of having a fixed margin for loans of differing upper end margins can be used for loans with higher maturities,
maturities i.e. set higher margins for loans with higher more risk, etc. and vice versa.
cu

maturities. Sometimes, the bank will be able to identify its operating and
Margins servicing costs and build it into its pricing model as a percentage
The word margin is used in a very broad sense in the above to the size of the loan. The loan price can then be assessed as
Do

expression. Consider the following equation: follows:


PBT = (Interest Income - Interest Expenses) + (Other Loan Price = Cost of funds + Costs of Servicing +
Income - Other Expenses) – Provisions….(2) Margin.…..(3)
From the above equation it can be observed that it is from the The loan price as per the above equation will have the margins
interest income that the bank’s PBT and provisions arise and that should contribute to the profit margin after making
also that it is from this income that the bank meets its interest provisions for risks.
expenses and the Burden, which is the difference between the Moving one step ahead in arriving at the price, the bank will try
other income and the other expenses. Thus, it implies that the to quantify the risk it has taken while extending the loan. If the
interest income includes margins. Depending on the break up, risk is identified then the provisioning required for the risks can
which the bank will have for its loan price, the composition of also be assessed.
the margins will differ. Before proceeding towards a discussion
on the different connotations of the word margin, it would be
useful to understand the following:

© Copy Right: Rai University


11.621.6 69
When the bank is able to do so, then the pricing model can be While the probabilities can be assessed from the past data, the
MANAGEMENT OF FINANCIAL INSTITUTION

further disintegrated as follows: recovery rate can be computed by considering the guarantees and
Loan Price = Cost of Funds + Cost of Servicing + value of collaterals attached to the loan. The recovery rate refers
Provisions for Risk + Profit Margin..…(4) to the percentage of the outstanding balance that can be
recovered by measures such, as enforcement securities, legal
Here the margin will be solely to meet the profits of the bank.
action, etc.
This can, be arrived at based on the Return on Equity, which the
bank would expect to maintain. When a default is expected from a loan, the bank will adjust the
recovered amount towards the principal. Thus, based on the
In its very basic framework, the cost plus pricing method
probability of payment and recovery -rate, the expected rate
discussed above is based only on the costs and since costs set
when the bank expects the payment of interest as well as the
the floor for pricing, the interest rate arrived at that first stage
principal amount, will be
(using (Eq. (3)) can be considered as the Hurdle Rate. This is
the rate below which a bank cannot offer any credit if it has to Expected Return = P1(r) + P2 P (1 + r) x R ………….(6)
remain profitable. To arrive at this hurdle rate, estimation of P

al
Where,
costs, expenses incurred and expected returns become essential.
However, by assessing the risk premium and the required P2 = Probability of default
P = Principal component
returns, the bank can actually improvise on its pricing approach.

i
R = Recovery rate.
But to arrive at this price, the bank should be able to quantify its

com Tr
risks and also decide on the required margin. In the above formula, P1(r) gives the returns using the
Discussed below is the procedure by which the bank can contractual rate and the probability of total repayment of the
gradually build a loan price that incorporates all parameters i.e. loan in the normal course of payment while the second part i.e.
the cost of funds, cost of servicing, risk premium and the P2{ [P(l + r) x R]/P – 1 } gives the returns using the recovery

rd. F
profit margin. The loan price using the Eq. (3) can be obtained rate and the probability of default. The expected rate when there
simply by assessing the cost of funds and its servicing costs and is only principal repayment will be assessed as follows:

iza D
adding the margin amount. The profit margin, which the bank
sets, should enable the bank to earn its required ROE. When
the ROE is met then the price charged which is known as the
Expected Rate = P1(r) + P2 (R - 1)…………….(7)
dfw P
Contractual Rate will become the expected return for that loan.
However, the bank will earn this expected return as long as there In the above equation, the second part i.e. P2 (R - 1) gives the
is no default in the repayment of the loan. In case there is a principal that is recovered.
default, the contractual rate will not give the bank the expected
w.p m

It is now understood that while pricing a loan proposal, it is


return. If the bank has to reach the targeted ROE, then the risk essential for the bank to adjust the contractual rate so that it
should be quantified to arrive at a contractual rate that in turn reflects the creditworthiness of the client. The bank should
gives the bank the expected rate. thus, build into its pricing, mechanism probability of default.
ww Co

Quantifying Risk Premium Such an exercise will, to a certain extent, reduce the loss in return
Generally, while performing the financial appraisal for the due to defaults. From the above equations, for a given
proposal, the internal rate of return (IRR) is calculated. If the contractual rate, the expected returns from the proposal can be
payments are made regularly by the clients, then the expected assessed by considering the probability of the repayment/
cu

rate of return will be equal to the contractual rate. default and the recovery rate. Using this approach, it is also
possible to decide the contractual rate to be offered once the
required rate is determined. The required rate, which includes
Expected Return = P1(r)……………………………..(5)
the cost of funds, transaction costs and the spreads, can be used
where,
Do

as the expected rate.


r = Contractual Rate
Questions to discuss:
PI = Probability of repayment
1. Which of the following approaches (A) Average cost of
funds (B) Pooled cost of funds should be used for financing
In the above case, since the payments are made regularly by the a 3 year loan proposal of Rs. 10 crore in order to maintain a
clients, P1 will be equal to one. margin of 4 percent over the cost of funds? Given below are
However, there will always be some uncertainty attached to the details of its liabilities portfolio.
future cash flows. This uncertainty attached to future cash flows. Amount Maturity (year) Interest rate (%)
This uncertainty relates mainly to the amount of cash inflows (Rs.crore)
25 - -
and the timing of the cash flows. In such uncertain situations, 40
35
0.5
1.0
5
9
the bank can arrive at the probability of repayment/default and 20
20
2.0
3.0
12
14
also the extent of recovery in case of a default. 140

2. Zenith Finance Ltd. assessed its cost of funds to be 15.75


percent. Further, the transaction cost for sanctioning a credit

© Copy Right: Rai University


70 11.621.6
proposal is 0.5 percent. On this cost, it expects to maintain 2

MANAGEMENT OF FINANCIAL INSTITUTION


percent as spreads. A proposal is received by the company for
financing a loan for Rs.950 lakh. The credit department in
their appraisal report have given the probability of
repayment as 0.95. However, on default, the recovery rate is
expected to be only 85 percent. From this information,
compute the expected rate of financing. Further based on the
creditworthiness of the client, what do you think the
contractual rate should be?
3. Venus Financials Ltd. had received a loan proposal for Rs. 12
crore. The contractual rate for the loan is 22 percent. In case
of a default, VFL expects to recover 90 percent of the
principal. If the probability of repayment is 0.9, then what

al
will be the expected return for VFL? Based on the answer
you get, assess the rate at which the loan should have been
financed to get a return of 22 percent.

i
4. L&M Bank Ltd. has received a 4-year loan proposal from a

com Tr
Deep Mines Ltd., which has a A+ credit rating, attracting a
risk premium of 2 percent. The PLR for a 2-year loan of the
bank is at 13.5% and the implicit forward rate for two years
form now is 15 percent. If the bank follows a prime-time

rd. F
pricing method, what should be the loan price?
Notes:

iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 71
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 19:
NON PERFORMING ASSETS (NPA)

Learning objectives Further, international rating agencies like, Standard & Poor have
After reading this lesson, you will understand lowered India’s credit rating to sub-investment grade. Such
negative aspects have often outweighed positives such as
• Introduction
increasing forex reserves and a manageable inflation rate.
• Indian Economy and NPAs
Under such a situation, it goes without saying that banks are no
• Global Developments and NPAs exception and are bound to face the heat of a global downturn.
• Meaning of NPAs One would be surprised to know that the banks and financial

al
• Why such a huge level of NPAs exists in Indian banking institutions in India hold non-performing assets worth Rs.
system (IBS)? 1,10,000 crores. Bankers have realized that unless the level of
NPAs is reduced drastically, they will find it difficult to survive.

i
• Why NPAs have become an issue for banks and financial

com Tr
institutions in India? Global Developments and NPAs
• RBI Guidelines on income recognition (interest income on The core banking business is of mobilizing the deposits and
NPA) utilizing it for lending to industry. Lending business is generally
encouraged because it has the effect of funds being transferred
• Accounting Standard 9 (AS 9)
from the system to productive purposes, which results into

rd. F
• Are RBI guidelines on NPAs and ICAI Accounting Standard economic growth.
9 on revenue recognition, consistent with each other?
However lending also carries credit risk, which arises from the

iza D
• RBI guidelines on classification of bank advances
• How to classify bank advances, if recovery is highly unlikely?
failure of borrower to fulfill its contractual obligations either
during the course of a transaction or on a future obligation.
dfw P
• Credit Risk and NPAs A question that arises is how much risk can a bank afford to
• Public Trust and NPAs take? Recent happenings in the business world - Enron,
WorldCom, Xerox, Global Crossing do not give much
• How important is credit rating in assessing the risk of
confidence to banks. In case after case, these giant corporates
default for lenders?
w.p m

became bankrupt and failed to provide investors with clearer


• Usage of financial statements in assessing the risk of default and more complete information thereby introducing a degree
for lenders of risk that many investors could neither neither anticipate nor
ww Co

• Can Universal Banking solve the problem of NPA for DFIs? welcome. The history of financial institutions also reveals the
• Capital Adequacy Ratio (CAR) of RBI and Basle Committee fact that the biggest banking failures were due to credit risk.
on Banking Supervision (BCBS) Due to this, banks are restricting their lending operations to
• Excess Liquidity? secured avenues only with adequate collateral on which to fall
back upon in a situation of default.
cu

• High cost of funds due to NPAs


• Conclusion Meaning of NPAs
An asset is classified as non-performing asset (NPAs) if dues in
Introduction the form of principal and interest are not paid by the borrower
It’s a known fact that the banks and financial institutions in
Do

for a period of 180 days. However with effect from March 2004,
India face the problem of swelling non-performing assets default status would be given to a borrower if dues are not paid
(NPAs) and the issue is becoming more and more for 90 days. If any advance or credit facilities granted by bank to
unmanageable. In order to bring the situation under control, a borrower becomes non-performing, then the bank will have
some steps have been taken recently. The Securitisation and to treat all the advances/credit facilities granted to that borrower
Reconstruction of Financial Assets and Enforcement of as non-performing without having any regard to the fact that
Security Interest Act, 2002 was passed by Parliament, which is an there may still exist certain advances / credit facilities having
important step towards elimination or reduction of NPAs. performing status.
Indian Economy and NPAs Why such a Huge Level of NPAs Exists in the Indian
Undoubtedly the world economy has slowed down, recession is
at its peak, globally stock markets have tumbled and business Banking System (IBS)?
itself is getting hard to do. The Indian economy has been much The origin of the problem of burgeoning NPAs lies in the
affected due to high fiscal deficit, poor infrastructure facilities, quality of managing credit risk by the banks concerned. What is
sticky legal system, cutting of exposures to emerging markets by needed is having adequate preventive measures in place namely,
FIIs, etc. fixing pre-sanctioning appraisal responsibility and having an
effective post-disbursement supervision. Banks concerned

© Copy Right: Rai University


72 11.621.6
should continuously monitor loans to identify accounts that Therefore complying with AS 9, interest income is not

MANAGEMENT OF FINANCIAL INSTITUTION


have potential to become non-performing. recognized based on uncertainty involved but is recognized at a
subsequent stage when actually realized thereby complying with
Why NPAs have become an Issue for Banks and
RBI guidelines as well.
Financial Institutions in India?
In order to ensure proper appreciation of financial statements,
To start with, performance in terms of profitability is a
banks should disclose the accounting policies adopted in respect
benchmark for any business enterprise including the banking
of determination of NPAs and basis on which income is
industry. However, increasing NPAs have a direct impact on
recognized with other significant accounting policies.
banks profitability as legally banks are not allowed to book
income on such accounts and at the same time banks are forced RBI Guidelines on Classification of Bank Advances
to make provision on such assets as per the Reserve Bank of Reserve Bank of India (RBI) has issued guidelines on
India (RBI) guidelines. provisioning requirement with respect to bank advances. In
Also, with increasing deposits made by the public in the terms of these guidelines, bank advances are mainly classified
into:

al
banking system, the banking industry cannot afford defaults by
borrower s since NPAs affects the repayment capacity of banks. Standard Assets
Further, Reserve Bank of India (RBI) successfully creates excess Such an asset is not a non-performing asset. In other words, it

i
liquidity in the system through various rate cuts and banks fail carries not more than normal risk attached to the business.

com Tr
to utilize this benefit to its advantage due to the fear of Sub-standard Assets
burgeoning non-performing assets. It is classified as non-performing asset for a period not
RBI Guidelines on Income Recognition (interest exceeding 18 months

Income on NPAs) Doubtful Assets

rd. F
Banks recognize income including interest income on advances Asset that has remained NPA for a period exceeding 18 months
on accrual basis. That is, income is accounted for as and when it is a doubtful asset.
is earned.
iza D
The prima-facie condition for accrual of income is that it should
not be unreasonable to expect its ultimate collection. However,
Loss Assets
Here loss is identified by the banks concerned or by internal
auditors or by external auditors or by Reserve Bank India (RBI)
dfw P
NPAs involves significant uncertainty with respect to its inspection.
ultimate collection. In terms of RBI guidelines, as and when an asset becomes a
Considering this fact, in accordance with the guidelines for NPA, such advances would be first classified as a sub-standard
w.p m

income recognition issued by the Reserve Bank of India (RBI), one for a period that should not exceed 18 months and
banks should not recognize interest income on such NPAs until subsequently as doubtful assets.
it is actually realized. It should be noted that the above classification is only for the
ww Co

What does Accounting Standard 9 (AS 9) on Revenue purpose of computing the amount of provision that should
be made with respect to bank advances and certainly not for the
Recognition Issued by ICAI say? purpose of presentation of advances in the banks balance sheet.
The Accounting Standard 9 (AS 9) on ‘Revenue Recognition’
The Third Schedule to the Banking Regulation Act, 1949, solely
issued by the Institute Of Chartered Accountants of India
governs presentation of advances in the balance sheet.
cu

(ICAI) requires that the revenue that arises from the use by
others of enterprise resources yielding interest should be Banks have started issuing notices under the Securitisation Act,
recognized only when there is no significant uncertainty as to its 2002 directing the defaulter to either pay back the dues to the
measurability or collectability. bank or else give the possession of the secured assets
Do

mentioned in the notice. However, there is a potential threat to


Also, interest income should be recognized on a time
recovery if there is substantial erosion in the value of security
proportion basis after taking into consideration rate applicable
given by the borrower or if borrower has committed fraud.
and the total amount outstanding.
Under such a situation it will be prudent to directly classify the
Are RBI guidelines on NPAs and ICAI Accounting Standard 9 advance as a doubtful or loss asset, as appropriate.
on revenue recognition consistent with each other?
RBI Guidelines on Provisioning Requirement of Bank
In view of the guidelines issued by the Reserve Bank of India
(RBI), interest income on NPAs should be recognised only Advances
when it is actually realised. As and when an asset is classified as an NPA, the bank has to
As such, a doubt may arise as to whether the aforesaid further sub-classify it into sub-standard, loss and doubtful
guidelines with respect to recognition of interest income on assets. Based on this classification, bank makes the necessary
NPAs on realization basis are consistent with Accounting provision against these assets.
Standard 9, ‘Revenue Recognition’. For this purpose, the Reserve Bank of India (RBI) has issued guidelines on
guidelines issued by the RBI for treating certain assets as NPAs provisioning requirements of bank advances where the recovery
seem to be based on an assumption that the collection of is doubtful. Banks are also required to comply with such
interest on such assets is uncertain.

© Copy Right: Rai University


11.621.6 73
guidelines in making adequate provision to the satisfaction of Banks do rely on credit rating agencies to measure credit risk and
MANAGEMENT OF FINANCIAL INSTITUTION

its auditors before declaring any dividends on its shares. assign a probability of default.
In case of loss assets, guidelines specifically require that full Credit rating agencies generally slot companies into risk buckets
provision for the amount outstanding should be made by the that indicate company’s credit risk and are also reviewed
concerned bank. This is justified on the grounds that such an periodically. Associated with each risk bucket is the probability
asset is considered uncollectible and cannot be classified as of default that is derived from historical observations of
bankable asset. default behavior in each risk bucket.
Also in case of doubtful assets, guidelines requires the bank However, credit rating is not foolproof. In fact, Enron was
concerned to provide entirely the unsecured portion and in case rated investment grade till as late as a month prior to it’s filing
of secured portion an additional provision of 20%-50% of the for Chapter 11 bankruptcy when it was assigned an in-default
secured portion should be made depending upon the period status by the rating agencies. It depends on the information
for which the advance has been considered as doubtful. available to the credit rating agency. Besides, there may be
For instance, for NPAs which are upto 1-year old, provision conflict of interest, which a credit rating agency may not be able

al
should be made of 20% of secured portion, in case of 1-3 year to resolve in the interest of investors and lenders.
old NPAs upto 30% of the secured portion and finally in case Stock prices are an important (but not the sole) indicator of the
of more than 3 year old NPAs upto 50% of secured portion credit risk involved. Stock prices are much more forward looking

i
should be made by the concerned bank. in assessing the creditworthiness of a business enterprise.

com Tr
In case of a sub-standard asset, a general provision of 10% of Historical data proves that stock prices of companies such as
total outstandings should be made. Enron and WorldCom had started showing a falling trend
many months prior to it being downgraded by credit rating
Reserve Bank Of India (RBI) has merely laid down the
agencies.
minimum provisioning requirement that should be complied

rd. F
with by the concerned bank on a mandatory basis. However, Usage of Financial Statements in Assessing the Risk
where there is a substantial uncertainty to recovery, higher of Default for Lenders

Credit Risk and NPAs iza D


provisioning should be made by the bank concerned. For banks and financial institutions, both the balance sheet and
income statement have a key role to play by providing valuable
dfw P
Quite often credit risk management (CRM) is confused with information on a borrower’s viability. However, the approach
managing non-performing assets (NPAs). However there is an of scrutinizing financial statements is a backward looking
appreciable difference between the two. NPAs are a result of approach. This is because, the focus of accounting is on past
past action whose effects are realized in the present i.e. they performance and current positions.
w.p m

represent credit risk that has already materialized and default has The key accounting ratios generally used for the purpose of
already taken place. ascertaining the creditworthiness of a business entity are that of
On the other hand managing credit risk is a much more debt-equity ratio and interest coverage ratio. Highly rated
ww Co

forward-looking approach and is mainly concerned with companies generally have low leverage. This is because; high
managing the quality of credit portfolio before default takes leverage is followed by high fixed interest charges, non-payment
place. In other words, an attempt is made to avoid possible of which results into a default.
default by properly managing credit risk. Capital Adequacy Ratio (CAR) of RBI and Basle
Considering the current global recession and unreliable
cu

Committee on Banking Supervision (BCBS)


information in financial statements, there is high credit risk in
Reserve Bank of India (RBI) has issued capital adequacy norms
the banking and lending business.
for the Indian banks. The minimum CAR, which the Indian
To create a defense against such uncertainty, bankers are expected Banks are required to meet at all, times is set at 9%. It should be
Do

to develop an effective internal credit risk models for the taken into consideration that the bank’s capital refers to the
purpose of credit risk management. ability of bank to withstand losses due to risk exposures.
How important is credit rating in assessing the risk of default To be more precise, capital charge is a sort of regulatory cost of
for lenders? keeping loans (perceived as risky) on the balance sheet of banks.
Fundamentally Credit Rating implies evaluating the The quality of assets of the bank and its capital are often closely
creditworthiness of a borrower by an independent rating agency. related. Quality of assets is reflected in the quantum of NPAs.
Here objective is to evaluate the probability of default. As such, By this, it implies that if the asset quality were poor, then higher
credit rating does not predict loss but it predicts the likelihood would be the quantum of non-performing assets and vice-
of payment problems. versa.
Credit rating has been explained by Moody’s a credit rating Market risk is the risk arising due to the fluctuations in value of
agency as forming an opinion of the future ability, legal a portfolio due to the volatility of market prices.
obligation and willingness of a bond issuer or obligor to make Operational risk refers to losses arising due to complex system
full and timely payments on principal and interest due to the and processes.
investors.

© Copy Right: Rai University


74 11.621.6
It is important for a bank to have a good capital base to Therefore, quite often corporates prefer to raise funds through

MANAGEMENT OF FINANCIAL INSTITUTION


withstand unforeseen losses. It indicates the capability of a commercial papers (CPs) where the interest rate on working
bank to sustain losses arising out of risky assets. capital charged by banks is higher.
The Basel Committee On Banking Supervision (BCBS) has also With the enactment of the Securitisation and Reconstruction of
laid down certain minimum risk based capital standards that Financial Assets and Enforcement of Security Interest Act,
apply to all internationally active commercial banks. That is, 2002, banks can issue notices to the defaulters to pay up the
bank’s capital should atleast be 8% of their risk-weighted assets. dues and the borrowers will have to clear their dues within 60
This infact helps bank to provide protection to the depositors days. Once the borrower receives a notice from the concerned
and the creditors. bank and the financial institution, the secured assets mentioned
The main objective here is to build a sort of support system to in the notice cannot be sold or transferred without the consent
take care of unexpected financial losses thereby ensuring healthy of the lenders.
financial markets and protecting depositors. The main purpose of this notice is to inform the borrower that
either the sum due to the bank or financial institution be paid
Excess liquidity? no Problem, but no Lending Please

al
by the borrower or else the former will take action by way of
!!! taking over the possession of assets. Besides assets, banks can
One should also not forget that the banks are faced with the also takeover the management of the company. Thus the

i
problem of increasing liquidity in the system. Further, Reserve bankers under the aforementioned Act will have the much

com Tr
Bank of India (RBI) is increasing the liquidity in the system needed authority to either sell the assets of the defaulting
through various rate cuts. Banks can get rid of its excess companies or change their management.
liquidity by increasing its lending but, often shy away from such But the protection under the said Act only provides a partial
an option due to the high risk of default. solution. What banks should ensure is that they should move

rd. F
In order to promote certain prudential norms for healthy with speed and charged with momentum in disposing off the
banking practices, most of the developed economies require all assets. This is because as uncertainty increases with the passage
of time, there is all possibility that the recoverable value of asset

iza D
banks to maintain minimum liquid and cash reserves broadly
classified into Cash Reserve Ratio (CRR) and the Statutory
Liquidity Ratio (SLR).
also reduces and it cannot fetch good price. If faced with such a
situation than the very purpose of getting protection under the
dfw P
Cash Reserve Ratio (CRR) is the reserve which the banks Securitisation Act, 2002 would be defeated and the hope of
have to maintain with itself in the form of cash reserves or by seeing a must have growing banking sector can easily vanish.
way of current account with the Reserve Bank of India (RBI), Conclusion
computed as a certain percentage of its demand and time
w.p m

To conclude with, till recent past, corporate borrowers even after


liabilities. The objective is to ensure the safety and liquidity of defaulting continuously never had any real fear of bank taking
the deposits with the banks. any action to recover their dues despite the fact that their entire
On the other hand, Statutory Liquidity Ratio (SLR) is the assets were hypothecated to the banks. This is because there was
ww Co

one which every banking company shall maintain in India in the no legal Act framed to safeguard the real interest of banks.
form of cash, gold or unencumbered approved securities, an However with the introduction of Securitisation Act, 2002
amount which shall not, at the close of business on any day be banks can now issue notices to their defaulters to repay their
less than such percentage of the total of its demand and time dues or else make defaulters face hard and tough actions under
cu

liabilities in India as on the last Friday of the second preceding the aforementioned Act. This enables banks to get rid of sticky
fortnight, as the Reserve Bank of India (RBI) may specify from loans thereby improving their bottomlines. Also a hallmark of
time to time. a good business is approaching it with a fresh, new perspective
A rate cut (for instance, decrease in CRR) results into lesser and requires management that is fully awake, fully alive and of
Do

funds to be locked up in RBI’s vaults and further infuses greater course fully focused on making things better.
funds into a system. However, almost all the banks are facing Also, the passing of the Securitisation Act, 2002 came as a
the problem of bad loans, burgeoning non-performing assets, bonanza for investors in banking sector stocks that in turn
thinning margins, etc. as a result of which, banks are little resulted into an improvement in their share prices.
reluctant in granting loans to corporates.
Questions to Discuss:
As such, though in its monetary policy RBI announces rate cut
1. NPAs of the bank as on 31/03/2004 are as follows:
but such news are no longer warmly greeted by the bankers.
Assess the amount of Provisioning the bank has to make as on
High Cost of Funds due to NPAs 31/03/2004
Quite often genuine borrowers face the difficulties in raising
funds from banks due to mounting NPAs. Either the bank is Nature of Asset
Standard
Amount (Rs Lakh)
1450
reluctant in providing the requisite funds to the genuine Sub -standard
Doubtful asset(secured)
540

borrowers or if the funds are provided, they come at a very high -1 Year
-1 -3Years
210
-
cost to compensate the lender’s losses caused due to high level -more than 3 Years
Loss
90
45
of NPAs.

© Copy Right: Rai University


11.621.6 75
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 20:
STATUTORY RESERVE REQUIREMENT

Learning objectives made market related. At the same time, the RBI helped create an
After reading this lesson, you will understand array of other market related financial products. At the next
stage, the interest rate structure was simultaneously rationalized
• Introduction
and banks were given the freedom to determine their major
• Reforms rates.
• Cash reserve ratio As a result of these developments, RBI could use OMO as an
• Reduction in CRR effective instrument for liquidity management including to curb

al
• Flexibility in the treatment of CRR short-term volatilities in the foreign exchange market. Another
important and significant change introduced during the period
• Statutory liquidity requirement (SLR)
is the reactivation of the Bank Rate by initially linking it to all

i
• Statutory liquidity ratio of regional rural banks other rates including the Reserve Bank’s refinance rates (April

com Tr
The core business of banks is mobilising the deposits and 1997). The subsequent introduction of fixed rate repo
utilising the same for credit accommodation. However, it (December 1997) helped in creating an informal corridor in the
should be taken into consideration that the banks are not money market, with the repo rate as floor and the Bank Rate as
allowed to use the entire amount for extending credit. In order the ceiling. The use of these two instruments in conjunction

rd. F
to promote certain prudential norms for healthy banking with OMO enabled RBI to keep the call rate within this
practices, most of the developed economies require all banks to informal corridor for most of the time. Subsequently, the
maintain minimum liquid and cash reserves. As such, banks are introduction of Liquidity Adjustment Facility (LAF) from June

iza D
required to ensure that these statutory reserve requirements are
met before directing on their credit plans.
2000 enabled the modulation of liquidity conditions on a daily
basis and also short term interest rates through the LAF
dfw P
Statutory reserve requirements could broadly be classified into window, while signaling the stance of policy through changes in
the Bank Rate.
• Cash Reserve Ratio (CRR) and
• Statutory Liquidity Ratio (SLR). Reforms
w.p m

It has been possible to reduce the statutory preemption on the


Cash Reserve Ratio (CRR) is the one which the banks have
banking system. The Cash reserve Ratio (CRR), which was the
to maintain with itself in the form of cash reserves or by way
primary instrument of monetary policy, has been brought
of current account with the Reserve Bank of India (RBI),
down from 15.0 per cent in March 1991 to 5.5 per cent by
ww Co

computed as a certain percentage of its demand and time


December 2001. The medium-term objective is to bring down
liabilities. The objective is to ensure the safety and liquidity of
the CRR to its statutory minimum level of 3.0 per cent within a
the deposits with the banks.
short period of time. Similarly, Statutory Liquidity Ratio (SLR)
On the other hand, Statutory Liquidity Ratio (SLR) is the has been brought down from 38.5 per cent to its statutory
one which every banking company shall maintain in India in the minimum of 25.0 per cent by october 1997
cu

form of cash, gold or unencumbered approved securities, an


It has also been possible to deregulate and rationalise the
amount which shall not, at the close of business on any day be
interest rate structure. Except savings deposit, all other interest
less than such percentage of the total of its demand and time
rate restrictions have been done away with and banks have been
liabilities in India as on the last Friday of the second preceding
Do

given full operational flexibility in determining their deposit and


fortnight, as the Reserve Bank of India (RBI) may specify from
lending rates barring some restrictions on export credit and
time to time.
small borrowings. The commercial lending rates for prime
In the pre reform period prior to 1991, given the command and borrowers of banks has fallen from a high of about 16.5 per
control nature of the economy, the Reserve Bank had to resort cent in March 1991 to around 10.0 per cent by December 2001
to direct instruments like interest rate regulations, selective credit
control and the cash reserve ratio (CRR) as major monetary CRR
instruments. These instruments were used intermittently to Effective date (i.e. the fortnight beginning from)
neutralize the monetary impact of the Government’s budgetary CRR on net demand and time liabilities (per cent)
operations. The administered interest rate regime during the September 18, 2004
earlier period kept the yield rate of the government securities 4.75
artificially low. The demand for them was created through
intermittent hikes in the Statutory Liquidity Ratio (SLR). The October 2, 2004
task before the Reserve Bank of India was, therefore, to 5.0
develop the markets to prepare the ground for indirect However, the effective CRR maintained by scheduled primary
operations. As a first step, yields on government securities were (urban) co-operative Banks on total demand and time liabilities

© Copy Right: Rai University


76 11.621.6
shall not be less than 3.00 per cent, as stipulated under the commencing from December 1,1999 to January 31,2000. It is

MANAGEMENT OF FINANCIAL INSTITUTION


Reserve Bank of India Act, 1934. clarified here that the cash in hand which will be counted for
Interest on cash balances maintained with Reserve Bank of CRR purposes, during the above period cannot be treated as
India under Cash Reserve Ratio eligible asset for SLR purposes simultaneously.(iii) As already
indicated, for operational convenience, the maintenance of CRR
At present, scheduled primary (urban) co-operative banks are
by banks is being lagged by two weeks. As such, for
paid interest at the Bank Rate on eligible cash balances
maintaining CRR during the fortnight beginning January 1,
maintained with Reserve Bank under proviso to Section 42 (1)
2000, the NDTL base would be December 17, 1999. With the
and 42 (1A) of the Reserve Bank of India Act, 1934. It has now
leverage of two weeks available, banks should not have any
been decided that with effect from fortnight beginning
problem in complying with the CRR requirement around the
September 18, 2004, the scheduled primary (urban) co-operative
century date change. Nevertheless, any bank that expects a special
banks will be paid interest at the rate of 3.5 per cent per annum
problem in meeting its CRR obligations at the end of the year
on eligible cash balances maintained with the Reserve Bank of
can approach the RBI for appropriate relaxation/assistance
India under CRR requirement.

al
Cash Reserve Ratio - Reduction and Rationalisation
Reduction in CRR
The Reserve Bank has been pursuing its medium-term
Among the unrealized medium-term objectives of reforms in
objective of reducing Cash Reserve Ratio (CRR) to the statutory

i
monetary policy, the most important is reduction in the
minimum level of 3.0 per cent. Taking into account the

com Tr
prescribed CRR for banks to its statutory minimum of 3.0 per
progress achieved in the areas of enforcing prudential standards
cent. The movement to 3.0 per cent can be designed in three
and operationalising the LAF, RBI has reduced CRR from 11.0
possible ways, viz., the traditional way of pre-announcing a
per cent in August 1998 to 5.0 per cent in June 2002 while
time-table for reduction in the CRR; reducing CRR as and when
withdrawing certain exemptions. Further, the modalities of
opportunities arise as is being done in recent years; and as a one-

rd. F
CRR maintenance have been rationalised with the introduction
time reduction from the existing level to 3.0 per cent under a
of a lagged (by one fortnight) maintenance system. In addition,
package of measures. In the initial years, the first approach was
RBI is remunerating the eligible CRR balances maintained by

iza D
effective but had to be abandoned when the timetable had to be
disrupted to meet the eruption of global financial uncertainties
and pressures on forex market. Hence, the second approach of
banks at the Bank Rate. As a further step in this direction of
moving towards the statutory minimum level of CRR, it is
proposed:
dfw P
lowering CRR when opportunities arise has been adopted, and
now it has been brought down to 5.5 percent. However, if it is To reduce CRR from 5.0 per cent to 4.75 per cent effective from
felt that this approach takes a longer time and a compressed the fortnight beginning November 16, 2002. (With this
time-frame is desirable to expedite development of financial reduction, CRR has been reduced by as much as 3.75 percentage
w.p m

markets, it is possible to contemplate a package of measures in points over the past two years).
this regard. The package could mean the reduction of CRR to At present, banks are required to maintain a minimum of 50
the statutory minimum level of 3.0 per cent accompanied by per cent of the required reserves in the first week and a
ww Co

several changes such as in the present way of maintenance of minimum of 65 per cent in the second week of the reporting
cash balances by banks with RBI. With the lagged reserve fortnight. Despite this flexibility given to banks on the daily
maintenance system now put in place, banks can exactly know maintenance, the actual daily CRR maintenance of majority of
their reserve requirements. With the information technology banks in relation to the prescribed level is now quite high. While
available with banks and with the operationalisation of Clearing moving towards a low CRR, it is necessary that the demand for
cu

Corporation of India Ltd. (CCIL) shortly and with the bank reserves in the inter-bank market is modulated and the
development of repo market, it would be appropriate if CRR is volatility in CRR maintenance is minimised. In this direction:
maintained on a daily basis. However, till banks adjust to such Banks will be required to maintain a minimum of 80 per cent
changes in the maintenance of CRR, a minimum balance of 95 of required CRR amount on a daily basis during a fortnight
Do

per cent of the required reserves on a daily basis may have to be with effect from the fortnight beginning November 16, 2002.
maintained when CRR is reduced to 3.0 per cent. The other The minimum level of 80 per cent would be applicable for all
elements of package have to be worked out carefully. Access the days in a reporting fortnight.
Flexibility in the Treatment of CRR Interest on Cash Balances Maintained with RBI
Normally, banks maintain minimum cash in their own vaults
since it is an idle asset, without the benefit of earning any under CRR
interest. In the context of date change at the turn of the century, At present, all scheduled commercial banks are paid interest at
in order to meet any additional demand for bank notes as a the Bank Rate on eligible cash balances maintained with RBI
contingency, banks may have to keep larger vault cash for under CRR requirement, without detailed scrutiny by RBI, on
meeting their business transactions. At present, such cash in the basis of quarterly interest claim statement submitted by
hand with the bank though an eligible asset for SLR, is not banks. Such interest payment is made to all banks within one
counted for CRR requirements. To facilitate banks to tide over month after the end of the quarter. Based on the
the contingency during the millennium change, it has been recommendations of the Regulations Review Authority, it has
decided to treat cash in hand maintained by the banks for been decided to:
compliance of CRR for a limited period of two months

© Copy Right: Rai University


11.621.6 77
Pay interest on eligible CRR balances on a monthly basis with have expressed difficulty in premature withdrawal of deposits
MANAGEMENT OF FINANCIAL INSTITUTION

effect from April 2003. In order to facilitate this, banks are urged reckoned for SLR purposes. Accordingly, it has been decided
to put in place proper technology including adoption of the that:
software package which will help transmission of Form A data SLR holdings of RRBs in the form of deposits with sponsor
by banks directly to RBI. banks maturing beyond March 31, 2003 may be allowed to be
Statutory Liquidity Requirement (Slr) retained till maturity. These deposits may be converted into
SLR = statutory liquidity ratio. Banks in India are required to government securities, on maturity, in case the concerned RRBs
maintain 25 per cent of their demand and time liabilities in have not achieved the 25 per cent minimum level of SLR in
government securities and certain approved securites. These are government securities by that time.
collectively known as SLR securities Although deposits with sponsor banks contracted before April
The RBI has announced a “Special Liquidity Support” measure 30, 2002 would be reckoned for SLR purpose till maturity,
under which banks will be eligible to avail of liquidity to the RRBs are advised to achieve the target of maintaining 25 per
extent of their holdings of dated Government of India cent SLR in government securities out of the maturity proceeds

al
Securities/Treasury Bills over the SLR required to be of such deposits with sponsor banks as well as from their
maintained. The rate of interest on this facility would be 2.5 per incremental public deposits at the earliest
cent over the bank rate. This means that liquidity will be The RBI has announced a very strong support system for

i
available to the banking system at a cost of 10.50 per cent anticipated enhanced liquidity needs during the century date

com Tr
(present bank rate is 8 per cent). The banking system is period. All the following measures announced by the RBI
estimated to hold securities in excess of the SLR requirements would be valid for the period December 1, 1999 to January 31,
to the extent of around Rs 600 billion. Thus, theoretically, this 2000
amount of liquidity will be available to the banking system
Questions to Discuss:

rd. F
during this period. The RBI has also asked those who do not
hold any significant amount of excess SLR, to get into standby 1. What do you understand by statutory reserve requirement?
arrangement with banks who hold excess SLR securities. 2. Explain cash reserve ratio (CRR).

iza D
During this period, the cash held by banks will be counted
towards the maintenance of CRR. Currently, banks’ holding of
3. Explain statutory liquidity requirement (SLR).
Notes:
dfw P
cash in their vaults is reckoned for SLR purposes. It was feared
that during this period, banks may have to hold cash in hand
much in excess of their normal holdings. This would cause a
reduction in the bank’s balances in their current accounts with
w.p m

the RBI. The reduced current account balances, which are


reckoned towards maintenance of CRR, could have caused an
additional demand for liquidity. By equating, for CRR
ww Co

maintenance purposes, the current account balances with the


cash in hand, the RBI has not only dealt with this anticipated
liquidity problem but ensured an additional liquidity of around
Rs 50 billion, which is the current holding of cash with banks.
The RBI has also allowed overseas banks to freely access
cu

liquidity from their respective head offices overseas during this


period.
Statutory Liquidity Ratio of Regional Rural Banks
Do

Regional Rural Banks (RRBs) were required to maintain SLR at


25 per cent of their NDTL in cash or gold or in unencumbered
government and other approved securities. In this regard,
balances maintained in call or fixed deposits by RRBs with their
sponsor banks were treated as “cash” and hence, reckoned
towards their maintenance of SLR. As a prudential measure, it
was considered desirable on the part of all RRBs to maintain
their entire SLR portfolio in government and other approved
securities. Accordingly, in the annual policy Statement of April
2002, it was decided that all RRBs should maintain their entire
SLR holdings in government and other approved securities by
converting their existing deposits with sponsor banks into
government securities by March 31, 2003. While a number of
RRBs have already achieved the minimum level of SLR in
government securities, some RRBs and their sponsor banks

© Copy Right: Rai University


78 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 21:
CAPITAL ADEQUACY OF REQUIREMENTS

Learning Objectives need for possessing healthy capital adequacy requirement is


After reading this lesson, you will understand essential for boosting the confidence of the savers.
• Capital adequacy of banks If the saver gives money to the bank in the form of a deposit
and if it is insured, it would be the insurer who should be
• Ratio of the paid-up capital to reserve
concerned in the level of equity in the bank.
• BIS Standards
The following criteria should be used in determining the capital
• Capital adequacy norms

al
adequacy of the bank:
• Capital funds
Ratio of the Paid-up Capital to Reserve
• Risk adjusted assets and off-balance sheet items The size of the reserve of banks in relation to their paid-up

i
• Foreign exchange and interest rate related contracts capital is an important index of their financial position and

com Tr
A financial intermediary needs capital to commence its strength. It is also a pointer to the management policy regarding
operations and to continue its existence as a running business. the retention of earnings. However, since the banks carry on
More so, a financial intermediary needs more capital to act as a their business mainly with the depositors’ funds, an increase in
buffer, since the losses if and when they arise, may be the paid-up capital may not keep pace with that in the reserve.

rd. F
substantial. Capital provides a cushion to absorb possible Equity Ratio
losses so that entities dealing with them are protected all the Equity Ratio is the ratio of its equity capital over its loans and
time. This will help sustain the existence of the intermediary,

iza D
which is very vital for proper functioning of the economic
system. The capital will provide a margin of safety that
investments, where loans and investments means all earning
assets, including loans and government securities.
Capital-Deposit Ratio
dfw P
preferably would allow the intermediary to continue operations
The capital-deposit ratio was used in past in the USA and in the
without loss of momentum and at the least, would buy time
UK to measure capital adequacy. The banking authorities in
in which it may re-establish its operational momentum.
India have considered the adequacy of capital in relation to
The significance for capital varies depending on the activity of
w.p m

deposit liabilities. A high capital-deposit ratio is indicative of


financial intermediary. A bank needs capital for servicing its the fact that the depositors will face low risks. It has been
depositors, for maintaining net worth requirements, for recognised by authorities that, with every decline in the ratio of
acquiring assets and establishing branch network as per the capital to deposits, the risks of depositors tend to increase
ww Co

requirements, etc. Comparatively for NBFCs is needed for sharply. In the US, in early 20th Century – banks were asked to
entering into fund based activities apart form servicing its maintain a capital fund equal to 10 percent of its deposit
depositors and acquisition of assets. liabilities as a margin of safety. It should be noted that the
Apart from specifying an entry capital for the intermediaries, deposits by themselves contain no risks until they are used to
regulatory authorities (warranted by legislations) fixed a
cu

make loans and investments; and the extent of the risk varies
proportion of capital and reserve to assets, on the basis of the with the character of the assets into which deposits are
type of intermediary. converted.
These requirements termed as Capital Adequacy Requirements By following the above said thumb-rules, one may have an idea
Do

are specified for banks and for NBFCs in particular, this chapter on the extent of coverage of assets on the liabilities. Here it is
will dwell on the Capital Adequacy Requirements as applicable necessary to caution ourselves that it is practically impossible to
to Commercial Banks. determine the capital adequacy of a particular bank or even of
Capital Adequacy of Banks the commercial banking system, since it is not possible to know
In the Indian context, the capital adequacy of banks is all the the future demand that will be made out of capital. Adequate
more important in view of existence of nationalized banks and capital is desirable and necessary, but capital alone cannot ensure
the social status of bank management. An adequate capital fund the safety of a bank and due consideration has to be given to
is needed to bring about solidarity, scope, operation and the the quality and character of its assets, the caliber of its
ultimate strength to a bank. As important players, involved in management and its modus operandi.
helping of the capital formation in this era of intensive Capital to Risk-Weighted Assets Ratio
infrastructural investment, banks need to possess adequate To assess the adequacy of capital based on the quality of assets,
capital funds to discharge this responsibility. the Capital to Risk-Weighted Assets Ratio (CRAR) or the
At the same time, a saver who is depositing his money in a Capital Adequacy Ratio (CAR) is now being focused upon.
bank assumes that the risks associated with the investment of Introduced in 1988 by the Basle Capital Adequacy Accord, this
the funds will be borne by this intermediary. Therefore, the

© Copy Right: Rai University


11.621.6 79
ratio has become the keyword to comment on the stability of a Tier I Capital
MANAGEMENT OF FINANCIAL INSTITUTION

bank. Tier I Capital in the case of Indian banks consists of


BIS Standards • Paid-up capital
As banking began to spread across nations and competition • Statutory reserves
began to heat up among banks from varied countries, it became • Disclosed free reserves
an unfair game for banks from the country imposing stricter
• Capital reserves representing surplus arising out of sale
capital standards as they will be at a competitive disadvantage.
proceeds of assets
Therefore, a need for uniform capital standards for banks was
felt. As a result, regulators from 13 countries including the US i. Equity investment in subsidiaries, intangible assets, and
came together to formulate uniform standards that would losses in the current period and those brought forward from
apply to all their banks. These standards, established under the previous periods, will be deducted from Tier I capital.
auspices of the Bank for International Settlements (BIS), an ii. Elements of Tier I capital in case of foreign banks:
international clearing bank for central banks, were adopted in iii. Interest-free funds from head office kept in a separate

al
November 1988. The committee has adopted weighted risk account in the Indian books specifically for the purposes of
assets approach, which assigns weights to both on off-balance meeting the capital adequacy norms.
sheet exposures of a bank according to the perceived risk. While

i
iv. Statutory reserves kept in Indian books.
the framework is being applied by the banking supervisory

com Tr
authorities in the G-10 countries, the committee has suggested v. Remittable surplus retained in Indian books which is not
that the banking supervisory authorities of the non- G-10 repatriable so long as the banks function in India.
countries could also try to adopt the framework, particularly, in vi. Cap9ital reserve representing surplus arising out of sale of
respect of banks conducting significant international business in assets in India held in a separate account and which is not
their jurisdictions. eligible for repatriation so long as the banks function in

rd. F
Indian Standards: Narasimham Committee India.
vii. Interest-free funds remitted form abroad for the purposes

iza D
Narasimham committee constituted by the Government of
India, to examine all aspects of banking procedures submitted
its reports in the early 90s. The committee observed that the
of acquisition of property and held in a separate account in
Indian books.
dfw P
capital ratios of Indian banks are generally low and some banks The net credit balance, if any, in the inter-office account with
are seriously undercapitalized. The banks in India should Head office / overseas branch will not be reckoned as capital
conform to the standards laid in the Basle Committee on funds. However, any debit balance in Head Office account will
Banking Regulations and Supervisory Practices appointed by the have to be set-off against the capital.
w.p m

BIS in a phased manner. Previously, various groups of banks


Tier II Capital
were subject to different minimum capital requirements as
Tier II capital for both Indian and foreign banks consists of the
prescribed in the statutes under which they were set up and
following:
ww Co

operate. In addition, it has been prescribed that the foreign


banks operating in India should have foreign funds deployed in Undisclosed reserves and cumulative perpetual preference
Indian business equivalent to 3.5 percent of their deposits as at shares often have characteristics similar to equity and disclosed
the end of each year. The framework of risk weighted assets reserves. These element have the capacity to absorb expected
ratio approach to capital adequacy measurement is more losses and can be included in capital, if they present
cu

equitable as it requires those institutions with a higher risk accumulations of post-tax profits and not encumbered by any
profile to maintain a higher level of capital funds. known liability and should not be routinely used for absorbing
normal loan or operating losses. Cumulative perpetual
Capital Adequacy Norms preference shares should be fully paid-up and should not
As mentioned earlier the Capital Adequacy Ratio is the ratio of
Do

contain clauses, which permit redemption by the holder.


the banks capital to its risk weighted assets. To assess the capital
Revaluation reserves often serve as a cushion against
adequacy of banks based on this ration it is essential to
unexpected losses, but they are less permanent in nature and
understand three aspects:
cannot be considered as ‘core capital’. Revaluation reserves arise
1. Composition of capital from revaluation of assets that are undervalued in the books,
2. Composition of Risk Weighted Assets typically premises, and marketable securities. The extent to
3. Assigning risk weights which the revaluation reserves can be relied upon as a cushion
for unexpected losses depends mainly upon the level of
Capital Funds
certainty that can be placed on estimates of the market values of
The Basle Committee has defined capital in two tiers: Tier I and
the relevant assets, the subsequent deterioration in values under
Tier II. While Tier I capital is the core capital, which provides the
difficult market conditions, or in a forced sale, potential for
most permanent and readily available support against
actual liquidation at those values, tax consequences of
unexpected losses. Tier II capital will consist of element that are
revaluation, etc. Therefore, it would be prudent to consider
not permanent in nature or are not readily available.
revaluation reserves at a discount while determining their value
for inclusion in Tier II capital. The revaluation reserves need to

© Copy Right: Rai University


80 11.621.6
be discounted by a minimum of 55 percent when determining In February 1999, RBI has given all scheduled commercial

MANAGEMENT OF FINANCIAL INSTITUTION


their value for inclusion in Tier II capital. Such reserves will have banks, including the foreign banks operating in India, the
to be reflected on the Balance Sheet as revaluation reserve. autonomy to raise rupee subordinated debt as Tier II capital,
General provisions and loss reserves (GPLR) are not subject to certain terms and conditions. The instruments that
attributable to the actual diminution in value or identifiable can be issued should be plain ‘Vanilla’ type with no special
potential loss in any specific asset and are available to meet features like options, etc. Further, all nationalised banks have to
unexpected losses; they can be included in Tier II capital. obtain permission from the Government for issuing the
Adequate care must be taken to see that sufficient provisions instruments. Permission from RBI is also essential to issue
have been made to meet known losses and foreseeable potential instruments to NRIs/OCBs/FII. RBI’s approval is also
losses before considering general provisions and loss reserves to necessary for the issue of subordinated debt instruments in
be part of Tier II capital. General provisions/ loss reserves will foreign currency or borrowings from head office, to include in
be admitted up to a maximum of 1.25 percent of weighted risk Tier II capital. It is to be noted that investment by banks in the
assets. subordinated debts of the other banks shall be subject to the

al
ceiling of 5 percent applicable to investments in shares of
In the category of Hybrid debt capital instruments fall in a
corporate bodies and they would be assigned 100 percent of
number of capital instruments, which combine certain
total of Tier I elements for the purpose of compliance with the
characteristics of equity and certain characteristics of debt. Each

i
norms.
has a particular feature which can be considered t affect its quality

com Tr
as capital. Where these instruments have close similarities to Risk Adjusted Assets and off-Balance Sheet Items
equity, in particular when they are able to support losses on an Risk adjusted assets would mean weighted aggregate of funded
on-going basis without triggering liquidation, they may be and non-funded items as detailed below. Degrees of credit risk
included in Tier II capital. expressed as percentage weightings have been assigned to
balance sheet assets and conversion factors to of-balance sheet

rd. F
For Subordinated Debt to be eligible for inclusion in Tier II
capital, the instrument should be fully paid-up, unsecured, items. The value of each asset/item shall be multiplied by the
subordinated to the claims of other creditors, free of restrictive relevant weights to produce risk-adjusted values of assets and

iza D
clauses and should not be redeemable at the initiative of the
holder or without the consent of the banks’ supervisory
of off-balance sheets. The aggregate will be taken into account
for reckoning the minimum capital ratio. The weights allotted
to each of the items of assets and off-balance sheet items are
dfw P
authorities. These instruments often carry a fixed maturity and.
As they approach maturity, they should be subjected to furnished below
progressive discount for inclusion in Tier II capital. The Risk Weights on Different Items of Assets and off-
subordinated debt instruments should have a minimum
w.p m

Balance Sheet Items


maturity of 5 years and if the instruments are issued in the last
quarter of the year, i.e. form January to March; they should have I. Domestic Operations
a minimum tenure of 63 months. Instruments with initial A. Funded Risk Assets
ww Co

maturity of less than 5 years or with a remaining maturity of


one year should not be included as part of Tier II capital. The
interest rate should not be more than 200 bp above the yield on
the Central Government securities of equal residual maturity at
the time of issuing bonds. Subordinated debt instruments will
cu

be limited to 50 percent of Tier I capital. The progressive


amount for various maturities to be included into Tier II capital
is given in the table below:
Do

Remaining term to maturity Discount rate


1. Where the date of maturity is beyond 5 0 percent
years
2. Where the date of ma turity is 20 percent
beyond 4 years but does not exceed 5
years
3. Where the date of maturity is beyond 3 40 percent
years but does not exceed 4 years

4. Where the date of maturity is beyond 2 60 percent


years but does not exceed 3 years

5. Where the date of maturity is beyond 1 80 percent


years but does not exceed 2 years

6. Where the date of maturity does not 100 percent


exceed one year

© Copy Right: Rai University


11.621.6 81
c. Interest due on Government securities;
MANAGEMENT OF FINANCIAL INSTITUTION

d. Accrued interest on CRR balances and claims on the


Assets Percentage weight
1. Cash and balance with Reserve Bank of India 0 Reserve Bank on account of Government transactions (net
2. Balances in current account with other banks 20
3.
4.
Claims on banks and Public Financial Institutions
Investments in government securities, other Approved
20
2.5
of claims of Government / Reserve Bank on banks on
Securities guaranteed by Central/State government, other
securities where payment of interest and repayment of account of such transactions).
principal are guaranteed by Central/State Government
In case of a default in interest/principal by State Government, banks
should assign 100 percent risk weight on investments in securities of
7. The investments in subordinated debt instruments and
the concerned State Government
5. Investments in other approved securities where payment of 20 bonds issued by other banks or Public Financial Institutions
interest and repayment of principal are not guarante ed by
Central/ State Government for their Tier II capital would carry 100 percent risk weight.
6. Investments in Government Guaranteed Securities of 20
Government undertakings which do not form part of the
approved market borrowing program 7A. Foreign exchange open position limit should carry 100
7. Investments in bonds issued by other banks / PFIs 20
8. Investments in securities which are guaranteed by banks or 20 percent risk weight with effect from 31-3-1999. Open position
PFIs as to payment of interest and repayment of principal
9. Investments in subordinated debt in the form of Tier II
Capital Bonds issued by other banks/PFIs
100 limit in gold should also carry 100 percent risk weight with effect
10. All other investments
11. Loans and advances including bills purchased and discounted
100 from 31-3-1999. Risk weights both in respect of foreign
and other credit facilities
exchange and gold open position limits should be added to the

al
12. Loans guaranteed by Government of India/State Government
13. In cases where guarantees have been invoked and the 0
concerned state Government has remained in default as on other risk weighted assets for calculation of CRAR.
31-03-2000, a risk weight of 20 percent on such advances
should be assigned. If State Governments continue to be in
default in respect of such invoked guarantees even after 31-03- B. Off-Balance Sheet Items

i
2001, a risk weight of 100 percent should be assigned
14. Loans granted to public sector undertakings of Government The credit risk exposure attached to off-balance sheet items has

com Tr
of India / State Government
15. Others
to be first calculated by multiplying the face amount of each of
the off-balance sheet items by the ‘credit conversion factor’ as
100
indicated in the table below. This will have to be again
multiplied by the weights attributable to the relevant
100
counterparty as specified above.

rd. F
16. Premises, furniture and fixtures 100
17. Other assets 100

Notes iza D Instruments


1. Direct credit substitutes, e.g. general
guarantees of indebtedness (including
standby letters of credit serving as
Credit conversion factor
100
dfw P
financial guarantees for loans and
1. Netting may be done only for advances collateralized by cash securities) and acceptances (including
endorsements with the character of
margins or deposits credit balances in current or other acceptances)
2. Certain transaction -related contingent 50
accounts which are not earmarked for any specific purpose items (e.g. performance bonds, bid
bonds, warranties and standby letters
and free from any lien in respect of assets where provisions
w.p m

of credit related to particular


transactions)
for depreciation or for bad and doubtful debts have been 3. Short-term self -liquidating trade -related 20
contingencies such as documentary
made. credits collaterised by the underlying
shipments
1A for the purpose of computing risk adjusted values of
ww Co

4. Sale and repurchase agreement and 100


asset sales with recourse, where the
assets, banks may “net off” against the total outstanding credit risk remains with the bank
5. Forward asset purchases, forward - 100
exposure of the borrower, the following items also: deposits and parity paid shares and
securities, which represent
i. Claims received from DICGC/ECGC and dept in a commitments with certain draw down
6. Note issuance facilities and revolving 50
separate account pending adjustment underwriting facilities
7. Other commitments with an original 50
cu

ii. Subsidies received against IRDP advances and kept in a maturity of over one year (e.g. formal
standby facilities and credit lines)
separate account. 8. Similar commitments with an original 0
maturity up to one year, or which can
be unconditionally canceled at any
2. Equity investments in subsidiaries, intangible assets and time.
losses deducted from Tier I capital should be assigned zero 9. Aggregate outst anding foreign
Do

exchange contracts of original maturity.


weight. Of less than one year
For each additional year or part thereof
2
3
3. Advances covered by the guarantee of DICGC / ECGC may
be assigned the risk weight of 50 percent. The risk weight of
50 percent should be limited to amount guaranteed and not
the entire outstanding balance in the accounts. Notes
4. Advances against term deposits, life insurance policies, life 1. Cash margins/deposits shall be deducted before applying
insurance policies, National Saving Certificates, Indira Vikas the conversion factor.
Patras and Kisan Vikas Patras where adequate margin is 2. After applying the conversion factor as indicated above, t he
available, would carry zero risk weight. adjusted off-balance sheet value shall again be multiplied by
5. Loans to staff of banks would also carry zero risk weight. the weight attributable to the relevant counterpart as
6. The under noted accounting heads should be assigned zero specified above.
risk weight under ‘other assets’: 3. In regard to off-balance sheet items, the following
a. Income tax deducted at source (net of provision) transactions with non-bank counterparties would be treated
b. Advance tax paid (net of provision); as claims on banks and carry a risk weight of 20 percent.

© Copy Right: Rai University


82 11.621.6
a. Guarantees issued by banks against the counter (net of claims of Government/Reserve Bank on banks on

MANAGEMENT OF FINANCIAL INSTITUTION


guarantees of other banks; account of such transactions).
b. Rediscounting of documentary bills accepted by banks. B. Non-funded Assets
Bills discounted by banks, which had been accepted, by
another bank would be treated as a funded claim on a Instruments Credit conversion factor (percent)
bank. 1. Direct
acceptances
credit substitutes and 100

2. Certain transaction -related contingent 50


4. Foreign exchange contracts with an original maturity of 14 items
calendar days or less, irrespective of the counterparty, may be 3. Short-term self -liquidating trade -related
contingencies
20

assigned ‘zero’ risk weight as per international practice. 4. Sale and repurchase agreement and
asset sales with recourse, where the
100

credit risk remain with the bank


II Overseas operations (applicable only to Indian banks 5. Forward asset repurchase, forward 100
repurchases, forward deposits and
having branches abroad) partly paid shares and securities which
represent commitments with certain
A. Funded Risk Asset drawdown
6. Note issuance facilities and revolving 50

al
underwriting facilities
7. Other commitments with original 50
maturity of over one year
Assets Percentage Weight
8. Similar commitments with an original 0
1. Cash 0 maturity up to one year, or which can
2. Balance with monetary authority 0 be unconditionally canceled at any time

i
3. Investments in government securities 0
4. Balances in current account with other 20

com Tr
banks
5. All other claims on banks including but 20
not limited to funds loaned in money
markets, deposit placements,
investments in CDs, FRNs, etc
Note
6. Investment in non- bank sectors
7. Loans and advances, bills purchased
100 Cash margins/deposits shall be deducted before applying the
and discounted and other credit
facilities
conversion factor. After applying the conversion factor as

rd. F
a. Claims gua ranteed by GOI 0 indicated above, the adjusted off-balance sheet value shall again
b. Claims guaranteed by State Governments 0
c. Claims on public sector undertakings of GOI 100 be multiplied by the weight attributable to the relevant
d. Claims on public sector undertakings of State 100
counterparty as specified in funded risk assets above.
Governments
e. Others

iza D
8. All other banking and infrastructural
assets
100
100
Foreign Exchange and Interest Rate Related
Contracts
dfw P
Foreign exchange contracts include the following:
Notes
i. Cross-currency interest rate swaps
1. Netting may be done only for advances collateralized by cash
w.p m

margins or deposits and in respect of assets where ii. Forward foreign exchange contracts
provisions for depreciation or for bad and doubtful debts iii. Currency futures
have been made. iv. Currency options purchased
ww Co

2. Equity investments in subsidiaries, intangible assets and v. Other contract of a similar nature
losses deducted from Tier I capital should be assigned zero As in the case of other off-balance sheet items, a two-stage
weight. calculation prescribed below shall be applied.
3. The investments in subordinated debt instruments and
Step 1
bonds issued by other banks or Public Financial Institutions
cu

The notional principal amount of each instrument is multiplied


for their Tier II capital would carry 100 Percent risk weight.
by the conversion factor given below:
4. Advances covered by the guarantee of DICGC/ECGC may
be assigned the risk weight of 50 percent. The risk weight of
Original Maturity Conversion Factor
Do

50 percent should be limited to amount guaranteed and not Less than one year 2
Between one and two years 5
the entire outstanding balance in the accounts. For each additional year 3

5. Advances against term deposits, life insurance policies,


National Saving Certificates, Indira Vikas Patras and Kisan STE
Vikas Patras where adequate margin is available would carry Setp 2
zero risk weight. The adjusted value thus obtained shall be multiplied by the risk
6. Loans to staff of banks would also carry zero risk weight. weightage allotted to the relevant counterparty as given in
7. The under noted accounting heads should be assigned zero funded risks above.
risk weight under ‘Other Assets’ Interest rate contracts
a. Income tax deducted at source (net of provision); Interest rate contracts include the following:
b. Advance tax paid (net of provision); i. Single currency interest rate swaps
c. Interest due on Government securities; ii. Basis swaps
d. Accrued interest on CRR balances and claims on the iii. Forward rate agreements
Reserve Bank on account of Government transactions iv. Interest rate futures

© Copy Right: Rai University


11.621.6 83
v. Interest rate option purchased
MANAGEMENT OF FINANCIAL INSTITUTION

vi. Other contracts of similar nature


Step 1
The notional principal amount of each instrument should be
multiplied by the percentage given below:
Original Maturity Conversion Factor
Less than one year 0.5
Between one and two years 1.0
For each additional year 1.0

Step 2
The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counterparty as given in II A
above.

al
Maintenance of CRAR
After assessing the capital funds and the risk weighted assets,

i
the bank will have to compute the ratio of the capital to risk

com Tr
weighted assets. The minimum CRAR was initially set at 8
percent. However, to meet the international standards, this is
being raised to 9 percent with effect from March 31, 2000.
Reporting
Banks should furnish an annual return commencing form the

rd. F
year ended March 30, 1992, indicating:
a. Capital funds

iza D
b. Conversion of off-balance sheet/non-funded exposures
c. Calculation of risk weighted assets and
dfw P
d. Calculation of capital funds ratio.
The format for the returns is given as a break-up and aggregate
in respect of domestic and overseas operation will have to be
w.p m

furnished. The returns should be signed by two official who are


authorized to sign the statutory returns submitted to the RBI.
Summary
ww Co

The minimum capital adequacy requirement is given statutorily


by RBI. This minimum level is aimed to bring global standards
into the Indian markets. And as the global operations of the
Indian banks increase, it is essential for banks to meet these
standards. Apart from this advantage, banks will also have a
cu

proper banking of their capital for the risks they face while
operating in the ever changing market environment.
Questions to Discuss
Do

1. Discuss Capital Adequacy Norms.


2. What are foreign exchange and interest rate related contracts?
3. What do you understand by risk adjusted assets and off-
balance sheet items?
Notes:

© Copy Right: Rai University


84 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 22:
TUTORIAL-3

Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 85
UNIT 4
DIFFERENT BANKING ASPECTS
LESSON 23:
COOPERATIVE BANKS
MANAGEMENT OF FINANCIAL INSTITUTION

Learning objectives Reserve Bank Of India and commercial banks. The apex banks
After reading this lesson, you will understand or state cooperative banks obtain their funds from share capital,
deposits, loans from commercial banks, the Reserve Bank of
• Introduction
India and the Government.
• Central Cooperative banks
Characteristics of Co-operative Banks
• State or provincial cooperative banks or apex banks

al
Some distinguishing characteristics of the nature of co-
• Agricultural credit-intensive development scheme operative banks are as follows:
• The agricultural refinance and development corporation 1. They are organised and managed on the principles of co-

i
• Nabard operation, self-help, and mutual help. They function with the

com Tr
Cooperative banks, another component of the Indian banking rule of “one member one vote”.
organisation, originated in India with the enactment of the 2. They function on “no profit no loss” basis. For commercial
cooperative credit societies act of 1904, a number of cooperative banks also, profitability is no longer the main objective, but
active credit societies. Under the act of 1904, a number of in their case this change has been brought about as a result

rd. F
cooperative credit societies were started. Owing to the increasing of social or public policy, while co-operative banks, by their
demand of cooperative credit, a new act was passed in 1912, very nature, do not pursue the goal of profit maximisation.
which provided for the establishment of cooperative central

iza D
banks by a union of primary credit societies or by a union of
primary credit societies or by a union of primary credit societies
3. Co-operative banks perform all the main banking functions
of deposit mobilisation, supply of credit and provision of
remittance facilities. However, it is said that the range of
dfw P
and individuals. services offered is narrower and the degree of product
The chief functions of these banks were: (1) attracting deposits differentiation in each main type of service is much less in
from non-agricul-turists, (2) using excess funds of some the case of co-operative banks, compared to commercial
societies temporarily to make up for shortage in other arid (3) to banks. In other words, co-operative banks are characterised
w.p m

supervise and guide the affiliated societ-ies. In 1914, the Mac by functional specialization. It should be added that this is
lagan Committee was appointed to examine the cooperative true, with much less force now, because many changes have
movement and to make recommendations regarding the taken place in the co-operative banking system since the
ww Co

improvement of the movement. It recommended the Banking Commission arrived at the above-mentioned
establishment of a State Cooperative Apex Bank. On this conclusion. For example, co-operative banks now provide
recommendation a Central Coop-erative Bank was established housing loans also. The UCBs provide working capital loans
in Bombay. Other provinces also took ac-tion on similar lines. and term loans as well. The State Co-operative Banks (SCBs),
Although these may be considered as the early beginnings in the Central Co-operative Banks (CCBs) and Urban Co-operative
cu

direction of establishing cooperative banks to meet the financial Banks (UCBs) can normally extend housing loans upto Rs
needs of agriculturists, the movement received momentum lakh to an individual. The scheduled UCBs, however, can
only after the Second World War. lend upto Rs 3 lakh for housing purposes. The UCBs can
Cooperative banking India is federal in its structure. At the provide advances against shares and debentures also.
Do

lower rung, there are primary credit societies, then there are the 4. As said earlier, co-operative banks do banking business
central unions or central cooperative banks and at the top there mainly in the agricultural and rural sector. However, certain
are the Provincial Cooperative Banks or State Cooperative types of banks viz., UCBs, SCBs and CCBs operate in semi-
Banks, otherwise known as “Apex” banks. The primary urban, urban, and metropolitan areas also. The urban and
societies may be compared with joint banks. Their main non-agricultural business of these banks has grown over the
function is that of lending money to villagers on easier terms. years. The co-operative banks demonstrate a shift from rural
Much of their work is done by members themselves on an to urban, while the commercial banks, from urban to rural.
honorary basis. They have their own funds supplemented by 5. Co-operative banks are perhaps the ‘first government-
funds drawn from the Central Cooperative Banks through the sponsored, government-supported, and government-
banking unions where such unions exist. The Banking unions subsidised financial agency in India. They get financial and
are federations of primary societies and they act as either other help from the RBI, NABARD, central government and
‘coordinating unions’ or ‘supervisory unions’ between primary state governments. They constitute the “most favoured”
societies and central cooperative banks. The central cooperative banking sector with no risk of nationalisation. For
banks obtain the funds from share capital, deposits, loans from commercial banks, the RBI is a lender of last resort, but for
the apex banks, and where apex banks do not exist, from the’ co-operative banks, it is the lender of first resort, which

© Copy Right: Rai University


86 11.621.6
provides financial resources in the form of contribution to with Demand and Time Liabilities over Rs 50 crore each are

MANAGEMENT OF FINANCIAL INSTITUTION


the initial capital (through state governments), working included in the Second Schedule of the RBI Act.
capital, and refinance. The promotional role Of the RBI can 10. As said earlier, co-operative banks accept current, saving, and
be seen in respect of co-operative banks, and this role fixed or time deposits from individuals and institutions
supersedes its regulatory role, in respect of these banks. including banks. Some DCBs numbering about 40 in 1989
A corollary of government’s help to co-operative banks is that are allowed to open and maintain NRI accounts in rupees
there is much government intervention in their working. Co- but not in foreign currency. Deposits mobilized by them in a
operative banks are subject primarily to the control, audit, given area are used for financing activities in that locality.
supervision and periodic inspection of the co-operative Some co-operative banks, namely, Land Development Banks
department of the state government under the Co-operative (LDBs), issue debentures to raise resources for their
Societies Act, but less rigorously, by the RBI under the Banking operations. These debentures are secured by mortgaging
Regulation Act. The RBI and the state government lay down lands belonging to borrowers from LDBs and are often
rules for investment of surplus resources, reserves, and the loan guaranteed by the state government are regarded as trustee

al
policy of co-operative banks. Consequently, compared to securities and are treated on par with government securities
commercial banks, they have less freedom and flexibility in for making advance. There are three types of such
conducting their operations. debentures: ordinary, rural, and special. These debentures are

i
6. Cooperative banks belong to the money market as well as to almost entirely subscribed by such institutional investors as

com Tr
the capital market. Primary agricultural credit societies provide banks, LIC, and the government.
short-term and medium-term loans. Land Development Types, Structure and Growth of Co-Operative Banks
Banks (LDBs) provide long-term loans, UCBs meet working The following figure present the structure and progress of co-
capital as well as fixed capital requirements, and SCBs and operative banking in India.

rd. F
CCBs also provide both short-term and term loans.
Similarly, they accept short-term and long-term deposits, and
some of them mobilise resources through the issue of
debentures.
iza D
7. Co-operative banks are financial intermediaries only partially.
dfw P
The sources of their funds (resources) are: (a) central and
state governments, (b) the RBI and NABARD, (c) other co-
operative institutions, (d) ownership funds, and (e) deposits
or debenture issues. It is interesting to note that intra-
w.p m

sectoral flows of funds are much greater in co-operative


banking than in commercial banking. Inter-bank deposits,
borrowings, and credit form a significant part of assets and
ww Co

liabilities of co-operative banks. This means that intra-


sectoral competition is absent and intra-sectoral integration is
high for co-operative banks.
As said earlier, the co-operative banking structure is federal in
However, co-operative banks face stiff competition from
character, with three-tier linkages between state, district and
commercial banks and other financial intermediaries. Till their
cu

village level institutions. At the state level, we have State Co-


nationalisation, commercial banks did not pose any
operative Banks (SCBs) and the State Land Development Banks
competition to co-operative banks. In fact, till then, certain areas
(SLDBs); at the district level, the Central Co-operative Banks
of operations were deliberately left to co-operative banks. But
(CCBs) or the District Central Co-operative Banks (DCCBs) and
recently, the competition from LIC, UTI, and small-savings
Do

the Central Land Development Banks (CLDBs); then at the


organisation has become quite tough, and co-operative banks
village level, the Primary Agricultural Credit Societies (PACSs),
are in a disadvantageous position in this area of inter-sectoral
the Primary Land Development Bank (PLDBs), and the
competition.
branches of SLDBs. The lower tiers are members and
8. Co-operative banks have a federal structure of three-tier shareholders of the immediate higher tier. Besides, there are the
linkages.Further,theiroperationismixed of banking type. Urban Co-operative Banks (UCBs) or the Primary Cooperative
Primary credit societies are unit banks; many DCBs also are Banks (PCBs), which are outside this federal structure. Though
unit banks. But SCBs, DCBs (CCBs), and SLDBs, PLDBs federal in its organisational structure, the system is integrated
and many DCBs have a number of branches. Subject to this, vertically on the basis of functional responsibilities of various
it can be said that each co-operative institution in each tier is a components of the system. The SCBs, CCBs and PACSs form
separate entity with definite jurisdiction and has an the short-term and medium-term credit structure and it is the
independent board of management. same in all the states. The land development banks at various
9. Some co-operative banks are scheduled banks, while others levels make the long-term credit structure, which is not uniform
are non-scheduled banks. For instance, SCBs and some in all the states.
DCBs are scheduled banks but other co-operative banks are
non-scheduled banks. At present, 28 SCBs and 11 DCBs

© Copy Right: Rai University


11.621.6 87
The state level co-operative banks are said to be the apex • Co-operative banks are not doing well in all the states; only a
MANAGEMENT OF FINANCIAL INSTITUTION

institutions in this federal structure” However, the apex few account for a major part of their business.
institutions from the point of view of promotion, supply of • These banks still rely very heavily on referencing facilities
resources, supervision and control, are the government, RBI, from the government, the RBI, and NABARD. They have
NABARD, and National Co-operative Bank of India (NCBI). yet not been able to become self-reliant in respect of
The SCBs and SLDBs are in an intermediate position between resources through deposit mobilisation.
the institutions just mentioned on the one hand, and the co-
• They suffer from dangerously low or weak quality of loan
operative banks on the other.
assets, and from highly unsatisfactory recovery of loans.
The SCBs co-ordinate and regulate the working of CCBs. They
• They suffer from infrastructural weaknesses and structural
act as custodians of surplus funds of the CCBs and
flaws. They do not look like banks and do not inspire
supplement them by attracting deposits and by obtaining loans
confidence in the potential members, depositors and
from the RBI. The CCBs mobilise resources in districts to
borrowers.
finance their members, and they also charnel’s funds from the
• They suffer from too much officialisation and politicisation.

al
SCBs to primary credit societies. The PACSs at the village1evel
form the base of the co-operative_ banking. Although they are Undue governmental interventions have prevented them
expected to be multi-purpose societies, they mostly deal in from developing steadily as a self-reliant and resilient credit

i
credit. system.

com Tr
Problems and Policy Central Cooperative Banks
As in the case of commercial banks, the quantitative growth of The Central Cooperative Banks are independent units inasmuch
co-operative banks has not been accompanied by a qualitative as the provincial cooperative banks have no powers to control
growth. There have always been a number of weaknesses in or supervise the affairs of central banks. They are of two kinds
viz pure’ and ‘mixed’. Those banks; the membership of which

rd. F
their performance. Many of these weaknesses were identified by
the All India Rural Credit Survey Committee (AIRCSC) in the is confined to cooperative organisations, only are Included in
early 1950s. By that time, co-operative banks had been in the the ‘pure’ type, while those banks, the membership of which is

iza D
business for 45 years and the AIRCSC had concluded that co-
operatives had failed, but that they must succeed. As a result,
open to cooperative organisations as well as to individuals, ate
included in the ‘mixed’ type. The Pure type of central banks can
be seen in Kerala, Bombay, Orissa, etc, while the mixed type can
dfw P
special measures were introduced by the government and the
RBI to revive and strengthen co-operative banks. Even after a be seen in the case of Andhra, Assam, Chennai, Mysore, etc.
span of 50 years, an assessment of the co-operative banks The pure type of banks is based on strict cooperative principles,
shows that many of the weaknesses of the co-operative credit while the mixed type does not adhere to any such strict
w.p m

system identified by the Rural Credit Survey Committee principles. However, the latter has an advantage over the former
continue to persist. in so far as they can draw their funds from the non-agricultural
section, too. But by allowing individuals to hold shares, loan
The Khusro Committee asserts: “No credit system has been
ww Co

facilities are necessarily extended to them; and in case some of


subjected to as much experimentation at the dictates of those
them happen to be middlemen, who’ may utilise the proceed
outside the system as the co-operative credit system has
of the loan to carry on their trading operations, then it would
been…The history of co-operative credit system has been the
be a hard blow on the very basic principles of cooperation,
history of alternating periods of growth, stagnation and
which strive for the elimination of middle-men.
reorganization and yet quantitatively the achievements of the
cu

co-operative systems have by no means been insignificant… As mentioned earlier, the central cooperative banks draw their
Thus looking to the stake of the movement even in the limited funds from share capital, deposits, loan from the State
sphere of credit, the classic assertion of the Rural Credit Survey Cooperative Banks and where the State Banks do not exist,
made 35 years ago still seems valid that Co-operation has failed from the Reserve Bank and other commercial banks: The main
Do

but Co-operation must succeed…” function of the central banks is to finance the primary credit
societies. In addition to this, they ‘carry on commercial banking
The main weaknesses of co-operative banks are as follows:
activities like acceptance of deposits, the giving of loans and
• The vital link in the co-operative credit system namely, the advances on the sculpt of first-class gilt-edged securities, fixed
PACSs, remain very weak. They are too small in size to be deposit receipts, gold, bullion, goods and documents of title to
economical and viable; besides too many of them are goods, the col-lecting of bills, cheques, handles, the receiving of
dormant, existing only on paper. valuables for safe cus-tody and the performance of services as
• With the expanding credit needs of the rural sector, the an agent to the customer to purchase and sell securities etc. They
commercial banks have come in actively to meet the credit also act, as ‘balancing centres’ making available temporary excess
requirements of this sector, and this has aggravated the funds of one primary to another, which is in need of them.
difficulties of co-operative banks. The theory that co- Defects of the working of the cooperative banks are not likely
operative banks would be buoyed up by the competition to pass uncensored. The linking of commercial banking
from other financial institutions does not appear to have activities with the central banks is often pointed out as against
worked. the principles of coopera-tion. But it should be remembered
that the volume of work is not enough to keep these

© Copy Right: Rai University


88 11.621.6
institutions fully occupied. The inadequacy of share capital has outstanding, but this is mainly owing to a substantial increase

MANAGEMENT OF FINANCIAL INSTITUTION


been characterised as the Achilles’ heel of the central banks. It is in fresh advances resulting in a Outspending in-crease in
also said that these banks do not maintain expert staff of outstanding.
examine the credit-worthiness of the primary societies, thereby
State or Provincial Cooperative Banks or Apex Banks
leading to accumulated overdues. Another criticism raised by the
State Cooperative Bank means the principal society in a state
Royal Commission on Agricul-ture was that the central banks
which is registered or deemed to be registered under the
combined both the financing and supervi-sory work. They
Government Societies Act, 1912, or any other law of the time
recommended that the financing and supervisory work should
being in force in India relating to cooperative societies and the
be separated, contending that the supervisory work of central
primary object of which is the financing of the other societies in
banks had been a failure. But against this, it may be argued that
the state which are registered or deemed to be registered. In
since the central banks are to finance the primary societies the
addition to such a principal society in a state or where there is no
supervisory work should be entrusted to them inasmuch as it is
such principal society in a state, the State Government may
their concern to see that primary credit societies are working in
declare anyone or more cooperative societies carrying on

al
order.
business in that State to be a state cooperative bank (or banks).
Further it has been found that certain cooperative central banks
As in the case of central banks the state cooperative banks may
are utilising the reserves funds as working capital. This is
be pare in which case, it will be a federation of central

i
definitely against fundamental principles, which will affect
cooperative banks only, or ‘mixed’ in which case it will be a

com Tr
adversely the working of these banks in the final end. It is
federation of both central cooperative banks as well as
highly necessary that adequate reserves should be built up and
individual members. The state banks re-ceive current and fixed
kept apart from working capital so that it may be used only in
deposits from its constituent banks as well as savings deposits
times of emergencies.
and fixed deposits from the general public and from local

rd. F
The case against ‘mixed’ societies has already been discussed in boards, municipalities, etc. Further they receive loans at call and
detail. But at present, the mixed type of societies is inevitable, short notice from the commercial banks at current rates of
since to raise enough capital from the agricultural masses itself interest and seasonal loans from the Reserve Bank of India to

iza D
is not possible, because of their poor resources. So the aim
should be to convert the mixed societies into pure societies step
by step as the income of the agricultural masses increases so
finance seasonal agricultural operations. The State Governments
contribute a certain portion of their working capital.
dfw P
The principal function of the state banks is to assist the central
that after a certain stage we can dispense with the mixed
banks and to balance excess and deficiencies in the resources of
societies.
central banks.
Further, the lending rates of these banks arc said to be very
w.p m

This function of the Apex bank to act as a ‘balancing centre’ is


high. The high administrative costs of small and uneconomic
important since direct lending is prohibited among the central
units of central cooperative banks, the difficulty experienced in
banks. The connec-tion between the state banks and the
raising the necessary funds from the Money Market at low rates
primary cooperative societies is not direct. The central banks are
ww Co

of interest and the problem of raising enough local funds have


acting as intermediaries between the Apex banks and primary
forced the central banks to charge high rates of interest. But in
societies. Of course, in the absence of a central bank. The state
order to make cooperative finance popular among agriculturists
cooperative bank may act as a central bank and in that case its
and to make the movement a crowning success, the rates of
connection with the primary societies will be direct.
lending should necessarily be brought down. To reduce the
cu

rates of inter-est, the Reserve Bank of India has suggested The working of state banks is not free from complaints. Most
certain measures such as strengthening the cooperative of the companies leveled against the central cooperative banks
movement and improving its efficiency, the mobilising of rural are also valid against the state cooperative banks. Among them,
savings and amalgamating of small uneconomic units into the important are the undesirability of linking commercial
Do

viable units. The state governments can also add their banking activities with cooperative banking, inadequacy of share
contribution in this direction by giving subsidies to the central capital, utilisation of reserve funds i as working capital and the
banks during the initial stages so that the loss arising from policy in allowing individuals to become share-holders of the
charging low rates of interest may be compensated. banks, which is against cooperative principles.
Recent trends in the working of central cooperative banks Agricultural Credit-Intensive Development Scheme
indicate that there is a decline in their number, as a result of The ACID scheme was conceived with a view to concentrating
amalgamation and reorganization of central banks with the efforts on a selective basis to strengthen the co-operative
object of having one song central banks for each district. The structure and link the credit programme with production
owned funds, apart from the bor-rowed funds, of these banks programmes. The scheme was ap-proved by the Reserve bank’s
show an overall increase during recent years. However, it is Agricultural Credit Board in December 1976 and received the
deplorable that many of them were not able to reach the support of the State Governments, All India Fed-eration of
standard of Rs. 3 lakhs per bank prescribed by the Standing State Co-operative Banks, the Planning Commission and the
Advisory Committee on Agricultural Credit as a ‘desirable Union Ministry of Agriculture, and other concerned agencies.
minimum limit” of owned capital. In the matter of overdues, Under the first phase of the scheme, 41 districts (including
there is a decline in the propor-tion of overdues to loans SFDA and DP AP dis-tricts) in 16 States have been selected for

© Copy Right: Rai University


11.621.6 89
intensive credit development in various sectors of the rural the concerned State Governments As decided by the sub-
MANAGEMENT OF FINANCIAL INSTITUTION

economy. Some of the important criteria followed in the committee in its second meeting held in April 1978, top priority
selecting the 41 districts were: (a) the districts which have scope under the Action Programme is being given to (1) reduction of
for development and a reasonable strong co-operative credit overdues, (2) full coverage of small farn1ers and (3) increase in
structure; (b) the central co-operative banks of the district borrow-ing members.
should not have heavy overdues (i.e. ordinarily these should be Since the introduction of the Scheme, there have been certain
less than 40 per cent (c) existence of SFDA and DPAP schemes; developments requiring a review of the Scheme, The lead banks
and (d) the districts where regional rural banks were not have been advised to tern1inate the existing plans by December
functioning (though in a few districts, some parts of the 1979 and formulate fresh District Credit Plans for their lead
districts were covered by regional rural banks). districts from January 19S0 and Annual Action Plan by
In particular, the central co-operative banks in these districts will December each year. The District Credit Plans would be a
have the following main objectives viz., (I) to improve their comprehensive credit plan for the District and would indicate
organisational and operational effectiveness; (2) to create an total credit outlays (sector-wise, scheme-wise and institution-

al
awareness for grow III and need for diversification; (3) to build wise) for technically feasible and economically viable schemes for
up own resources and manpower so as to ensure gradual financing pro-duction and investments by the bank. Co-
independence from outside help; (4) to progressively operatives, among other finan-cial institutions, are also

i
professionalism their managements and (5) to bring about participating agencies in the formulation and implementation

com Tr
orientation of policies towards benefiting the common of the plans. In the context of these developments it has been
interests of the rural population, especially the weaker ones. decided to integrate the ACID Programme with District Credit
The selection of the districts for the scheme was done in Plans from 1980 onwards.
consultation will the State Governments at a 2-day meeting in The Agricultural Refinance and Development

rd. F
Bombay in January 1977, Subsequently, four zonal meetings Of
Corporation
senior officers of the State Governments, the Chairman and the
In the sphere of long-term agricultural credit, an important
Chief Executive Officers of the state Co-operative Banks and

iza D
land development banks were held at Bombay, Madras, Calcutta
and New Delhi during February and March I 977 for explaining
the objectives of the scheme. As envisaged under the scheme,
development during the Third Five Year Plan had been the
establishment of the Agri-cultural Refinance Corporation. The
Plan elaborated the functions of the Corporation in the
dfw P
following terms.
quick surveys of the selected districts in 16 States were
conducted to collect basic data for preparation of district credit “The Corporation will purchase debentures floated by central
plans for the districts. land mortgage banks in the normal course and will also provide
w.p m

funds for schemes for increasing agricultural production which


Action programmes to be implemented during kharif 1977
are remunerative in character, but involve considerable invest-
were also prepared for the selected districts. Preliminary
ment or long periods of waiting, such as rubber, coffee, cashew
guidelines were prepared for the formulation of district credit
nut and areca nut plantations, irrigation, contour-bonding and
ww Co

plans and arrangements made to prepare such plans in one


soil conservation, and development of orchards and fruit
district of each of the four zones in the country in the first
gardens. The loans advanced by the corporation will be chal-
instance. Steps were also initiated to ensure full co-ordination
lenged through the Central Land Mortgage Banks.”
with commercial banks so that at the district level, where these
banks work as lead banks, duplication of efforts may be The functions of the Corporation have since been transferred to
cu

avoided. the National Bank for Agriculture and Rural Development.


A sub-committee was set up by the Agricultural Credit Board in National Bank for Agricultural and Rural
its meeting held on IS July 1977 with Prof. M.L. Dantwala as
Development (Nabard)
chainman to guide the Reserve Bank in matters of policy and
Do

NABARD started its operations in November 1982 by taking


implementation. The main activity during 1977 -7S, under the
over the developmental and refinancing functions of the
scheme pertained to the prepara-tion of Credit and Action
Agricultural Refinance and Development Corporation on the
Programmes for the selected districts. In the programmes an
one hand and the Reserve Bank of India on the other. The
effort is made to: (1) identify the on-going bankable schemes
National Bank was organised with the basic objective of
financed by various agencies and also that might be fom1ulated
establishing an apex institution in the field of agricultural and
in the near future, (2) assess their credit requirements in a
rural development finance in such a way as to integrate the
realistic man-ner, (3) suitably adjust the credit programmes of
financing of various institutions involved the development of
the concerned financial institutions operating in the district, and
rural areas.
(4) specify the action that is necessary to implement the
programme, The Bank has all authorised capital of Rs. 500 crores and a paid
up capital of Rs. 100 crores. Its paid up capital is shared equally
Such programmes have already been prepared in respect of
by the Government of India and the Reserve bank of India. It
various districts. In pursuance of the scheme’s objective to
can augment its resources by drawing funds from the Central
strengthen the banks organizationally, staffing pattern studies
Government, the State Governments. The Reserve Bank,
of state co-operative banks and the central co-operative banks
international agencies including the World Bank Group and by
have also been undertaken in various States in consultation with

© Copy Right: Rai University


90 11.621.6
raising funds from the market through bonds and debentures. programmes-to suit the requirements or different areas of

MANAGEMENT OF FINANCIAL INSTITUTION


In addition the resources of the National Agricultural (Long rural development; and
Term Operations) and the National Agricultural (Stabilisation) (viii) inspection of cooperative banks and RRBs.
Funds of the Reserve Bank stand transferred to the National
During the short period of its existence, the Banks has played
Rural Credit (Long Term Operations) and the National Rural
its dual role as an apex institution and as a refinancing agency
Credit (Stabilisation) Funds of the NABARD. It can also
creditably by participating actively in the development policy
borrow from the Reserve Bank for financing its short term
formulation, planning, coordination, monitoring, research,
lending operations. In short, the Bank is well equipped with
training and consultancy as well as refinancing areas relating to
adequate financial resources to meet its commitment in the field
agricultural and rural development. It may be noted in this
of agricultural and rural development.
connection the Bank is a single integrated agency cater-ing to the
The management or the Board is vested in a Board of Directors credit needs of all types of agricultural and rural development.
consisting of the following members. It is gratifying to note that the Research Cell of the National
a. A Deputy Governor of the Reserve Bank as Chairman. Bank is paying particular attention to ensure that weaker

al
b. Three nominees of the Reserve Bank. sections of the rural population benefit more by schemes of
refinance by the Bank, that there is simplification of the
c. Three nominees of the Central Government.
procedures so that quick disposal of applications is possible

i
d. Three members, two Wit1l experience in cooperative banking and that the Government’s programmes for poverty eradica-

com Tr
and one in commercial banking. tion are supported in a meaningful way.
e. Two nominees of the State Governments.
Assistance for Agriculture
f. Two experts in rural economics and rural development. As an apex refinancing agency in the field of rural credit, the
g. A managing director. National Bank provides refinance assistance to the eligible

rd. F
h. One or more whole time directors. cooperatives and commercial banks for different purposes and
durations. It provides short term credit for periods not
Functions

iza D
NABARD performs all the functions performed by the
erstwhile Agricultural Refinance and Development Corporation
exceeding 18 months to State Coopera-tive Banks/Regional
Rural Banks for seasonal agricultural operations (crop loans)
marketing of crops, purchase and distribution of fertilizers and
dfw P
as well as those performed by the Agricultural Credit working capital requirements of cooperative sugar factories. It
Department of the Reserve Bank in the field of agricultural and also provides medium term credit (I8 months to 7 years) to
rural credit. These include: State Cooperative Banks/Regional Rural Banks for approved
(i) provision of short term, medium term and long tem1 agricultural purposes, pur-chase of shares of processing
w.p m

financial assistance of Land Development Banks, State societies and conversion of short term crop loans into medium
Cooperative Banks, RRBs, and commercial banks for term loans in areas affected by natural calamities. Long term
promoting agricultural and rural development: credit for a period of 25 years is provided to State Coopera-tive
ww Co

(ii) provision of long term loans to State Governments for a Banks/land development banks/Regional Rural Banks/
peri0d Upl.0 20 years for contribution to the share capital of Commercial banks for investment in agriculture under
cooperative credit institutions; schematic lending. Lending term loans (for periods not
(iii) provision of long term loans to any institutions approved exceeding 20 years) are provided to State Governments to
enable them to contribute to the share capital of the cooperative
cu

by the Central Government:


credit institutions.
(iv) contribution to the share capital or ordinary rural
debentures issued by any institution involved in agricultural Refinance Assistance
and rural development: The aggregate credit limits sanctioned by NABARD for co-
Do

operative and State Governments stood at Rs. 4,133.2 crore


(v) provision of necessary resources by way of refinance to the
during 1993-94. Drawals against these limits stood at Rs. 5358.7
primary lenders including State Cooperative Banks,
crores, NABARD has revised the rates of interest on its
commercial banks and RRBs for facilitating integrated rural
refinance with effect from March I, 1994 which would be
development.
applicable to all fresh lending/disbursements. The Bank
These cover all kinds of production and investment credit continues to pursue the policy of development and promotion
agriculture, small scale, cottage and village industries, handi- of agricultural investments in less developed and/or under
crafts, rural artisans and other allied economic activities in banked States.
rural area.
Co-operative Development Fund
(vi) coordination of the activities of central and State
An important development in the area of institutional
Governments the Planning Commission and other all-India
development during 1992-93 was the setting up of a Co-
and State-level institutions entrusted with the development
operative Development Fund by NABARD with an initial
of economic activities in rural areas;
corpus of Rs. 10 crore contributed by it out of its profits for
(vii) promotion of research in agricultural and rural 1992-93 to provide financial assistance by way of grants loans to
development: (viii) formulation of projects and co-operative banks for human resources development with suit-

© Copy Right: Rai University


11.621.6 91
able training input and to build up better management
MANAGEMENT OF FINANCIAL INSTITUTION

information sys-tems and infrastructural facilities for primary


agricultural societies for mobilising deposits. Upto March 1994,
a total assistance of Rs. 6.32 crore has been sanctioned to 10
State Co-operative banks and 3 State Land Development Banks
which include Rs. 3.62 crore in grants ado the balance of Rs.
2.70 crore in interest free loans.
Institutional Strengthening Programme
NABARD has prepared components and guidelines for
institutional strengthening programme aimed at making ‘non
solvent’ and ‘near non solvent’ banks ‘solvent’ and ‘viable’ as
per the recommendations of the Agricultural Review
Committee. The basic components of institutional

al
strengthening programme would comprise identification of
overdues and bad debts and to make provisions there against,
reduction in cost of management, rationalisation of loan

i
policies and procedures, expansion and diversification of loans

com Tr
portfolio, mobilisation of resources both manpower and
financial and their development, etc.
Questions to Discuss:
1. Discuss Central Cooperative banks.

rd. F
2. What do you understand by State or provincial cooperative
banks or apex banks?

iza D
3. Discuss Agricultural credit-intensive development scheme.
4. Discuss the agricultural refinance and development
dfw P
corporation.
5. Explain the features of NABARD.
Notes:
w.p m
ww Co
cu
Do

© Copy Right: Rai University


92 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 24:
DEVELOPMENT FINANCIAL INSTITUTION

Learning objectives Notes


After reading this lesson, you will understand 1. * the erstwhile Industrial Reconstruction Bank of India
• Role of DFls in the financial system (IRBI), established in 1985 under the lDBI Act, 1984, was
renamed as Industrial! Investment Bank of India Ltd.
• Operations of major Fls in India – IFCI
(IIHO with effect from March 27, 1997.
• Operations of major Fls in India –IDBI
# IVCF-IFCI Venture Capital Funds Ltd.
We will discuss the nature and operations of the present

al
2. Figures in brackets under respective institutions indicate the
financial institutions operating in India in today’s class. Today
year of establishment year of incorporation.
we shall focus on IFCI and IDBI.
3. Figures in the brackets under SFCs/SIDCs indicated the

i
Introduction number of institutions in that category.

com Tr
Financial Institutions play an important role in the Indian
financial system. In fact, most of the financial intermediation Industrial Finance Corporation of India
taking place outside banks can be attributed to the operations At the time of Indian independence, there were lacunae in its
of the financial institutions. Financial Institutions (Fls) provide financial system. One among them was the lack of adequate
project finance to the needy corporates and government industrial financing, especially to meet the medium to long-

rd. F
institutions, thereby performing an important role in the term requirements of the industries. In such a set up, it became
infrastructural development in the country. necessary to develop an institutional structure for meeting the

iza D
There are various kinds of financial institutions performing
their role in financial intermediation and infrastructural
development, differing on the basis of their inception and
large fund requirements of the industry. The first step in this
direction was the incorporation of the Institute of Finance
Corporation under the Institute of Finance Corporation Act,
dfw P
1948 (IFC Act). Subsequently the IFC Act, 1948 was repealed
operations. Broadly, the existing financial institutions may be
and in its place, the Industrial Finance Corporation (Transfer of
classified as (a) All India institutions like Industrial
Undertaking and Repeal) Act, 1992 (lFCI (Repeal) Act), was
Development Bank of India (lDBI) etc., or (b) Regional/State
formulated which came into force on July 1, 1993. lFCI was
w.p m

level institutions like the Gujarat State Financial Corporation etc


converted into a public limited company and was registered
or (c) Other Institu1ions like DICGC etc.
under the Companies Act in July, 1993. In December, 1993, it
It is to be noted that our definition of financial institutions also made its maiden public issue.
ww Co

does not encompass Non-Banking Financial Companies. This


The erstwhile IFCI was set up under an Act of Parliament in
is because of the fact that the characteristic of a typical financial
1948, with the share capital subscribed by Government of India
institution, which we are discussing here, and the characteristics
(GOl), RBI, Scheduled Commercial Banks, Insurance
of a NBFC differ in many ways.
Companies, Investment Trusts and Cooperative Banks. With
Organisational Structure of Financial Institution the establishment of the IDBI in 1964, the shareholding of
cu

GOI and RBI was transected to IDBI. IDBI holds 30% of IFls
equity.
All Financial Institution
The management of IFCI is vested in its BODs, comprising
Do

professionals drawn from diverse fields like banking, finance,


All India Financial Institution State Level Institutions Other Institutions
economics, insurance, etc.
IFCI is headquartered in New Delhi and has 17 regional offices.
All India
Development Banks
Specialised Financial
Institution
Investment
Institution
Refinance
institutions
Besides Delhi, regional offices are also located at Mumbai, Pune,
IDBI (1964)
ICICI (1955)
EXIM Bank (1982)
IVCF (formerly
UTI (1964)
LIC (1956)
NABARD
(1982) Kolkata, Hyderabad, Lucknow, Chennai, Ahmedabad,
SIDBI (1990) RCTC) (1988)# GIC &
Bangalore, Bhopal, Jaipur, Kochi, Punjab, Chandigarh,
NHB (1980)
IIBI (1997)* ICICI Venture subsidiaries
IFCI (1948) (formerly TDICI) (1972)
(1988)
TFCI (1989)
Guwahati, Bhubaneswar and Patna.
IDFC (1997)

SFC SIDC Product Profile


The main functions of IFCI are to provide various kinds of
(18) (28)

ECGC DICGC
financial services to the industries. Primarily, its services focus
(1957) (1962) on project finance as it provides assistance to all viable industrial
projects above Rs.50m. IFCI provides assistance to industrial
concerns for their new projects, expansion, diversification and
modernization schemes. Loans are generally extended for a
period of 5-7 years with a moratorium of 2-3 years. Loans are

© Copy Right: Rai University


11.621.6 93
extended both in rupee and foreign currency. The latter is • Tourism Advisory & Financial Services Corporation of India
MANAGEMENT OF FINANCIAL INSTITUTION

normally for import of capital equipment. Loans are provided (TAFSIL)


after a detailed project appraisal. Typically, the loans are secured • Institute of Labour Development (LTD.)
by the assets of the borrowers, in some cases along with
Other organizations in which the ‘IFCI acts as a co-promoter
corporate/personal guarantee, as additional collateral. After
are
performing the appraisal, depending on the borrower, the
interest rates are fixed. Apart from extending loans. IFCI also • Stock Holding Corporation of India.
underwrites/directly subscribes to equity/debentures of the • Entrepreneurship Development institute of India
companies. offers financial assistance in the form of equipment • OTC Exchange of India
leasing, equipment credit, suppliers’ and buyers’ credit,
• National Stock Exchange of India
equipment procurement and installment credit. Besides IFCI
provides guarantees for deferred payment and offers • Securities Trading Corporation of India
promotional services like support for technical consultancy, • Biotech Consortium India.

al
housing development, management development, • AB Home Finance
entrepreneurial development etc. IFCI has introduced capital
• LIC Housing Finance
subsidy scheme for converting palaces/castles/forts, etc. of any
• GIC Grih Vitta

i
size into heritage hotels. Disbursals during the year have

com Tr
registered a growth of 13%. In terms of new sanctions major Financial Resources
sectors are power generation, textiles and iron and steel together Equity, rupee and foreign currency loans and bonds form the
accounting for over 40% of sanctions in FY 1999. IFCI’s loan different types of finance resources for the IFCI. The resource
portfolio is well diversified across industries and geographic management function at IFCI is handled by a separate division
locations. from the headquarters at New Delhi. The requirements for

rd. F
IFCI has diversified from its traditional role in pJrojec1 finance funds are communicated by the accounts departments of
to provide finance for leasing and hire purchase concerns, various divisions in the form of monthly cash flow statements

iza D
corporate loans and short-term loans. It also offers a wide range
of financial services including issue management, corporate
advisor and trusteeship. Wholly owned subsidiaries were set up
(current and projected) to the resources Department at New
Delhi. The targets are set in conformity with the projections for
sanctions and disbursements in various activities. Rs.42.6bn
dfw P
to enable this diversification of its product portfolio. rupee borrowings were raised- during 1998-99 (67.1%- long-
term; l1.4%-medium-term; and 21.5%- short-term funds). The
These include:
average cost of the aforesaid borrowings Was about 13.5%.
• IFCI Financial Services Ltd. - Merchant Banking Stock IFCI has also issued preference share capital of Rs.3.4bn. The
w.p m

Broking and Allied Activities average maturity and average coupon rate of the preference share
• IFCI Investor Services Ltd. - Registrar and Transfer Services capital raised during the year was about 4.5 years and 10.6%
• IFCI Custodial Services Ltd. - Custodial Services respectively.
ww Co

• Risk Capital & Technology Finance Corporation Ltd. Performance


The IFCI Financial Services Ltd. undertakes merchant banking, Amongst the 4 AIFIs, lFCI ranks 3rd in terms of asset -base.
underwriting, issue management etc. IFC’I is a Category-I The lower ranking of IFCI amongst its power group can be
Merchant Banker and Debenture Trustee IFCI set up MBASD attributed to its bad asset quality. The outstanding have been
cu

(Merchant Banking and Allied Services Division) in July, 1986. mostly from (exiles, iron& steel; metal products, chemicals,
IFCI also provides underwriting and guarantees. synthetic fibers & resins, and food products industries. The
factors that have led to such a high level of NPAs included the
To face the challenges offered by the increasing competition a
slowdown in industrial growth, slack demand conditions,
need was felt to spruce up the activities of the Corporation.
Do

excess capacity in a number of industries, technological


Moving in this direction in 1998, IFCI has decided to merge the
obsolescence and the loss of competitiveness in some
wholly owned subsidiaries, IFCI Custodial Services Ltd. and
industries.
IFCI-Investor Services Ltd., with IFCI Financial Services Ltd.
In an effort to control the rising NPAs, IFCI is now playing a
Further, its wholly Owned subsidiary, Risk Capital &
playing a proactive role in the restructuring of borrower
Technology Finance Corporation Ltd., was renamed as IFCI
concerns for which it has set up the Corporate Restructuring
Venture Capital Funds Ltd., and its operations would
Division. The reduction of NPAs are made through the timely
henceforth be concentrated on managing venture capital funds
grant of relief’s and concessions, encouraging mergers and
in some select industries.
amalgamations with healthy companies, one-time settlement of
Apart from the above mentioned wholly owned subsidiaries. dues, etc. To take proactive measures and prevent any further
IFCI has also promoted various specialised institutions such as rise in the NPAs, the Corporate Monitoring Department has
• Management Development Institute (MDI) been set up at the corporate office to oversee and monitor cases
• Tourism Finance Corporation of India Ltd. (TFCI) with large exposure as well as likely problem loans.
• Rashtriya Gramin Vikas Nidhi (RGVN)
• Investment information & credit rating agency (ICRA)

© Copy Right: Rai University


94 11.621.6
In addition, an Industry Research Division has been set up for Operations

MANAGEMENT OF FINANCIAL INSTITUTION


the purpose of carrying out industry, studies to facilitate the IDBI initially provided long-term assistance to industries such
work of the Credit Department Regional Offices. This research as textiles, fertilizers, chemicals products and machinery. The
studies provided by this division on various industries would assistance was mainly in the form of long-term loans and to a
enable the IFCI to take more informed lending decisions. With small extent, in the form of project lending. In 1964, IDBI also
all these measures, the IFCI is trying to upgrade its asset quality. began a role in assisting the State Finance Corporations (SFCs)
Apart from these new divisions, IFCI has reconstituted its of various states, taking over from Refinance Corporation of
internal management committees. The management India. This assistance was in the form of providing refinancing
committees at the corporate office include the Business Review the term loans granted by the institutions. By 1965, IDBI
Committee, the Credit and Investment Committee. Head entered into rediscounting of -machinery bills to promote the
Office Loan Committee, the Asset Liability Committee, the sale of indigenous machinery on deferred payment basis.
Disinvestment Committee and the Official Language Subsequently, IDBI entered into finanancing exports on a
Implementation Committee. The setting up of the ALM different payment basis, till the time Export- Import (Exim)

al
Committee was mainly to enable it to conform .to the RBI Bank of India was formed in 1982.
guidelines on ALM for financial institutions. In 1986, IDBI created a Small Industries Development Fund
In an effort to manage its interest rate risk, IFCI has been (SIDF) to provide a special focus to the needs of the small scale

i
following a policy of linking its interest rate to the prevailing sector. This fund is intended to provide financial as well as non-

com Tr
prime lending rate (PLR) at the time of disbursement. In the financial inputs catered to the specific needs of the small scale
case of Foreign currency loans the pricing is one at LIBOR + sector. In 1990, the operations of the fund were hived off in to
spread. Further to tackle the foreign exchange risk management, a wholly owned subsidiary, the small industries development
the repayment for the funds that are borrowed in a foreign bank of India (SIDBI), in order to provide greater focus to the
sector.

rd. F
currency is ‘made’ in the same currency resulting in no exchange
rate risk on the part of the Corporation. Through the late ’80s and the early ’90s IDBI played a
significant role in the development of financial markets. While
Future
iza D
To face the competition, there is a need to reorient its strategies.
For this purpose, it is envisaged that in the due course of time
it played a major role in setting up of the Stock Holding
Corporation of India Limited (SHCIL), for providing impetus
to the depository services to the financial institutions in 1987, it
dfw P
IFCI may operate as a universal bank that has a major focus on
was also the nodal agency for establishing the National Stock
corporate banking. And in order to tap on the other financial
Exchange (NSE) in 1992. Other institutions promoted by
services that offer greater scope for the corporation, IFCI is
IDBI by direct contribution of capita] include: Credit Analysis
diversifying into bill discounting, trade bills important financing
w.p m

and Research Limited (CARE) and Investor Services of India


and working capital financing. Most important move in this
Limited (ISIL). Both established in the early nineties, CARE
direction is the joint venture it is entering into with a foreign
offers credit rating, information and equity research services to
partner to diversify into the insurance sector.
ww Co

Indian Industry and institutions, ISIL provides registrar


Industrial Development Bank of India transfer and custodial services. IDBI joined other All India
Industrial Development Bank of India (IDBI) is the largest Financial Institutions (AIFls) to promote: Over The Counter
financial institution in India, with assets at the end of 1999 Exchange of India (OTCEI). Shipping credit and Investment
approximating to Rs.600 bn. This apex financial institution in Corporation of India (SCICI)- now merged with ICICI,
cu

India, is also the 10th largest development bank in the world. Tourism Finance Corporation of India (TFCI) and Biotech
Industrial Development Bank of India (IDBI) owes its birth to Consortium of India Limited (which provides aid for
Industrial Development Bank Act (IDBI Act), 1964. As per its commercialization of indigenously developed processes and
charter IDBI is required to play a significant role in (a) planning, products in the field of biotechnology.
Do

promoting and developing industries to fill the gaps in the


Over the years IDBI evolved from being a government arm for
industrial sector (b) co-coordinating the working of institutions
doling developmental credit to various slate finance institutions
engaged in such activities and assisting in their development (c)
and bodies to being a complete one stop shop for long-term
providing technical and administrative assistance for
lending. By the mid-90s, when the first stage liberalization has
promotion, management or expansion of industry (d)
taken its full effect the strength of IDBI of being big came into
undertaking market and investment research and techno-
force. Core sector projects especially in Iron and Steel have been
economic studies to contribute to the development of industry.
major borrowers from IDBI. Approvals and disbursals during
Initially, IDBI was established as a wholly-owned subsidiary of the years) have grown at an average of 99f- and 8% per annum
the Reserve Bank of India (RBI). In 1976, the ownership of respectively.
IDBI was transferred to the Government of India. The IDBI
Act was amended in October 1994 enabling IDBI to raise equity Financial Performance -
from the public, subject to the holding of the Government or The Bank’s working during the year 2001 yielded a Profit Before
India not falling below 51 % of the issued capital. Tax of Rs.734 crore (Rs.1027 crore for the previous year). After
making a net provisioI1 of Rs.43 crore towards taxation for the
year, Profit After Tax was Rs.691 crore (Rs.947 crore). After
apparitions to reserves and reserve funds, the Board of

© Copy Right: Rai University


11.621.6 95
directors have proposed a dividend of 45% on the equity profits. IDBI has been receiving loans from this fund on
MANAGEMENT OF FINANCIAL INSTITUTION

capital. concessional terms. In recognition of its development role,


Total assets of the Bank as on March 31, 2001, increased by IDBI was initially exempted from income tax, which was
15.3% to Rs.71,783crore.(Rs.72,285crore). IDBI’s net worth as subsequently placed in the tax bracket of 30 percent. This tax
on that date also recorded a rise of 8.6% to Rs. 9,126 crore bracket is applicable uniformly to all the AIFls.
(Rs9,025 crore). Apart from the NIC[LTO] a separate Development Assistance
The Bank’s performance can be seen from various indicators. Fund (DAF) was created as per the requirement of the IDBI
The margin, measured by the difference between the average Act. Funds from DAF were source to finance large infrastructure
return on assets and financial cost of liabilities was 2.6% in projects, which, probably, would not have qualified for
1998-99 as against 3.9 % in 1997-98. The return on average assistance on commercial considerations.
assets was 2lk as compared to 2.7%. Return on average net In the pre-reform era, IDBI has been relying on the
worth for the year declined to 15.1 % (19.9%). Earnings per Government of India for funding. ‘IDBI was initially granted
Share and Book Value per Share at the year-end stood at Rs.9.37 an interest free loan amounting to Rs.10 crore at the time of its

al
and Rs.139.S0 respectively. setting up. Government of India has also been providing
The Bank continued to maintain sound capital adequacy various loans on a concessional basis, while providing
requirement, as represented by the capital adequacy ratio (CAR), budgetary support to IDBI until 1970. Even after 1970, IDBI

i
which at end-March, 2001 stood at 15.8% as against 8(1() last enjoyed budgetary support towards the funds that were

com Tr
year. The Debt equity ratio (including contingent liabilities) disbursed through IDA line of credit from the World Bank. It
stood at 6.53:1 (6.08:1). has to be noted that these loans met the foreign currency
requirement of the industry and in such borrowings. FIs
In 2000 -01, IDBI sanctioned and disbursed Rs.287.1 bn and
normally do not bear any direct exchange risk. which is borne
Rs.174.9 bn respectively. Of it direct finance constituted 95.4%

rd. F
either by the borrower or the GOI. Government of India, in
of total sanctions and 92.6% of total disbursements. Protect
order to further help IDBI augment its resources, introduced
Non-Project loans given for eligible industrial.
Companies Deposits (Surcharge on Income Tax) Scheme. As

iza D
These types of loans are disbursed by IDBI either for a
particular project of as a-general Joan, either in foreign currency
or Indian Rupees. Normally, these loans are provided for a
per this scheme companies were exempted from paying then
existing surcharge on income tax provided they deposit an
equivalent amount, repayable after five years, with IDBI. This-
dfw P
period of 5-7 years with a moratorium of 2-3 years. Also, the scheme was discontinued in April, 1978. In 1981, in response to
loans will be secured by a fixed charge on fixed assets. As in the the shortage of resources faced by the IDBI the Government
case of banks, the rate of interest that is charged will be a of India extended a budgetary support of Rs.50 crore.
w.p m

markup to the Prime Lending Rate (PLR). IDBI also provides


Subsequent to the new thinking imbibed through the
direct assistance through underwriting of securities of corporate
liberalization measures in early 90s, concessional funding by the
enterprises. Such underwriting, though a small part of the
Government of India and RBI began dwindling. Statutory
financing also provides an alternative avenue for investments in
ww Co

Liquidity Ratio (SLR) status for bonds issued by FIs was


securities.
withdrawn in 1993. These bonds, eligible for investments by
In 1987, IDBI began providing venture capital essentially to the banks under the mandatory SLR category, were a major source
technology oriented start up ventures, which was subsequently of funds for IDBI They carried a lower interest rates (10-11 %)
broadened to provide assistance to wide spectrum of projects and had 15 year maturity period. IDBI then began relying
cu

which are not necessarily technology driven. The venture capital increasingly on the market borrowings sourcing money through
assistance was provided to finance cost of fixed assets, certificate of deposits, floating rate bonds, term money bonds
operating and market development expenditure, among other and other commercial borrowings in both rupees and foreign
venture capital related activities. - currencies.
Do

IDBI provides indirect assistance through refinancing state level In 1994, IDBI act was amended through an ordinance, allowing
institutions for small loans disbursed by them. For approved IDBI to raise equity capital form the market as long as the GOI
loans IDBI makes a fixed spread with government providing a holding did not fall below 51 percent. Also, IDBI’s status was
guarantee for such refinance. changed from a government Undertaking to a. company
The share of different industries in total sanctions during FY registered under the Companies Act, 1956. Subsequent to the
1998 were power 6.2% core (iron & steel, oil, cement, fertilizer) amendment in the Act; IDBl made Rs.21.8bn IPO In July 1992
24.7% chemicals 11.2%m textiles 12.2%, paper 5.48%, other through public offerings of 168m equity shares of Rs. 10 each
industries 30.44% and pharmaceutical 4.11%. at a premium of Rs.120. The issue was over subscribed
approximately 1.4 times. The share was quoted at
Funding
approximately Rs.25 on 28.6.2001.
With its wide-ranging lending requirements with concentration
on long-term finance, IDBI needed huge money at a cheap rate. Current Position
In the 70s, to enable IDBI perform various developmental The valuation of IDBI’s stock, relative to HDFC and ICICl,
activities and also to finance small scale industries, at itself shows that IDBI is not viewed favorably by the market.
concessional rates, RBI created a separate National Industrial Due to IDBI’s relatively high exposure to iron and steel
Credit [Long-Term Operations]-(NIC[LTO]), fund out of its projects, which are languishing due to over capacity and global

© Copy Right: Rai University


96 11.621.6
recession, IDBI had to reconcile with high NPAs. NPAs have

MANAGEMENT OF FINANCIAL INSTITUTION


been appropriately provisioned as per the regulations applicable
to banks. Sub-standard and doubtful. Assets constituted 7.7%
(7.0%) and 4.3% (3.1%)respectively of the assets. Loss assets
were fully written off. IDBI made full provisions/ write-offs in
respect of its non-performing assets as per RBI norms.
Questions to Discuss:
1. Discuss the role of DFls in the financial system.
2. What are the operations of major Fls in India namely IFCI?
3. What are the operations of major Fls in India namely IDBI?
Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 97
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 25:
DEVELOPMENT FINANCIAL INSTITUTION

Learning objectives resources added on to the list. Broadly, the financial resources of
After reading this lesson, you will understand ICICI are as follows:
• Operations of major Fls in India –ICICI Share Capital
• Regulatory framework for Fls. ICICI is a public limited company and its six lakh shareholders
include Indian promoters (_9.1 %), Indian institutes/Mutual
We will discuss the nature and operations of the present
funds (7%), FIIs (34.8%), Public/ Free float (29.1%). These
financial institutions operating in India in today’s class. Today
figures are pre-IPO issue of 1999, when ICICI came out with a

al
we will focus on ICICI.
issue priced at Rs.85. In middle of 1999, ICICI became the first
Industrial Credit and Investment Corporation of Indian company to have an ADR listing on the New, York

i
India Ltd. Stock Exchange (NYSE). American Depository Receipts

com Tr
ICICI is India’s second largest Financial Institution with assets (ADRs) were issued in the ratio of 2:1 to the domestic equity
totaling Rs.424.5 bn in 1999. Initially, playing a role of a typical shares of ICICI traded on the Bombay Stock Exchange.
development financial institution-of giving long-term loans, it Reserves
has gradually evolved into a one-stop shop for most retail Reserves which are the internal resources- contribute
finance instruments. The corporation has its presence in significantly towards the fund requirements of the ICICI.

rd. F
investment and commercial banking, venture capital funding, Generally, internal generations of ICICI meet 50-60% of its
custodial services, InfoTech, brokerage, consultancy and funds requirement.

iza D
advisory services. Compared to IDBI, which is seen as
conservative, ICICI is of late being more aggressive. ICICI has
increased its market share to 42 percent in sanctions and 43
Borrowings
The borrowings of ICICI fall into the following three types:
dfw P
percent of disbursements: • Rupee Borrowings

ICICI was initially established as Industrial-Credit and • Foreign Currency Borrowings


Investment Corporation of India in 1955. It was promoted by • Commercial Borrowings
w.p m

the Government, the World Bank and a steering committee of Borrowing storm the Government of India, institutional
5 prominent businessmen and others. The objective of ICICI borrowings, bonds guaranteed by Government and. other
was to assist the private sector. Later on, its services were public issue of bonds feature under the rupee borrowings
ww Co

extended even to the public sector, joint sector and the co- category of ICICl. The borrowings from GOI/RBI were mainly
operative sector. Primarily, assistance was provided for the to support developmental objectives of industrial growth. The
following purposes: bonds issued by the FIs, including the ICICI were guaranteed
• Creation expansion and modernisation of companies in the by the Government and qualified as SLR investments for
private sector. commercial banks. They carried lower interest rates (10-11 %)
cu

• Encouraging and promoting industrial investment and the and had a 15-year maturity period. In addition to these low cost
expansion of investment markets. Government borrowings, SLR bonds also were a major source
of funds for most of the FIs till 1993. However, in order to
For these purposes, the ICICI provides long and medium term
ensure a level planning ground, access to such low cost funds is
Do

loans or equity finance, sponsors and underwrites securities


slowly being cut off. Presently, about 10 percent of the FIs
issues, guarantees loans, providing managerial, technical and
balance sheet reflect these resources which are repayable by 2004.
administrative consultancy.
The foreign currency borrowings of the ICICI comprises of the
Headquartered in Mumbai, ICICI also has zonal offices at
multilateral/ bilateral borrowings. ICICI has been playing a
Bangalore, Baroda, Calcutta, Chennai, Coiambatore, Hyderabad,
crucial role in canalizing the foreign currency borrowings it has
New Delhi and Pune.
obtained from the Government, World Bank, KFW, IFC and
Apart form providing assistance to the companies, ICICI has other international agencies to meet the foreign currency
also promoted a number of specialised financial institutions for requirements of the industry. While extending lines of credit,
various other purposes. These include HDFC, CRISIL, TDICI the ICICI will not have to bear the exchange risk as it will be
etc. borne either by the borrower or the Gar.
Financial Resources The other commercial borrowings of ICICI have been coming
Initially, the financial resources of ICICI included share capital, from the international market, where it has been borrowing
interest free loan from Gal and foreign currency advances from funds in various currencies. These borrowings have enabled it
the World Bank. Subsequently, other rupee and foreign currency to reduce its interest costs and also diversify its currency risk.

© Copy Right: Rai University


98 11.621.6
Deposits ITC Classic Finance and Anagram finance has resulted in

MANAGEMENT OF FINANCIAL INSTITUTION


Due to limited access to government borrowings which has widening its retail network in the western and northern parts of
been a chief source of finance, ICICI is now looking at various the country. In addition to this, the merger of ITC Classic
market borrowings as another source of finance. ICICI issues Finance has resulted in a tax shield of Rs.l billion as ITC Classic
certificate of deposits (CDs) in the wholesale market was a loss-making unit.
an4.borrows in the retail market through fixed deposits (FDs)
Future
schemes.
ICICI has been accepting the changes in the market and as also
Deployment of Resources in acting fast to keep pace with these changes. And to continue
Long-term lending, investment and commercial banking, this trend the FI now aims to move on to become a global
venture capital financing and consultancy and advisory services, player. The strategic acquisitions and diversification activities
debenture trusteeship and customer services are all the major have played a great role in moving ICICI from the role played
financial service offered by ICICI and where most of its funds by a traditional FI. The focus of ICICI is to become is to
are developed. As the objective of ICICI is to promote and become a universal bank and to offer a comprehensive range of

al
encourage industrial investment, project finance is the key area financial services.
for fund deployment. Exim Bank
ICICI is into equipment finance also as it supports financing of Export-Import Bank of India (Exim Bank), an apex financial

i
imported and locally manufactured equipment by deferred

com Tr
institution, was established in 1982 under an act of the
credit. Two types of credit facilities are offered (1) credit facility parliament to finance facilitate and promote India’s international
that enables the manufacturer to extend credit to’ the customer trade.
for purchasing the specified equipment, (2) asset credit facility The vision of Exim Bank is to develop commercially viable
that enables the purchaser to get the credit and repay over a fixed relationships with a targeted set of externally oriented

rd. F
period of line. Further, as the cost of funds is rising, ICICI is companies by offering them a comprehensive range of products
also entering into more profitable financing options. Having and services aimed at helping Indian companies to globalise.
began leasing Operations in 1983, ICICI has emerged as the

iza D
single largest lessor in India While offering this service, ICICI
buys the equipment, retains the legal title and leases it. The
The bank has five overseas offices at Washington DC.
Singapore, Rome. Budapest and Johannesburg. The overseas
offices are strategically located to enhance institutional linkages
dfw P
average lease period is 5 years and the lease rentals are
determined as per the market rate. As the thrust on the with multilateral agencies viz., World Bank, International
infrastructure sector is growing, big ticket leasing in Monetary Fund, European Bank of Reconstruction and
infrastructure is gaining interest due to the large size of Development. Asian Development Bank, African Development
w.p m

operations. Taking advantage of this, ICICI has enhanced its Bank and regional banks like the PTA in Africa and also
operations in big ticket leasing. interacting with various Export Credit Agencies.

The fee based services offered by ICICI include merchant The overseas offices also assist Indian companies in identifying
ww Co

banking corporate advisory services, underwriting, corporate partners of business or joint ventures. Exim Bank has forged
finance, etc. In extending these services, ICICI has been alliances with banks, trade and investment promotion agencies
leveraging on in-house skill base, large client network and the in 31 countries through 53- co-operation agreements and
relationship with their clients. With the scope of these fee based Memoranda of Understanding (MoU).
services rising. ICICI has spun off most of these activities into Exim Bank finances exports of Indian machinery, manufacture
cu

subsidiary companies. goods, consultancy and technology services on deferred


payment terms. It also seeks to co-finance projects with global
Subsidiaries and Acquisitions
and regional development agencies to assist Indian exporters in
In 1993, ICICI has floated a new company, the ICICI Securities
their effort to participate in such overseas projects: Companies
Do

and Finance Company Ltd. (I-Sec) in joint venture with a


can avail of facilities such as forfeiting, underwriting of issues,
subsidiary of J.P.Morgan, with ICICI holding 60 percent of the
import finance through lines of credit from other export credit
shares. I-Sec is a Category I merchant banker, and engages in
agencies and bulk import finance for import of raw materials
new issue management, underwriting, corporate advisory
and intermediates.
services. Being a member of the OTCEI and NSE, it also
engages in securities trading and allied financial services. Equity finance is available for acquiring or setting up companies
abroad for manufacturing, marketing. trading and other
The Technology Development and Information Company of
services.
India (IDICI) is yet another wholly owned subsidiary of ICICI,
which it has acquired by taking up-the 50 percent stake of UTI. Companies can also avail finance from Exim Bank for export
This acquisition along with the 50 percent stake, which it already market development activities and for export product
has, made TDICI a wholly owned subsidiary of ICICI. It is development.
now renamed as ICICI Venture. Companies collaborating for technology particularly with the
As the market began, to liberalise, the competition has also companies from Asian countries can access concessional finance
been increasing. To counter the competition, ICICI’s strategy through Exim Bank under the ACIP programs.
has been synergistic acquisition. In this context, the merging of

© Copy Right: Rai University


11.621.6 99
Foreign governments and agencies in other developing schemes involving short-term export finance, pre-shipment
MANAGEMENT OF FINANCIAL INSTITUTION

countries are offered buyer’s credit and lines of credit to import finance, investment loans and. export marketing finance.
Indian goods and services. It provides competitive finance at various stages of the business
Exim Bank had posted a 6.6 percent dip in net profit at Rs.154 cycle, covering import of technology, export product
crore for the financial year ended March. 2001 from its previous development export production, export marketing, export
year net profit of Rs.165 crore. This is attributed to low lending credit at pre-shipment and post-shipment stage, and
rate/declining margins and intense competition in financial investment overseas. Finance is provided in Indian rupees and
sector. Sanctions by Exim for the period grew by 20 percent at foreign currency.
Rs.2,174 crore as compared to Rs1,640 crore for 1999-2000. The recent initiative of the government of India to create special
The bank has introduced several new initiatives to promote economic zones (SEZs) to provide an internationally-
India’s international trade. Some of the recent initiatives are competitive and hassle free environment for exports, have
• A program to finance R&D of export oriented companies at opened a new avenue for establishing financing and banking
concessional interest rates; arrangements to attract foreign direct investments in SEZs.

al
• Bank’s participation in the equity of Indian ventures abroad; Four export processing zones (EPZs) at Kandla, Santa Cruz,
Kochi and Visakhapatnam have been converted to SEZs. while
• Working capital finance for exporting companies:
six more SEZs are being set up. Globally, Offshore Financial

i
• Financing packages for knowledge based industries such as Centers (OFCs) and offshore banks have come to play a vital

com Tr
information technology computer software and role in facilitating investment worldwide, and are a focal point
pharmaceuticals; for the collection and channeling of wealth into onshore
• Co-operation agreement with US Exim Bank for promoting financial centers. The Indian banking regulations require
bilateral trade between USA and India: amendments to enable banks and financial institutions to seek

rd. F
• Co-operation agreement with PTA Bank - a regional exemption from a wide range of regulations.
development bank in Africa to sponsor Indian consultants It undertakes research studies on subjects concerning

iza D
for PTA Bank funded projects in Africa;
• Co-operation agreements wit business promotion agencies
in Vietnam, Italy, China, UAE, Uzbekistan, African
international trade, international economics, sector and product
studies and country studies and publishes these studies in the
form of occasional papers (OPs). So far the bank has brought
dfw P
Development Bank and Eastern & Southern African Trade out 79 OPs.
and National Association of Software & Services Companies. In addition to finance, Exim Bank provides a range of analytical
Exim Bank plays the role of a consultant to share its own information and related services necessary for globalization of
w.p m

experience in institution building. It has provided consultancy Indian companies. The advisory services enable exporters to
to many developing countries. Some recent assignments are in evaluate international risks, export opportunities and enhance
South Africa and Zimbabwe. In addition to finance, Exim competitiveness.
ww Co

Bank provides a range of analytical information and related Exim Bank assists externally-oriented Indian companies in their
services necessary for globalization of Indian companies. quest for excellence and globalization.
The advisory services enable exporters to evaluate international SIDBI
risks, export opportunities and enhance competitiveness. Exim SIDBI was established in April, 1990 under an act of the Indian
Bank through its wide network of alliances with financial Parliament to serve as the principal financial institution for
cu

institutions, trade promotion agencies, information providers promotion, financing and development of industry in the
across the globe assists externally-oriented Indian companies in small scale sector ,and to coordinate with similar institutions
their quest for excellence and globalization. Services include engage(in the same. SIDBI offers a wide range of assistance
search for overseas partners, identification of technology through its direct finance, refinance, bills finance, equity finance,
Do

suppliers negotiating an alliance and consummating a joint venture capital, foreign currency loans, lines of credit and other
venture. schemes of assistance besides support services. It has setup the
Over the years, the bank has evolved from financing and Technology Development and Modernization Fund to
facilitating and promoting India’s foreign trade to developing encourage technology upgradation In small enterprises.
commercially-viable relationship with a target set of externally- Set up under the SIDBI Act, 1989, SIDBI’s operation have been
oriented companies by offering them a comprehensive range of guided by its mandate of serving as the principal financial
products and services aimed at helping Indian companies institution for promotion, financing and development of.
globalise. Indian industry in the small scale sector which forms the
The evolution from traditional export credit programs to backbone of the Indian economy, contributing around percent
overseas investment credit, import credit, advisory and of India’s total manufacturing sector output, around 35 percent
promotional programs and global network of institutional of total manufacturing sector output, around 35 percent of
linkages, reflect the adaptation to the changing global trends. total exports and providing employment to nearly 17 million
The need to utilise all possible financing mechanisms to persons. While entrusting the bank with the significant
promote export capabilities has motivated the bank to go responsibility of performing the role of an apex level
beyond provision of post-shipment credit, and operate institution for the small scale industries (SSI) sector, the statute

© Copy Right: Rai University


100 11.621.6
also empowers the Bank with considerable ‘flexibility in its Sector”. The Report, which aims to serve as a single point

MANAGEMENT OF FINANCIAL INSTITUTION


operations. Since inception. SIDBI has been striving to enhance source of information on the SSI Sector, is being published
the inherent strength and resilience of the SSI sector with annually and has been well received and acclaimed both in India
innovative measures and initiatives going beyond mere funding and abroad. Furthering its initiatives in this area, the Bank also
of the sector. proposes to publish a compendium on sector specific usage -of
Commencing its operations primarily as a refinance institution, technology and emerging needs of technologies of Indian SSIs.
the Bank has transformed itself into a purveyor of wide range SIDBI is a professionally managed institution functioning with
of financial products aimed at plugging the gaps in the credit considerable emphasis on corporate governance. Although a
delivery system. Direct financial assistance, wherein special fairly young institution, its financials have kept pace with its
emphasis is given to technology development and growing operations. As of March 31. 2000, the Bank’s asset
modernization as also marketing of SSI products, is offered base stood at Rs.166 billion (US$ 3.81 billion) whereas its net
through SIDBI’s network of 3.8 offices. Substantial assistance worth was over Rs.26 billion(US$ 0.61 billion). The Bank has
is being channelised indirectly to the sector by way of refinance been rated as one of the top 25 Development Banks in the

al
mechanism through nearly 900 primary lending institutions world by the ‘The Banker’, London. SIDBI was the winner of
including commercial banks and State Level institutions, viz. Asian Banking Award, 1999.
SFCs, SIDCs, etc. having over 65,000 outlets throughout India. In order to help the Indian SSI sector cope up with the

i
Besides funding of the sector, SIDBI has also been providing challenges posed by the WTO regime, SIDBI would be

com Tr
developmental ‘and support services aimed at improving the concentrating on certain specific industry segments for strategic
inherent strength of the SSI units and employment generation interventions where the sector has got inherent advantages. The
and economic rehabilitation of rural poor. The initiatives of the changes in the economy in the last decade which brought in
Bank emphasize on entrepreneurship development, enterprise liberalization, deregulation, competition for the SSIs and
promotion and strengthening, rural industrialization, human

rd. F
technology advances particularly in information technology, to
resources development, technology upgradation, environment cite a few hold significance both for SIDBI as well as the SSI
management, etc. sector, and the same have formed the underpinnings of the

iza D
Another feature of SIDBI’s operations has been focused
initiatives and institution building in tandem with Government
of India, NGOs, technical/management institutions,
Bank’s strategies and initiatives.
As a proactive apex level institution, the Bank will continue to
dfw P
make its contribution towards strengthening the SSI sector
international agencies and industry associations for reaching out through innovative and tailor made programs.
to the SSI sector. In this regard, the Bank has co-promoted 2
factoring companies, a commercial bank in the private sector viz. NABARD
w.p m

IDBI Bank Ltd. and a Technology Bureau for Small Enterprises NABARD is an apex institution, accredited with all matters
in collaboration with Asian and Pacific Center for Transfer of concerning policy, planning and operations in the field of credit
Technology. Besides, SIDBI and Ministry of S51 and ARI. for agriculture and other economic activities in rural areas in
India. It is an apex refinancing agency for the institutions
ww Co

Government of India have jointly set up a Credit Guarantee


Fund Trust for Small Industries (CGTSI) to operationalise the providing investment and production credit for promoting the
new credit guarantee scheme for ,small industries that would various developmental activities in rural areas.
cover octahedral free loans extended to tiny units up to a It takes measures towards institution building for improving
maximum limit of Rs.2.5 million by scheduled commercial absorptive capacity of the credit delivery system, including
cu

banks and select Regional Rural Banks. SIDBI has also launched monitoring, formulation of rehabilitation schemes,
a National Venture Fund for Software and IT Industries restructuring of credit institutions, training of personnel, etc.
(NFSIT) and has co-promoted several state level venture funds It co-ordinates the rural financing activities of all the
in association with respective State Governments. The SIDBI institutions engaged in developmental work at the field level
Do

Foundation for Micro Credit aims at creating a national network and maintains liaison with Government of India, State
of strong, viable and sustainable Micro Finance Institutions Governments, Reserve Bank of India and other national level
from the informal and formal financial sectors to; provide micro institutions concerned with policy formulation.
finance services to poor. SIDBI also offers fee-based
It prepares, on annual basis, rural credit plans for all districts in
consultancy to developing _ nations on appropriate strategy and
the country these plans form the base for annual credit plans of
approach for growth of small industries including assistance for
all rural financial institutions. It undertakes monitoring and
joint ventures with Indian SSIs. With a view to fostering seed
evaluation of projects refinanced by it. It promotes research in
stage projects in knowledge based sectors having high R&D
the fields of rural banking, agriculture and rural development.
content and preparing them for venture capital assistance, the a
The Committee to Review Arrangements for Institutional
Bank has a program for-innovation and incubation for small
Credit for Agriculture and’ Rural Development (CRAFICARD),
industries which is being taken up In situation with – reputed
set up by the Reserve Bank of India (RBI) under the
technical/research institutions of the country.
Chairmanship of Shri B. Sivaraman, conceived and
For bridging the information gap in the small scale sector, recommended the establishment of the National Bank for
SIDBI has been presenting information relating to different Agriculture and Rural Development. (NABARD). The Indian
facets of the SS! sector in the form of “SIDBI Report on S5I

© Copy Right: Rai University


11.621.6 101
Parliament through the Act 61 of 1981, approved the setting up Regulatory Framework
MANAGEMENT OF FINANCIAL INSTITUTION

of NABARD. The reforms taking Place in the financial sector have been
The Bank which came into existence on 12 July, 1982, was affecting all the players in the market, DFIs being no exception
dedicated to the service of the Nation by the Hon’ble Prime to it. While the deregulations have unleashed the competition,
Minister, Smt. Indira Gandhi on 5th November, 1982. the guidelines introduced to streamline the Indian market
players operations with that of the international player have
NABARD was established, in terms of the preamble of the
posed significant challenges for the profitable sustenance of
Act, “for providing, credit for the promotion of agriculture,
these players.
small scale industries, cottage any village industries, handicrafts
and other rura1 crafts and other allied economic activities in rural Significant changes that have been witnessed in the operational
are as wife a view to promoting integrated rural development environment of the Fls are as follows:
any securing prosperity of rural areas and for material connected • Capital adequacy requirements: the capital to risk
therewith or incidental thereto.” weighted assets ratio (CRAR) that the Fls are supposed to
NABARD took over the functions of the erstwhile Agricultural maintain is 9 percent. The details relating to the computation

al
Credit Department (ACD) and Rural Planning and Credit Cell of CRAR remain the same as for banks. In addition to this,
(RPCC) of RBI and Agriculture Refinance and Development the non-cumulative preference shares permissible for issue
Corporation (ARDC). Its subscribed and paid-up Capital was under the companies act and which have a maturity of 20

i
Rs.100 crore which was enhanced to Rs.500 crore, contributed years will form a part of the tier-1 capital. However, the Fl

com Tr
by to Government of India (GOI) and RBI in equal will have to create a corpus to be invested in the government
proportion It is now enhanced to Rs.2,OOO crore. securities having maturity of such preferences shares to
eliminate the reinvestment risk. The corpus should be a
Refinance Support minimum amount, which when invested will equal the
The National Bank’s refinance support to co-operative banks,

rd. F
preference shares amount. Adjustment will have to be made
commercial banks and RRBs and loans to state governments in this corpus for the changes taking place in the tax rates. If
and NGOs during the year 1999—2000 aggregated Rs.14,178 a shortfall arises, it has to be provided from the reserves.

iza D
crore compared to Rs.l2366 crore during the previous year
registering a growth of 1.6 percent.
Long-Term Loans to State Governments
Further, transfers from the reserve will also have to be made
for the differential interest rates i.e. if the yield on the G-Secs
at the time of the initiation of the corpus and the yield at
dfw P
The National Bank provides long-term loans to state which the interest proceeds are reinvested each year the
governments for contribution to the share capital of co- corpus should not be used for the other operations of the
operative credit institutions subject to certain norms. During FI. The amount and the purpose of the corpus, will have to
w.p m

the year 1999- 2000, loans aggregating Rs.91.07 crore were be disclosed separately in the balance sheet, prospectus for
sanctioned to 13 state government for contribution to the share raising resources, etc. The amount of preference shares less
capital of 4 SCBs. 1 SLDB. 46 DCCBs, 61 PLDBs and 9112 the amount of corpus created as above will be considered as
ww Co

PACS/LAMPSIFSS compared to. sanction of Rs.65.33 crore Tier-I capital.


during; the previous year. • Prudential Norms: FIs are also subjected to the prudential
Credit Authorization Scheme norms on the same lines as banks. The asset classification.
During 1999-2000, authorizations were granted in respect of Income recognition and the provisioning norms with effect
218 proposals for working capital assistance of Rs.4,678.53 from 31-3-2002 are: interest and/or principal remain overdue
cu

crore, of which the SCBs accounted for 68 percent while DCCBs for 180 days (earlier it was 365 days).
accounted for 32 percent. Commodity wise, sugar accounted for However, in addition, to those guidelines, the Reserve Bank has
Rs. 3,305.89 crore (71%) cotton Rs. 992.00 crore (21 %) and also released prudential norms for takeout financing by financial
fertilizer Rs.245.00 crore (5%) while other commodities institutions in India. Under a takeout finance management, the
Do

accounted for Rs.135.64crore (3%). For block capital finance, FII Bank financing an infrastructure project transfers the
authorizations aggregating Rs.167.49 crore were granted in outstanding loan amount to another on a pre-determined
respect of 34 proposals. basis. The taking over institution will have to make provisions
on the NPAs being taken over in their accounts from the date
Investment Credit
of it turning into a NPA in the lending institution’s books.
The refinance budget for schematic lending for the year1999-
2000 was originally fixed at Rs.5,200 crore. However, during the Further, in cases of unconditional takeover, the lending
course of the year taking into account the availability of funds institutions should prescribe a risk weightage of 20% in its
and additional demand from client institutions as also the need books when the credit risk is taken over entirely. The taking over
to maintain a positive growth rate in the various states as institution has to prescribe a risk weightage of 100% in such
compared to the previous year, the refinance budget was cases. The weightage for the lending institution in cases of
enhanced to Rs.5, 215 crore. The total disseminates during the assumption of partial credit risk has been prescribed at 20% on
year reached the programmed level of Rs.5.215 crore registering the loan to be taken over and 100% on amount not taken over.
a growth of 15 percent compared to the disbursement The central bank has also prescribed 100% risk weightage in
ofRs.4.521 crore disbursed during 1998-99. cases of conditional takeover financing for both lending and
taking over institution.

© Copy Right: Rai University


102 11.621.6
• ALM Guidelines: The Reserve Bank of India has issued

MANAGEMENT OF FINANCIAL INSTITUTION


comprehensive guidelines on asset liability management
(ALM) system for the ten all-India term lending and
refinancing institutions (Fls) on December 31, 1999. The
guidelines, which will be effective from April 1, 2000, will
ensure a structured asset liability management (ALM) system
by the Fis
• Exposure Norms: While deploying funds the exposure
norms that need to be adhered to are - Industry - 15 percent
of the net worth, Individual Company - 25% of the net
worth and.; Group of Companies - 50% of the net worth.
For participating in the equity, ICICI undertakes direct
subscription, underwriting, loan conversion etc. Extension

al
of credit by Fls does not have any restrictive clauses relating
to the priority sector lending but however, they have to
ensure balance regional development, export promotion etc.

i
Summary

com Tr
During 1999-2000, financial assistance sanctioned and disbursed
by All India Financial Institutions (AIFIs) at Rs.1, 03,567 crore
and Rs.67, 066 crore, respectively, registered increases of 26.3
percent and 19.1 percent, as compared with 8.6 percent and 8.5

rd. F
percent during 1988-99. The substantially higher growth in
both sanctions and disbursements during 1999-2000 was an
indicator of improved investment activity. Financial assistance

iza D
sanctioned by All India Development Banks (AIDBs), which
accounted for the bulk of the sanctions (84.6 percent of total
dfw P
sanctions of AIFls) grew by 22.2 percent, while their
disbursements grew by 16.5 percent. During 1999-2000,
specialized financial institutions increased their disbursements
by 61.6 percent. Many of them are entering into venture capital
w.p m

activity. Investment institutions also recorded a gimlet of 31.1


percent in their disbursements.
Apart from these measures, various high powered committees
ww Co

are being set up to review the role, structure and operations of


the DFIs and banks. Significant recommendations have been
made by the working group under the chairmanship of Shri
S.H.Khan. The committee has recommended a progressive
move towards Universal Banking and the development of an
cu

enabling regulatory framework for this purpose. The measures


taken relating to the CRAR, prudential norms, etc. are to ensure
the international standards for the Indian FIs. Based on these
recommendations, RBI will bring in more measures to ensure
Do

the strengthening of Fls in India. And taking cue from these


developments, Fls are also making moves to ensure a smooth
transition from their traditional role of Fls into Universal
Banking.
Questions to Discuss:
1. Discuss the operations of one of a major Fls in India
namely ICICI
2. Discuss the Regulatory framework for Fls.
Notes:

© Copy Right: Rai University


11.621.6 103
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 26:
INSURANCE COMPANIES

Learning objectives the teenager gets into an accident. The reason for this rule is
After reading this lesson, you will understand that insurance companies do not want people to buy policies
as a way of gambling.
• Introduction
• The insured must provide full and accurate information to
• Fundamentals of insurance
the insurance company.
• Adverse selection and moral hazard in insurance
• The insured is not to profit as a result of insurance coverage,
• Selling insurance

al
• If a third party compensates the insured for the loss, the
• Growth and organisation of insurance companies insurance company’s obligation is reduced by the amount of
• The practicing financial institution manager the compensation.

i
Today we shall discuss the insurance companies, why should • The insurance company must have a large number of

com Tr
these investment companies be considered as an important insured so that the risk can spread out among many different
investment alternative. policies.
Insurance Companies • The loss must be quantifiable. For example, an oil company
Insurance companies are in the business of assuming risk on could not buy a policy on an unexplored oil field.

rd. F
behalf of their customers in exchange for a fee, called a • The insured company must be able to compute the
premium. Insurance companies make a profit by charging probability of the loss occurring;

iza D
premiums that are sufficient to pay the expected claims to the
company plus a profit. Why do people pay for insurance when
they know that over the lifetime of their policy, they will
The purpose of these principles is to maintain the integrity of
the insurance process. Without them, people may be tempted
to use insurance companies to gamble or speculate on future
dfw P
probably pay more in premiums than the expected amount of events. Taken to an extreme, this behavior could undermine the
any loss they will suffer? Because most people are risk averse: ability of insurance companies to protect persons in real need.
they would rather pay a certainty equivalent (the insurance In addition, these principles provide a way to spread the risk
premium) than accept the gamble that they will lose their house
w.p m

among many policies and to establish a price for each policy that
or their car. Thus it is because people are risk-averse that they will provide an expectation of profitable return.
prefer to buy insurance and know with certainty what their
wealth will be (their current wealth minus the insurance Adverse Selection and Moral Hazard in Insurance
ww Co

premium) than to incur the risk and run the chance that their The implication of adverse selection is that loss probability
wealth may fall. statistics gathered for the entire population may not accurately
reflect the loss potential for the persons who actually want to
Consider how people’s lives would change if insurance were not
buy policies.
available.
The adverse selection problem raises the issue of which policies
cu

Instead of knowing that the insurance company would help if


and insurance company should accept. Because someone in
an emergency occurred, everyone would have to set aside
poor health is more likely to buy a supplemental health
reserves. These reserves could not be invested long-term but
insurance policy than someone in perfect health, we might
would have to be kept in an extremely liquid form.
predict that insurance companies should turn down anyone
Do

Furthermore, people would be constantly worried that their


who applies. Since this does not happen, insurance companies
reserves would be inadequate to pay for catastrophic events such
must have found alternative solutions. For example, most
as the loss of their house to fire, the theft of their car, or the
insurance companies require physical exams and may examine
death of the family breadwinner. Insurance allows us the peace
previous medical records before issuing a health or life insurance
of mind that a single event can have only a limited impact on
policy. If some previous illness is found to be a factor in the
our lives.
person’s health, the company may issue the policy but exclude
Fundamentals of Insurance this preexisting condition. Insurance firms often offer better
Although there are many types of insurance and insurance rates to insure groups of people, such as everyone working at a
companies, all insurance is subject to several basic principles: particular business, because the adverse selection problem is
• There must be a relationship between the insured (the party then avoided.
covered by insurance) and the beneficiary (the party who In addition to the adverse selection problem, moral hazard
receives the payment should a loss occur). In addition, the plagues the insurance industry. Moral hazard occurs when the
beneficiary must be someone who may suffer potential insured fails to take proper precautions to avoid losses because
harm. For example, you could not take out a policy on your losses are covered by insurance. For example, moral hazard may
neighbour’s driver because you are unlikely to suffer harm if

© Copy Right: Rai University


104 11.621.6
cause you not to lock your car doors if you will be reimbursed old age. The problem is that you could die too young and not

MANAGEMENT OF FINANCIAL INSTITUTION


by insurance if the car is stolen. have time to provide for your loved ones, or you could live too
One way that insurance companies combat moral hazard is by long and run out of retirement assets. Wither option is very
requiring a deductible. A deductible is the amount of any loss unappealing to most people. The purpose of life insurance is to
that must be paid by the insured before the insurance company relieve some of the concerned associated with either eventuality.
will pay anything. Although insurance cannot make you comfortable with the idea
of a premature death, it can at least allow you the peace of mind
Selling Insurance that comes with knowing that you have provided for your heirs.
Another problem common to insurance companies is that Life insurance companies also want to help people save for their
people often fail to seek as much insurance as they actually need. retirement. In this way, the insurance company provides for the
Human mature tends to cause people to ignore their mortality, customer’s whole life.
for example. For this reason, insurance, unlike many banking
The basic products of life insurance companies are life insurance
services, does not sell itself. Instead, insurance companies must
proper, disability insurance, annuities, and health insurance, life
hire large sales forces to sell their products, the expense of

al
insurance pays off if you die, protecting those who depend on
marketing may account for up to 20% of the total cost of a
your continued earnings. As mentioned, the person who
policy. A good sales force can convince people to buy insurance
receives the insurance payment after you die is called the
coverage that they never would have pursued on their own yet

i
beneficiary of the policy. Disability insurance replaces part of
may have a need for.

com Tr
your income should you become unable to continue working
Insurance is unique in that agents sell a product that commits due to illness or an accident. An annuity is an insurance
the company to a risk. The relationship between the agent and product that will help if you live longer than you expect. For an
the company varies: independent agents may sell insurance for initial fixed sum or stream of payments, the insurance company
a number of different companies. They do not have any agrees to pay you a fixed amount for as long as you live. If you

rd. F
particular loyalty to any one firm and simply try to find the best live a short life, the insurance company pays out less than
product for their customer. Exclusive agents sell the insurance expected. Conversely, if you live unusually long, the insurance

iza D
products for only one insurance company.
Most agents, whether independent or exclusive, are
compensated by being paid a commission. The agents
company may pay out much more than expected.
Term Life
dfw P
The simplest form of life insurance is the term insurance policy,
themselves are usually not at all concerned with the level of risk
which pays out if the insured dies while the policy is in force.
of any one policy because they have little to lose if a loss occurs.
This form of policy contains no savings element, once the
(Rarely are commissions influenced by the claims submitted by
policy period expires, there are no residual benefits.
w.p m

an agent’s customers). To keep control over the risk that agents


are incurring on behalf of the company, insurance companies As the insured ages, the probability of death increases, so the
employ underwriters, people who review and sign off on each cost of the policy rises. Some term policies fix the premiums for
policy an agent writes and who have the authority to turn down a set number of years, usually five of ten. Alternatively,
ww Co

a policy if they deem the risk unacceptable. decreasing term policies have a constant premium, but the
amount of the insurance coverage declines each year. Term
Growth and Organisation of Insurance Companies policies have been historically hard to sell because once they
Types of Insurance expire, the policyholder has nothing to show for the premium
Insurance is classified by which type of undesirable event is paid. This problem is solved with whole life policies.
cu

insured. The most common types are life insurance and Whole Life
property and casualty insurance. In its simplest form, life A whole life insurance policy pays a death benefit if the
insurance provides income for the heirs of the deceased. Many policyholder dies. Whole life policies usually require the insured
insurance companies provide retirement benefits as well as life
Do

to pay a level premium for the duration of the policy. In the


insurance. In this case, the premium combines the cost of the beginning, the insured pays more than if a term policy had been
life insurance with a savings program. The cost of life insurance purchased, this overpayment accumulates as a cash value that
depends on such factors as the age of the insured, average life can be borrowed by the insured at reasonable rates.
expectancies, the health and lifestyle of the insured (whether the
Survivorship benefits also contribute to the accumulated cash
insured smokes, engages in a dangerous hobby such as sky
values. When members of the insured pool die, any remaining
diving, and so on), and the insurance company’s operating
cash values are divided among the survivors. Of the
costs.
policyholder lives until the policy matures, it can be surrendered
Property and casualty insurance protects property (houses, cars, for its cash value. This cash value can be used to purchase an
boats, and so on) against losses due to accidents, fire, disasters, annuity. In this way, the whole life policy is advertised as
and other calamities. covering the insured for the duration of his or her life.
Life Insurance Universal Life
Life is assumed to unfold in a predictable sequence. You work These types of policies combine the benefits of the term policy
for a number of years while saving for retirement; then you with those of the whole life policy. The major benefit of the
retire, live off the fruits of your earlier labour, and die at a ripe

© Copy Right: Rai University


11.621.6 105
universal life policy is that the cash value accumulates at a much Health Insurance
MANAGEMENT OF FINANCIAL INSTITUTION

higher rate. Individual health insurance coverage is very vulnerable to


The universal life policy is structured to have two parts, one for adverse selection problems. People who know that they are
the term life insurance and one for savings. One important likely to get ill are the most likely to seed health insurance
advantage that universal life policies have over many alternative coverage. This causes individual health insurance to be very
investment plans is that the interest earned on the savings expensive. Most policies are offered through company-
portion of the account is tax-exempt until withdrawn. To keep sponsored programs in which the company pays all or part of
this favorable tax treatment, the cash value of the policy cannot the employee’s policy premium.
exceed the death benefit. Most life insurance companies also offer health insurance.
Annuities If we think of term life insurance as insuring against Health insurance premiums account for about 25% of the total
death, the annuity can be viewed as insuring against life, as we premium income. There has been an extensive debate over
noted earlier, one risk people have is outliving their retirement medical insurance reason being the spiraling costs of health care.
funds. If they live longer than they projected when they initially For most of the past decade, the cost of health care has risen

al
retired, they could spend all their money and end up in poverty. much faster than the cost of living and real wages. One factor
One way to avoid this outcome is by purchasing annuities. contributing to this increase is the more sophisticated and
Once an annuity has been purchased for a fixed amount, it expensive treatments constantly being offered. Another way

i
makes payments as long as the beneficiary lives. that insurance companies are attempting to deal with increased

com Tr
medical costs is by controlling them. This is done by
Annuities are particularly susceptible to the adverse selection
negotiating contracts with physician groups to provide services
problem. When people retire, they know more about their life
at reduced cost and through managed care, where approval is
expectancy than the insurance company knows. People who are
required before services can be rendered.
in good health, have a family history of longevity, and have

rd. F
attended to their health all of their lives are more likely to live Property and Casualty Insurance
longer and hence to want to buy an annuity than people in poor Property and casualty insurance was the earliest form of
or average health. To avoid this problem, insurance companies insurance. It protects against losses from fire, theft, storm,

iza D
tend to price individual annuities expensively. Most annuities
are sold to members of large groups where all employees
explosion, and even neglect. Property insurance protect
businesses and owners from the impact of risk associated with
dfw P
covered by a particular pension plan automatically receive their owning property. This includes replacement and loss of
benefit distribution by purchasing an annuity from the earnings from income-producing property as well as financial
insurance company. losses to owners of residential property. Casualty insurance
(or liability insurance) protects against liability for harm the
Assets and Liabilities of Life Insurance Companies
w.p m

insured may cause to others as a result of product failure or


Life insurance companies derive funds form two sources. First,
accidents.
they receive premiums that represent future obligations that
must be met when the insured dies. Second, they receive Property and casualty insurance is different form life insurance.
ww Co

premiums paid into pension funds managed by Life Insurance First, policies tend to be short-term, usually for one year or less.
Company. These funds are long term in nature. Since life Second, whereas life insurance is limited to insuring against one
insurance liabilities are predictable and long-term, life insurance event, property and casualty companies insure against many
companies can invest in long-term assets. The pie chart below different events. Finally, the amount of the potential loss is
shows the tentative distribution of assets of the average life much more difficult to predict than for life insurance. These
cu

insurance company. Most of the assets are in long-term characteristics cause property and casualty companies to hold
investments such as corporate stocks and bonds. more liquid assets than those of life insurance companies.
Reinsurance
Do

One way that insurance companies may reduce their risk


Distribution of life insurance company assets
exposure is to obtain reinsurance. Reinsurance allocates a
Government portion of the risk to another company in exchange for a
Securities portion of the premium. Reinsurance allows insurance
Miscellaneous companies to write larger policies because a portion of the
Corporate
Loans Bonds policy is actually held by another firm.

Mortgages
The Practicing Financial Institution Manager
Insurance Management
Stocks
Insurance companies, like banks, are in the financial
intermediation business of transforming one type of asset into
another for the public. Insurance companies use the premiums
paid on policies to invest in assets such as bonds, stocks,
mortgages, and other loans; the earnings from these assets are
then used to pay out claims on the policies. In effect, insurance
companies transform assets such as bonds, stocks, and loans

© Copy Right: Rai University


106 11.621.6
into insurance policies that provide a set of services (for Ram too little. Sita could go to another insurance company and

MANAGEMENT OF FINANCIAL INSTITUTION


example, claim adjustments, savings plans, friendly insurance get a lower rate, while Ram would sign up for the insurance.
agents). If the insurance company’s production process of asset Because Ram’s premium isn’t high enough to cover the
transformation efficiently provides its customers with adequate accidents he is likely to have, on average the company would
insurance services at low cost and if it can earn high returns on lose money on Ram. Only with a premium based on a risk
its investments, it will make profits; if not, it will suffer losses. classification, so that Ram is charged more, can the insurance
In the case of an insurance policy, moral hazard arises when the company make a profit.
existence of insurance encourages the insured party to take risks Restrictive Provisions
that increase the likelihood of an insurance payoff. For example, Restrictive provisions in policies are another insurance
a person covered by burglary insurance might not take as many management tool for reducing moral hazard. Such provisions
precautions to prevent a burglary because the insurance discourage policyholders from engaging in risky activities that
company will reimburse most of the losses if the theft occurs. make an insurance claim more likely. One type of restrictive
Adverse selection holds that the people most likely to receive provision keeps the policyholder from benefiting from behavior

al
large insurance payoffs are the ones who will want to purchase that makes a claim more likely. For example, life insurance
insurance the most. For example, a person suffering from a companies have provisions in their policies that eliminate death
terminal disease would want to take out the biggest life and benefits if the insured person commits suicide. Restrictive

i
medical insurance policies possible, thereby exposing the provisions may also require certain behavior on the part of the

com Tr
insurance company to potentially large losses. Both adverse insured that makes a claim less likely. A company renting motor
selection and moral hazard to reduce these payouts is therefore scooters may be required to provide helmets for renters in order
an extremely important goal for insurance companies. to be covered for any liability associated with the rental.
Screening Prevention of Fraud

rd. F
To reduce adverse selection, insurance companies try to screen Insurance companies also face moral hazard because an insured
out poor insurance risks from good ones. Effective information person has an incentive to lie to the company and seek a claim
collection procedures are therefore an important principle of
insurance management.
iza D
When you apply for auto insurance, the first thing your
even if the claim is not valid. For example, a person who has
not complied with the restrictive provisions of an insurance
contract may still submit a claim. Even worse, a person may file
dfw P
insurance agent does is ask you questions about your driving claims for events that did not actually occur. Thus an important
record (number of speeding tickets and accidents), the type of management principle for insurance companies is conducting
car you are insuring, and certain personal matters (age, marital investigations to prevent fraud so that only policyholders with
status). If you are applying for life insurance, you go through a valid claims receive compensation.
w.p m

similar grilling, but you are asked even more personal questions Cancellation of Insurance
about such things as your health, smoking habits, and drug and Being prepared to cancel policies is another insurance
alcohol use. The life insurance company even orders a medical management tool. Insurance companies can discourage moral
ww Co

evaluation (usually done by an independent company) that hazard by threatening to cancel a policy when the insured person
involves taking blood samples. Based on this information, the engages in activities that make a claim more likely. If your auto
insurance company can decide whether to accept you for the insurance company makes it clear that if a driver gets too many
insurance or to turn you down because you pose too high a risk speeding tickets, coverage will be canceled, you will be less likely
and thus would be and unprofitable customer for the insurance
cu

to speed.
company.
Deductibles
Risk-Based Premium The deductible is the fixed amount by which the insured’s loss
Charging insurance premiums on the basis of how much risk a is reduced when a claim is paid off. Deductibles are an
Do

policyholder poses for the insurance company is a time-honored additional management tool that helps insurance companies
principle of insurance management. Adverse selection explains reduce moral hazard. With a deductible, you experience a loss
why this principle is so important to insurance company along with the insurance company when you make a claim.
profitability. Because you also stand to lose when you have an accident, you
To understand why an insurance company finds it necessary to have an incentive to drive more carefully. A deductible thus
have risk-based premiums, let’s examine an example of risk- makes a policyholder act more in line with what is profitable for
based insurance premiums that at first glance seems unfair. Ram the insurance company; moral hazard has been reduced. And
and Sita, both college students with no accidents or speeding because moral hazard has been reduced, the insurance company
tickets, apply for auto insurance. Normally, Ram will be charged can lower the premium by more than enough to compensate
a much higher premium than Sita. Insurance companies do this the policyholder for the existence of the deductible.
because young males have a much higher accident rate than Another function of the deductible is to eliminate the
young females. Suppose, though, that one insurance company administrative costs of small losses by forcing the insured to
did not base its premiums on a risk classification but rather just bear these losses.
charged a premium based on the average combined risk for
males and females. Then Sita would be charged too much and

© Copy Right: Rai University


11.621.6 107
Coinsurance
MANAGEMENT OF FINANCIAL INSTITUTION

When a policyholder shares a percentage of the losses along


with the insurance company, their arrangement is called
coinsurance. For example, some medical insurance plans
provide coverage for 80% of medical bills, and the insured
person pays 20% after a certain deductible has been met.
Coinsurance works to reduce moral hazard in exactly the same
way that a deductible does. A policyholder who suffers a loss
along with the insurance company has less incentive to take
actions, such as going to the doctor unnecessarily, that involve
higher claims. Coinsurance is thus another useful management
tool for insurance companies.
Limits on the Amount of Insurance

al
Another important principle of insurance management is that
there should by limits on the amount of insurance provided,
even though a customer is willing to pay for more coverage. The

i
higher the insurance coverage, the more the insured person can

com Tr
gain from risky activities that make an insurance payoff more
likely and hence the greater the moral hazard. For example, if
Sita’s car were insured for more than its true value, she might
not take proper precautions to prevent its theft, such as making
sure that the key is always removed or putting in an alarm

rd. F
system. If her car were stolen, she comes out ahead because the
excessive insurance payoff would allow her to bur an even

iza D
better car. By contrast, when the insurance payment is lower
than the value of her car, she will suffer a loss if it is stolen and
will thus take the proper precautions to prevent this from
dfw P
happening. Insurance companies must always make sure that
their coverage is not so high that moral hazard leads to large
losses.
w.p m

Questions to Discuss:
1. What are the fundamentals of insurance?
2. Discuss the adverse selection and moral hazard in insurance.
ww Co

3. What is selling insurance?


4. Discuss Growth and organisation of insurance companies?
5. Explain the characteristics of the practicing financial
institution manager?
cu

Notes:
Do

© Copy Right: Rai University


108 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 27:
MUTUAL FUND

Learning objectives A mutual fund uses the money collected from the investor to
After reading this lesson, you will understand buy those assets, which are specifically permitted by its stated
investment objective. Thus, an Equity Fund would buy mainly
• Concept
equity assets- ordinary shares, preference shares, warrants etc; a
• Structure Bond Fund would mainly buy debt instruments such as
• Types of mutual fund debentures, bonds, or government securities. It is these assets,
• SIP or SWP or STP which are owned by the investors in the same proportion as

al
their contribution bears to the total contributions of all the
• Tax benefits in mutual fund
investors put together.
• Net asset value (NAV) – the concept
When an investor subscribes to the mutual fund, he or she

i
• Importance of NAV to the investor buys a part of the assets or the pool of funds that are

com Tr
• Advantages of investing in mutual fund outstanding at that time. It is no different from buying
• Disadvantages of investing in mutual fund “shares” of a joint stock company, in which case the purchase
makes the investor a part owner of the company and its assets.
Students, today in the class we shall discuss one of the most
In India, a mutual fund is constituted as a Trust and the
popular investment alternatives available in the market. It is

rd. F
investor subscribes to the “units” issued by the fund, which is
popular both with retail investors as well as high networth
where the term Unit Trust comes from. In any case, a mutual
individual because of its capacity to earn more returns with less
fund shareholder or unit-holder is a part owner of the fund’s
risk.
iza D
Let us start with the concept of Mutual Fund. What exactly do
we understand by mutual fund?
asset.
Since each owner is a part owner of a mutual fund, thus it is
dfw P
necessary to establish the value of his part. In other words, each
Concept share or unit that an investor holds needs to be assigned a
Investment can be done in different forms. An investor can value. Since the units held by investor evidence the ownership
either invest directly in securities, or can invest through an of the fund’s assets, the value of the total assets of the fund
w.p m

investment company. An investment company is a financial when divided by the total number of units issued by the
intermediary that collects money from investors and invests in mutual fund gives us the value of one unit. This is generally
various securities on their behalf. The returns from these called the Net Asset Value (NAV) of one unit or one share.
ww Co

investments are passed on to the investors, either periodically, The value of an investor’s part ownership is thus determined
or at the end of a specified time period. The investment by the NAV of number of units held.
company charges fees for its services, referred to as management
A mutual fund is the ideal investment vehicle for today’s
fees.
complex and modern financial scenario. Markets for equity
There are two kinds of investment companies – Open-end and
cu

shares, bonds and other fixed income instruments, real estate,


Close-end. Open–End investment companies are those, which derivatives and other assets have become mature and
have an unlimited investment horizon. They sell and buy back information driven. Price changes in these assets are driven by
their shares at regular intervals through out their existence. global events occurring in faraway places. A typical individual is
Hence their investible funds or portfolio size keeps on unlikely to have the knowledge, skills, inclination and time to
Do

changing. Close- End companies are those which have a limited keep track of events, understand their implications and act
investment horizon. The investors invest in the company for a speedily. An individual also finds it difficult to keep track of
specified time period, and the investment company manages for ownership of his assets, investments, brokerage dues and bank
the said period. At the end of the period the investments are transactions etc. A mutual fund is the answer to all these
liquidated and the investors funds are returned along with the situations. It appoints professionally qualified and experienced
returns. staff that manages each of these functions on a full time basis.
In India both close-end and open-end investment companies The large pool of money collected in the fund allows it to hire
are called Mutual Funds. Thus Mutual fund is a trust that such staff at a very low cost to each investor.
pools the savings of a number of investors who share a In effect, the mutual fund vehicle exploits economies of scale in
common financial goal. The money thus collected is then all three areas - research, investments and transaction processing.
invested by the fund manager on behalf of the investors in While the concept of individuals coming together to invest
different types of securities. The income earned through these money collectively is not new, the mutual fund in its present
investments and the capital appreciated realized by the schemes form is a 20th century phenomenon. In fact, mutual funds
are shared by its unit holders in proportion to the number of gained popularity only after the Second World War.
units owned by them.

© Copy Right: Rai University


11.621.6 109
Globally, there are thousands of firms offering tens of schemes in all categories i.e. equity, balanced, income etc with
MANAGEMENT OF FINANCIAL INSTITUTION

thousands of mutual funds with different investment some being open-ended and some being closed-ended. The
objectives. Today, mutual funds collectively manage almost as Unit Scheme 1964 commonly referred to as US 64, which is a
much as or more money as compared to banks. This gives the balanced fund, is the biggest scheme with a corpus of about
investor number of options and gives him optimal returns Rs200bn. UTI was floated by financial institutions and is
accompanied by minimum risk. governed by a special act of Parliament. Most of its investors
All in all mutual fund is the best means to invest by not only believe that the UTI is government owned and controlled,
minimizing the risk but also maximizing returns. which, while legally incorrect, is true for all practical purposes.
The following flow chart would make our understanding very The second largest category of mutual funds is the ones floated
clear. by nationalized banks. Canbank Asset Management floated by
Canara Bank and SBI Funds Management floated by the State
The flow chart below describes broadly the working of a
Bank of India are the largest of these. GIC AMC floated by
mutual fund:
General Insurance Corporation and Jeevan Bima Sahayog AMC

al
floated by the LIC are some of the other prominent ones. The
aggregate corpus of funds managed by this category of AMCs
is about Rs150bn.

i
The third largest category of mutual funds is the ones floated

com Tr
by the private sector and by foreign asset management
companies. The largest of these are Prudential ICICI AMC and
Birla Sun Life AMC. The aggregate corpus of assets managed
by this category of AMCs is in excess of Rs250bn.

rd. F
Further the Mutual Fund Industry has a Four –tier structure.
The four parties that are required to be involved are:

iza D • Sponsor
• Board of Trustees
• Asset Management Company (AMC)
dfw P
• Custodian.
Structure
These four entities operate in the following manner:
Now lets come to the structure of the overall functioning of
w.p m

Mutual Fund.
The organisational set up of the Mutual Fund is as follows:
SPONSOR
ww Co

BOARD OF TRUSTEES/DIRECTORS OF TRUSTEES COMPANY


cu

ASSET MANGEMENT COMPANY


Do

CUSTODIAN

The structure of a mutual fund differs from country to country.


The Sponsor of a fund is the entity that sets up the mutual
In India the structure of a mutual fund is determined by SEBI
fund. The fund is governed either by a Board of Trustees, or
regulations. These regulations are required to be established in
The Directors Of A Trustees Company. The sponsor selects
the form of a trust under the Indian Trust Act, 1882. In India
them. The Board of Trustee is responsible for protecting the
Mutual Fund industry can be divided into three categories- The
investors’ interests. The sponsor or the trustee if so authorized
Unit Trust of India, the Asset Management Company floated
by the Trust Deed appoints the Asset Management Company
by Nationalized Banks and the Asset Management Company
(AMC) for the investment and administrative functions. The
floated by Private sector.
AMC does the research, and manages the corpus of the fund. It
The Unit Trust of India dominates the Indian mutual fund launches the various schemes of the fund, manages them, and
industry, which has a total corpus of Rs700bn collected from then liquidates them at the end of their term. It also takes care
more than 20 million investors. The UTI has many funds/ of the other administrative work of the fund. It receives an

© Copy Right: Rai University


110 11.621.6
annual management fees from the fund from its services. The Trustees are empowered to terminate the appointment of the

MANAGEMENT OF FINANCIAL INSTITUTION


Custodians are appointed by the sponsor for looking after the AMC by majority and appoint a new AMC with prior approval
transfer and storage of the securities and co-ordinate with the of SEBI and unit – holder.
brokers. The AMC of a mutual fund must have a net worth of at least
It is important for the people associated with the Mutual Fund Rs.10crs. at all times. Directors of AMC, both independent and
Industry to be aware of the special nature of its structure, non-independent, should have adequate professional experience
because it determines the rights and responsibilities of the in financial services and should be individuals of high moral
fund’s constituents viz. sponsors, trustees, custodians, transfer standing, a condition also applicable to other key personnel of
agent and the fund and the asset management company. In the the AMC. The AMC cannot act as a trustee of any other mutual
following readings each component will be discussed in details: fund. Besides its role as the fund manager it may undertake
specified activities such as advisory services and financial
The Fund Sponsor
“Sponsor” is defined under SEBI regulations as any person consulting provided these activities are run independently of
who, acting alone or in combination with another body one another and the AMC’s resources are properly segregated by

al
corporate, establishes a mutual fund. The sponsor of a fund is activity.
akin to the promoter of accompany as he gets the fund The AMC are responsible to invest on behalf of the investors
registered with SEBI. The sponsor will form a trust and who have entrusted them with their money .So they are

i
appoint a board of trustees. The sponsor will also generally expected to act in the interest of the investors.

com Tr
appoint an Asset Management Company as fund managers.
The Custodian
The sponsor, either directly or acting through the trustees, will
Mutual funds are in the business of buying and selling of
also appoint a Custodian to hold the fund assets. All these
securities in large volumes. Handling these securities in terms of
appointments are made in accordance with SEBI Regulations.
physical delivery and eventual safekeeping is therefore a

rd. F
As per the existing SEBI regulations, for a person to qualify as a specialized job. The custodian is appointed by the Board of
sponsor, he must contribute at least 40% of the net worth Trustees for safekeeping of physical securities or participating in

prior to registration.
The Trustee
iza D
AMC and posses a sound financial track record over five years any clearing system through approved depository companies on
behalf of the mutual fund in case of dematerialized securities.
The mutual fund industry does not work with the help of one
dfw P
A mutual fund in India is constituted in the form of a Public entity. All the four constituents have to operate in harmony and
Trust created under the Indian Trusts Act 1882. The Fund in co-operation with each other. One must not forget that they
Sponsor acts as the Settler of the Trust, contributing to its are inter-related and has to function together.
w.p m

initial capital and appoints a trustee to hold the assets for the
Types of Mutual Fund
benefit of the unit-holders, who are the beneficiaries of the
Mutual funds differ from each other on the basis of various
trust. The fund then invites investors to contribute their money
factors like their structure, their investment objectives, and the
in the common pool, by subscribing to units issued by various
ww Co

types of investors, management style and load. The various


schemes established by the trust, units being the evidence of
classes of funds are:
their beneficial interest in the fund.
The trust – the mutual fund- may be managed by a Board of
Trustees- a body of individuals, or a trust company- a corporate
cu

body. The Board of Trustees manages most of the funds in


OPEN-ENDED
STRUCTURE

India. While the Provisions of the Indian Trusts Act, govern CLOSE-ENDED

the Board of Trustees where the Trustee is a corporate body, it EQUITY (GROWTH)

would also be required to comply with the provisions of the INCOME


Do

companies Act, 1956. The Board or the trustee company, as an INVESTMENT BALANCED
OBJECTIVE
independent body, acts as protector of the unit-holders interest LIQUID

the trustees do not directly manage the portfolio of securities. GILT

For this specialist function, they appoint an Asset Management OTHER SPECIALIZED FUNDS (MIP, SECTORAL,
etc.)

Company. They ensure that the fund is managed by the AMC TYPES OF OFFSHORE FUNDS
as per the defined objectives and in accordance with the Trust INVESTORS
PENSION FUNDS
Deed and SEBI Regulations.
The trustees being the primary guardians of the unit holders’ MANAGEMENT MANAGED FUNDS

funds and assets, a trustee has to be a person of high repute S TYLE

and integrity. He acts as a watchdog over the AMC so that the


INDEX FUNDS

investor’s money is safe and secure. LOAD FUNDS

LOAD
The Asset Management Company NO LOAD FUNDS

An AMC is the investment manager of the trust. The AMC


functions under the supervision of its own Board of Directors,
and also under the direction of the Trustees and SEBI. The

© Copy Right: Rai University


11.621.6 111
Open- Ended Fund companies, the performances of these funds are more
MANAGEMENT OF FINANCIAL INSTITUTION

An open-ended fund is a fund, which remains open for issue consistence. Then there are diversified schemes were the money
and redemption of its shares throughout its duration. This is invested over a wide area thus minimizing risk. So an investor
means an investor can invest or put in his money at any point according to his risk taking ability can invest in these funds.
of time and similarly redeem or withdraw his investment at any
Income Fund
given time depending on the market and other factors.
The aim of such fund is to provide regular and steady income
Examples: Birla Advantage Fund, HDFC equity, Canaganag, etc.
to investors. These funds or schemes generally invest in fixed
As an open-ended fund is required to redeem its shares any
incomes such as bonds and corporate debentures. Capital
time the investors wish to liquidate their holdings, a relatively
appreciation in such schemes may be limited. These are suitable
higher portion of its assets need to be highly liquid.
for retired people and others with a need for capital stability and
Close-Ended Fund regular income.
A close – ended fund can issue shares only in the beginning, The largest segment of the market in terms of traded volume
and cannot redeem them or reissue them till the end of their and outstanding debt is the government securities market. This

al
fixed investment duration. This means that once an investor is the most liquid segment of the market with maturity of debt
puts in his money he cannot withdraw till the maturity period. issues ranging from 91day Treasury bill right up to 30 yr dated
Example: UTI’s US 92. A close-ended fund does not face the securities. This class of securities would account for more than

i
problem of shortfall, as it does not require to redeem its shares 90% of traded volume in the secondary market. People who are

com Tr
before the maturity period of the fund. very low risk takers can opt for these schemes. Here the investor
Equity or Growth Fund gets regular returns at minimum risk, but the returns are not as
The objective of Growth Fund Scheme is to provide capital high as equity.
appreciation over the medium to long term. These schemes Balanced Fund

rd. F
normally invest a major portion of their fund in Equities and They aim to provide both growth and income periodically
are willing to bear short-term decline in value for future distributing a part of the income and capital appreciation to the

iza D
appreciation in the net asset value of the scheme. These
schemes are not for the investors seeking regular income or
needing their money back in the short term and are suitable for
investors or reinvesting (in case of reinvestment scheme) such
income and capital appreciation to enhance the net asset value
of the fund. They invest in both shares and fixed income
dfw P
investors in their prime earning years or investors seeking securities in the proportion indicated in their offer document.
growth over the long term. Such funds are suitable for investors, who are willing to take
Growth or Equity funds offer two options-Dividend Option some risk and seeks both income and capital appreciation.
w.p m

and Growth Option. In Dividend Option, the investor gets the Here a part of the investment is in debt market so the risk is
dividend on a regular basis as and when declared by the AMC. minimum, and the other part is invested in equities to
The dividend is calculated on the face value of that particular maximize returns. Hence the investors enjoy the benefit of high
scheme of the Mutual Fund. This dividend is tax-free in the returns along with security. The aim of balanced funds is to
ww Co

hands of investors. In the case of Growth Option, no provide both growth and regular income. In a rising stock
dividend is declared so the NAV continues to appreciate on a market, the NAV of these schemes may not normally keep pace,
regular basis. or fall equally when the market falls. These are ideal for investors
Dividend option comprises of Dividend Pay-Out and looking for a combination of income and moderate growth.
cu

Dividend Reinvestment. In the case of Dividend Pay-Out Here the maximum exposure is towards Equity as compared to
option, the investors receive the dividend when declared by the debt. However the proportion of equity: debt may change from
AMC and the NAV of that scheme gets reduced in proportion time to time, as the market trend is as well as on the call of
to the percentage of dividend declared. On the other hand, in fund manager. In the recent months the proportion of equity:
Do

the case of Dividend Reinvestment Option, the dividend debt is 60: 40. This is because the equity market is doing well.
amount gets automatically reinvested in the scheme instead of Balance fund tries to strike a balance between that equity offers
coming in the hands of the investor. Here the number of units and the safety that debt provides, and thus maximizes
gets increased accordingly. In this case too the NAV gets reduced investments at moderate levels of risk.
in accordance with the percentage of the dividend declared.
Liquid Fund
The Growth Option is bifurcated into Growth Plan and Liquid funds are short-term investments, which are not marked
Bonus Plan. In Growth Plan when the company declares to market (not traded). In this case the investors instead of
bonus the investors who have opted for this plan are not keeping the money with them for a very short period say a
entitled for the bonus shares. In this case the NAV of the weekend invests in liquid fund. The aim of Liquid funds is to
scheme keeps on appreciating. On the other hand investors who provide easy liquidity, preservation of capital and moderate
have opted for bonus plan receive the bonus shares and the income. These schemes generally invest in safer short-term
NAV of the scheme decreases in the same proportion. instruments such as treasury bills, certificates of deposit,
Some schemes can be aggressive, where the weightage is more commercial paper and inter-bank call money. Returns on these
on mid-caps. Here the fluctuations are more, or there are schemes may fluctuate depending upon the interest rates
conservative funds where the weightage is on Blue-chip prevailing in the market. These are ideal for Corporate and

© Copy Right: Rai University


112 11.621.6
individual investors as a means to park their surplus funds for Managed Fund

MANAGEMENT OF FINANCIAL INSTITUTION


short periods. However the amount of money invested in the The corpus of the fund can be managed actively or passively.
above mentioned areas might differ from one fund house to Active management of funds involves gathering of security
the other. specific information, analyzing it, and selecting those securities
that are most expected to fulfill the investment objectives. This
Gilt Fund
process entails a heavy cost that is charged to the scheme.
These funds are majorly, investing in government securities, this
Funds, which manage their corpus actively, are called Managed
includes treasury bills. This fund is for those people who are
Fund. Active management of funds is undertaken with the aim
looking at investing in government securities, which enjoy no
of performing better than the Index Funds. However,
credit risk, hence ensuring the safety of their money. Here the
empirical evidence suggests that risk- adjusted after-cost returns
primary objective is to generate credit risk – free returns by
from managed funds may not be necessarily higher than the
investing in a portfolio of securities issued and guaranteed by
returns from index fund.
Central and State Government.
Other Specialized Fund Index Fund

al
These funds invest in particular industries, instruments sectors Passive management of fund involves selection of a market
or markets. If they are Industry Specific Schemes then they index. After an index is selected, the securities that form a part
invest only in the industries specified in the offer document. of the index are bought in the proportion in which they are

i
represented in the index. No further transaction is done and

com Tr
The investment of these funds is limited to specific industries
like InfoTech, FMCG, and Pharmaceuticals etc. For Example: these securities are held till a need to liquidate the corpus arises.
Alliance Basic Industries fund, Prudential ICICI Technology If a part of the corpus is required to be liquidated for
fund, etc. redemption purposes, it is liquidated in the same proportion in
which the securities are held. The cost of managing funds
If they are Sector Specific Schemes then they invest passively is quite less as compared to active management. Index

rd. F
exclusively in a specified sector. This could be an industry or a funds bases on BSE or NSE are examples of passively
group of industries or various segments such as ‘A’ Group managed funds. Index funds perform in line with the

iza D
shares or initial public offerings.
Then there is Tax Saving Schemes. These schemes offer tax
rebates to the investors under specific provisions of the Indian
performance of the index, which is reflective of the market as a
whole.
dfw P
Load Fund
Income Tax laws as the Government offers tax incentives for
A fund incurs two types of costs- marketing costs and
investment in specified avenues. Investments made in Equity
operating costs. While the operating costs of the scheme are
Linked Savings Schemes (ELSS) and Pension Schemes are
charged to the schemes’ earnings, the marketing costs may not
w.p m

allowed as deduction u/s 88 of the Income Tax Act, 1961. The


be so charged. In case of Load Fund they charge the marketing
Act also provides opportunities to investors to save capital
costs to the scheme. Further the load fund is of two types –
gains u/s 54EA and 54EB by investing in Mutual Funds. The
Front Load and Back Load. In a front load fund, the load is
objective of this scheme is to help the tax paying investors in
ww Co

charged at the time the investors invest in the fund, this is also
minimizing their tax liability.
called Entry Load. In the case of back load fund, investors are
Offshore Funds required to pay the load charges while exiting from the fund.
Funds that invest solely in the foreign markets are referred to as This is also called the Exit Load. There can be a Partial Load
international funds (also called offshore funds) the majority of scheme, wherein a part of the load is borne by the scheme and
cu

funds have been routed through Mauritius. Funds that invest the rest by the Asset Management Company.
in both domestic and international markets are referred to as
No- Load Fund
Global Funds. At present the Indian mutual funds are not
In these kinds of funds the marketing costs as a part of the
allowed to invest in the international market, nor are the foreign
management fee. The management is allowed to charge an
Do

investors are allowed to invest in the Indian mutual fund


additional management fees from the scheme up to 1% of the
directly.
weekly average corpus of the scheme in any financial year.
Internationally, there is a category of funds, which invest in a
Further the management is entitled to charge a load on
portfolio of other mutual funds. Such funds are called Multi-
redemptions during the first four years of the scheme, subject
Funds.
to the following limits:
Pension Fund During th e 1s t year Maximum 4% of the redemption proceeds.
There are some categories of funds that are different from other During the 2 nd year
During the 3 r d year
Maximum
Maximum
3%
2%
of
of
the
the
redemption
redemption
proceeds.
proceeds.
funds because of their investor profile. They are the Pension During the 4 th year Maximum 1% of the redemption proceeds.

Funds. These funds manage the pension money of their


clients. These funds aims at investing the money of the SIP or SWP or STP
investor in areas, which give, assured returns with minimum Rather than investing, disinvesting or switching the entire
risk. portfolio at a single point of time, it is prudent to spread these
actions systematically over a period of time. This also curbs the
tendency of an investor to time the market -an investment style
that several researchers have statistically proved has a low

© Copy Right: Rai University


11.621.6 113
probability of success. This principle has given rise to the this does not mean that there is no tax at all on income
MANAGEMENT OF FINANCIAL INSTITUTION

concepts of Systematic Investment Plan (SIP), Systematic distributions by mutual funds.


Withdrawal Plan (SWP) and Systematic Transfer Plan (STP).
Income Distribution Tax
Systematic Investment Plan (SIP) As per prevailing tax laws, income distributed by schemes other
SIP refers to the practice of investing a constant amount every than open-end equity schemes is subject to tax at 20 % (plus
month. Thus, when the market goes up, then the money surcharge of 10 %). For this purpose, equity schemes have been
invested gets translated into less number of units. If the defined to be those schemes that have more than 50 % of their
market goes down, then the same money invested gets assets in the form of equity. Open-end equity schemes have
translated into-more number of units. been left out of the purview of this distribution tax for a
SIP ensures that your acquisition cost approximates the average period of three years beginning from April 1999.
NAV.Therefore;thisinvestmentstyleisalsocal Rupee
led Cost Income Received from Mutual Funds
Averaging. The Finance Bill 1999 made income (i.e. dividends) received
A related concept is Value Averaging. Here, the investor from all mutual funds tax free in the hands of investors).

al
operates with a certain target value for his investment. If the Investors need not pay any tax on dividend received from a
investment appreciates beyond the target value, he encashes part mutual fund for a period of three years effective from April 1,
1999. For the investor it does not matter what kinds of mutual

i
of the investment. If the investment depreciates below the

com Tr
target value, the investor brings in fresh funds equivalent to the fund scheme they have invested in. Dividend whether received
difference. from equity, equity & debt or a debt scheme will all be tax-free
for the investors.
Systematic Withdrawal Plan (SWP)
SWP is a mirror image of the SIP. In a SWP, the investor would While dividends in the hands of the investor are free from tax,
withdraw constant amounts periodically. The learning is the mutual funds are now required to pay a “distribution tax” of

rd. F
same viz. that through a SWP the investor can temper gains and 20% from the financial year 2000-2001 (instead of 10% as
losses, though it does not prevent losses. distribution tax last year. The distribution tax is not to be paid

Systematic Transfer Plan (STP)


iza D
Mutual funds make It convenient, and economical, to
on all types of mutual fund schemes. Effective April 1,1999, for
a period of three years, open-end equity oriented schemes will
be exempt from paying the distribution tax
dfw P
systematically transfer Investments between schemes of the
same mutual fund. Tax Implication for Income Received on Open-end

Tax Benefits in Mutual Fund Equity Oriented Scheme:


As per the Finance Bill 1999, income distributed under the US-
w.p m

The taxman has, over the years, been more or less kind to
Mutual Funds. With laws varying from time to time, the overall 64 scheme and other open-ended equity oriented scheme of
objective has been to encourage the growth of the Mutual UTI and Mutual Funds are exempt from the levy of this tax for
Funds industry. Currently, a variety of tax laws apply to Mutual a period of three financial years starting from 1.4.1999. An
ww Co

Funds, which are broadly listed below: - open-end equity oriented scheme is defined as one where more
than 50% of the scheme’s investible funds are invested in
Capital Gains domestic equities. The 50% is computed taking the annual
Units of Mutual Fund schemes held for a period for more than average of the monthly averages of the scheme’s equity
twelve months are treated as long-term capital assets. In such holdings. The monthly average, in turn, is calculated by taking
cu

cases, the unit holder has the option to pay capital gain tax at the opening and closing percentage of a particular month’s
either 20% with indexation or 10% without indexation. equity holdings.
Tax Deducted at Source (TDS) Difference Between TDS and Distribution Tax
For any income credited or paid by a fund, no tax is deducted or
Do

The distribution tax is different from “TDS” or tax deducted at


withheld at source. The relevant sections in the Income Tax Act source. In the case of TDS, the tax has to be deducted at the
governing this provision are Section 194K and 196A. time of payment or redemption by the issuer of the security
Wealth Tax and deposited with the Government. The issuer from income
Mutual fund units are not currently treated as assets under payable to the investor deducts this tax and the investor gets
Section 2 of the Wealth Tax Act and are therefore not liable to credit of the same while filing his annual return of tax. In cases
tax. where the investor is not liable to pay tax he may claim an
exemption from TDS by filing a Form 15H with the issuing
Income from Units
body of the security. Distribution tax is, however, a tax that has
Any income received from units of the schemes of a mutual
to be paid by the mutual fund, not the investor. It is not a
fund specified under section 23 (D) is exempt under Section 10
direct tax paid by the investor therefore, he cannot file for
(33) of the Act. While section 10(23D) exempts income of
exemption from distribution tax. Hence, while the dividend pay
specified mutual funds from tax (which currently includes all
out will be tax-exempt in the hands of the investors, in all
mutual funds operating in India), Section 10(33) exempts
schemes where the mutual fund has to pay a distribution tax,
income from funds in the hands of the unit-holders. However,
the dividend pay out will be affected to that extent by the 22%
distribution tax.

© Copy Right: Rai University


114 11.621.6
Long Term Capital Gains Arising from Sale of Fund companies typically calculate fund NAV’s at the end of the

MANAGEMENT OF FINANCIAL INSTITUTION


day, after the markets have closed. This allows the fund
Mutual
company to value the holdings in each fund and determine the
Fund Units total number of shares in which to base the NAV calculation.
As per the current provisions of the budget, long-term capital NAV’s are usually available two to three hours after market
gains arising from the sale of listed securities and shares as close. Investors can track fund performance by looking at the
defined under the Securities Contracts (Regulation) Act, 1956 change in NAV, like they would if they were tracking stock
(SCRA) are now chargeable to tax at a maximum rate of 10 %. performance using stock prices.
As per the earlier Income Tax law, units of mutual funds did
When a fund has a sales charge, called load, the price you have to
not qualify as listed securities under the Securities Contracts
pay is called the offering price and that’s equal to the NAV plus
(Regulation) Act, 1956 (SCRA) but as per the provisions of
any sales charges (loads). Funds sold through financial advisors
Union Budget 2000-2001 units of all Mutual funds will be
often have sales charges. As for no-load funds, the NAV and
considered as listed securities and long-term capital gains from
offering price are the same. If that is confusing, stick to no-load
units of mutual funds will be taxed at 20 per cent after giving

al
funds and you’ll be safe.
benefit of cost inflation indexation, or a flat rate of 10 % which
ever is lower. That is, persons would have the option of either Calculation of Nav
availing of cost indexation on the capital gains and paying 20 The most important part of the calculation is the valuation of

i
the assets owned by the fund. Once it is calculated, the NAV is

com Tr
per cent capital gains tax or paying a flat rate of 10 per cent
without cost indexation. As a result, the maximum capital gains simply the net value of assets divided by the number of units
tax payable has been capped at 10 per cent. outstanding. The detailed methodology for the calculation of
the asset value is given below.
Deletion of Sections 54 EA and 54 EB of the Income
Asset Value is Equal to

rd. F
Tax Act, 1961 Sum of market value of shares/debentures + Liquid assets/
The above two sections provided relief from capital gains tax if cash held, if any + Dividends/interest accrued Amount due on
investments were made in specified securities and locked in for a

iza D
period of 3 years in the case of 54EA and 7 years in the case of
54EB. Mutual fund units were one of the specified securities
unpaid assets - Expenses accrued but not paid
Details on the above Items
For liquid shares/debentures, valuation is done on the basis of
dfw P
and this resulted in a lot of money realized as profit from sale
of securities being reinvested in the market through mutual the last or closing market price on the principal exchange where
funds. the security is traded
With the withdrawal of the exemption to mutual funds, For illiquid and unlisted and/or thinly traded shares/
w.p m

investors have lost out on a very viable alternative for tax saving debentures, the value has to be estimated. For shares, this could
and funds also would be faced with the problem of ‘hot be the book value per share or an estimated market price if
money’ as there would no longer be any lock in period for suitable benchmarks are available. For debentures and bonds,
ww Co

investments. However this facility will be available till 30th value is estimated on the basis of yields of comparable liquid
September 2000 for all capital gains accrued till 31st march 2000. securities after adjusting for liquidity. The value of fixed interest
bearing securities moves in a direction opposite to interest rate
Net Asset Value (NAV) – the Concept
changes Valuation of debentures and bonds is a big problem
The Net Asset Value is the market value of the assets of the
since most of them are unlisted and thinly traded. This gives
cu

scheme minus its liabilities. It is calculated on a daily basis. The


considerable leeway to the AMCs on valuation and some of the
NAV is usually below the market price because the current value
AMCs are believed to take advantage of this and adopt flexible
of the fund’s assets is higher than the historical financial
valuation policies depending on the situation.
statements used in the NAV calculation. It is the cumulative
Interest is payable on debentures/bonds on a periodic basis say
Do

market value of the assets fund net of its liabilities. It


represents the market value or price of one fund share. In other every 6 months. But, with every passing day, interest is said to
words, if the fund is dissolved or liquidated, by selling off all be accrued, at the daily interest rate, which is calculated by
the assets in the fund, this is the amount that the shareholders dividing the periodic interest payment with the number of days
would collectively own. This gives rise to the concept of net in each period. Thus, accrued interest on a particular day is equal
asset value per unit, which is the value, represented by the to the daily interest rate multiplied by the number of days since
ownership of one unit in the fund. NAV It is calculated by the last interest payment date.
dividing the fund’s total net assets by the total number of Usually, dividends are proposed at the time of the Annual
shares outstanding. Except for money market funds, which are General meeting and become due on the record date. There is a
pegged to a constant NAV, a fund’s NAV may change every day gap between the dates on which it becomes due and the actual
to reflect changes in the value of its portfolio holdings, which in payment date. In the intermediate period, it is deemed to be
turn respond to changing market conditions. Further, mutual “accrued”.
funds are open-ended, meaning they allow for daily purchases Expenses including management fees, custody charges etc. are
and redemptions, which affects the total number of shares calculated on a daily basis.
outstanding.

© Copy Right: Rai University


11.621.6 115
The Net Asset Value per unit on any business day is computed increases as the value of the portfolio’s holdings increase. For
MANAGEMENT OF FINANCIAL INSTITUTION

as follows: example, if a share of a stock fund costs Rs.30 today and Rs.18
one year ago, there has been a gain (or profit) of Rs.12 a share,
or about 66%, before fund expenses. The change in a fund’s
Market value of the funds’ investments + NAV determines its performance. Comparing NAV
Receivables + Accrued Income –
Liabilities – Accrued Expense performance enables investors to differentiate funds on a
Net Asset Value =
No of Shares or Units outstanding
relative basis. NAV per share is a reliable, credible, and accepted
measuring stick for portfolio performance.
Tracking Fund Performance
For the majority of investors, investment performance is
The calculation of the NAV may be illustrated with the help of
ultimately the most important factor in determining which
the following example: mutual fund to invest in. A mutual fund’s performance can be
measured in several different ways, depending on its investment

al
Name of the scheme: AB Balanced objectives. Whether a fund aims for long-term growth, current
Size of the scheme: Rs.200 Crore income, or a combination of the two, investors can track fund
performance and judge profitability by:

i
Face value of the Share: Rs 10

com Tr
No. Of outstanding units: 20 Crore • Following changes in share price or net asset value (NAV)
Market value of the funds investments: Rs.280 Crore
Receivables: Rs.2 Crore • Calculating total return
Accrued Income: Rs.2 Crore • Figuring yield
Liability: Rs.1 Crore
While each calculation enables investors to compare a fund’s
Accrued Expense: Rs.1 Crore

rd. F
performance to similar funds offered by different companies,
there is no simple calculation for comparing funds to individual
securities, because each return is figured differently depending

iza D
NAV = 280+2+2 -1-1
20 on the type of investment.
As individual investors, we are all investment managers- of our
dfw P
= Rs. 14.1 per share.
own portfolios! Therefore, to accurately answer the question of
how are my investments doing? I we need to gauge our
Importance of Nav to the Investor investment performance at the portfolio level, rather than by
What is NAV? It’s the answer to the question, “how am I each individual security. Utilizing the net asset value (NAV)
w.p m

doing?” After taking all the steps needed to find great method of performance tracking allows us to measure the
investment ideas, how do you then measure and compare the performance of our entire portfolio and accurately compare our
success of those ideas as investments? At Marketocracy, we results with the universe of professionally managed funds.
ww Co

think the best way to track your performance is to do it the The NAV method is also the only accurate means of accounting
same way that mutual funds track their own performance, using for cash placed into, or taken out of, an investment portfolio.
Net Asset Value per share. New investments in the portfolio are made at the closing NAV
If you’re a typical investor, you want to know how well your on the day of the investment. Similarly, money taken out of a
investments are doing over time. If you only buy one stock and portfolio is taken out at the NAV on the day of the withdrawal.
cu

then hold onto it, it’s pretty easy to figure out how you’re doing In either case, because a fund ís shares increase or decrease with
by simply comparing the current value of the stock to the the flow of investments, accurate performance measurement is
amount you initially invested. assured. Remember, the net asset value equals the value of the
fund investments divided by the shares outstanding.
Do

Things get a lot more complicated once you have multiple


stocks in your portfolio and you’re buying and selling shares at When new investments are made, look at the closing NAV on
different times for different prices. Performance gets even harder that day and divide the amount of your new investment by it.
to measure if you invest additional cash or take money out of This will give you the correct number of shares to add to your
the portfolio every once in a while. portfolio shares outstanding. The same calculation when the
Adding cash to the portfolio increases its value, but not its investors takes money out of his investment portfolio, but
performance. Net Asset Value provides a way to objectively subtract the equivalent number of shares from the total
measure the performance over time in spite of all the changes portfolio shares outstanding.
that an investor makes to his portfolio. Since other investment Through NAV it is possible to gauge the performance of the
vehicles like mutual funds use NAV, it also provides a way to scheme and thereby chose the best scheme for the portfolio.
compare the investors investment performance to
professionally managed funds and indices, like the S&P 500.
For open-ended mutual funds, new shares are issued as money
flows into the fund. Likewise, the number of shares
outstanding is reduced as investments are redeemed. The NAV

© Copy Right: Rai University


116 11.621.6
Advantages of Investing in Mutual Fund Returns

MANAGEMENT OF FINANCIAL INSTITUTION


In India, dividend received in the hands of the investor is tax-
Diversification benefits
free. This enhances the yield on mutual funds marginally as
Diversified investment improves the risk- return profile of the
compared to income from other investment options. Also in
portfolio. Small investors may not have the amount of capital
the case of long term (more than one year) capital gains, the
that would allow optimal diversification. Since the corpus of a
investor gets the benefit of indexation and lower capital gains
mutual fund is substantially big as compared to individual
tax.
investments, optimal diversification becomes possible. As the
individual investors’ capital gets pooled into a mutual fund, all Flexibility
of them are able to derive the benefits of diversification. Mutual funds possess features such as regular investment plan
Low Transaction Cost: (i.e. one can invest in installments), regular withdrawal plan and
The transactions of a mutual fund are generally very large. These dividend reinvestment plan. Because of these features, one can
large volumes attract lower brokerage commissions (as a systematically invest or withdraw funds according to one’s needs
percentage of the value of the transaction) and other costs, as and convenience.

al
compared to the smaller volumes of the transactions entered Well-Regulated
into by individual investors. The brokers quote a lower rate of All mutual funds are registered with SEBI and they function
commission due to two reasons. The first is competition for within the provisions of strict regulations designed to protect

com Tr
i
the institutional investors’ business. The second reason is that the interest of investors. The options of mutual funds are
the overhead costs for executing a trade does not differ much regularly monitored by SEBI.
for large and small orders. Hence, for a large order, these costs
Transparency
spread over a large volume, enabling the broker to quote a lower
Mutual Funds have to disclose their holdings, investment
commission rate.
pattern and the necessary information before all investors under

rd. F
Availability of Various Schemes a regulation framework. Other than this the Asset Management
Mutual funds generally offer a number of schemes to suit the Companies do not have any control over the money of the

iza D
requirements of the investors. Thus the investors can choose
between regular income schemes and growth schemes, between
schemes that invest in the stock market and those that invest in
investors. The bankers manage the entire money. This makes
mutual funds transparent and reliable.
dfw P
Disadvantages of Investing in Mutual Fund
the stock market, etc. some schemes provide some added
advantages. For example: automatic reinvestment schemes No choice to the Investors
reinvest the distributed income automatically, thus making the The investors cannot choose the securities they want to invest
in, or the securities they want to sell. They are dependent on the
w.p m

management of funds easier. In case of direct investment in


securities, the reinvestment of the income in the same fund manager for this purpose. He decides where the
proportion as the assets held is very difficult and at times investments should be made.
impossible. Funds that invest in overseas markets offer the
ww Co

Wrong Call of the Fund Manager


additional advantage of international diversification, which may The investors face the risk of the fund manager not performing
otherwise may not be feasible to the lay investors. However in well. Also, if the fund manager’s compensation is linked to the
India mutual funds cannot invest in overseas market. funds’ performance, he may be tempted to show good results
Professional Management in the short–term without paying attention to the expected
cu

Management of a portfolio involves continuous monitoring of long-term performance of the fund. This would harm the
various securities and the innumerable economic and non- long-term interests of the investors.
economic variables that may affect the portfolio’s performance. Expense Ratio
This requires a lot of time and effort on the part of the Management fees charged by the fund reduce the returns
Do

functioning of the financial markets. Mutual funds are generally available to the investor. Though the maximum limit of the
managed by knowledgeable, experienced professionals whose expense ratio is 2.5%. The higher the expense of the fund the
time is solely devoted to tracking and updating the portfolio. less return is given to the investor.
Thus, investments in a mutual fund not only saves time and
No Discretion in Withdrawal
effort for the investor, it is also likely to produce better results.
While investor in securities can decide the amount of earnings
Liquidity they want to withdraw in a particular period, investors in a
Liquidating a portfolio is not always easy. There may not be a Mutual Fund have no such discretion as the amount of
liquid market for all securities held. In case only a part of the earnings that are to be paid out to the investor in a particular
portfolio is required to be liquidated, it may not be possible to year is decided by the Mutual Fund.
sell all the securities forming part of the portfolio in the same
proportion as they are represented in the portfolio. Investing in Uncertainty
the mutual funds can solve these problems. A mutual fund Today’s environment is characterized by a deep industrial
generally stands ready to buy and sell its units on a regular basis. recession and consequent high level of defaults on loans
Thus, it is easier to liquidate holdings in a mutual fund as provided by banking sector to industry. In such a scenario, it
compared to direct investment in securities.

© Copy Right: Rai University


11.621.6 117
may be prudent to look at the credit quality aspect very carefully
MANAGEMENT OF FINANCIAL INSTITUTION

before investing in an income mutual fund.


Questions to Discuss:
1. What is Mutual Fund?
2. Explain the structure of Mutual Fund?
3. What are the types of mutual fund?
4. Discuss SIP or SWP or STP?
5. What are the Tax benefits in mutual fund?
6. What is Net Asset Value (NAV)?
7. Discuss the importance of NAV to the investor.
8. What are the advantages of investing in mutual fund?

al
9. What are the disadvantages of investing in mutual fund?
Notes:

com Tr
i
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


118 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 28:
SMALL SAVINGS AND PROVIDENT FUNDS

Learning objectives raised in their respective areas as a loan for a period of ten years
After reading this lesson, you will understand since may 1970, for every 5 percent of receipts obtained in excess
of the national average of net or gross collections, the state
• Introduction
governments have been getting 2.5 percent as an additional
• Importance of small savings loan. This sharing of proceeds with the states, and the increase
• Types and nature of small savings instruments in it, have been undertaken to induce states to mobilise greater
• Innovations and instruments connected with the small resources and meet their growing financial requirements.

al
savings media Whether used by the central or state governments, there is at a
present no direct mechanism to ensure that the funds raised in a
• Growth and composition of small savings
particular area would be spent only there. The resources are

i
• Interest rates on small savings ‘drained’ away from rural areas. It is surprising now that when

com Tr
• Provident funds the government has set a target by which at least 60 percent of
• Pension fund deposits mobilised by banks in rural areas should be loaned
there, no similar step has been taken with regard to collections
Today you will get to know some facts and details about small
of small savings. They also could be loaned in rural areas
savings and provident funds. Though you must be quite aware

rd. F
through primary agricultural credit societies, commercial banks,
of what it is and what it does, nevertheless our discussion
and unit banks, which ought to be set up in such areas.
today would help us make our understanding more clear.
Introduction
iza D
Before we turn to non-banking institutions, it is convenient
and useful to familiarise ourselves with two very important,
Types and Nature of Small Savings Instruments
Small savings media can be divided into two groups:
(a) Post office deposits, and
dfw P
highly popular and diversified savings media namely, small (b) Savings certificates and bonds.
savings and provident funds. Post offices function as banks in
Over the years, quite a few changes have been introduced in the
respect of mobilisation of savings and time deposits, but not
media and the facilities made available to the public; some of
w.p m

in respect of mobilisation of funds in the form of certificates.


the schemes have been discontinued, others modified, and still
Because of the difficulty of making a strict categorisation and
others newly introduced. Funds mobilised through some of
for convenience, post office savings are included here. Provident
the schemes (known as incurrent schemes) and later
ww Co

funds are a category by them selves. Both small savings and


discontinued, have not yet been repaid. At present, we have
provident funds supply budgetary resources to the government.
current and noncurrent media of small savings. The diversity of
Importance of Small Savings financial assets offered by a small savings organisations is truly
If we compare forms of financial savings, next to commercial remarkable, and except the Post Office Savings Bank (POSB)
banks, the small savings organisations mobilise the largest deposits, all other schemes have been introduced during the
cu

volume of savings, followed by cooperative banks, and the unit plan period. The real diversification of small savings claims has
trust of India. (UTI). In a country like India, where small savers occurred during the 1970s and 1980s.
predominate and where savers are dispersed over a vast area in A number of important characteristics the small savings media
innumerable villages, the work of small savings organisations are as follows:
Do

assumes great significance not only in quantitative, but also in


qualitative terms. Even after two decades of nationalised (1)These assets represent medium term and long-term
banking, it is the agency of post offices, through which small investment opportunities. They are good substitute, from
savings schemes are administered, that has reached the largest the point of view of spread of maturity, liquidity and safety,
number of villages in India. On 31 march 1986, savings bank for other investment media such as bank deposits,
facilities were available at 847 head post officers, 29,518 sub post debentures, government securities and units.
offices, and 1,11,766 branch post officers. Although post offices (2)Many of them are in the form of reinvestment plans.
have great potential for channelising resources into rural areas, Therefore, they offer good opportunities to those investors
they appear to be draining resources form the rural to the urban who can forgo current income they are also desirable from
areas. the point of view of mitigating inflationary pressures. These
Small savings are directly available to the central government as a assets are liquid. With Cumulative Time Deposits (CTD), 50
part of its budgetary resources and they constitute the non- per cent of the outstanding balance can be withdrawn twice,
marketable debt of the government. Although the entire which may be repaid in lump sum or in installments. With
volume of small savings is technically available to the central Recurring Deposits (RD) also, one withdrawal. upto 50 per
government, in practice to receive two thirds of net collections cent of deposit is permitted. The interest rate charged-on the

© Copy Right: Rai University


11.621.6 119
withdrawn amount with regard to both CTD and RD is 9.6 Post Office Recurring Deposits (PORD)
MANAGEMENT OF FINANCIAL INSTITUTION

per cent per annum. Time deposits, if there is not more than This scheme has been in existence since April 1970. Its maturity
one deposit in the account, can be pledged for obtaining period is 5 years; at present it carries an interest rate of 12.5 per
loans/advance from banks for meeting a temporary need or cent per annum, and it is subject to the same tax concessions as
furnishing a security for entering into a contract. Alternatively, POSBD and POTD. There is no limit to the amount that can
the deposit account can be, after the expiry of the year be invested in it.
prematurely closed in which case the depositor earns interest
National Savings Certificates (NSCs)
at 2 per cent below the rate applicable to the deposit. There
Three issues (II, III, IV) of seven-year NSCs were introduced in
are no facilities for borrowing against deposits from post
1970, out of which II was discontinued from April 1989. Issue
offices as there are from banks.
V of seven-year NSCs was introduced in April 1974. Two six-
(3)Similarly, NSCs art also pledge able. year NSCs (VI and VII issues) were introduced in 1981-82 but
(4)POSB deposits are as liquid as bank demand deposits, they have been discontinued from April 1989. Another six-year
perhaps a little more so. They can be withdrawn by cheque, NSCs (VIII) issue was introduced in May 1989 on which a

al
and there are no restrictions on the number of withdrawals. compound rate of interest of 12 per cent is paid, and one can
It is for tips reason that the RBI now includes these deposits invest unlimited amount in this. Interest income from NSCs is
as one of the constituents of money supply in the economy. not tax-free but the amount invested in them’ qualifies for

i
(5)As with unit linked insurance plans, RD and CTD provide deduction while calculating taxable income.

com Tr
insurance cover to the investor Rs A small saver (who saves Indira Vikas Patras (IVP)
in one of the denominations of Rs 5, 10, 15, and 20) in RD These were introduced in November 1986. the IVP is a bearer
and CTD is eligible for the benefit of protection of his 1
contemplated savings in the event of his death before the bond whose value doubles every 5 years giving a compound
2

rd. F
maturity value of the account. . His heir or nominee is rate of return of 13.43 per cent annum. Its purchase price,
entitled to get the full amount of the account as if the therefore, is half of its face value. It is not a registered
depositor had continued to make deposit till the end of the instrument nor does it carry the name of the buyer or the
maturity period.
iza D
(6)Finally, for those who belong to the income-tax brackets,
holder. It is transferable by mere delivery. There is no limit to
investment in them but this investment is not eligible for any
type of tax benefits.
dfw P
small savings carry excellent tax benefits.
Many of the innovations and instruments connected with the Kisan Vikas Patras (KVP)
small savings media-some of these have been recently Introduced in April 1988, they also have a maturity period of 5
years and the interest paid on them is 13.43 percent. There is no
w.p m

discontinued-are discussed below.


limit to investment in them but the investment does not enjoy
Post Office Savings Bank Deposit (POSBD) any tax benefits.
This scheme has been in existence since 1896. At present it pays
National Savings Scheme (NSS)
ww Co

5.5 per cent rate of interest. The limits of investment are a


minimum of Rs 20 and a maximum of Rs 50,000 in case of a This was introduced in April 1987; it offers an interest rate of
single account, and Rs 100,000 for a joint account. The interest 11 percent annum; the maximum amount of investment is
earned on this deposit is tax-free, but the amount of deposit Rs.40, 000; and 100 percent of the amount of deposit in a year
itself is not deductible for tax purposes. Further, the is eligible for deduction from the income of the depositor for
cu

investment in deposit qualifies for exemption from wealth-tax income-tax purposes. Similarly, the total amount (including
within the prescribed limit of Rs 5 lakh but not beyond. interest) withdrawn in a given year is considered as an addition
to the income of the depositor during the year of withdrawal.
Post Office Cumulative Time Deposits (POCTD)
They were introduced in January 1959 but the opening of new Post-Office Monthly Income Scheme (POMIS)
Do

accounts for these deposits has been discontinued from This fixed deposit scheme was introduced in August 1987. Its
November 1973. The maturity period could be 5 or 10 or 15 maturity period is 6 years; interest rate is.12 per cent per annum
years. The rate of interest was 6.25 per cent on compound basis, and interest is payable every month; minimum investment is Rs
and interest was paid on maturity of deposit. Interest income 5000, and maximum investment is Rs 2,00,000 for single
on deposit was tax-free and deposit amount qualified for account and Rs 4,00,000 for joint account. Interest income is
income-tax rebate as well as wealth-tax exemption. eligible for tax rebate. A bonus of 10 per cent on deposit
amount is payable at the end of 6 years when the deposit
Post Office Time Deposits (POTD) matures.
Post offices have been accepting time deposits of one-year,
The following instruments of post-office savings have not
three-year, and five-year maturity since March 1970, and two-year
assumed much importance as means of saving: National Saving
maturity since August 1973. The current rate of interest on
Annuity Certificates (NSAC); Social Security Certificates (SSC);
these deposits ranges between 10.5 to 12.5 per cent. The interest
five-year National Development Bonds (NDB); Saving
income is tax exempt. The deposit amount is eligible for
(Deposit) Scheme for Retiring People; and Drought Relief
wealth- tax exemption (within the limit of Rs 51akh) but not
Bonds (DRB) or Rahat Patras (RP) replacing Capital Investment
for income tax rebate. There is no limit on investment in these
Bonds (CIB).
deposits.

© Copy Right: Rai University


120 11.621.6
It goes without saying that not all these instruments are equally (c) Central and State Government Employees’ (non-industrial)

MANAGEMENT OF FINANCIAL INSTITUTION


popular with invest Rs The CTD, the two-year and three-year Provident Fund,
TDS, II, III, IV, V and VII issues of NSCs, NSAC, SSC, NDB, (d) Coal Mines Provident Fund,
and DRB do not bring in much money every year.
(e) Assam Tea Plantations Provident Fund, and
Growth and Composition of Small Savings (f) Public Provident Fund.
The yearly receipts as well as outstanding of small savings have
The EPF scheme for industrial workers was introduced with the
increased phenomenally over the years In the total small
passage of the Employees’ Provident Fund Act, 1952.
savings, deposits were far more important than certificates till
Originally, public sector units were not covered under this Act,
1985-86, but thereafter, deposits and certificates have been
but since 1958 type have also overbought under it. Among
maintaining an almost equal share in total receipts. Of the total
these schemes, the volume of investible resources of PF of
deposits, post-office savings bank deposits have a major share,
exempted establishments is the largest followed by that of the
but this share has declined over the years. It was 83 per cent in
first category. The resources of the PFs of coal mines and
1970-71 and 57 per cent in 1988-89, and 50 per cent in 1995-96.

al
plantations are meager.
The monthly income and recurring deposits schemes have been
attracting many investors Small savings organisations, rather A novel scheme, namely, Public Provident Fund, was
surprisingly, have not been able to induce investors to hold introduced in 1968. This was earlier operated through the SBI

i
more time deposits with themselves. The competition from and its subsidiaries, but with effect from January 1979, PPF

com Tr
commercial banks in rural areas appears to have had an adverse account can also -be opened at head post offices. It was
effect on the growth of deposits with post offices. Table 10.3 originally meant for self-employed persons or the general
shows that five-year deposits have accounted for 65 to 95 per public, but now salaried employees can also take advantage of
cent of total time deposits during 1980-81 to 1995-96. Among it.
the certificates, Kisan Vikas Patras (KVPs) are the most popular,

rd. F
The nature of PPF and Employees PF can be understood better
accounting for 50 to 73 per cent of total receipts from all by contrasting the provisions of the two schemes in some
certificates during the 1990s. NSCs and Indira Vikas Patras important respects”. The maturity period of the PPB is 15

respectively. iza D
(IVPs) are the second and third most important certificates years, while the maturity period of the EPF depends on the age
at which the employee joins the Fund. While in the case of
EPF, if the employee joins the contributory PF alternative there
dfw P
Interest Rates on Small Savings
The rates of return on small savings have undergone a distinct is a specified contribution to be made by the employer to the
change over the years, particularly after 1970. Before 1968-69, employee’s PF, no such provision is possible in the case of PPF.
interest rates on various small savings schemes were lower than During the term of the PPF scheme, withdrawals to the extent
w.p m

those offered by banks, private non-banking companies, and of 50 per cent of the outstanding amount to the credit of the
others after 1969-70, however, interest rates on these schemes concerned person’s account are allowed at the end of the 7th,
have been made comparable; at present, they are more attractive 11th and 15th year. Before the withdrawal facility begins, i.e.,
ww Co

than the rates on bank deposits. What is more important is during the first six years, it is possible to get a loan upto 25 per
that, unlike in the earlier period, interest rates on small savings cent of the balance to one’s credit provided two years have
are now changed simultaneously with changes in the Bank rate expired after opening the PPF account. In the case of EPF,
and other rates of interest in the economy Earlier, there was a withdrawal facilities are more restricted. The employee can
tendency for changes in interest rate on small savings to lag withdraw his part of the contributed only when he has reached
cu

behind changes in rates offered by competing financial 50 years of age. Meanwhile, although he can obtain a loan
intermediaries. However, changes in these rates have now against his PF account, the account holder has to repay the loan
become an integral part of changes in the interest rates structure in the form of an increased contribution, which does not enjoy
in the economy. tax benefits. In the some of PPF, it is possible to vary the
Do

amount of contribution, from year to year, while the flexibility


Provident Funds in the case of EPF In this respect is limited. The rules with
This is way of saving mostly by people who earn their income regard to loan, its repayment, and interest on loan are the same
in salaries. However, recently, with the starting of the public for PPF and EPF. The loan has to be repaid in 24 equal
Provident Fund Scheme, it is possible for non-salaried earners installments. Similarly, both schemes enjoy similar tax benefits.
also to save in this form. Saving in PFs is a contractual
The rate of return on contributions to PFs has become quite
obligation, and the main motive behind saving in this form is
attractive. The rate of interest was increased successively from l5
not to make profits nor to seek capital growth. Salaried people
percent in 1955-56 to 4. 75 percent in 1965-67, and 9 per cent in
can save in this form small amounts on a regular basis to
1978; it is 12 per cent at present. Earlier there was provision that
provide for old age or for the family after one’s death.
if the PF holder did not withdraw any amount by way of loan
There are a variety of PF schemes in operation in India. They for five consecutive years, he would get a bonus rate of interest
are: of one per cent per annum on the entire sum. This provision
(a) Employees’ Provident Fund Scheme (EPF) covering non- has been withdrawn now. The effective rate OF return on PF is
exempted establishments (industrial), much higher because of the income tax and wealth-tax benefits,
(b) Provident Funds of exempted industrial establishments,

© Copy Right: Rai University


11.621.6 121
which the yearly contribution to PF, interest on PF, and the (d) The introduction of a novel scheme like PPF;
MANAGEMENT OF FINANCIAL INSTITUTION

wealth in the form of PF enjoy. (e) The provision of tax benefits to such savers;
The rules with regard to investments of PFs are laid down in (f) The increase in the minimum rates of contribution by the
the Indian Trusts Act, 1882, and Employees Provident Fund employees and employers;
Act, 1952, which, in essence, specify that funds mobilised
(g)The changes in the pay structure, like raising the basic pay of
through small savings and PF should be invested either wholly
employees; and
or substantially in the central and state government securities,
and also the securities guaranteed by these governments. This (h) The increase in the level of money income in the economy.
has been done to enhance the safety of these savings, but it has Pension Funds
also involved some sacrifice of return for the savers. The rules In other countries, pension funds are a, powerful financial
governing investments by the government PF and private PF intermediary. It was estimated that at the world level, pension
have come to differ over the years. PF contributions of the state funds controlled $6,700 billion in 1995. In India, private
and central government employees used to be and still are pension funds still do not exist but many people have begun to

al
merged with the funded debt of the government, and the stress the need for setting up such funds; and a small beginning
Ministry of Finance has recently ruled out changes in this was recently made in this respect. The setting up of the first
practice. investment-based pension fund proposed by the UTI was

i
The rules or restrictions with regard to private provident funds, approved by the government in October 1994. This retirement

com Tr
superannuation and gratuity funds, however, have undergone benefit plan is meant to enable self-employed people to
the following changes. The prescribed pattern of investment in contribute to a pension fund so as to provide security in their
1955-56 was: NSCs 10 per cent, short-term government old age. It is as open-ended plan in which anyone between the
securities 10 per cent, medium-term securities 30 per cent, and age of 18-52 years can contribute and receive regular monthly
income from 58 years onwards. The subscriptions to the fund

rd. F
long-term securities 50 per cent. The obligatory investment in
government securities was 50 per cent in 1970-71, which was are expected to grow by investment in equities and debt in the
reduced to 45 percent in 1971-72, and the residual part (55 per ratio of 40:60. The minimum subscription is to be Rs 10,000 to

iza D
cent) of the PF resources could be invested in state government
securities, government guaranteed securities, small saving
certificates, and post-office time deposits since that year. The
be paid in not more than 20 instalments of a minimum of Rs
500 each. The withdrawal is permitted after 70 years of age, and
even a premature withdrawal is allowed at a discount.
dfw P
Special Deposit Scheme (SDS) for this purpose was created Thus, a fund set up by a company, union, government entity, or
recently for a period of three years which was to end in 1996, other organisation to invest the pension contributions of
but was extended further. Private PF investment in SDS has members and employees, and pay out pensions to those people
w.p m

progressively reduced from 85 percent in April 1993 to 20 per when they reach retirement age is known as pension funds.
cent now. The SDS investment earns a standard rate of interest Pension funds accumulate huge pools of capital, which they
of 12 per cent. There is now a view that upto 25 per cent of PF invest in the stock and bond markets. Because of the weight of
ww Co

collections should be invested in industrial debentures and money, they exert considerable influence on the markets, and
shares of financially sound companies. Investment of PF in their decisions on which shares to hold in which sectors have a
equities will have to be undertaken with extreme caution. substantial impact on prices.
There has been a tremendous growth of investment in PFs Some pension funds employ their own fund managers; others
since the beginning of the planning period. The volume of delegate responsibility to external fund managers. Invariably
cu

savings of the household sector in the form of PF has they will try to achieve a diversified portfolio of investments,
increased from Rs 19 crore in 1950-51 to Rs 1,172 crore in 1976- some in low risk areas, others in high-risk areas. Actuaries
77, and Rs 7,194 crore in 1988-89 and Rs 25,438 crore in determine how much is going to have to be paid out to
1995-96. For many years now, PF has emerged as one of the pension holders in forthcoming years, and the pension fund
Do

most important financial assets in the Indian economy; its has to try to achieve a rate of return on its capital that will meet
importance is excelled only by bank deposits and small savings. (or better still exceed) this target.
PF accounted for 13 per cent of savings in financial assets of the
household sector in 1955-56, 24 per cent in 1975-76, and 18 per Questions to Discuss:
cent in 1988--89, and 20.4 per cent in 1995-96. 1. What do you understand by the small savings instruments?
Several factors have contributed to the growth of provident 2. Discuss the importance of small savings.
funds in India: 3. What are the types and nature of small savings instruments?
(a) The adoption of statutory measures to make provident fund 4. Discuss the innovations and instruments connected with the
compulsory for industrial and other establishments; small savings media.
(b) The increase in the number of establishments covered 5. Discuss the growth and composition of small savings.
under the statutory provisions;
6. What is the relevance of Interest rates on small savings?
(c) The expansion in the industrial and service sector of the
7. What are Provident funds?
economy and the consequent increase in the number of
salary-earners; 8. What are Pension fund?

© Copy Right: Rai University


122 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 29:
NON BANKING FINANCIAL COMPANIES

Learning objectives housing finance company, (iv) an insurance company, (v) an


After reading this lesson, you will understand investment company, (vi) a loan company, (vii) a mutual benefit
financial company, and (viii) a miscellaneous non-banking
• Definition
company.
• Regulatory Measures
A ‘non-banking non-financial company’ is an industrial concern
Non-banking financial companies (NBFCs) in the Indian as defined in Industrial Development Bank of India Act or a
financial sector are a force to reckon with rough estimates company whose principal activities are agricultural operations or

al
indicates that there are about 40,700 non-banking finance trading in goods and services or real estate and which is not
companies in the country. Of course, the number includes classified as financial or miscellaneous or residuary non-banking
many small companies operating in the unorganised sector such company.

i
as in this, chit funds, etc. The NBFCs registered with the

com Tr
‘Regulated Deposit’ is a deposit, which is subject to certain
Reserve Bank of India number only about 745 of which about
ceilings, and other restrictions as imposed by the regulatory
121 have credit ratings with them. Till the others are also
measures. It includes unsecured deben-tures, debentures
brought under the ambit of the regulatory framework, the
secured by movable assets, deposits received by public limited
guidelines and rules issued by the Re-serve Bank of India will
companies from its shareholders, deposits guaranteed by

rd. F
continue to be largely imposed on the registered NBFCs alone.
directors in their personal capacity and fixed deposits, etc.
We have to appreciate the fact that it is a Herculean task to
received from public. Effective April 12, 1993 intercompany
supervise effectively all the 40,000 odd finance companies

iza D
scattered all over the country. This task becomes all the more
difficult since these companies do not have a transparent,
uniform or laid down accounting standards, strict vigilance or
borrowings and money received from directors/shareholders of
private companies constitute regulated deposits. ‘Exempted
Deposit’ signifies those types of deposits/borrowings, which
dfw P
are outside the scope of the regulatory pleasures. It includes
audit systems or an effective supervisory system as compared to
borrowings from banks and specified financial institutions,
those in the organised financial sector.
money received from Central/State/foreign Governments,
Definitions security deposits, ad-vances received against orders, etc.
w.p m

A miscellaneous non-banking company is a company carrying Taking into consideration the fact that the operations of the
on all or any of the following types of business: NBFCs affect adversely the efficacy of fiscal and monetary policy,
a series of measures have been initiated’ during the last few
ww Co

(a) Managing, conducting or supervising as a promoter,


foreman or agent of any transaction or arrangement by years to regulate their operations. The present chapter deals with
which the company enters into an agreement with a specified these measures in a chrono-logical order.
number of subscribers that every one of them shall Regulatory Measures
subscribe a certain sum in installments over a definite period The first serious attempt to regulate NBFCs (including non-
cu

and that every one of such subscribers shall in his turn, as banking non-financial companies) was taken in October 1966,
determined by lot or by auction or by tender or in such by issuing two new directives, viz., (i) Non-Banking Financial
manner as may be provided for in the agreement be entitled Companies (Reserve Bank) Directives, 1966 and (ii) Non-
to the prize amount. Banking Non-Financial Companies (Reserve Bank) Directives,
Do

(b) Conducting any other form of chit, which is different from 1966. These directives extended the control of the Reserve Bank
the type of business referred to in (a). to all: (i) non-banking financial companies and (ii) non-banking,
(c) Undertaking or carrying on or engaging in or executing any non-financial companies accepting deposits and they were
other busi-ness similar to the business referred to in (a) and brought into force with effect from 1 January 1967. The
(b). directives pro-vided for restricting acceptance of deposits to 25
per cent of paid-up capital and free reserves in the case of both
A residuary non-banking company is a company which receives
non-banking financial and non-banking non-financial
any deposit under any scheme or arrangement, by whatever
companies (other than housing finance and hire-purchase
name called, in one lump sum or in installments by way of
finance companies).
contributions or subscrip-tions or by sale of units or certificates
or other instruments, or in any other manner and which, To obviate hardships, particularly to industrial undertakings, in
according to the definitions contained in the Non Banking com-plying with the provisions of the directives within the
Financial Companies (Reserve Bank) Directions, 1977 or the specified time limit, the Reserve Bank made certain
Miscellaneous Non-Banking Companies (Reserve Bank) modifications in the directives on 23 August 1967, as follows:
Directions, 1977, as the case may be, is not (i) an equipment
leasing company, (ii) a hire purchase finance company, (iii) a

© Copy Right: Rai University


11.621.6 123
(i) In the case of all non-banking companies, financial or non- The two principal notifications containing the directions issued
MANAGEMENT OF FINANCIAL INSTITUTION

finan-cial; the Bank decided that any amount held in the in October 1966, respectively to non-banking companies were
statutory development rebate reserve, created under section further amended during 1973. The principal features of the
4(3) of the Income Tax Act, 1961, may (notwithstanding the amendments were: (i) any loan secured by the creation of a
fact that the period of 8 years specified in that section might mortgage or pledge of the assets of the company or any part
not have been completed in respect of ‘all the assets) be thereof would be exempt from the ceiling restrictions relating
counted as a free reserve and to deposits only if there is a margin of only at least 25 per cent
(ii)In the case of industrial concerns as defined in the directives of the market value of the assets charged as security for the
which (a) have paid dividends on their equity shares at, six loan, the mortgage or pledge, as the case may be, is created in
per cent or more per annum in the five years or in five out of favour, of a trustee which should either be a scheduled
six years immediately preceding 1 January 1967, or (b) have commercial bank or ‘an executor and trustee company which is a
unencumbered fixed assets of a book value in excess of subsidiary of such scheduled commercial bank and the
twice the amount of deposits and the unsecured loans, the company has to execute a trust deed in favour of the scheduled

al
time limit of two years, for the adjustment of the deposits commercial bank or its subsidiary. If the Reserve Bank is
already received in excess of 25 per cent of the paid-up capital satisfied that the mortgage or pledge created by a company is
and free reserves including the development rebate reserve, not in the public interest, it may declare that the deposits

i
will increase to five years, i. e., upto the end of December sought to be secured by such mortgage of pledge shall not be

com Tr
1971. entitled to the benefit of the aforesaid provision. Companies
accepting such secured deposits will, however, have to comply
The directives issued to non-banking companies were amended
with all other provisions contained in the direc-tions as
in December 1971 so as to bring within their purview,
applicable to ordinary deposits or unsecured loans. (ii) Loans
unsecured loans from shareholders as also loans guaranteed by
obtained from a registered moneylender would henceforth be

rd. F
directors, ex-managing agents or secretaries and treasurers. Such
treated as deposits for the purposes of the directions.
loans, hitherto exempted from the restrictions relating to
deposits, were subjected to a separate ceiling of 25 per cent of After an examination of the recommendations of the Banking

iza D
the net owned funds of companies with effect from 1 January
1972. A period of 3 years and 3 months was provided for the
adjustment of excess, if any, over the ceiling prescribed, of the
Com-mission in regard to non-banking financial intermediaries
and the Reserve Bank’s view thereon, the Government of
India, decided that statutory powers shall be taken to prohibit
dfw P
unsecured loans mentioned above. To provide for the ‘genuine acceptance of deposits by all unincorporated non-banking
business requirements of companies, however, certain institutions and that the existing legal provi-sions and the
categories of loans, particularly loans obtained on guarantees directions issued by the Reserve Bank must be tightened to
w.p m

furnished by Government and any loan obtained from foreign plug the loop-holes. In June 1974, the Reserve Bank
source were specifically exempted from the purview of the constituted a Study Group headed by Shri James ‘S. Raj to
directives. examine in depth all aspects of the matter and make suitable
recommendations for implementing Govern-ment’s decision.
ww Co

During 1973, the Reserve Bank issued a new set of directions


known as the Miscellaneous Non-Banking Companies (Reserve In 1974, more powers were vested with the Reserve Bank to
Bank) Direc-tions, 1973 which sought to regulate the acceptance exercise control over non-banking institutions receiving
of deposits by com-panies conducting prize chits, lucky draws, deposits from the public and financial institutions under the
savings schemes, etc. These directions which came into effect Reserve Bank of India (Amendment) Act, 1974. The
cu

from 1 September, 1973, had clarified that the amounts received amendments:
by such companies by way of contributions or subscriptions or (a) Empower the Reserve Bank to inspect non-banking financial
by sale of units, certificates, etc., or other instruments or any insti-tutions whenever such inspection is considered
other manner or as membership fees or service charges to or in necessary or expe-dient by the Bank;
Do

respect of any savings, or mutual benefit, thrift or any other (b) Cast a statuary obligation on the auditor of a non-banking
scheme or arrangement also constitute deposits. It was further institu-tion to report to the Reserve Bank the aggregate
clarified that the usual ceiling on deposits (25 per cent of paid- amount of deposits held by it where the institution had
up capital plus free reserves less accumulated balance of loss), failed to furnish to return etc., required to be submitted by it.
would also apply to such deposits. Any amount in excess of
(c) Insert the definition of the term ‘deposit’ in statute itself so
the ceiling existing on 1 September 1973 would have to be
as to place beyond any doubt that any money received by
adjusted before October 1976. All other requirements applicable
non-banking institutions otherwise than by way of share
to other non-banking companies such as these relating to the
capital constitutes deposits.
issue of advertisements, acceptance of deposits on the basis of
application forms, maintenance of registers of deposits and (d) Make the definition of the term ‘financial institution’ precise
furnishing of receipts to depositors, would also apply to these and comprehensive so as to plug the loop-holes;
companies. However, company’s coming within the purview of (e) Make it compulsory not only for non-banking institutions
these directions would be re-quired to submit their returns to but also for brokers to disclose full particulars and
the Reserve Bank twice a year. information before soliciting deposits; and

© Copy Right: Rai University


124 11.621.6
(f) Provide for enhanced penalties for contravention of the the opinion of Study Group, avail-ability of funds to that

MANAGEMENT OF FINANCIAL INSTITUTION


provisions of the Act and the directions issued by the Bank. extent would give them a reasonable chance of profitable
The ceiling of 25 per cent of the paid-up capital and free working and enable them to become, viable units. While in
reserves less the balance of accumulated loss, if any, imposed by regard to hire-purchase finance companies, which are at present
the Reserve Bank with effect from January 1972, in respect of exempt from ceiling restriction, a ceiling (not exceeding ten
deposits accepted by non-banking companies in the form of times their net owned funds) as in the case 01 loan companies
unsecured loans guaranteed by the directors, deposits raised has been proposed, hous-ing finance companies, however, will
from shareholders (excluding those received by private continue to be exempted from the ceiling restrictions. Since such
companies from their shareholders subject to certain special considerations will not be relevant in respect of
stipulations) etc., was lowered by the Bank to 15 per cent with investment companies, the existing composite ceiling of 40 per
effect from the 27th January 1975, by issue of three notifications cent of the net owned funds is proposed to be reduced to 25
amending the directions in force. Non-banking financial and per cent in two stages. The Group had (lot recommended any
non-financial companies having depos-its in excess of the Ceilings on deposits with nidhis which deal only with their

al
reduced ceiling were given time till 31st December 1975, to wipe members. Apart from the restric-tions on the quantum of
out the excess. Miscellaneous non-banking companies viz., deposits that may be accepted by the companies, the Group has
those conducting prize chits/lucky draws/savings schemes etc., recommended minimum capital requirements for starting new

i
which had been allowed time up to the end of September 1976, financial companies and also in respect of existing companies

com Tr
to wipe out the excess over the ceiling of 25 per cent fixed earlier other than nidhis. Some of the other recommendations made
were allowed further time up to the 31st December 1976, to by it relate to the creation of reserve funds, maintenance of
bring down their outstanding in respect of the unsecured loans, liquid assets, prohibition of grant of loans and advances to the
etc., within the reduced ceiling of 15 per cent. directors and firms and companies in which they are interested
and enactment of the Provisions on the lines of certain sections

rd. F
The Companies (Amendment Act), 1974 which came into force
of the Banking Regulation Act, 1949. In view of the
from the’ 1st February 1975, has inserted anew Section 58 A in
substantive nature of the recommendations made by it for the
the Companies Act, 1955 regulating acceptance of deposits by

iza D
non-banking companies. Under the powers vested by the
aforesaid Section, the Cen-tral Government has in consultation
with the Reserve Bank, framed rules governing acceptance of
purpose of tightening the control over the deposit acceptance
activities of the financial companies as also the operational
aspects relating to their working, it has been decided to enact a
dfw P
separate comprehensive legislation in place of Chapter III B of
deposits by non-financial companies. The rules came into force
the Reserve Bank of India Act, 1934. The drafting of the
with effect from the 3rd February 1975. Conse-quently, the
legislation is in progress and in the meantime, steps are also
directions issued by the Reserve Bank to non-financial com-
being taken to implement such of the recommendations as
w.p m

panies have since been withdrawn.


could be given effect to by invoking the power vested in the
The Study Group headed by Shri James S. Raj referred to above Reserve Bank under the existing provisions of Chapter III B of
submitted its Report to the Reserve Bank on 14th July 1975. the said Act by suitable amend-ments to the directions now
ww Co

The main recommendations of the Study Group cover non- force. The amendments to the directions have been finalised.
financial companies, financial companies and companies
As regards companies conducting prize chits benefit savings
conducting prize chits and/or con-ventional chits. These
schemes, etc., the Group had come to the conclusion that such
recommendations had been accepted in principle by the Reserve
schemes benefited primarily the promoters and did not serve
Bank and the Government of India.
cu

any social purpose. Such schemes were prejudicial to public


With regard to non-financial companies, the Study Group interest and also adversely affected the efficacy of fiscal and
observed that the acceptance of deposits by such companies monetary policy, It had, therefore, suggested that the conduct
may not be prohibited altogether but the measures should be of such schemes should be totally banned in the larger interests
so designed as to ensure the effica-cy of monetary policy and to of the public and suitable legislative measures should be taken
Do

avoid disruption of the productive process consistent with for the purpose, the provisions of the existing enactment were
need to safeguard the depositors’ interests. At the same time considered inadequate.
the ultimate objective should be to discourage further growth
of these deposits and to roll them back gradually so that they Questions to Discuss:
would cease to be a significant source of finance for industry 1. Discuss some of the non-banking financial companies.
and trade. 2. Discuss the Regulatory Measures.
In the case of non-banking financial companies, the Study
Group recommended effective regulation of their activities
considering the large number of depositors involved as well as
the incidence of malpractices in these companies. The Study
Group suggested that such companies should be subjected, by
and large, to the same type of controls as banks under the
Banking Regulation Act, 1949. As the operations of loan
companies are analogous to those of banks, the Study Group
recommended a ceiling of ten times the net owned funds. In

© Copy Right: Rai University


11.621.6 125
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 30:
NON BANKING FINANCIAL COMPANIES

Learning objectives Growth of NBFCs in India


After reading this lesson, you will understand NBFCs started in a small way in the sixties and the seventies
and tries to serve the needs of the savers and investors whose
• Activities Of NBFCs
needs remained unfulfilled by the Banking system. Along with
• Growth Of NBFCs the growth of India economy NBFCs have also grown
• Problems gradually into institutions that can provide services similar to
• Prospects that of Commercial Banks in a Country.

al
Activities of NBFC The growth of NBFCs in India was more pronounces in last
NBFCs with their diversified structure and methods of two decades. Several factors have contributed to the growth of
these institutions. Their tailor made services, customer-

i
business are serving the economy in a variety of ways. They
orientation, minimum procedures and simplicity, speed of

com Tr
form an integral part of the Country’s financial system with
asset base in excess of 90,000 crore. The growth of NBFC operations and higher rate of interest on their deposits have
Sector in India has been accompanied by a corresponding attracted more and more customers to them. Further, the
growth in the diversified range of financial services and monetary and credit policy followed in the Country in the recent
products they offer. NBFCs help to bridge the credit gaps in past has left a Section of borrowers outside the purview of

rd. F
several sectors which traditional institution are unable to fulfill. banking system and these NBFCs increasingly hatred to these
NBFCs are more flexible in their operations and quick in sections. Comprehensive regulation of the Commercial Banks
and the absence or less rigorous regulations over NBFCs have

iza D
decision-making. This gives them a major advantage over Banks
since the latter follow lengthy procedures. In the area of deposit
mobilisation certain points work out to the advantage of
also contributed to the phenomenal growth or the latter in
terms of heir numbers, clientele deposits and net owned fund
dfw P
NBFCs. While Public Sector Banks wait for deposits to flow in, (NOF).
NBFCs reach out to the customers to mobilise deposits. However, the growth was not uniform in the past. In the initial
In a broader sense, NBFC means a Company whose principal years (early eighties) there was virtually a boom, when
Entrepreneurs suddenly wokeup to the tremendous
w.p m

business is financing in whatever form, but not qualifies


enough to be called a ‘Bank’ as defined in Banking Regulation possibilities offered in an economy chronically affected by the
Act, 1949. massive paucity of funds and a growing realization of
enormous resource mobilisation capacity offered by the capital
ww Co

NBFCs offer a variety or services. The table 1 gives the broad market. However, most of these new-borns ignored that
range of services offered by important Finance Companies in rendering financial services was a complicated and demanding
India. For the purpose of brevity description of individual business, involving the continuous raising and deployment of
service is avoided. funds in a judicious manner and involved the consistent
Table 1 identification and entry into newer and optimally lucrative areas
cu

of financial returns. Sadly, most of these Companies did


Activities of NBFCs possess neither the inclination nor the mental and attitudinal
Fund-Based Activities Fee-Based Activities
ability to acquire these traits. A host of factors such as the
erosion of margins due to over concentration of blue chip
Do

1. Equipment leasing 1. Issue Management


2. Hire Purchase 2. Portfolio Management
companies, a high rate of default by lessees, severe problems in
3. Bill discounting 3. Corporate Counseling sustaining consistent and adequate utilisation of resources, sales
4. Loan and Investment 4. Loan and Lease Syndication
5. Venture Capital 5. Project Counseling tax and turnover tax levied on lease by respective State
6. House Finance 6. Arranging Foreign Collaboration Government and dubious accounting practices by some
7. Factoring 7. Advising on acquisitions and mergers
8. Equity Participant 8. Advising on Capital restructuring companies, all combined in an unholy alliance to sound the
9. Short-term loans death knell for most companies in this budding industry. As a
10. Inter-Corporate Loans
result, growth rate had slowed down, gradually leading to a
negative growth rate in 1988. However, from 1989 the trend has
The activity mix of NBFCs has all dimensions- Width, Depth
changed for the better, there are a host of reasons that have led
and Consistency, the three essential characteristics of any
to the revival of interest in financial services. Firstly, the
product mix. Width refers to variety, depth refers to range in
enormously progressive measured of liberalisation and
each variety and consistency refers to over all synergy of the
dismantling of the hitherto control ridden economy have to a
service mix.
great extent opened up larger vistas of growth. The financial
service Sector also reacted very favorably and grew by leaps and
bounds, the revamping of MRTP Act has unleashed large

© Copy Right: Rai University


126 11.621.6
corporate houses from the restraints earlier inhibiting their entry operating in violation of provisions when these offenses

MANAGEMENT OF FINANCIAL INSTITUTION


and operations in this Sector. become a cognizable offence.
The pre-scam era, i.e., the beginning of 90s saw the equity scrips Another pressing problem related to acquisition of funds.
of such companies being fancied by investors. In this period Other than capital the various sources of funds for NBFCs are
financial management was reduced to a dictum; the more the fixed deposits, ICDs, selling a part of their asset portfolio, asset
borrowing s the greater the profits. Money was borrowed by all securitisation and bank finance. Public deposits accounted for a
means to earn a quick buck. This made the RBI suspect that via major chunk of funding for NBFCs. But the CRB fiasco and
these companies Banking Sector was using the bill route to the capabilities of the Finance Companies have severally
divert money to the stock market. The suspicion was partially curtailed this source of funding to NBFCs. As far fund raising
true and the scam burst out. Consequently, several restrictive through debenture their competition would be with Blue Chip
orders that affected this industry was clamped. The major and Public Sector issues. There was a time when NBFCs
casualty being a ban on bill-discounting in August 1992. Along commanded hefty premium in the equity market. Today, they
with the ban the image of NBFCs also took a severe beating. cannot raise money via this route as the primary market

al
This in turn led to resource crunch, with even committed funds especially for finance companies scrips is virtually in a shambles.
not forthcoming from Banks. However, fiscal relief announced Companies, in want of money, are forced to sell-off their asset
in 1992-93 and 1993-94 created favourable climate again for this portfolio. Buyers usually banks and financial institutions might

i
industry. The ban on bill discounting, though affected some seek favorable terms, which will mean a higher cost to NBFCs.

com Tr
players of the field adversely was blessing in disguise for others, Mergers and acquisitions take place only when it makes business
forcing them to explore other areas. Many turned their attention sense. Since too many small companies will be looking for a
from fund-based activities to the non-fund-based activities like strong partner the deal which may emerge is likely to be
merchant banking activities, investment advisory services, unfavorable to small NBFCs. Bank finance is available only to a
securitisation of debts, forex trading operations, etc.

rd. F
few big players.
All the major sectors had responded to economic reform with However, there are reasons to cheer also. In the recent move, the
dynamism and witnessed significant acceleration of their RBI has classified bank credit to NBFCs for on lending to small

iza D
respective growth rate and thereby widening the scope of
activities of NBFCs as well as improving their profit levels.
transport operators as priority sector lending. This move has
prompted Bank to extend more credit to NBFC sector to meet
dfw P
But the recent time have seen again a reversal of this trend, the their priority sector lending. Further NBFCs are allowed to
increased competition, depressed stock markets and the explore opportunities of raising funds off shore. One more
prolonged recession have made life difficult for NBFCs. The thing for which NBFCs are really excited about is ‘asset
greed of a few players, sand long-term vision has made the securitisation’. Presently at nascent stage, the concept of
w.p m

general public as well as the regulatory authorities view the entire securitisation is picking up very fast in Finance Service Industry,
sector with suspicion. With international majors entering the especially in the auto-finance Sector. Given the various steps
sector is in trouble. The extinction of most of the unfit is taken in the current budget to revive the debt market, it will
ww Co

inevitable. grow further.


Problems Ultimately, good and sound finance companies should aim at
Problems confronting NBFCs are essentially arising out of long-term solutions by raising resources equally from net
growth and adjustment. Take the question of their mushroom owned funds borrowing and deposits from public. NBFCs
growth. A large number of Finance Companies came up should give serious thought to broad base the sources of
cu

encouraged by the spurt in profit. A number of them went to funding as well as the cost of funding. Their future growth
the Capital market for raising equity with inadequate depends to a large extent on the success they achieve in this area.
preparations and many promises. The quality and composition Another area of concern for NBFCs is to find matching
of assets leave much to be desired, a situation of this kind deployment avenues. As the economy sometimes reels under
Do

raised doubt about their credibility with both authorities and recession finding quality borrowers has become a difficult task.
the public. The CRB Fiasco has underscored the vulnerability of However there is no denying the fact that this is basically a
the NBFCs. Even the high profile well managed Companies are cyclical problem. As the correlation between the growth of
viewed with suspicion. Players with short-term approach NBFCs and economy is well established, the moment the
obstructed the long-term growth prospectus of the industry. economy picks up NBFCs would again be making money.
Better late than too late. The regulatory authorities have taken Another aspect, which is boosting the morale of the NBFCs
steps in this direction by prescribing entry norms including new sector- the growth of an increasingly affluent middle class.
owned funds (minimum Rs. 25 lakh, say) and capital adequacy Hence a raise in demand for consumer electronics and durables
level. An environment is created in which of course entry is not is expected. This urge has given way for a powerful potential
closed for new companies but the inefficient and loss-making market segment for finance companies in the form of
companies get weeded out. Reserve Bank of India regularly Consumer Financing.
comes out with a list of NBFCs and unincorporated bodies Banks look upon NBFCs as their competitors in terms of both
who are soliciting deposits despite being prohibited from deposit mobilisation and credit expansion. This perception
accessing deposits. This list which will be published regularly needs to be corrected as soon as possible by the industry
will enable prosecution against persons and companies

© Copy Right: Rai University


11.621.6 127
leaders. NBFCs are actually complementary to the Banking system. It should enable regulators, investors and creditors, to
MANAGEMENT OF FINANCIAL INSTITUTION

System. They play a supportive role to the Banks and Financial spot deviant behaviour so that corrective measures can be
Institutions. While there could be a debate on whether NBFCs undertaken swiftly. Further a strong self-regulatory framework is
play any useful role at all in the areas of equipment leasing, definitely desired, and would improve the state of affairs.
share market operations, merchant banking, etc. There can be no
Prospects
dispute on the conclusion that without NBFCs the credit
The sector is heading towards consolidation. Sound companies
delivery system tot eh road transport sector particularly trucks
with soundest of fundamental would emerge stronger, and
and commercial passengers carrying vehicles like buses will
weak companies with poor Balance Sheets would be weeded
collapse leading to a crisis in the total automobile sector. It is
out of the system. NBFCs have survived all over the World and
also certain that a healthy NBFC Sector is vital for the growth of
would continue to survive even in our Country.
the Consumer durable Industry, because Banks and Financial
Institutions cannot manage credit delivery to these Sectors as However, the coming time would be quite crucial for NBFCs.
cost effectively as NBFCs have demonstrated they can. From being a small business unit in a major industrial group,
the financial services are going through a phase where they

al
There are areas where NBFCs should not even dream of
themselves are major business with each of its segment being a
competing with Bank and Financial Institutions let alone out
separate industry in itself.
performing them. To amplify this point, with Banks and

i
Financial Institutions in the field of Corporate financing Size would be a major determinant of the survival of the

com Tr
NBFCs like ITC Classic have all ruined themselves. Bill NBFCs along with promoters credentials and group backing. To
discounting to Corporate by NBFCs is another area where survive a lot of mergers and acquisitions are taking place in the
mistakes have been made and will continue to be made if industry. It is evident that only the top few will be able to
NBFCs do not realise that Bank are much better equipped to withstand the test of times. Already more that 60% of the total
handle this business. business of the NBFCs is in the hands of around 50 players.

rd. F
However, there would also be a small NBFCs operating into
Now when almost every Bank is doing what NBFCs have been
niche markets. They would take advantage of their expertise, in
doing, NBFCs will have to first identify areas where they can

iza D
build on the strengths and desist from operating in areas where
other entities (Bank and Financial Institution) have significant
strength. Retail Financing consisting of Car Loans, Consumer
their particular areas and operate at a premium. However, their
operations would be local in nature and their ability to grow
limited.
dfw P
Durable Finance, Commercial Vehicle Financing, Mortgage loans Questions to Discuss:
to individuals, share loans, housing loans are areas where 1. Discuss the activities of NBFCs.
NBFCs can have a more cost effective operation than what 2. Discuss the growth of NBFCs.
w.p m

Commercial Banks with their wide spectrum of activities can


3. What are the problems and prospects of NBFCs?
achieve. The need of hour is that NBFCs should learn to
appreciate this limitation on the scope of operations and Notes:
ww Co

develop skills needed for operating successfully by covering


these constraints into opportunities.
The regulatory framework specifies norms regarding Capital
Adequacy debt-equity ratio, credit concentration ratio, income
recognition, provision against doubtful debts, following the
cu

sound and transparent accounting practices, uniform disclosure


requirements and asset valuation. The regulations also specify
eligibility criteria for entry, growth and exit of the Institutions.
No financial system anywhere in the World is unregulated. In
Do

fact, with greater liberalisation of financial services there is a


greater need for effective non-discriminatory rule-bound
regulation. But one need to draw a distinction between the need
for regulation as such and the way it is to be carried out from
now on. The ever-changing regulatory environment of NBFC is
causing considerable hardship. It is creating confusion among
players. Regulation at the cost of killing the Sector would serve
no purpose. The regulations have to recognise that there are
limits to regulation. Of special relevance to the current Indian
scene, regulation over different entities is not going to be a
safeguard against frauds and other malfeasant acts. Frauds will
continue to be committed as long as businesses are run. No
regulatory system however well designed or comprehensive can
take care of each and every contingencies. What a regulatory
system should seek to achieve, is to bring order into a chaotic

© Copy Right: Rai University


128 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 31:
THE INTERNATIONAL MONETARY SYSTEM

Learning objectives (3) To help members with temporary balance of payments


After reading this lesson, you will understand difficulties to tide over them without resort to exchange
restrictions.
• Objective of International Monetary Fund
(4) To promote growth of multilateralism in trade and
• Sources of fund
payments and thus expand world trade and aid.
Now let us focus our attention to the International Monetary
(5) To help achieve the balance of payments equilibrium
System. You all must be having an overview of IMF. However,

al
shortens the duration of disequilibrium and promotes
our study of Management of Financial Institution is
orderly international relations.
incomplete without the discussion of IMF.
The main object of the Fund is to promote exchange stability
Introduction

i
and encourage multilateral trade and payments. It is also a

com Tr
The International Monetary System is the short-term wing of financing institution and has schemes for provision of short-
the international financial system. It encompasses all relations as term finance for meeting the balance of payments purposes. It
between the national market sys-tems. I.M.F is the Apex body provides international liquidity in tune with the requirements
for this system and acts as a central bank of central banks of the of world trade and fosters the growth of world trade and freer
nations. system of payments. Gold was originally the unit of account in

rd. F
The establishment of the International Monetary Fund (IMF) which the various currencies were denominated. This was
in 1945 was a landmark in the international monetary field. subsequently, replaced by Special Drawing Rights (SDRs), which

iza D
Before 1945 there was international monetary disorder,
exchange restrictions and a host of other undesirable trade and
exchange practices. The need for international monetary co-
is a standard unit of account, whose value is fixed in terms of a
basket of currencies. These functions of the Fund are reviewed
briefly.
dfw P
operation and under-standing was felt soon after the war, and
Fund’s Role of Consultation
the Bretton Woods Conference resulted in the establishment of
In all matters of exchange rate changes, imposition of
IMF and the World Bank. Originally 44 member countries met
restrictions on current account, use of discriminatory practices,
at the Conference and the IMF was set up as per the agreement
w.p m

members are obliged to consult the Fund. Failing this, the


reached among them in December 1945. It had an original
members could be ineligible to have recourse to financial
membership of 29 countries and by end of 2002 rose to cover
resources of the Fund. Such consultations may take the form
almost all the, countries, (182) barring a few smaller countries.
ww Co

of supply of economic and financial data to the Fund by the


The IMF is governed by a policy-making body, viz. the Board member country. Secondly, the staff of the Fund can call for
of Governors but the day-to-day affairs are looked into by the various types of data from a member country as and when they
Board of Executive Directors consisting of the representatives require on an ad hoc basis. Thirdly, the staff teams visit
of 16 elected countries and 6 nominated countries. . The Board member countries at least once a year for a first-hand study of
cu

of Executives Directors meets as often as is necessary to decide economic and financial conditions in the member country. At
on all matters pertaining to the role of the Fund. The Managing the time of annual general meeting or at the time of
Director is the chief executive of the Fund and is appointed by negotiating a credit arrangement, representatives of member
the Board of Executive Directors. It has a secretariat in countries hold consultations and discus-sions with the Board
Do

Washington. of Executive Directors. Many times informal consultations also


Objectives of IMF take place between the member’s Governor or Executive
Director with the IMF staff, particularly at a time when the
The IMF is primarily a short-term financial institution - a lender
member country approaches the Fund for a standby
and a borrower - and a central bank of central banks and
arrangement or a credit drawn.
secondarily, aims at promoting a code of conduct among
members for orderly exchange arrangements and international Sources of Funds – Quotas
monetary management. The objectives of the Fund as laid Every member country is given a quota in the Funds. These
down in its Articles may be briefly set out as follows: quotas were fixed originally on a formula: (a) 2 per cent of the
(1) To promote international monetary co-operation through national income; (b) 5 per cent of gold and dollar balances; (c)
consultation and mutual collaboration. 10 per cent of average annual imports; (d) 10 per cent of
maximum variation in annual exports. The sum of the above,
(2) To promote exchange stability and maintain orderly
increased by the percentage ratios of average annual exports to
exchange arrange-ments and avoid competitive exchange
national income of a member, is used as the basis for fixing the
depreciation.
quotas.

© Copy Right: Rai University


11.621.6 129
Each member’s quota was thus fixed as his or her initial similar terms. The IMF can also acquire any member’s currency,
MANAGEMENT OF FINANCIAL INSTITUTION

contribution to the Fund. A member had to contribute its as desired, in exchange for the gold, which it holds.
quota to the Fund in the form of gold up to 25 per cent of its Since August 1975, as agreed by the members in the Interim
quota or 10 per cent of its net gold holdings or U.S. dollars on Committee to reduce the role of gold, about one-sixth of its
September 12, 1946, whichever was less and the rest of the gold holdings was sold in auctions and in non-competitive bids
quota was payable in member currency. Since 1980, the clause of and the proceeds realized amounted to US $ 5.7 billion of
25 per cent of the quota in gold or US dollar was replaced by which $ 1.1 billion representing the capital value of the original
contribution of SDR and convertible currencies. At the time, gold was added to Trust Fund. About one-sixth of the gold
gold was valued at $ 35 per fine ounce and India paid $ 27,5 out of the Fund holdings has been distributed to members so
million in gold for a quota of $ 400 million. The quota of far. The Fund has still two-third of the original quantity of
India stood at 3056 million SDRs after the 10th General Quota gold with it.
increase in 1995. IMF holds substantial gold reserves, which
were received as part of members’ contribution towards their Financial Assistance
Thus, the IMF lends money only to member countries with

al
quotas, and liquid reserves in the form of convertible currencies
of member countries. balance of payments problems. A member country with a
payments problem can immediately withdraw from the IME
The total of quotas of 44 nations which gathered at Bretton
the 25 per cent of its quota. A member in greater difficulty may

i
Woods in 1944 was fixed at $ 8800 million, By end December
request for more money from the IMF and can borrow up to

com Tr
1994, the membership rose to 178 with a total of quotas at
three times its quota provided the member country undertakes
SDRs 144,620 million after the 9th General Review of quotas
to initiate a series of reforms and uses the borrowed money
made in 1990. The work of Tenth general Review of Quotas
effectively. The frequently used mechanisms by the IMF to lend
was undertaken in 1994-95, and Eleventh quota review was
money are
completed in 1998 and the quota increase of 45% was effected

rd. F
in 1999. . 1. Standby Arrangements
2. Extended Arrangements
Share Capital of IMF

iza D
In January 1999, the increase of share capital or total quota of
IMF from SDR 145.6 billion (US $ 204; billion) to SDR 212
3. Structural Adjustment Mechanism (with low interest rates)
Areas of Activity
dfw P
billion (US $ 297 billion) took effect, with the consent given by • Surveillance is the process by which the IMF appraises its
the requisite 85% of the memberships. The fund’s usable members’ exchange rate policies within the framework of a
resources raised by SDR 45 billion or US. $ 63 billion. India’s comprehensive analysis of the general economic situation
current quota is SDR 3055.5 million, which comes to about and the policy strategy of each member. The IMF fulfils its
w.p m

2.098 per cent of the total IMF quota. This quota is now surveillance responsibilities through annual bilateral Article
increased to SDR 4158.2 million, which comes to about 1.961 N consultations with individual countries; multilateral
per cent. Thus, in relative terms, the position of India came surveillance twice a year in the context of its World
ww Co

down considerably in the Fund. Economic Outlook (WEO) exercise; and precautionary
When it was set up, India was among the top five quota arrangements, enhanced surveillance and programme
holders. Now she has been pushed down to 13th position in monitoring which provide a member with close monitoring
the list. The current top countries are U.S.A. Japan, Germany, from the IMF in the absence of the use of IMF resources.
Prance, U.K, Italy, Saudi Arabia, Canada, Russia, Netherlands, (Precautionary arrangements serve to boost international
cu

China Belgium and India. confidence in a member’s policies. Programme monitoring


The increase of IMP quotas has been affected by conventional may include the setting of benchmarks under a shadow
calculations for determining the quotas of countries, referred to programme but does not constitute a formal IMF
earlier. But, if economic strength of a country is determined by endorsement.)
Do

relative purchasing power parity, it is understood that China • Financial assistance includes credits and loans extended by
would be number two or three and India number five or six. the IMF to member countries with balance of payments
Other Sources of Funds problems to support policies of adjustment and reform. As
The IMF has, in addition to member’s quotas, other sources of of July 31, 1999 the IMF had credit and loans outstanding
funds. In 1962 IMF concluded a General Agreement to borrow to 94 countries for an approved amount of SDR 63.6 billion
(GAB) under which IMF could borrow from the participating (about $87 billion).
members (Group of Ten Developed Countries) specified • Technical assistance consists of expertise and support
amounts of their currencies. The amounts which the Ten provided by the IMF to its members in several broad areas:
Countries (Belgium, Canada, France, West Germany, Italy, the design and implementation of fiscal and monetary
Japan, Netherlands, Sweden, U.K. and USA) undertook to policy; institution building (such as the development of
provide was set in the agreement. Interest and service charges central banks or treasuries); the handling and accounting of
were payable on such loans in agreed terms (upto 5 years) in transactions with the IMF; the collection and refinement of
gold, later replaced by SDR. The IMF borrowed not only from statistical data; training officials at the IMF Institute together
above countries but also from others such as Saudi Arabia on with other international financial organisations, through the

© Copy Right: Rai University


130 11.621.6
Joint Vienna Institute, the Singapore Regional Training quota of that member, and this condition was waived many

MANAGEMENT OF FINANCIAL INSTITUTION


Institute, the Middle East Regional Training Programme and times.
the Joint Africa Institute. The conditionality of drawings under various credit tranches
Fund’s Lending Operations and other finan-cial facilities will vary according to the state of
As a financial institution, the Fund provides temporary financial the country and the economic and financial policies pursued.
assistance for balance of payments purposes in the form of sale Requests for drawings beyond the first credit tranche require
of currencies. When a member borrows from the Fund it substantial justification and the conditions laid down would be
purchases foreign currencies against its own currency. When it more rigorous in terms of policies to be pursued by the
repays loans, it is repurchasing its own currency against foreign member country. These conditions are imposed with a fair
currency. degree of flexibility.
The Fund’s exchange operations are classified into four Standby Arrangements
categories as follows: When a member feels that the need for credit might arise during
(1) Gold Tranche is upto the amount of gold paid by the any year, it may enter into standby arrangements with the Fund.

al
member towards its quota plus its credit position with the This will give an assurance of financial support from the Fund
Fund (which is the same thing as other countries borrowings in time of need. This facility was introduced in 1952 to meet a
felt need for it although there was no specific provision for it in

i
of its currency). If a country has 25 per cent of its quota in
the Fund’s Articles of Agreement. Since then such facility was

com Tr
gold, then upto this limit this member can draw upon the
Fund automatically. If that country has also a credit position frequently used by the members and both the Fund and the
of l0 percent of its quota as borrowings by other countries, members are happy for such prior arrangement in the nature of
then that country can borrow automatically upto 35 per cent an overdraft limit. The standby facility is repayable generally in
of its quota (gold tranche of 25 percent plus super gold three years, while other types of borrowings are repayable in 3

rd. F
tranche of 10 per cent). to 5 years. A member’s obligation to repurchase also arises if its
exchange reserves rise beyond a limit. The repurchase is made in
(2) Four Credit Tranches: There are four credit tranches, each
terms of the currency borrowed or in any convertible currency or

iza D
equivalent to 25 per cent of its quota. If gold payment is 25
per cent of the quota and the rest of the 75 per cent is paid
in own currency, the Fund can hold upto 200 per cent of a
a currency, which is in demand, and the Fund’s holdings of it
are less than 75 per cent of that country’s quota. A member’s
dfw P
indebtedness to the IMF can be repaid in three ways: (1)
member’s quota in its currency and credit tranches would
Repurchase with gold and convertible currencies; (2) The
aggregate to 100 per cent of quota.
drawings of its currency by other countries; and (3) The offset
(3) Compensatory financing facility was started in February 1963 of an earlier creditor position.
w.p m

to provide credit in connection with any shortfalls in export


proceeds below some average annual figure. The member IMF Charges
was permitted credit upto 50 per cent of the member’s The schedule of IMF charges on the member’s drawings is such
that the rate varied with the period for which it is outstanding
ww Co

quota, which was raised in stages to 100 per cent of the


quota in 1980. and the tranche position of the country. For a long time the
maximum rate of interest was 5 per cent and now it varied
(4) The international buffer stock financing facility was
from time to time. The rates for supplementary financing facility
established in June1969 in respect of any primary
were higher at 10-11.5 per cent or even more, as these rates
commodity that the member country produces. The credit is
depended on the rates at which the Fund borrowed from the
cu

upto a limit of 50 per cent of its quota for special stocks of


lender countries and on the money market conditions of the
sugar, tin, cocoa, etc, under various international
major creditor countries. The margin kept by the IMF is about
commodities agreements.
0.2 to 0.325 per cent. Since May 1, 1981, IMF had adopted a
The above facilities, except in the case of gold tanche which is uniform charge of 7.0 per cent per annum on outstanding
Do

automatic, are subject to the following conditions: borrowings of members from the Fund’s own resources and a
(1) No member should draw in any 12-month period more higher rate for those resources borrowed from outside. The
than 25 percent of its quota. Fund makes a service charge of 0.5 per cent on all purchases
(2) No member should draw in total beyond a point where the other than those in reserve tranche and 0.25 per cent on all
Fund’s holdings of the member’s currency reaches 200 per standby and extended Fund facilities.
cent of its quota which it will have if it has borrowed upto These charges are payable normally in gold or US dollars or
125 per cent of its quota with a gold subscription of 25 per SDRs but as in the case of other provisions of the Fund which
cent and its own currency upto 75 per cent. are operated with flexibility, this may be waived if the nation’s
(3) The combined drawal under compensatory financing and external reserves are below half of its quota. Thus, Fund’s
buffer stock financing should not exceed 75 per cent of the charges were paid by India in rupees only. These charges are very
member’s quota. nominal in view of the fact that Fund does not pay any interest
on currencies held by it. Since 1969, IMF was paying about 11/2
(4) Total holding of IMF of any member’s currency under all
per cent per annum to a creditor position of a member that is,
the above facilities should not exceed 275 percent of the
when its currency held by the Fund fell below 75 per cent of its
quota.

© Copy Right: Rai University


11.621.6 131
Other Facilities adjustment is expected to be of about three years during which
MANAGEMENT OF FINANCIAL INSTITUTION

The oil facility was originally designed in 1974.These funds were the country’s balance of payments position would be
lent to countries in balance of payments difficulties due to oil strengthened and its debt repayment capacity revived.
price escalation during 1970-73. Arrangements to borrow SDR Enhanced structural adjustment facility was continued upto
6.9 billion for this Fund from 17 member countries with a 1993 for helping the low-income countries, in strengthening
strong external payments position were made in 1974. This their payments position. Many additional Facilities were created
facility was extended from year to year and by 1982 borrowing from time to time to suit to the changing conditions. Thus, in
members have repaid most of the outstanding debt. April 1993, the Fund created a new temporary facility called
In 1974, the Fund also established an Extended Fund facility to systemic transformation assistance to members with, systemic
provide special medium-term loans to meet the balance of disruption of economies moving from planned economies to
payments deficits over a longer period and to help correct the private market-oriented economies. In December 1997 the
structural imbalances in the economy of a member country. fund, had set up the supplementary Reserve Facility to provide
This assistance is up to three years and in amounts larger than additional finance to members facing exceptional balance of

al
that permitted by the member’s quota. . payments problems due to loss of funds following the loss of
In August 1975, a Subsidy Account was set up with market confidence.
contributions from 24 members for an amount of SDR 160 Exchange Rates and Par Values

i
million to assist the member countries in balance of payments An important aspect of IMF activities is to maintain orderly

com Tr
difficulties due to a rise in oil prices and to provide subsidy to exchange arrange-ments. The exchange rate system set up by the
interest payments on the use of resources made available to Articles of Agreement was called par value system. Each
them through the oil facility. The effective interest rate to member is required to express the par value of its currency in
borrowing members, which include India, is 2.7 per cent as terms of gold as a common denominator or US dollar at a

rd. F
against the original rate of 7.7 per cent. The final payment under value of $ 35 per fine ounce of gold. Thus, gold was the basis
this Account was completed in August 1983. of valuation and exchange rate fluctuations were to be kept
In May 1976, a Trust fund was started for providing special within a narrow margin of 1 per cent on either side. While the

iza D
balance of payments assistance to developing countries at highly
concessional rates. The sources of funds for this Trust are the
USA performed this by buying and selling gold for US dollar,
other countries did it through an intervention currency, such as
dfw P
realizations from the sale proceeds of one-sixth of IMF gold US dollar of UK sterling.
holdii1g, income from investment and loans and proceeds of The par value can be changed at the initiative of the country but
repayment and donations. Only about 60 member countries with the concurrence of the IMF. For any change up to 10 per
(including India), which are developing, were eligible for this cent in the par value, to make adjustments in the balance of
w.p m

assistance. The first auction sale of gold by the Fund took place payments, the Fund would not raise any objection. For any
in June 1976. change beyond 10 per cent, the country has to justify to the
A Supplementary Financing Facility was established in August Fund that it would be needed to correct a “fundamental
ww Co

1977 (Wittaveen Facility) with the objective of extending disequilibrium” - a concept that has not been defined by the
financial assistance to members with large payments difficulties, Fund but relates to a structural change in the economies and in
which are larger in relation to their incomes, and quotas with the cost price parities.
Fund. This is usable by members under a standby or under an Besides, members are obligated to avoid control on current
extended arrangement for a period of 1 to 3 years. Some 14- account except under Article XIV which permits member
cu

member countries agreed to provide SDR 7.8 billion for this countries to have such restrictions on a temporary basis. Some
facility. The borrowings on this Fund by members were started members who opted for this clause continue to have these
in May 1979 and IMF has in turn borrowed from the lending restrictions in some form or the other. Article VIII enjoins on
members at a rate calculated for each of the six months on the the members to free current transactions from all restrictions,
Do

basis of yield on US Government securities of 5-year maturity. which was adopted by the major developed countries in the
A subsidy account was also started in December 1980 for sixties. About 60 members have accepted Article VIII of the
subsidizing the interest rate on the borrowings of the low- Fund so far and India is one of them since 1994. But a majority
income developing members under this Wittaveen facility. This of members are still following Article XIV provisions, under
facility could not be extended beyond 1982 due to further non- which some forms of control on Current Account transactions
committal of funds by lender-members. . were permitted.
A new Structural Adjustment Facility (SAP) was established in The stable par value system has broadly served the purpose of
October 1985 and became operative in March 1986 financed’ out larger trade and greater international co-operation. This system
of SDR 2.7 billion that are available during 1985-91 from continued to prevail up to August 1971 during which time
repayment of Trust Fund loans and interest dues. This facility is there was international monetary stability and orderly growth in
confined to the lowest income countries with protracted balance world trade.
of payments problems needing a structural adjustment
So long as the dollar convertibility into gold was maintained,
programme. This loan carries a rate of 1/2% of 1 per cent with
IMF served the purpose and dollar and gold shared the honour
a grace period of 5 years and subsequent semi-annual
of serving as an international medium of exchange. While the
repayments extending over five years. The programme of

© Copy Right: Rai University


132 11.621.6
surplus countries have not been adjusting their economies, the

MANAGEMENT OF FINANCIAL INSTITUTION


burden of adjustment fell on the deficit countries. When the
US was one of such deficit countries and found it difficult to
adjust the domestic economies to the requirements of the IMF
system and its role as an international banker, the fixed parity
system lost its credibility.
The Bretton Woods system in respect of exchange rates was
formally aban-doned in August 1971 when convertibility of the
US dollar into gold was with- drawn. The continued inflation at
home, deficits in balance of payments and persistent pressure
on the US dollar by its creditor countries along with speculative
attacks on the dollar particularly in Euro-currency market, led to
the suspension of its convertibility. The US abandoned its

al
obligation to buy and sell gold in interna-tional settlements
since August 1971. This was followed by a system of floating
rates and a temporary regime of central rates and wider margins

i
since December 1971.

com Tr
The Smithsonian Agreement of December 1971 put back the
broken pieces of the system together into a new shape, based
on (I) A realignment of currency value against the dollar with a
small devaluation of $ (revaluation of gold $ 38 = 1 fine ounce)

rd. F
and (ii) A return to fixed parity system by December 1971. But
this system was short-lived and UK sterling was the first to
abandon the fixed parity system in June 1972, followed by

iza D
others in favour of a floating system of exchange -rates. In
February 1973, there was a further devaluation of dollar by 10
per cent in terms of gold in the midst of rampant speculation
dfw P
in dollar. A Committee of Twenty and subsequently the
Interim Committee took up to formulate in 1972 a package of
reforms in the international monetary system concerning
w.p m

exchange rates, role of gold, SDRs etc. After years of


deliberation, they agreed on the following measures, in 1978.
Questions to Discuss:
ww Co

1. What are the objectives of International Monetary Fund?


2. What are the sources of fund?
Notes:
cu
Do

© Copy Right: Rai University


11.621.6 133
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 32:
THE INTERNATIONAL MONETARY SYSTEM

Learning objectives (1) A member shall avoid manipulating exchange rates to its
After reading this lesson, you will understand advantage or prevent effective balance of payments
adjustment.
• International Monetary reforms and International liquidity
(2) A member shall intervene in the exchange market if
• Special Drawing rights (SDR)
necessary to” counter disorderly conditions.
Today we shall discuss international monetary reforms and
(3) Members should take into account the interests of other
international liquidity and also special drawing rights of the

al
members of the Fund in their intervention policy.
IMF.
Members are free to choose their exchange rate arrangements
International Monetary Reforms except to main-tain values in terms of SDR and co-operate with
In respect of exchange rates it was agreed that the floating

i
the Fund in the orderly exchange arrangements.

com Tr
exchange system, which was a fait accompli, should be legalised.
But members are still under an obligation to collaborate with International Liquidity
the Fund to ensure orderly exchange arrangements and International liquidity is defined to include all the assets gold
promote a system of stable exchange rates. It was also provided and currencies that are freely and unconditionally usable in
that countries may return to a stable but adjustable par value meeting the balance of payments deficits and other

rd. F
system at a future date. Meanwhile, floating rates with a wider international obligations of countries. Gold has for long served
band of fluctuations of 2.25 per cent on either side, which was as a unit of account, measure of value and medium of
exchange. In the narrow official sense, the liquid assets used to

iza D
prevailing since the Smithsonian Agreement would continue.
A new concept of “international surveillance of the exchange
rate systems” was developed arid accepted as a new approach to
meet balance of payments deficit by governments or monetary
authorities include gold, convertible foreign exchange assets and
dfw P
reserve position with the IMF. In a sense, all owned and
the exchange rate systems. Of the 149 members in the Fund, as
potential borrowings should be included as liquidity. These
at end December 1986, there were about 14 countries
potential borrowings are vast and the scope for them is
independently floating 8 countries in a joint float and 32
expanding with the passage of time. Besides, in a wider sense,
countries linked to the US dollar, 14 to the French Franc, 12 to
w.p m

all currencies and currency deposits and credits, actual and


SDR, 31 to a currency basket and the rest, linked to other
potential are part of the liquidity whether available to the
currencies. The fixed parity system had disappeared completely.
governments and monetary authority or private parties. But
ww Co

As regards gold, it would no longer function as an international since reserves held by private parties are not available monetary
unit of value or medium of exchange for the purpose of the authorities for meeting balance of payments requirements, only
Fund. The official price for gold is abolished and obligatory gold, official reserves, gold tranche and super-gold tranche
payments and receipts in gold between the Fund and members (creditor position) with the IMF are considered as freely usable
were withdrawn. Members are free, however, to deal in gold liquid assets by the authorities. Gold and super-gold tranche
cu

among themselves, SDR will be the unit and medium of positions are drawable without conditions like the current
exchange in future. The existing gold stocks of the fund are to account position with banks. SDRs, which have been created by
be disposed of by returning to members half of their original the IMF since 1969, are also included as liquid assets. In a
contributions and by selling the other half in the market narrow sense, thus, the official foreign exchange assets include
Do

through auctions and to use the proceeds for the Trust Fund. gold, foreign currency deposits and investments in currencies
Provisions are made for greater use and resort to SDRs, referred which are freely convertible if that country has accepted Article
to later. VIII of the IMF Articles of Agreement, whereby no current
Two amendments were made to the Articles of Agreement, in account restrictions are used. India has accepted this position in
connection with the reforms. Firstly, in 1969 an amendment March 1994.
was made to create a system of SDRs, which will be referred to
Need for Reserves
later. Secondly, Articles were amended in 1978 to introduce
With the growth of world trade and payments, the need for
reforms in the international monetary system referred to earlier.
reserves increases to meet the payments and deficit
The principle of surveillance of the Fund over the members’ requirements. Just as in the case of domestic cash requirements
exchange rate systems was embodied in the Second for transactions, precautionary and speculative motives, and
Amendment. So also was the abandonment of gold as an international reserves also serve these three motives. Under a
international unit of account or a medium of exchange for system of fixed par values adopted by the IMF and operative
which SDR .is redesigned. upto 1971, intervention in the markets to maintain the
Surveillance involves the following principles. exchange rates stable used to require a large volume of liquid
assets by the authori-ties. However, under the system of

© Copy Right: Rai University


134 11.621.6
floating rates with a wider band of fluctuations, a larger need credits etc. With increased access to international capital markets,

MANAGEMENT OF FINANCIAL INSTITUTION


for reserves exists for various reasons. Firstly, the larger the more recently by creditwor-thy countries like India, the question
balance of payments deficits, the larger is the need for reserves, of adequacy of reserves became less important to them.
and these deficits are growing. Secondly, then existing exchange At end September 2003 total reserves of India totaled about
rate system called “managed float” requires a larger official $88 billion, which covers all import bill for about 11 months.
intervention, which depends on the official holding of reserves.
Thirdly, the IMF has put an obligation on members to return Problems of Liquidity
to the fixed par value system as and when conditions permit, The basic problems of international liquidity are as follows:
for which a comfortable stock of reserves is necessary. Fourthly, 1.Inadequacy of Growth: Compared to the growth of world
increasing deficits in balance of payments of non-oil producing trade and increased deficits in balance of payments or judged
countries in more recent years require to be financed by reserves. by any other criteria, the inadequacy of reserves was felt more
Fifthly, a large number of poor countries have their exchange in the sixties and seventies than before. This was the justifi-
rates pegged to a currency or basket or currencies for which cation for the creation of SDRs by the IMF.

al
central bank’s intervention in the market is necessary, particularly 2. Unsatisfactory Distribution of Reserves.’ The bulk of the
when their deficits are growing. The demand for reserves for reserves, namely, around 60 percent, was held by the
precautionary motives emerges out of the need for developed world and more recently by the combined groups

i
contingencies and to maintain their credit standing. The of developed countries oil-producing developing countries.

com Tr
speculative demand for reserves may not be felt in a country The poor developing countries and non-oil producing
where all exchange dealings are strictly controlled and supervised countries are left with inadequate reserves.
by the authorities. 3. Unsatisfactory Composition of Reserves: The proportion of
Composition and Level gold to total re-serves in 1952 was 68 per cent, which fell to
The official reserve composition of India in 1971 and the latest 53 per cent in 1968 and future to 23 per cent in 1973. Since

rd. F
position are presented below: then gold was completely replaced in official transactions by
the SDRs. Gold, however, continued to play an important

Gold *
End March

1971
182
iza D
End March

1981
226
Jan.

1994
12,665
Dec.

1999
12,790
(Rs. crore;)
June
2002
16,272
role with some countries because of its intrinsic worth,
despite its demonetisations by IMF in 1973. Gold was
revalued in terms of the US dollar from $ 35 to $ 38 per
dfw P
Foreign Exchange
. fiancé ounce in 1971 and again to $ 42.2 per fine ounce in
Assets 438 4,822 61,440 1,39,134 2,67,333
SDR Units 112 497 233 18 47 Febl11ary 1973.
Total 732 5,545 74,338 1,51,942 2,83,652
In December 1997, the fund establishes the supplementary
w.p m

Valued at London market price.


Source: RBI Bulletins.
Reserve Facility to provide additional financial assistance to
countries in financial crisis due to balance of payments
difficulties and loss of market confidence. From time to time
Historically, the role of gold was taken by the US dollar and UK
ww Co

many facilities were added while some have lapsed.


Sterling in interwar and post-war periods and was replaced by
SDR in the seventies. Gold is now completely replaced by SDR Augmentation of Liquidity
in the international monetary system. The methods of augmenting the liquidity adopted by the Fund
are the quota increase; borrowing from members under GAB
Adequacy of Reserves
and creation of SDRs. Increase, in quotas of all members with
cu

The currency composition of foreign exchange has also


the IMF would improve global liquidity as their borrowing
undergone substantial changes since 1975. The role of the US
operations could simultaneously increase. Normally, quota
dollar was replaced partly by other currencies such as DM, Swiss
reviews are held at intervals of not more than 5 years. Then the
franc and Japanese yen and partly by SDR.
Fund would consider the growth of world economies, growth
Do

If reserves are important, the adequacy of reserves of of international transactions and world trade and judge the
international liquidity is equally important. Firstly, adequacy of adequacy of existing international liquidity. The quotas of
reserves may be judged by the relationship of reserves to members would determine their existing subscriptions to the
imports, secondly, by the rate of growth of world trade as Fund, their drawing rights on the Fund under both regular and
compared to the rate of growth of reserves and thirdly, by ‘the special facilities and their share of allocation of SDRs and their
magnitude of balance of payments deficit today as against a voting power in the Fund.
base year. Reserves as percentage of imports for all countries
So far eleven quota increases took place in the past. The eighth
stood at 85 per cent in 1950 but declined to 38 per cent by 1966.
General Review of quotas made in 1984 raised the total quotas
By 1970 when SDR allocation started the inadequacy of reserves
with the Fund by 47.5 per cent to 90 billion. Under the ninth
in relation to imports was glaring.
quota increase, in 1990, total quotas increased further by 51.7%
The adequacy of reserves is also assessed sometimes with to SDR 136.7 billion. Even so, the ratio of Fund quotas to
reference to the degree of fluctuations in exports earnings. The world imports is still lower at 4 per cent at present as compared
symptoms of inadequacy include increased restrictions on to 9 per cent in 1970 and 12 percent in 1965. Such general
current account transacti0l1s such as imports, efforts to curtail increases in quotas had taken place earlier in addition to some
foreign aid, depreciation of currency and greater reliance on trade

© Copy Right: Rai University


11.621.6 135
special increases of quotas of a few members whose currencies use of SDRs must be such that the average of its daily holdings
MANAGEMENT OF FINANCIAL INSTITUTION

were supposed to be lower than the general requirements. over a five year period should be not less than 30 per cent
(reduced to 15 per cent and later removed altogether) implying
Special Drawing Rights (SDR)
thereby that it could use only 70 per cent of the allocation on
The Special Drawing Rights (SDRs) are another source of
average. This puts an obligation on the members using SDRs
augmenting inter-national liquidity. This is an asset specially
to repurchase them also.
intended to take the place of gold and as such called paper gold,
Each SDR is equal to O.88671 gms of fine gold, equivalent to SDR Allocation
one US dollar prior to devaluation in 1971. The value of SDR Starting with January 1970, SDRs were allotted to all member
was changed with the devaluation of dollar in 1971 and 1973. countries of the IMF who accepted the SDR scheme. The first
During 1974 to 1980 the value of SDR was fixed on a daily SDR allocations were made during each of the years 1970-72
basis as a weighed average value of a basket of 16 currencies of totaling SDR 9.3 billion. Further allocations were made for each
countries with more than 1 per cent of world trade. In 1981 of the years during 1979-81, totaling SDR 12 billion. The
these 16 were replaced by 5 major currencies, namely US $ DM, cumulative allocations since the beginning of the scheme were

al
UK £ French Franc and Yen. SDR 21,433 million. Such cumulative allocations amounted to
These reserve assets have been created by the Fund since 1969 as only 5-7 per cent of the total world reserves other than gold. In
and when required as part of the long-term strategy of timing of the allocations, the Fund kept in view the global need

i
augmenting world liquidity to keep pace with the requirements to supplement the existing reserve assets. Since then, in

com Tr
of a growing world economy and world trade. The actual September 1997, a special one-time allocation of SDR 21.4
allocation of SDRs to members would depend on the then billion was made which raised all participants’ cumulative
quotas with the Fund. The acceptability of the SDR as an allocations to a common benchmark ratio of29.3157 88813 per
international liquid asset would depend upon the cent of the quotas based on the Ninth General Review.

rd. F
unconditional acceptance of this asset by the members of the Limitations
Fund. The Fund members have been given the option to join The SD Rs cannot be used directly as reserves as they have to be
the SDR scheme and those who have joined are bound to abide

iza D
by the rules of unconditional acceptance for international
payments, conversion into reserve currencies, payment and
converted into reserves of one or other currency before use for
payments. They can be used by official agencies and for
designated purposes only. These are not money as such but are
dfw P
receipt of interest etc. About US members had joined it comparable to near money or credit instruments. The fact that
originally in 1970 but now all its members have accepted and are interest is payable on SDRs used by the debtors to the creditors
allotted the SDRs. would indicate that the SDRs are credit facilities.
SDR accounts are kept separate from the General Account of
w.p m

Uses
the Fund. The SDR is like a coupon or a credit facility, which can Countries have made considerable use of these facilities since
be exchanged for reserve currency as, needed by the user and their first alloca-tion in 1970. These transfers were partly
approved by the Fund. The governments of the countries are designations by the IMF or by voluntary agreements among the
ww Co

holders of the SDR and their accounts in SDRs are maintained members or in transactions with the Fund by members and
by the Fund through book-entries. If a member wants to use partly in transactions by other international bodies who are
the SDR, it requests the Fund to designate another member to holders of SDRs. Since then gold has been replaced by SDR in
accept them in exchange for a reserve currency to use the Fund’s transactions as we has in the international
international payments and the latter member is obliged to
cu

transactions of members. The SDRs cannot, however, be


accept as designated by the Fund. This would then tantamount exchanged for gold or for changing the composition of reserves
to a credit granted by the latter member to the former for which of a country.
an interest rate of 1½ per cent is paid to the creditor by the
There are charges payable for use of SDRs. The charge for a
debtor through the Fund. In this sense, SDRs are better than
Do

creditor position in SDRs with the Fund is paid to the member


gold as no interest was received on gold. In order to encourage
holding excess SDRs than allocated. This charge of 1½ per cent
acceptability of these SDRs, a member country may be required
was raised to 5 per cent in June 1974. Subsequently, the interest
to hold in all 300 percent of the cumulative allocations 100 per
rate on borrowings in SD Rs is determined quarterly by
cent representing the original allocation and 200 percent
reference to a combined market interest which is weighted
representing the part received from others as designated by the
average rate on specified short-term instruments in the money
Fund. These SDRs are the liability of the member borrowing
markets of the same five countries in whose currencies the SDR
currencies in exchange for SDRs and not of the Fund, which
value is determined, namely, the USA, West Germany, UK,
keeps only the accounts with surveillance over the operations.
J1rance and Japan. The interest rates in the money markets of
The members are not expected to transfer SDRs for changing
these five countries are weighted according to the same weights
the composition of its international reserves. The Fund may
as used for SDR valuation. The IMF rate of remu-neration to
also acquire SDRs in the process of its operations on General
creditor countries was fixed in terms of SDR interest rate.
Account as the members may repurchase in SDRs or pay
interest or service charges in SDRs. Further with a view to put SDRs can also be used in swap arrangements and in forward
limit on the use of this facility by deficit countries, the principle operations, as a unit of account or measure of value or a means
of “reconstitution” is laid down under which a member’s net of payment. The SD R is used as a currency peg by some

© Copy Right: Rai University


136 11.621.6
countries and as security or pledge. The Asian Currency Union The IMF and the World Bank - How do

MANAGEMENT OF FINANCIAL INSTITUTION


and a number of international and inter-regional bodies are they Differ?
using SD Rs in the above applications.
IMF Supported Programmes and the Poor (Low
SDRs in India Income Countries)
India was allocated SDRs in the name of the Government of
India since January 1970. These SDRs do not enter into the In 1987, the IMF established the Enhanced Structural
accounts of the RBI. During 1979--81, India was given further Adjustment Facility (ESAF) to provide resources to low income
allocations on the basis of its quota with the Fund beginning countries for longer periods on concessional terms. Like its
with January 1979. India had a total allocation of about SD R predecessor, the Structural Adjustment Facility (SAF), the ESAF
681 million during 1970-81. was created in response to a need to better address the
macroeconomic and structural problems of low income
India has used the SDRs in a very active manner since their countries.
inception and as at end July 2003, SDRs stood at Rs. 36 crores.
SDR was used by India for payment of interest and repurchases Concessional Imf Facility

al
from the Fund. India has also accepted them under the Enhanced Structural Adjustment Facility (ESAF) was
“Designation” Plans of the Fund. India has very comfortable established in 1987 and enlarged and extended in 1994.
exchange reserve position due to economic reforms affected Designed for low-income member countries with protracted

i
since July 1991. balance of payments problems, ESAF drawings are loans and

com Tr
not purchases of other members’ currencies. They are made in
India’s IMF Net Position
support of three year programmes and carry an annual interest
India actively participated in IMF operations since 1947 when
rate of 0.5 per cent, with a 5½ year grace period and a 10 year
they were started. India has drawn IMF credits under most of
maturity. Quarterly benchmarks and semi-annual performance
its schemes. Any country can count as its reserves its IMF

rd. F
criteria apply; 80 low income countries are currently eligible to
position in gold and super-gold tranches. Similarly, its
use the ESAF.
repurchase obligations with the IMF are to be deducted from its

iza D
official gross -reserves. It is in this context that India’s IMF
position becomes relevant. India’s repurchase obligations were
nil in 1970-71, when it had repaid Rs. 154 crores due to IMF.
Other Facilities
• Systemic Transformation, Facility,(STF) was in effect from
April 1993 to April, 1995. The STF was designed to extends
dfw P
But India had a major drawal of about Rs. 815 crores in August financial assistance to transition, economies experiencing
1980 under two credits, namely, Rs. 540 crores from the Special severe disruption in their trade and payments arrangements.
Trust Fund and Rs. 275 crores from the compensatory financing Repurchases are made over 4½ to 10 years.
facility. Our gold tanche position was about 25 per cent of the
w.p m

• Compensatory and Contingency Financing Facility (CCFF)


quota, which stood at 2207 million SDRs taking into account provides compensatory financing for members experiencing
the 8th General Quota increase granted in January 1984. India temporary export shortfalls or excesses in cereal. Import cost,
has drawn into its credit tranches and stand by credit
ww Co

as well as financial assistance for external contingencies in


arrangement, Extended Fund Facility also the compen-satory Fund arrangement Repurchases are made over 3¼ to 5 years.
and contingency financing facility, oil facility and special Trust
• Supplemental Reserve Facility (SRF) provides financial
Fund facility. In June 2002, we have a reserve position in the
assistance for exceptional balance of payments difficulties
IMF at $ 651 million and outstanding use of IMF credit (net)
due to a large short-term financing need resulting from a
stood at nil SDR our net debt position to IMF is zero as at end
cu

sudden and disruptive loss of market confidence.


June 2003. Our foreign exchange reserves stood at US. $ 66.9
Repurchases are expected to be made within 1 to 1½ years,
billion at end Nov. 2002, which were roughly equal to 11
but can be extended, with IMF Board approval, to 2 to 2½
months of imports.
years.
Do

Additional SDRs • Contingent Credit Lines (CCL) is aimed at preventing he


SDRs allocation to India was increased in 1997 by an additional spread of a crisis. Whereas the SRF is for use by members
240 million SDRs due to special. One time SDR allocation already in the throes of a crisis, the CCL is intended solely for
amounting to 21.4 billion. The principle of equitable shares of members that are concerned with potential vulnerability. This
cumulative SDR allocation to member countries as agai.1st the facility will enable countries that are basically sound and well
earlier principle of allocation as a ratio of quotas benefited managed to put in place precautionary financing should a
India. As against the earlier share of 22%, it has now got 29%, crisis occur. Short-term financing - if the need arises - will be
which secured for India an additional 240 million SDR in 1997. provided under the CCL to help members overcome the
Besides in the 11th general quota review, the present quota exceptional balance of payments financing needs that can
funds would be increased by 45%, in which India will also arise from a sudden and disruptive loss of market
benefit. The total of IMF quotas will be increased and 75% of confidence, largely generated by circumstances beyond the
the overall increase will be distributed in proportion to the members’ control. Repurchase terms are the same as under
present quotas of member countries, as against the earlier the SRF.
proportion of 60%. India will stand to gain in this respect also.

© Copy Right: Rai University


11.621.6 137
Saf/Esaf: A Concessional Facility to beginning 5½ years and ending 10 years after the date of each
MANAGEMENT OF FINANCIAL INSTITUTION

Assist Poorer Countries disbursement, The interest on ESAF loans is 0.5 per cent a year.
The IMF’s executive board established the Enhanced Structural By contrast, charges for standby arrangements are linked to the
Adjustment Facility (ESAF) in 1987 to better address the IMF’s SDR market determined interest rate and repayments are
macroeconomic and structural problems faced by low income made within 3¼ to 5 years of each drawing. A three-year access
countries. It offers loans with lower interest rates and for longer under the ESAF is up to 190 per cent of member’s quota. The

International Monetary Fund World Bank


• Oversees the International • Seeks to promote the economic
Monetary System development of the world's poorer
countries.
• Promotes exchange stability and • Assists developing countries through

al
orderly exchange relations long-term financing of development
among its member countries projects and programmes.
• Assists all members - both • Provides to the poorest developing

i
industrial and developing countries whose per capita GNP is

com Tr
countries - that find themselves less than $865 a year special financial
in temporary balance of assistance through the International
payments difficulties by Development Association (IDA).
providing short to medium term
credits.

rd. F
• Supplements the currency • Encourages private enterprises in
reserves of its members through developing countries through its

iza D
the allocation of SDRs (special
drawing rights); to date SDR
affiliate, the International Finance
Corporation (IFC).
dfw P
21.4 billion has been issued to
member countries in proportion
to their quotas.
• Draws its financial resources • Acquires most of its financial
w.p m

principally from the quota resources by borrowing on the


subscriptions of its member international bond market.
countries.
ww Co

• Has 'at its disposal' fully paid-in • Has an authorised capital of $184
quotas now totalling SDR 212 billion, of which members pay in
billion (about $300 billion). about 10 per cent.
• Has a staff of 2,300 drawn from • Has a staff of 7,000 drawn from 180
182 member countries. member countries.
cu

terms than the typical IMF market-related arrangements. The access limits of standby arrangements are 100 per cent of quota
Do

principal objectives are annually and 300 per cent cumulatively.


• To promote balance of payments viability; and An eligible member seeking to use ESAF resources develops,
• Foster sustainable long-term growth. with the assistance of the IMF and the World Bank, a policy
framework paper (PEP) for a three-year adjustment
Although the objectives and features of the ESAF are similar to
programme. The PEP, updated annually, sets out the
those of its predecessor, the Structural Adjustment Facility
authorities’ macroeconomic and structural policy objectives and
(SAF) set up in. 1986, the ESAF was expected to be more
the measures that they intend to adopt during the three years.
ambitious with regard to macroeconomic policy and structural
The PEP also lays out the associated external financing needs of
reform measures. The IMF no longer makes disbursements
the programme, a process that is meant to catalyse and help
under the SAP.
coordinate financial and technical assistance from donors in
ESAF loans are disbursed semi-annually (as against quarterly for support of the adjustment programme.
regular IMF standby arrangements) initially upon approval of
an annual arrangement and subseq6ently on the observance of
performance criteria and after completion of a mid-term review.
ESAF loans are repaid in 10 equal semi-annual installments

© Copy Right: Rai University


138 11.621.6
Questions to Discuss:

MANAGEMENT OF FINANCIAL INSTITUTION


1. What do you understand by International Monetary reforms
and International liquidity?
2. Explain Special Drawing rights (SDR)?
Notes:

i al
com Tr
rd. F
iza D
dfw P
w.p m
ww Co
cu
Do

© Copy Right: Rai University


11.621.6 139
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 33:
INTERNATIONAL FINANCIAL INSTITUTIONS

Learning objectives development of its Latin American member countries. In


After reading this lesson, you will understand general, both public and private entities are eligible to borrow
money from such agencies as long as private funds are not
• The World Bank
available at reasonable rates and terms. Although the interest
• A Global cooperatives rate can vary from agency to agency, these loan rates are very
• Economic Reform Programmes attractive and very much in demand.
• International Monetary fund Of all the international financial organizations, the most

al
• Asian development bank familiar is the World Bank, formally known as the International
Bank for Reconstruction and development (IBRD). The World
An international inspection of the financial institution would
Bank has two affiliates that are legally and financially distinct

i
ease your understanding of the functioning of the financial
entities, the International Development Association (IDA) and

com Tr
institution.
the International Finance Corporation (IFC). Exhibit 1
Introduction provides a comparison among IBRD, IDA and IFC in terms of
At the Bretton Woods Conference in 1944 it was decided to their objectives, member countries, lending terms, lending
establish a new monetary order that would expand international qualifications as well as other details. All three organizations

rd. F
trade, promote international capital flows and contribute to have the same central goals: to promote economic and social
monetary stability. The IMF and World bank were born out of progress in poor or developing countries by helping raise
this Conference at the end of World War II .The World Bank standards of living and productivity to the point at which

iza D
was established to help the restoration of economies disrupted
by War by facilitating the investment of capital for productive
development becomes self-sustaining.
Toward this common objective, the World Bank, IDA and IFC
dfw P
purposes and to promote the long-range balanced growth of have three interrelated functions and these are to end funds, to
International trade. On the other hand, the IMF is primarily a provide advice and to serve as a catalyst in order to stimulate
supervisory institution for coordinating the efforts of member investments by others. In the process, financial resources are
countries to achieve greater cooperation in the formulation of channelled from developed countries to the developing world
w.p m

economic policies. It helps to promote exchange stability and with the hope that developing countries, through this
orderly exchange relations among its member countries. It is in assistance, will progress to a level that will permit them, in turn,
this context that the present lesson reviews the purpose and to contribute to the development process of other less
ww Co

working of some of the international financial institutions and fortunate countries. Japan is a prime example of a country that
the contributions made by them in promoting economic and has come full circle. From being a borrower, Japan is now a
social progress in developing countries by helping raise major lender to these three organisations. South Korea is
standards of living and productitivity to the point at which moving in a direction similar to that of Japan nearly a quarter
development becomes self-sustaining. of a century ago.
cu

In this lesson, we will review the working and objectives of Table:


some of the important international financial institutions. The The World Bank and its Affiliates
lesson begins with a comparison of the World Bank and its
affiliates. The lesson then gives a brief review of the five The World Bank
Do

international financial institutions - World Bank, IBRD, IDA, The World Bank group is a multinational financial institution
IFC and MIGA. The next section discusses the various established at the end of World War II (I944) to help provide
dimensions of the World Bank in detail. A comparison of the long-term capital for the reconstruction and development of
IMF and World Bank is also discussed. The lesson finally number countries. The group is important to multinational
concludes with a discussion of the Asian Development Bank corporations because It provides much of the planning and
tracing its strategic objectives, operating objectives and financial financing for economic development projects involving billions
management. dollars for which private businesses can act as contractors and
suppliers of goods and engine related services.
One major source of financing is international nonprofit
agencies. There are several regional development banks such as The purposes for the setting up of the Bank are
the Asian Development Bank, the African Development Bank • To assist in the reconstruction and development of
and Fund and the Caribbean Development Bank. The primary territories of members by facilitating the investment of
purpose of these agencies is to finance productive development capital for productive purposes, including the restoration of
projects or to promote economic development in a particular economies destroyed or disrupted by war, the reconversion
region. The Inter-American Development Bank, for example, of productive facilities to peacetime needs and
has the principal purpose of accelerating the economic

© Copy Right: Rai University


140 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
The World Bank
International International
Bank for Development
Reconstruction Association International Finance
and Development
(IBRD)

Corporation
(IFC)

al
Objectives of the institutions To promote economic progress in To promote economic
developing countries by providing progress in developing

i
financial and technical assistance, countries by helping to

com Tr
mostly for specific projects in both mobilise domestic and
public and private sectors. foreign capital to
stimulate the growth of
the private sector.

rd. F
Year established 1945 1960 1956
Number of member 144 131 124
countries
(April 1983)
iza D
dfw P
Types of countries assisted Developing The poorest: 80% All developing
countries other of IDA credits go countries, from the
than the very to countries with poorest to the more
w.p m

poorest. Some annual per capita advanced.


countries Incomes below
ww Co

borrow a $480. many of these


“blend” of countries are too
IBRD loans poor to be able to
and IDA borrow part or any
credits. of their
cu

requirements on
IBRD terms
Types of activities assisted Agriculture and rural development, Agribusiness,
Do

energy, education, transportation, development finance


telecommunications, industry, mining, companies, energy,
development finance companies, fertilizer, manufacturing,
urban development, water supply, mining, money and
sewerage, population, health and capital market
nutrition. Some non-project lending, institutions, tourism and
including structural adjustment. services, utilities.

Lending commitments (fiscal $10,330 million $2,686 $580 million


1982) million

© Copy Right: Rai University


11.621.6 141
MANAGEMENT OF FINANCIAL INSTITUTION

Equity investments (fiscal IBRD and IDA do not make equity $32 million
1982) investments.
Number of operations (fiscal 150 97 65
1982)
Terms of lending: Generally 15 to 50 years 7 to 12 year
Average maturity period 20 years
Grace period Generally 3 to 10 years An average of 3 years.
5 years
Interest rate (as of April 10.97% 0.0% In line with market

al
1, 1983) rates.
Other charges Front-end fee Annual Commitment fee of 1 %

i
of 0.25% on commitment charge per year on undisbursed

com Tr
loan. of 0.5% on amount of loan.
Commitment undisbursed and
charge of service charge of
0.75% on 0.75% on disbursed

rd. F
undisbursed amounts of the
amount of credit.

iza D
Recipients of financing
loan.
Governments,
government
Government.
But they may re-
Private enterprises;
government
dfw P
agencies and lend funds to organisations that assist
private state or private the private sector.
enterprises, which organisations.
w.p m

can get a
government,
guarantee for the
ww Co

IBRD loan.
Government guarantee Essential Essential
Neither sought nor
accepted
Main method of raising funds Borrowings capital Grants from in Borrowings and IFC's
cu

markets. world's capital, subscribed by m


governments. governments.
Main sources of funds Financial markets Governments of Borrowings from IBRD.
Do

in US, Germany, US, Japan,


Japan and Germany,
Switzerland. France, other
OECD
countries and
certain. OPEC
countries.

encouragement of the development of productive facilities made by private investors; and when private capital is not
and resources in less developed countries. available on reasonable terms, to supplement private
• To promote private foreign investment by means of investment by providing, on suitable conditions, finance for
guarantees or participation in loans and other investments

© Copy Right: Rai University


142 11.621.6
productive purposes out of its own capital, funds raised by economy; alleviating scarcity in term financing; and improving

MANAGEMENT OF FINANCIAL INSTITUTION


it and its other resources. the capacity of institutions involved in financing, regulating and
• To promote the long-range balanced growth of international promoting free zones.
trade and the maintenance of equilibrium in balance of The World Bank lays special operational emphasis on
payments by encouraging international investment for the environmental and women’s issues. Given that the Bank’s
development of the productive resources of members, primary mission is to support the quality of life of people in
thereby assisting in raising productivity, the standard of developing member countries, it is easy to see why
living and condition of labour in their territories. environmental and women’s issues are receiving increasing
• To arrange- the loans made or guaranteed by it in relation to attention. On the environmental side, it is the Bank’s concern
international loans through other channels so that the more that its development funds are used by the recipient countries in
useful and urgent projects, large and small alike, can be dealt an environmentally responsible way. Internal concerns, as well as
with first. - pressure by external groups, are responsible for significant
research and projects relating to the environment.
• To conduct its operations with due regard to the effect of

al
international investment on business conditions in the The women’s issues category, specifically known as Women In
territories of members and, in the immediate post-war years, Development (WID), is part of a larger emphasis on human
to assist in bringing about a smooth transition from a resources. The importance of improving human capital and

i
wartime to a peacetime economy. improving the welfare of families is perceived as a key aspect of

com Tr
development. The WID initiative was established in 1988 and it
The World Bank is the International Bank for reconstruction
is oriented to increasing women’s productivity and income.
and development (IBRD)and the international Development
Bank lending for women’s issues is most pronounced in
association (IDA). The IBRD has two affiliates, the
education, population, health and nutrition and agriculture.
International Finance Corporation (IFC) and the Multilateral

rd. F
Investment Guarantee Agency (MIGA). The Bank, the IFC and International Development Association
the MIGA are sometimes referred to as the “World Bank The IDA was formed in 1960 as a part of the World Bank
Group”.
iza D
International Bank for Reconstruction and
Group to provide financial support to LDCs on a more liberal
basis than could be offered by the IBRD. The IDA has 137
member countries, although all members of the IBRD are free
dfw P
Development to join the IDA. IDA’s funds come from subscriptions from its
The IBRD was set up in 1945 along with the IMF to aid in developed members and from the earnings of the IBRD. Credit
rebuilding the world economy. It was owned by the terms usually are extended to 40 to 50 years with no interest.
governments of 151 countries and its capital is subscribed by Repayment begins after a ten-year grace period and can be paid
w.p m

those governments; it provides funds to borrowers by in the local currency, as long as - it is convertible. Loans are made
borrowing funds in the world capital markets, from the only to the poorest countries in the world, those with an annual
proceeds of loan repayments as well as retained earnings. At its per capita gross national product of $480 or less. More than 40
ww Co

funding, the bank’s major objective was to serve as an countries are eligible for IDA financing.
international financing facility to function in reconstruction and An example of an IDA project is a $8.3 million loan to
development. With Marshall Plan providing the impetus for Tanzania approved in 1989 to implement the first stage in the
European reconstruction, the Bank was able to turn its efforts longer-term process of rehabilitating the country’s agricultural
towards the developing countries. research system. Cofinancing is expected from several countries
cu

Generally, the IBRD lends money to a government for the as well as other multilateral lending institutions.
purpose of developing that country’s economic infrastructure Although the IDA’s resources are separate from the IBRD, it has
such as roads and power generating facilities. Funds are directed no separate staff. Loans are made for similar projects as those
towards developing countries at more advanced stages of
Do

carried out by IBRD, but at easier and more favourable credit


economic and social growth. Also, funds are lent only to terms.
members of the IMF, usually when private capital is unavailable
at reasonable terms. Loans generally have a grace period of five As mentioned earlier, World Bank/IDA assistance, historically,
years and are repayable over a period of fifteen or fewer years. has been for developing infrastructure. The present emphasis
seems to be on helping the masses of poor people in the
The projects receiving IBRD assistance usually require importing developing countries become more productive and take an
heavy industrial equipment and this provides an export market active part in the development process. Greater emphasis is
for many US goods. Generally, bank loans are made to cover being placed on improving urban living conditions and
only import needs in foreign convertible currencies and must be increasing productivity of small industries.
repaid in those currencies at long-term rates.
International Finance Corporation
The government assisted in formulating and implementing an
The IFC was established in 1956. There are 133 countries that
effective and comprehensive strategy for the development of
are members of the IFC and it is legally and financially separate
new industrial free zones and the expansion of existing ones;
from the IBRD, although IBRD provides some administrative
reducing unemployment, increasing foreign-exchange earnings
and other services to the IFC. The IFC’s main responsibilities
and strengthening backward linkages with the domestic
are (i) To provide risk capital in the form of equity and long-

© Copy Right: Rai University


11.621.6 143
term loans for productive private enterprises in association with about half the votes in the Bank. And the Bank’s cooperative
MANAGEMENT OF FINANCIAL INSTITUTION

private investors and management (ii) To encourage the spirit is reflected in the fact that voting is rare because consensus
development of local capital markets by carrying out standby is the preferred way of making decisions.
and underwriting arrangements and (iii) To stimulate the Only developing countries can borrow from the Bank. But all
international flow of capital by providing financial and technical members, including the richer nations, gain from economic
assistance to privately controlled finance companies. Loans are growth in developing countries. A world increasingly divided
made to private firms in the developing member countries and between rich and poor is in no one’s interest. Everybody
are usually for a period of seven to twelve years. benefits from increased trade and investment, higher incomes,
The key feature of the IFC is that its loans are all made to fewer social tensions, better health and education and
private enterprises and its investments are made in conjunction environmental protection. The Bank’s member countries -
with private business. In addition to funds contributed by IFC, particularly the industrial countries - also benefit from
funds are also contributed to the same projects by local and procurement opportunities derived from World Bank financed
foreign investors. projects.

al
IFC investments are for the establishment of new enterprises as What does the World Bank do?
well as for the expansion and modernisation of existing ones. The World Bank is the world’s largest source of development
They cover a wide range of projects such as steel, textile assistance, providing nearly $30 billion in loans, annually, to its

i
production, mining, manufacturing, machinery production, client countries. The Bank uses its financial resources, its highly

com Tr
food processing, tourism and local development finance trained staff and its extensive knowledge base to individually
companies. Some projects are locally owned, whereas others are help each, developing country’ onto a path of stable,
joint ventures between investors in developing and developed sustainable and equitable growth. The main focus is on helping
countries. In a few cases, joint ventures are formed between the poorest people and the poorest countries but for all its

rd. F
investors of two or more developing countries. The IFC has clients, the Bank emphasises the need for investing in people,
also been instrumental in helping to develop emerging capital particularly through basic health and education; protecting the
markets. environment; supporting and encouraging private business

iza D
The Multilateral Investment Guarantee Agency
(Miga)
development; strengthening the ability of the governments to
deliver quality services efficiently and transparently; promoting
dfw P
reforms to create a stable macroeconomic environment
The MIGA was established in 1988 to encourage equity conducive to investment and long-term planning; focusing on
investment and other direct investment flows to developing social development, inclusion, governance and institution
countries by offering investors a variety of different services. It building as key elements of poverty reduction. The Bank is also
w.p m

offers guarantees against noncommercial risks; advises. helping countries to strengthen and sustain the fundamental
developing member governments on the design and conditions that help to attract and retain private investment.
implementation of policies, programmes and procedures With Bank support - both lending and advice - governments
related to foreign investments; and sponsors a dialogue
ww Co

are reforming their overall economies and strengthening


between the international business community and host banking systems. They are investing in human resources,
governments on investment issues. infrastructure and environmental protection, which enhance the
A Global Cooperative attractiveness and productivity of private investment. Through
The World Bank is comparable to a global cooperative which is World Bank guarantees, MIGA’s political risk insurance and in
cu

owned by member countries. The size of a country’s partnership with IFC’s equity investments, investors are
shareholding is determined by the size of the country’s minimising their risks and finding the comfort to invest in
economy relative to the world economy. Together, the largest developing countries and countries undergoing transition to
industrial countries (the Group of seven or G-7) have about 45 market-based economies.
Do

per cent of the shares in the World Bank and they carry great Where does the World Bank Get it$ Money?
weight in international economic affairs, generally. So it is true The World Bank raises money for its development programmes
that the rich countries have a good deal of influence over the by tapping the world’s capital markets and in the case of the
Bank’s policies and practices. The United States has the largest IDA, through contributions from wealthier member
shareholding - about 17 per cent - which gives it the power to governments. IBRD, which accounts for about three-fourths of
veto any changes in the Bank’s capital base and Articles of the Bank’s, annual lending, raises almost all its money in
Agreement (85 per cent of the shares are needed to effect such financial markets. One of the world’s most prudent and
changes). However, virtually all other matters, including the conservatively managed financial institutions, the IBRD sells
approval of loans, are decided by a majority of the votes cast by AM-rated bonds and other debt securities to pension funds,
all members of the Bank. insurance companies, corporations, other banks and individuals
The Bank’s board of executive directors, which is resident at the around the globe. IBRD charges interest from its borrowers at
Bank’s headquarters in Washington DC, represents all the rates which reflect its cost of borrowing. Loans must be repaid
members. Policies and practices are regularly and frequently in 15 to 20 years; there is a three to five year grace period before
debated and decided upon by the board, so every members’ repayment of principal begins. IDA helps to promote growth
voice is heard. In fact, developing countries, together, have and reduce poverty in the same ways as does the IBRD but

© Copy Right: Rai University


144 11.621.6
using interest free loans (which are known as IDA “credits”), loss making state enterprises may lose their jobs. Civil servants

MANAGEMENT OF FINANCIAL INSTITUTION


technical assistance and policy advice. IDA credits account for may be made redundant as a consequence of cuts in
about one-fourth of all Bank lendings. Borrowers pay a fee of government spending. Groups of poor people, are also
less than 1 per cent of the loan to cover administrative costs. particularly vulnerable, for instance, poor pregnant women and
Repayment is required in 35 to 40 years with a 10 years grace nursing mothers, young children and poor elderly people.
period. Nearly 40 countries contribute to IDA’s funding, which So, not surprisingly, Bank support for these developing
is replenished every three years. IDA’s funding is managed in the countries carrying out structural reforms generally includes
same prudent, conservative and cautious way as is the IBRD’s. social; safety nets and other measures to ease the problems that
Like the IBRD, there has never been default op. an IDA credit. poor people may experience. The Bank helps governments in
Who Runs the World Bank? financing unemployment compensation, job creation schemes
The World Bank is owned by more than 180 member countries and retraining programmes. In addition it helps governments
whose views and interests are represented by a board of target health and nutrition spending on the most needy people
governors and a Washington based board of directors. Member and also finances investments that are specifically designed to

al
countries are shareholders who carry ultimate decision making attack deep-seated poverty.
power in the World Bank. Each member nation appoints a But poor people can also benefit quickly from adjustments:
governor and an alternate governor to carry out these farmers get higher prices for their crops and currency devaluation

i
responsibilities. The governors, who are usually officials such as helps, workers in export industries: And in the long run, these

com Tr
ministers of finance or planning, meet at the Bank’s annual adjustments lead to higher incomes, strengthen civil
meetings each fall. They decide on key Bank policy issues, admit institutions, and create a climate more favourable to private
or suspend country members, decide on changes in the enterprise - all of which benefit the poor. For example, in the
authorised capital stock, determine the distribution of the past few decades, East Asia has achieved some of the most
IBRD’s net income and endorse financial statements and

rd. F
remarkable poverty declines in history -27% per cent from
budgets. 1975-85 2 and 35per cent from 1985-95 - alongwith substantial
Economic Reform Programmes improvements in the education and health of the poor.

iza D
World Bank programmes are designed to help the poor and the
record is good. The Bank has lent almost $400 billion since it
Asian Development Bank (ADB)
Introduction
dfw P
started more than 50 years ago. During this time, developing
The Asian Development Bank is a multilateral developmental
countries, with the help of the international community,
finance institution founded in 1966 by 31 member
including the Bank, have doubled their incomes, halved infant
governments to promote social and economic progress of
mortality rates and increased life expectancy. The absolute
w.p m

Asian and the Pacific region. The Bank gives special attention to
number of poor people is still rising; largely because of rapid
the needs of smaller or less developed countries and gives
population growth. But as a percentage of the world’s
priority to regional/non-regional national programmes.
population, the number of poor is falling. Economic progress
ww Co

has been faster than during any similar period in history. History
Economic reform programmes are part of that progress. The In early 1960, the United National Economic Commission for
economic shocks of the 1970s . and early 1980s - high interest Asia and Far East (UNECAFE) estimated that Asia and the
rates, low commodity prices and sluggish growth in the world Pacific region had an annual deficit of US $ one billion. The
economy - hit many developing countries hard. Countries ADB was formed to fill this gap. The inaugural meeting was
cu

needed to make reforms in the way they ran their economies to held in Tokyo and the newly named bank was installed in
encourage long-term and sustainable development: not Manila (Philippines). The first President was Mr Wanatanade
spending more than a country can afford; ensuring the policy and during his initial years the bank conducted regional surveys
that benefits, the whole country rather than only the elite; to develop a fuller understanding of the social and economic
Do

investing where scarce resources have impact - for example, in conditions of the Developing Member Countries (DMC).
basic education, and health instead of excessive military In 1974, the Asian Development Fund was established to
spending; and in encouraging a productive private sector. streamline the bank’s means of financing. During 1972-76, the
Far from being the victims of reforms, the poor suffer most Banks’ commitment to the DMCs increased from $316 million
when countries don’t reform. What benefits the poor the most to $776 million. In the late 70s, the bank recognised the need to
is rapid and broad based growth. This comes from having develop additional strategy to reduce poverty in the region, so
sound, macroeconomic policies and a strategy that favours they evolved the concept of multi-project loans, which was a
investment in basic humans capital -primary health care and cost-effective means for funding projects too small for the
universal primary education. . Bank’s involvement.
Reform ‘is not” unique to developing countries. The long In 1978, the Asian Development Fund was increased to 2.15
struggle to reduce the United States’ budget deficit, a struggle billion. 1986 was a significant year for the Bank because the
mirrored in many other industrial countries, is also a form of Peoples Republic of China joined the Bank and India received
economic reform or structural adjustment. Such changes can be her first loan of $100 million to the ICICI (Investment Credit
painful. In the short-term unemployment may rise. Workers in and Investment Corporation of India) for one lending to
private sector enterprises. In 1993, annual lending

© Copy Right: Rai University


11.621.6 145
commitments rose to $5 billion and the cumulative total by • Agriculture: In the agriculture sector, the projects with a
MANAGEMENT OF FINANCIAL INSTITUTION

1991 was $37.6 billion for 1039 projects. growth focus had diversified emphasis from building
On the borrowing front, in 1991, the Bank offered Dragon irrigation systems in Indonesia to developing rural financial
Bonds, which was a US $ 300 million offering in the capital institutions in the Kyrgyz Republic.
markets of Hong Kong, Singapore and Taipei. • Energy: Energy projects financed power transmission in
The present President is Mr. Tadao Chino, who was Japan’s People’s Republic of China (PRC), Lao People’s Democratic
former Vice Minister of Finance for International Affairs, before Republic (Lao PDR), Maldives, Philippines and Vietnam and
he rook over in January 1999. LPG transmission in India. The broad focus for the energy
sector was restructuring of the power sector; expansion of
Bank Profile power supply and enhancement of power operational
Over the past 31 years, the bank’s membership has grown from efficiency.
31 to 57, of which 41 are from within the region and 16 from
• Transport and communications: The largest number of
outside the region.
growth projects were in the transport and communications

al
The Bank gives special attention to the needs of the smaller or sector (ten projects) including three airport projects
less developed countries and priority to regional, sub-regional (Indonesia, Nepal and Philippines), two port projects
and national projects and programmes. (Indonesia and the PRC), two railway projects (Bangladesh

i
The Bank’s principal functions are and the PRG) and three road projects (Fiji, Lao PDR and Sri

com Tr
i. To extend loans and equity investments for the economic Lanka). Significant emphasis was placed on promoting
and social development of its Developing Member sector and institutional reforms to enhance the
Countries (DMCS); commercialisation of the private sector -participation in, the
ii. To provide technical assistance for the preparation and provision and operation of transport and communications

rd. F
execution of development projects and programmes and for infrastructure. The Bank also assisted in the improvement of
advisory services; ports and air transport network in Indonesia to support
growth initiatives in the East Asian region.

iza D
iii. To promote and facilitate investment of public and private
capital for development purposes; and
iv. To respond to requests for assistance in coordinating
• Capital and financial markets: The numerous projects in
the capital and financial markets sector reflected the key role
dfw P
that these sectors play in the development process and the
development policies and plans of its DMCs. Bank’s emphasis on being a catalyst of financial resources
Shareholders rather than simply a provider of financial assistance. The role
The two largest shareholders of the Bank, as of 31 December of the Bank in promoting reforms in the capital and financial
w.p m

1997, were Japan and the United States, each accounting for 16 markets became particularly critical in the wake of the
per cent of the total subscribed capital. Forty one regional financial crisis shaking East Asian markets. The five financial
members accounted for 63 per cent of total shareholding while sector loans included, among others, a $4 billion financial
ww Co

16 non-regional members contributed 37 per cent, of the total. sector programme for the Republic of Korea as part of a
total assistance package amounting to more than $57 billion
Location
to be contributed by the ADB, IMF, World Bank and
The Bank’s head quarters are in Manila, Philippines. It has
bilateral sources. In addition, the Bank provided $300 billion
resident missions in Bangladesh, Cambodia, India, Indonesia,
for the financial market reform programme in Thailand
Nepal, Pakistan, Sri Lanka and Vietnam and has opened
cu

which is part of the Bank’s pledge of $1.2 billion in the


resident missions in Kazakhstan and Uzbekistan. These
context of the assistance package to be provided also by the
resident missions improve the Bank’s coordination with we
ADB, IMF, World Bank and several bilateral donors.
governments and donor agencies; assist with activities related to
country programming and processing of new loans and • Technical assistance: The Bank’s technical assistance
Do

technical assistance projects; and help ensure project quality. programme was an integral component of efforts to
promote economic growth. Technical assistance operations
Strategic Objectives continued to support the preparation of numerous projects
The Bank’s strategic development object1ves, as defined in the promoting economic growth and to assist in policy reforms,
Bank’s medium-term strategic framework (1995-1998) are institution building and the creation of an enabling
Economic Growth environment for private sector development.
In 1997, the Bank lent $6.4 billion for 28 traditional, growth Poverty Reduction
projects. The unusually large volume of lending for economic Poverty reduction is a strategic objective of the Bank. Poverty
growth, projects was because of the programme loan to the remains a trap for more than 950 million people in, the Asian
Republic of Korea. Excluding the financial sector programme and Pacific region, with a large part, of this total facing absolute
for the Republic of Korea, the total lending for growth projects poverty. The total number of poor in the region represents
was $2.4 billion. These projects covered most of the Bank’s nearly three-quarters of all the world’s poor. While the absolute
DMCs and were widely spread across sectors including number of poor persons in the region is expected to decrease,
agriculture, energy, industry finance, transport and gradually, by the year 2000, the region will still have more than
communication. half of the world’s poor. The roots of poverty lie in a complex

© Copy Right: Rai University


146 11.621.6
fabric of social and economic factors, making poverty reduction Water Supply and Sanitation

MANAGEMENT OF FINANCIAL INSTITUTION


one of the most persistent development challenges the Bank The Bank’s main objective for the water supply and sanitation
addresses. Further exacerbating the challenge of poverty is the sub-sector is to increase the availability of safe drinking water
fact that with its complexity and multifaceted nature, there is and adequate sanitation facilities. Appropriate water and
difficulty in defining and measuring the many aspects of sanitation services are essential for the health and well--being of
poverty. the population and the provision of such services should be
Poverty reduction has been an implicit element of all operations cost-effective, sustainable and affordable.
since the Bank was established. The Bank pays close attention to Urban Development
poverty reduction issues in the formulation and Addressing the rapid pace of urbanisation throughout Asia is a
implementation of its project and technical assistance activities. formidable challenge facing the majority of the Bank’s DMCs.
One approach in the Bank’s poverty reduction efforts is the The Bank encourages an integrated approach to urban
promotion of broad-based economic growth and support for development by supporting investments for a balanced range
targeted interventions. This approach is based on the experience of infrastructure and services, targeted at meeting the basic

al
of countries that have been most successful in reducing poverty. needs and improving the living conditions of the urban poor.
Sustained rates of economic growth, in turn, provide Gender Development
opportunities for the poor to participate in and benefit from Improving the status of women is one of the strategic

i
this growth. Support for basic social services, particularly

com Tr
objectives of the Bank. Gender development is no longer seen
education and health services, helps the poor participate more as merely an issue of human rights or social justice; investment
effectively. . in women now is widely recognised as crucial to achieving
At the same time, the Bank pursues poverty reduction through sustainable development.
initiatives that are oriented toward the needs of specific Economic analysis recognises that low levels of education and

rd. F
countries. These initiatives are based on particular country-level training, poor health and nutritional status and limited access to
conditions and concerns and have a specific country-based focus. resources not only depress the quality of life for women but
Poverty reduction efforts increasingly are becoming an element

processes. iza D
of country strategy studies and country programming
also limit their productivity and subsequently, contribution to
economic efficiency, economic growth and development..
Public policies and investments that raise the status of women
dfw P
Supporting Human Development have specific benefits such as improved public health, lower
The Bank has continued to emphasise its strategic objective of infant and maternal mortality, lower fertility rates, increased life
promoting human development by expanding investments in expectancy and reduced welfare costs.
w.p m

the critical sectors of education, health and nutrition, water Development programmes -that include measures to expand
supply and sanitation and urban development. Human economic opportunities for women and increase their incomes,
development is an expanding area of activity for the Bank. Of a combined with efforts to improve women’s health and
total of 72 projects approved during 1997, excluding private
ww Co

education, result in greater economic efficiency and decreased


sector and engineering technical assistance loans, 27 projects had levels of poverty.
human development as either their primary (22) or secondary
(5) objective. Environmental Protection
Commitment to the principles of sustainable development and
Supporting human development is not only a means to
environment protection is one of the primary strategic
cu

achieving sustainable and 1ong-term development but is also


objectives of the Bank.
an end in itself. Sustained economic growth requires educated,
skilled and healthy people. At the same time, the objectives of The Banks major environmental activities include
reducing poverty, meeting basic needs and providing access to a • Providing financial and technical assistance to facilitate
Do

better quality of life now and for future generations cannot be institutional and policy reforms and build staff capacity in
achieved without investing in human development. environmental agencies, enabling them to effectively carry out
Education their mandate for environmental protection and
The Bank aims to support the education sector in its DMCs by management;
investing in basic education, improving the quality of education • Promoting cooperation among countries in the region or
and making education in general –– and skills training in subregion to address transboundary environmental concerns
particular - more relevant to market needs. and to enhance possible environmental benefits occurring
from sub regional cooperation;
Health and Nutrition
The Bank’s main strategies for supporting the health • Ensuring, through the use of environmental assessment
improvement efforts of its DMCs are to focus on primary and review procedures, that Bank--funded projects are
health care services, the control of communicable diseases and environmentally sustainable;
capacity building. • Financing projects that promote the sound management of
natural resources and rehabilitate and protect .the
environment;

© Copy Right: Rai University


11.621.6 147
• Undertaking resource centered activities to enhance Bank and Project Quality
MANAGEMENT OF FINANCIAL INSTITUTION

DMC staff awareness on current and emerging The Bank aims to achieve better, project quality and
environmental issues; and development impact. An important ingredient of project
• Ensuring inter-agency collaboration to avoid costly quality is effective implementation. While implementation, of
duplication of efforts and to enable the Bank to focus its projects is mainly the responsibility of its DMCs, the Bank
assistance in critical areas. emphasises project administration and portfolio review to
enhance project effectiveness and efficiency. The four attributes
Operating Objectives of project quality are
Operating objectives in each DMC fall within four areas 1. Economic and financial viability
1. Policy support; 2. Social impact
2. Capacity building of development management; 3. Implementability
3. Creating/Strengthening productive capacity, infrastructure and 4. Sustainability
services;

al
Emphasis is placed on tile, broader objectives of capacity
4. Regional cooperation. building, beneficiary participation, and project performance,
Sector Coverage rather than simply on the physical completion of projects.

i
The Bank’s operations cover a wide spectrum of activities that Operation Evaluation

com Tr
have been classified according to the following sectors The Bank evaluates projects and programmes final1ced by it to
1. Agriculture and natural resources obtain a systematic and comprehensive assessment of the
2. Energy extent to which the project or programme objectives have been,
3. Industry and non-fuel minerals or are likely to be, achieved. Feedback from this activity is used

rd. F
to improve the Bank’s policies and procedures and quality of
4. Finance the design and execution of its lending to DMCs.
5. Transport and communications
6. Social infrastructure
iza D
7. Combinations of some of the sectors (1) to (6)
Evaluation Activities Include
1. Project completion reporting and independent performance
evaluation of a project or programme, including evaluation
dfw P
Project Process of the efficiency of its implementation after the project or
Before any project is identified for Bank financing, Bank staff programme is completed; and
review the country’s economy, particularly its national and 2. Intensive analysis of both ongoing and completed projects
w.p m

sectorial development programmes and determines the concerning certain specific issues or subjects of broader
prospects for its success. Country programming missions visit significance to the Bank’s strategic objectives and policies.
DMCs regularly to discuss topics of mutual interest with
Private Sector Development
ww Co

government officials and to select suitable projects for Bank


The Bank helps selected private enterprise to undertake
assistance. Since the levels of economic growth, as well as the
financially viable projects that have significant economic merit
priorities for development, vary from one DMC to another, the
and for which normal sources of commercial finance are not
Bank tries to select those projects that will contribute most
available. Bank support is provided directly to private
effectively to the economic and social development of the
enterprises and financial institutions through loans,
cu

country concerned, in conformity with the country and,


underwriting, investment in equity securities, cofinancing,
Bankwide strategies. Once it is confirmed that investment in the
investment advisory services and guarantees. The Bank’s private
project is justified, the Bank evaluates the project.
sector operations focus primarily on assistance to
In responding to requests from member governments for
1. Financial intermediaries involved in leasing, venture capital
Do

loans, the Bank assesses the technical arid economic viability,


financing, merchant banking, mutual funds, insurance,
social impact and financial soundness of projects and the way in
securitisation, credit enhancement and credit rating;
which the projects fir into the economic framework and
development priorities of the borrowing countries. Standards 2. Infrastructure projects such as in the power, water supply,
of accounting and project implementation are maintained. transport and telecommunications sectors, including build-
Most contracts are awarded on the’ basis of international own-operate/build-operate-transfer projects;
competitive bidding, local competitive bidding or international 3. In limited cases, industrial, agribusiness and other projects
shopping, as appropriate. Projects are analysed and executed with significant economic merit.
and, where appropriate, external consultants are hired to ensure
Cofinancing
that high standards of performance are achieved throughout
The Bank’s cofinancing and guarantee policy supports the
the life of the project.
Bank’s emphasis on resource mobilisation and catalytic
investment strategy. The basic objective of confinancing
operations is to help leverage the Bank’s resources and expand
the bank’s catalytic role in directing official and private financial

© Copy Right: Rai University


148 11.621.6
flows to its DMCs. The bank derives its confinancing funds Technical Assistance

MANAGEMENT OF FINANCIAL INSTITUTION


from The basic objective of the Bank is to maximise development
1. Official aid agencies impact not only in terms of lending volume but also through
technical assistance that is not directly related to lending. The
2. Export credit agencies and
emphasis is on support for various DMC programmes in terms
3. Market institutions. of policy reforms, fiscal strengthening, support for good
For every dollar lent by the Bank, an additional 49 cents have governance, capacity building, promotion of financial and
been mobilised by way of cofinancing. The Bank’s cofinancing capital markets, subregional economic cooperation,
operations include increasing emphasis on commercial environmental protection and natural resource management.
confinancing and the use of credit enhancements such as the Technical assistance activities are funded by the Bank through
Bank’s complementary cofinancing scheme, guarantees and grants, loans, or a combination of both.
related services.
Financial Policy
Financial Management The Bank was established primarily to perform the financial

al
Lending Policies intermediation role of transferring resources from global
The Bank is authorised to make, participate in, or guarantee markets to developing countries to promote socio-economic
loans to its DMCs or their governments or any of their development. The ultimate goal of the financial policy of the

i
Bank is to achieve effective financial intermediation. Its major

com Tr
agencies, public or private enterprises operating within such
countries, as well as to international or regional entitles elements include net income and reserves policy, liquidity policy,
concerned with economic development in the region. Loans are loan product and credit risk policy, borrowing policy and capital
approved by the Bank only for projects or programmes of high management policy.
development priority. The Bank provides financing to its Borrowings

rd. F
borrowers to cover foreign exchange expenditures and also The Bank has been an active borrower in world capital markets
finances local currency expenditures in certain cases. since 1969. Its borrowing programme is broadly determined by
Financial Resources
iza D
The financial resources of-the Bank consist of Ordinary Capital
Resources (OCR) comprising subscribed capital, reserves and
a number of factors, including the Bank’s lending operations,
cash flow requirements, its liquidity policy and its perception of
current and future market conditions. In the initial years of
dfw P
operations, the Bank’s capital was the major source of funds for
funds raised through borrowings; and special funds,
ordinary lending but since the early 1980s, Bank borrowings
comprising contributions made by member governments,
have accounted for a greater share than capital and reserves.
repayments from past loans and amounts previously set aside
w.p m

from paid-in capital. Loans from OCR lending operations are Liquidity Management
generally made to member governments which have attained a It is the policy of the Bank to maintain liquid assets amounting
somewhat higher level of economic development. Loans from to at least 40 per cent of the total of undisbursed balances of
the Asian Development Fund (ADF) are made on highly pool based loans at the end of the year. The main purpose of
ww Co

concessional terms and almost exclusively to DMCs with a low the liquidity policy is to ensure the uninterrupted availability of
per capita gross national product and limited debt-repayment funds to meet loan disbursements, debt servicing and other
capacity. expenditures. Investment of liquid assets is governed by the
Lending Windows Investment Authority approved by the board of directors.
cu

The Bank has three lending windows for OCR loans. These are Review Questions
1. The pool based multicurrency loan window where loan 1. What are the goals and function of World Bank, the IDA
disbursements are made in a variety of currencies of the and the IFC?
Bank’s choice; 2. How did Bretton woods agreement provide a stable
Do

2. The pool based single currency loan window in US dollars; monetary environment?
and 3. What does World Bank Do? What are its purposes?
3. The Market Based Loan (MBL) window which provides 4. What are the objectives of Asian Development Bank ?
single currency loans to private sector borrowers and to
5. How do inflation and interest rate determine the value of
financial intermediaries in the public sector.
currency?
The MBL window provides single currency loans in US, dollars,
Japanese yen, or Swiss francs to private sector borrowers and
government guaranteed financial intermediaries at current terms
prevailing in international financial markets. MBL borrowers
have the option of having the interest rates of their loans in
either fixed or floating rate terms. MBL lending to government
guaranteed financial intermediaries is limited to US $1 billion in
loan commitments.

© Copy Right: Rai University


11.621.6 149
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 34:
TUTORIAL-4

Tutorial on World Bank and IMF 2. The Bail –out package suggested by IMF for India in 1991
For any socialist or for that matter propounder of Swadeshi, included financial sector reforms and devaluation of rupee.
the very mention of IMF India adhered to the package and seemed to forgot the
( International Monetary fund) and world bank would bring causes for such a crisis. If(we hope it would not) a similar
out the images of a best feasting on a hapless and innocent crisis recurs, what would be the list of measures that may be
victim. The explanation would follow on how Indian was suggested by IMF today? In such a case does India have any
nearly ‘ duped’ in accepting the norms set by IMF that made it choice?

al
an easy ‘Prey’ for multinationals( red US government) to sell
out India.

i
The fears are probably over exaggerated, but not unfounded

com Tr
either. The packages suggested by the IMF and World Bank
were interpreted in some circles as a mere method of arm-
twisting by the west in accepting their norms and principles.
However, it cannot be forgotten how India was saved from a
near default in yester years, the 1991 bal out package being one

rd. F
of them. Nor can one afford to see the other side of the story
when the IMF comes forward to lend in an hour of crisis. The

iza D
advocates of free market would not let us forget that the
measures suggested for IMF, as far as India is concerned
worked , at least till the present. If the measures suggested by
dfw P
IMF or conditions set by World Bank seem like ‘feeding the
turkey before the feast’, is because of ignorance of working of a
free market economy, say the expert.
w.p m

Questions for Discussion


1. With full flowering of the international capital market,
intermediation between First World lenders and third World
ww Co

borrowers redundant. What is the role of these international


bodies in international intermediation and how does it end? 3. The main argument against IMF’s and World Bank’s
What are the sources and uses of funds for these financial existence is that the factors that caused these entities to be
intermediaries.? born are no longer in existence. Also, with improved crisis
management and rapidly changing domestic conditions,
cu

these entities need not exit. What are the main functions of
the world Bank? Do both the entities perform same
functions? How is it different from other entities such as the
Asian Development bank(ADB)
Do

© Copy Right: Rai University


150 11.621.6
MANAGEMENT OF FINANCIAL INSTITUTION
LESSON 35:
OFFSHORE BANKING

Learning Objectives The current laws in some countries, including the USA, allow
After reading this lesson, you will understand the government full access to anyones domestic financial
information for almost any reason at all. The act of creating a
• Introduction
foreign bank account helps make some of your assets harder to
• Purposes of offshore banking access by those who should be minding their own business. A
• Benefits of offshore banking good foreign bank will usually not require your Social Security
• Offshore banking locations number, they wont answer questions from US sources about

al
your credit and banking history, and they will not provide your
• Operational aspects of offshore banking
financial information to any domestic data collection agency.
• Advantages of offshore banking
An offshore account can also help you with wealth building.

i
Today we shall discuss offshore banking in detail. First, there are the tax advantages. Offshore accounts can be

com Tr
An Introduction to Offshore Banking arranged in jursdictions that do not impose taxes on income
Offshore banking can be explained as the carrying on of earned abroad. This can be very beneficial when arranged
banking and financial activities in an environment, which is correctly. There is also the ability to earn a higher return on your
essentially free of fiscal, and exchange controls i.e. tax havens or investments with an offshore account.

rd. F
low tax areas, commonly referred to as offshore finance centres. Many foreign banks are not as tightly regulated as domestic
These conditions normally would also include favourable ones and can offer higher interest rates on accounts. This is due

iza D
banking regulations or banking laws considerably less stringent
than those in most domestic jurisdictions.
“Offshore Banking” - maybe this term conjures up images of
to their ability to make more lucrative investments and also the
fact that the overhead to operate a bank is lower in many
countries.
dfw P
secret Swiss accounts, James Bond, and sipping Martinis at a Finally, the ability to expand your business globally increases
chalet in Lichtenstein. The fact is though that doing a portion when you create an additional bank account outside your own
of your banking in a financial institution outside of your borders. Many offshore banks allow you to do business and
national borders is not only easy, it also offers numerous
w.p m

hold your funds in multiple currencies. This allows expansion


benefits to those who make their living via the internet. Here we of your customer base which in return can help increase profits.
will also try to answer some of the most common questions
What Country Should You Bank in?
regarding offshore banking in the hopes of demystifying the
ww Co

Choosing the jurisdiction to do your offshore banking in will


topic for the benefit of our fellow internet marketers and others
depend on a combination of your business situation, asset
who make their income online.
planning goals and even to some extent your personal taste.
Is Offshore Banking Legal? There are several factors that should certainly be considered
This is among the first questions asked when discussing this when doing your initial reasearch though. Is the country your
cu

topic. The answer is YES. Many of the largest companies in the are considering a stable country? You usually do not want your
USA do their banking offshore including Exxon and Boeing, account in a country where coup detats are a regular occurrence.
among others. You do not need to be a giant corporation On the other hand, if the financial system is strong enough, it
though to reap the benefits of an offshore bank account as we will withstand even political turmoil as in Panama when Manuel
Do

will soon explain. Noreiga was forcibly removed by an outside government.


You may wonder why you dont see many ads for offshore Most of those with bank accounts and corporations in Panama
banking. If you live in the US, the reason is that federal law were not affected by this, since the financial system had a solid
denies international banks the right to advertise within the backbone. What are the country’s banking secrecy laws? There
borders of America. Of course this is to the benefit of are still several countries with strong banking secrecy laws who
domestic banks. Remember, you have just as much legal right will go all out to protect your financial privacy as long as you are
to a bank account offshore as you do to a domestic account. not breaking the law.
Why Bank Offshore? Switzerland and Panama come to mind immediately for not
For the internet marketer and any business that creates income bending to international pressure to allow outside government
online, there are several benefits to having an offshore bank agencies to peer into their customers accounts whenever they
account. These benefits encompass privacy, asset protection and want. How far away is the country? Some individuals prefer
wealth building. One concern that offshore banking helps deal their offshore accounts to be geographically close, since the time
with is privacy. zones are often similar and communication is a little more
convenient.

© Copy Right: Rai University


11.621.6 151
Americans might prefer their offshore accounts to be located in 6 Many other offshore banks are created by corporate groups
MANAGEMENT OF FINANCIAL INSTITUTION

the Carribean or Latin America, while a citizen of the U.K. to handle external borrowing or to consolidate intra-group
might prefer an account at an institution located on the Isle of finance or banking transactions. Corporations involved in
Man, all other considerations being equal. international trade may use an offshore bank as a foreign or
multi-currency management centre. Eurocurrency market
Accessing and Managing Your Money
underwriting are often raised through captive offshore banks
Thanks mainly to the internet and advances in international
or finance companies.
communication technology, offshore banking is fairly
straightforward. Most accounts can be arranged with online The activities of international finance companies also fall within
access to your information. the category of offshore banking. These activities may include
external loan raising, provision of confirming finance to clients
Transfers of funds can be done online as well. As far as
and group entities, discounting or factoring of intra-group and
accessing your money, most offshore banks will offer a debit
other debts, and tax effective intra-group loans.
card with your account so you can retrieve your money whenever
you want, wherever you are from most ATMs. As you can see, The leasing of equipment through an offshore based captive

al
accessing and managing your funds in an offshore account need finance company is another useful offshore banking concept.
not be any more difficult than doing the same with a domestic This activity may be for the purpose of providing vendor lease
account. finance to group customers or to fund group asset acquisitions.

com Tr
i
Acquiring an Offshore Bank Account Benefits of Offshore Banking
Once you decide that an offshore account is right for you and The benefits of offshore banking can accrue to the banking
you have done some further investigating to select the institution and its clients. Freedom from taxation and exchange
appropriate country to open your account in, the actual process controls are important reasons for the formation of an offshore
of acquiring the account can be relatively straightforward. bank and usually these will be of significant advantage and

rd. F
There are a number of legitimate offshore financial planning mutual benefit to both the offshore bank and its client.
and asset management firms who will complete and submit all A tax free or low tax environment will not only allow the

iza D
the paperwork for you for a reasonable fee. The advantage to
this is they usually have connections with the banks they
represent and can arrange your accounts more quickly and easily.
offshore bank to generate a better bottom-line but will also
provide it with a stable operating base by avoiding the vagaries
or contingencies of onshore fiscal policies. The earnings of the
dfw P
Also, they can often offer you added perks such as secured credit offshore bank from currency management, participation in
cards, merchant accounts and incorporation services. Be sure to syndicated loans, money market and securities dealings and
compare the fees charged and services offered and always get deposit-taking activities can be protected from the high rates of
w.p m

feedback from previous customers. Of course, be wary of any income taxes applicable in domestic banks or financial
offers that sound too good to be true, such as outfits offering institutions which may well be subject to interest withholding
unsecured credit cards with your offshore bank account. taxes imposed by the domestic fiscal authority. However, these
can usually be minimised by careful forward planning.
ww Co

This is almost impossible to arrange with a new account, and


anyone offering an unsecured credit card offshore may just be The absence of exchange controls will obviously enable the
planning on taking your money and disappearing. Otherwise, offshore bank to move funds with a greater degree of freedom
do your research, ask questions and check testimonials. Deal and flexibility than from within an exchange controlled area.
with a reputable firm and you will be well on your way to The offshore bank should benefit from this enhanced flexibility
cu

reaping the benefits of an offshore bank account. by being able to conclude transactions promptly, particularly in
volatile market conditions.
Offshore Banks are used for a Variety of Purposes.
The banking institution which offers offshore banking facilities
Frequently they may be formed as a subsidiary of a domestic or
to its clients should be able to increase its deposit base at a
international bank to:
Do

greater rate that its wholly domestic competitors, its clients will
1 Accept deposits outside the controlled environment. This is benefit by receiving their interest income free of any
an increasingly popular activity, particularly for foreign withholding tax and the lower tax base of the offshore bank
currency deposits. should enable it to be more competitive with its interest rates.
2 Book transactions which do not fall within the domestic If the client is also able to structure his own assets through an
jurisdiction such as large internationally syndicated loans offshore trust or investment holding company then his interest
particularly where the participating banks are located in income may also be free from tax in his domestic jurisdiction
various jurisdictions. and his deposits not subject to onshore exchange controls. The
3 Make loans which are tax effective to their clients. availability of banking secrecy in the offshore banking
environment may be a further benefit to the client.
4 Avoid onerous debt-equity ratios and lending restrictions
applicable in the more severely regulated jurisdictions in Corporate groups which establish offshore banks benefit in a
which they operate. variety of ways, including the tax advantages outlined above. In
general, the corporate group will aim to maximise interest
5 Provide their clients with banking secrecy.
deductions against profits in high-tax areas whilst protecting
group interest income from tax by accumulation in an offshore

© Copy Right: Rai University


152 11.621.6
environment The offshore bank is therefore a most effective Non-disclosure of client activities

MANAGEMENT OF FINANCIAL INSTITUTION


means of deploying accumulated group funds. Eurobond Obviously some of these benefits will not be required by all
issues and foreign currency loans are often raised through the offshore banks, particularly those, which are owned by
medium of an offshore bank to maximise the overall tax effect international banking groups.
by enabling the corporate group to disperse the funds as
The corporate legislation or the offshore banking centre is also
appropriate within the group. Fee income from intra-group
an important factor and should complement the banking laws.
confirming finance, discounts from debt factoring and interest
Preferably the corporate law should be consistent with that
derived from leasing or hire purchase transactions can be
adopted in jurisdictions in which the banking or corporate
protected from the high tax rates applicable in the onshore
group operates. Special factors, such as anonymity of
jurisdictions.
ownership, corporate secrecy provisions, transfer of corporate
By conducting its banking ordinance activities through an domicile and minimal reporting requirements may be attractive
offshore bank the corporate group will be able to carry out these for some offshore banks.
operations essentially without interference from domestic
Taxation

al
regulatory authorities. The absence of banking laws requiring
minimum debt-equity ratios, high capitalisation, and arm’s In order to obtain the benefits previously outlined the offshore
length rules as imposed by most onshore central monetary bank requires an operating environment which is tax free, has a

i
authorities, will undoubtedly be of benefit to the corporate low tax rate or provides concessional rates of tax to an offshore

com Tr
group. bank. Normally the former is preferred. The need for specific tax
factors will vary with the requirements of the offshore bank. In
The use of an offshore bank as the currency management centre
some instances it may be desirable to utilise double tax treaties.
of a corporate group will provide a flexible and fiscally effective
However, in many circumstances they will be of no benefit and
means of controlling foreign exchange exposure. Group
their exchange of information provisions may be detrimental to

rd. F
exchange gains or losses, whether realised or unrealised, can be
the activities of the offshore bank.
consolidated into one entity with resultant cost and
administration benefits Overall foreign exchange risk can be An offshore banking centre which does not impose interest

iza D
reduced and hedging or borrowing costs minimised. Exchange
gains, fees, discounts, and interest income can be treated on a
group basis in the most tax effective way. Centralisation of the
withholding taxes will normally be preferred by clients of the
offshore bank and will also be attractive to the offshore bank as
interest withholding taxes are often part of its funding costs.
dfw P
currency management function allows more direct involvement The absence of a dividend withholding tax will also be an
by the group treasurer and the offshore environment permits important consideration for the shareholders of the offshore
him greater flexibility. bank.
w.p m

Taxes other than income taxes must also be considered. Stamp


Offshore Banking Locations
duty on loan or mortgage documents, receipt taxes and stamp
The principal criteria in determining the location of an offshore
duty on securities transfers can be significant cost factors where
bank are:
ww Co

appropriate. Capital registration fees and business or banking


Legislation licence fees should be kept to a minimum.
All countries have legislation which regulates the carrying on of
Exchange Controls
banking activities within their respective jurisdictions and in
The flexible banking policies available under suitable offshore
some cases also extends their authority to the external activities
banking legislation will be severely restricted unless they are
cu

of domestic based banks. Locations which are suitable for


complemented by free movement of moneys. The offshore
offshore banking normally limit their primary regulations to
bank must be able to move its funds freely through the
control banking operations within the domestic sphere and
international banking network and the offshore banking centre
provide a more relaxed set of banking rules for activities
should provide direct access to that network.
Do

conducted with non-residents. Many offshore banking centres


have a dual licensing system with full licences for domestic Other Criteria
banking operations and restricted licences for offshore banks Various other factors should be considered in selecting a
which conduct their banking activities with non-resident location suitable for offshore banking. These include:
entities. Political and economic stability
The banking legislation of a suitable offshore banking centre Availability of banking and professional expertise
should permit:
Access to telecommunications
Low capitalisation without statutory minimum capital and
reserve requirements Operational Aspects of Offshore Banking

Loan raising without mandatory debt-equity ratios Formation


The procedures for incorporation of an offshore bank vary in
Unrestricted lending activities
each location. However, most of the more suitable jurisdictions
Complete foreign ownership of offshore banks the incorporation of an offshore bank is effected by the usual
Cash management without minimum liquidity rules English law registration system. An application for a permit to
Administration free from excessive reporting obligations incorporate must be lodged together with an application for an

© Copy Right: Rai University


11.621.6 153
offshore bank or financial institution licence. Licence What Makes Owning an Offshore Bank so Special...
MANAGEMENT OF FINANCIAL INSTITUTION

applications must be accompanied by the information specified Offshore banks operate on an offshore basis. Offshore banks
in the offshore bank guidelines. If the application satisfies the provide services only to non-residents of the jurisdiction where
guidelines then a licence will be issued promptly. Normally the such banks are established. For example a Belize-registered
application is a confidential document and may be subject to the offshore bank can provide services to clients from any country,
secrecy provisions of the relevant corporate legislation. except to permanent residents of Belize. This is the main
formal difference between offshore and onshore banks.
Banking Activities
Subject to the terms of its licence the offshore bank will be able What is more important is the environment in which offshore
to undertake any form of banking activity but the most banks operate. Offshore banks carry on banking and financial
common offshore banking operations include: activities in an environment which is free of fiscal and exchange
controls, i.e. tax havens or low tax areas, commonly referred to
Deposit taking
as offshore finance centers. These conditions normally also
Syndicated loans or Eurocurrency under writings include favorable banking legislation which is considerably less

al
Corporate loan raising strict than those in most onshore jurisdictions.
Intra-group lending Offshore banks can be controlled by residents of any country in
Foreign currency management most offshore banking jurisdictions. It is much easier to obtain

i
a banking license in an offshore location than in strictly

com Tr
Provision of confirming finance
controlled domestic jurisdictions. You can enhance your
Lease finance business structure and gain extra advantages compared to your
Debt factoring competitors by establishing an offshore bank.
Management The Purposes of Offshore Banks

rd. F
The management and administration of the offshore bank Offshore banks are used in many typical situations. Offshore
should not be conducted in the domestic jurisdictions of the banks are often established by already existing onshore banking

iza D
corporate group and care must be taken to ensure that offshore
deposit-taking activities do not breach domestic banking laws.
If too many of the management activities of the offshore bank
or financial institutions for the following reasons:
Access international credit market
Access international correspondent account networks
dfw P
are effected in the domestic locations the offshore bank may be
deemed to be carrying on business there through a branch, with Provide clients with tax effective loans
adverse consequences under both tax and banking legislation. Provide clients with actual banking secrecy
The management functions should therefore be carried out by
w.p m

Provide clients with other services that would be impossible in


the offshore bank. severely regulated onshore jurisdictions
The offshore bank can either employ its own permanent staff Provide Letters of Guarantee
and base them in the offshore location or in another suitable
ww Co

management location. Alternatively it can engage the services of Accept deposits outside the controlled environment
a local trust company or professional management firm who Avoid strict debt-equity ratios and lending restrictions imposed
would work closely with the management of the corporate by more severely regulated onshore jurisdictions
group. Avoid huge minimum capital requirements imposed by more
severely regulated onshore jurisdictions
cu

Most offshore banks choose the latter alternative which keeps


management on an arm’s length basis. It should also be Operate in the securities market without limitations
remembered that the appointment of local management in the By-pass intermediaries while carrying out certain financial
offshore location will avoid potential complications with tax operations
Do

and banking authorities in the domestic jurisdictions.


Minimize political risk (that could be higher in some East
THE GLOBAL SOLUTIONS GROUP INC., provides a full European countries for example)
range of offshore bank management services and manages a
number of international offshore banks, and has many years Enhance group’s image
experience of selecting the most suitable offshore banking Offshore banks are established not only by banking or financial
jurisdiction for it’s clients. institutions, but also by corporate groups to handle external
THE GLOBAL SOLUTIONS GROUP INC., has several ready borrowing or to consolidate the group’s financial or banking
made Licensed Offshore Banks & Financial Companies available transactions. For example, when your company is involved in
for immediate purchase and delivery. Clients wishing to international trade and financial resources are handled through
establish or purchase an offshore bank are invited to contact our an outside bank, it may seem quite reasonable to establish your
offices where they will receive prompt and personal attention own offshore bank. You may well want to use an offshore
from an experienced staff. bank as a foreign or multi-currency management center.
Frequently large, and very often, medium sized, companies have
their own offshore banks, which handle their liquid assets and
current accounts of their branches. Thus, if a group of your
companies requires banking services, it really makes sense to

© Copy Right: Rai University


154 11.621.6
establish your very own offshore bank as you can conduct all More Competitive Interest Rates

MANAGEMENT OF FINANCIAL INSTITUTION


your transactions with regular clients or suppliers, provide An offshore bank is able to increase its deposit base at a greater
Letters of Credit, etc. through your own bank. The activities of rate than its wholly onshore competitors. Its clients will benefit
international finance companies also fall within the category of by receiving their interest income free of any withholding tax
offshore banking. These activities may include external loan and the lower tax base of the offshore bank should enable it to
raising, provision of confirming finance to clients and group be more competitive with its interest rates. If the client is also
entities, discounting or factoring of the group and other debts, able to structure his own assets through an offshore trust or
and tax effective corporate group’s loans. The leasing of investment holding company then his interest income may also
equipment through an offshore based captive finance company be free from tax in his domestic jurisdiction and his deposits
is another useful offshore banking concept. This activity may be not subject to onshore exchange controls.
for the purpose of providing vendor lease finance to group
Maximum Confidentiality
customers or to fund group asset acquisitions.
Offshore banks provide the highest level of confidentiality.
However, offshore banks are established also to satisfy the There are some cases, when an anonymous offshore company

al
needs of small groups or even one person. Offshore banking opens an anonymous account in an anonymous offshore bank.
is traditionally oriented towards fulfilling the needs of the This way, triple-layered protection of confidential commercial
wealthy. information is achieved. Nominee owners and directors are

i
Advantages often assigned to ensure anonymity.

com Tr
The advantages of offshore banks are two-dimensional. Both - Small Amount of Required Equity Capital
the banking institution and its clients - benefit from the In offshore banking jurisdictions, it is significantly lower than in
advantages of an offshore bank. the onshore locations of the world. For the majority of
Low Tax or Tax Free Environment businessmen it is the only opportunity to establish a foreign

rd. F
Offshore banks are either tax exempt or taxes are reduced to commercial bank, since other possibilities are unacceptable due
several per cent of the amount of the profit. This enables an to the requirement of high capital, personnel, reputation and

iza D
offshore bank not only to generate a better bottom-line but will
also provide it with a stable operating base by avoiding the
vagaries or contingencies of onshore fiscal policies. No taxes are
business-planning of the bank. It is no secret that by
establishing an offshore bank large companies and banks can
keep their expenses low and business opportunities are
dfw P
levied at the source of income, e.g. on bank interest, dividends boosted.
and other similar payments. Expenses are limited to No Reserve Requirements and Liberal Bank Control
administrative expenditures and annual dues necessary to renew There are no requirements, or they are minimal, on required
an off-shore status. The earnings of the offshore bank from
w.p m

reserves, capital structure, liquidity of funds, compulsory


currency management, participation in syndicated loans, money deposit insurance, etc. Auditors’ and local agencies’ control is
market and securities dealings and deposit-taking activities can very moderate. Offshore banks are operated via management
be protected from the high rates of income taxes applicable in companies and other banks on special agreement basis.
ww Co

domestic banks or financial institutions which may well be


subject to interest withholding taxes imposed by the domestic Effective Currency Management.
fiscal authority. No taxes are levied at the source of income, e.g. The use of an offshore bank as the currency management center
on bank interest, dividends and other similar payments. of a corporate group will provide a flexible and fiscally effective
Expenses are limited to administrative expenditures and annual means of controlling foreign exchange exposure. Group
cu

fees necessary to renew an offshore status. exchange gains or losses, whether realized or unrealized, can be
consolidated into one entity with resultant cost and
No Exchange Control administration benefits. Overall foreign exchange risk can be
The absence of exchange control will obviously enable the reduced and hedging or borrowing costs minimized. Exchange
Do

offshore bank to move funds with a greater degree of freedom gains, fees, discounts, and interest income can be treated on a
and flexibility than from within an exchange controlled area. group basis in the most tax effective way. Centralization of the
The offshore bank should benefit from this enhanced flexibility currency management function allows more direct involvement
by being able to conclude transactions promptly, particularly in by the group treasurer and the offshore environment permits
volatile market conditions. him greater flexibility.
Less Strict License Requirements Enormous Business Opportunities
The license requirements for offshore banks are simplified to a Eurobond issues and foreign currency loans are often raised
large extent and quite a lot of applicants are eligible for such a through the medium of an offshore bank to maximize the
license. Unlike the majority of the countries throughout the overall tax effect by enabling the corporate group to disperse the
world, a foreign applicant does not have to be a “world class funds as appropriate within the group. Free income from the
bank” to get a banking license in an offshore jurisdiction. Such group’s confirming finance, discounts from debt factoring and
a license could be issued to a small bank, financial institution, interest derived from leasing or hire purchase transactions can be
trading company or even an individual. protected from the high tax rates applicable in the onshore
jurisdictions. By conducting its banking ordinance activities
through an offshore bank the corporate group will be able to

© Copy Right: Rai University


11.621.6 155
carry out these operations essentially without interference from Obviously some of these advantages will not be required by all
MANAGEMENT OF FINANCIAL INSTITUTION

domestic regulatory authorities. offshore banks, particularly those which are owned by
In general, the corporate group will aim to maximize interest international banking groups.
deductions against profits in high-tax areas whilst protecting The corporate legislation or the offshore banking center is also
group interest income from tax by accumulation in an offshore an important factor and should complement the banking laws.
environment. The offshore bank is therefore a most effective Preferably the corporate law should be consistent with that
means of deploying accumulated group funds. adopted in jurisdictions in which the banking or corporate
group operates. Special factors, such as anonymity of
Choosing the Right Jurisdiction
ownership, corporate secrecy provisions, transfer of corporate
The main in determining the location of an offshore bank are:
domicile and minimal reporting requirements may be attractive
Taxation for some offshore banks.
In order to obtain the benefits previously outlined the offshore
bank requires an operating environment which is tax free, has a Exchange Controls
The flexible banking policies available under suitable offshore

al
low tax rate or provides concessional rates of tax to an offshore
bank. Normally the former is preferred. The need for specific banking legislation will be severely restricted unless they are
tax factors will vary with the requirements of the offshore bank. complemented by free movement of funds. The offshore bank
must be able to move its funds freely through the international

i
In some instances it may be desirable to utilize double tax
banking network and the offshore banking center should

com Tr
treaties. However, in many circumstances they will be of no
benefit and their exchange of information provisions may be provide direct access to that network.
detrimental to the activities of the offshore bank. An offshore Other Criteria
banking center which does not impose interest withholding Various other factors should be considered in selecting a
taxes will normally be preferred by clients of the offshore bank location suitable for offshore banking. These include:

rd. F
and will also be attractive to the offshore bank as interest Political and economic stability;
withholding taxes are often part of its funding costs. The
Availability of banking and professional expertise;

iza D
absence of a dividend withholding tax will also be an important
consideration for the shareholders of the offshore bank. Taxes
other than income taxes must also be considered. Stamp duty
Access to telecommunications.
Operational Aspects
dfw P
on loan or mortgage documents, receipt taxes and stamp duty
Banking Activities
on securities transfers can be significant cost factors where
appropriate. Subject to the terms of its license the offshore bank will be able
to undertake any form of banking activity but the most
w.p m

Capital registration fees and business or banking license fees


common offshore banking operations include:
should be kept to a minimum.
Deposit taking
Legislation.
Syndicated loans or Eurocurrency under writings
ww Co

All countries have legislation which regulates the carrying on of


banking activities within their respective jurisdictions and in Corporate loan raising
some cases also extends their authority to the external activities Intra-group lending
of domestic based banks. Locations which are suitable for Foreign currency management
offshore banking normally limit their primary regulations to
cu

Provision of confirming finance


control banking operations within the domestic sphere and
provide a more relaxed set of banking rules for activities Lease finance
conducted with non-residents. Many offshore banking centers Debt factoring
have a dual licensing system with full licenses for domestic In other words, an offshore bank can carry out all usual banking
Do

banking operations and restricted licenses for offshore banks operations of an ordinary onshore bank. However, in some
which conduct their banking activities with non-resident jurisdictions an offshore banking license is issued on a special
entities. condition that the bank may accept deposits from only a limited
The banking legislation of a suitable offshore banking center circle of clients. Usually these are the bank’s share-holders or
should permit: persons mentioned in the bank’s charter or license. Such a
Low capitalization without statutory minimum capital and license is defined as “limited”. In this case the bank may have a
reserve requirements; limited number of clients. Sometimes, an off-shore bank may
begin its activities with “limited” operations and widen the
Loan raising without mandatory debt-equity ratios;
spectrum of its services by acquiring a less regulated license in
Unrestricted lending activities; the future.
Complete foreign ownership of offshore banks; Foundation documents of an offshore bank usually provide
Cash management without minimum liquidity rules; for trust operations. The bank functions as a trustee and
Administration free from excessive reporting obligations; manages the clients’ securities portfolios. Investment
portfolios may include not only financial resources but also
Non-disclosure of client activities.

© Copy Right: Rai University


156 11.621.6
precious metals and other assets. Clients are serviced on a trust The offshore bank can either employ its own permanent staff

MANAGEMENT OF FINANCIAL INSTITUTION


contract basis. and base them in the offshore location or in another suitable
The following structures are often used: combinations of an management location. Alternatively it can engage the services of
offshore bank and an offshore investment fund, or offshore a local trust company or professional management firm who
bank and an insurance company. Business activities of would work closely with the management of the corporate
commercial banks are becoming more and more international group.
and trust operations constitute a large part of these activities. Most offshore banks choose the latter alternative which keeps
management on an arm’s length basis. It should also be
Formation
remembered that the appointment of local management in the
The procedures for incorporation of an offshore bank vary in
offshore location will avoid potential complications with tax
each location. However, most of the more suitable
and banking authorities in the domestic jurisdictions.
jurisdictions the incorporation of an offshore bank is effected
by the usual English law registration system. An application for Questions to Discuss:
a permit to incorporate must be lodged together with an 1. What do you understand by offshore banking?

al
application for an offshore bank or financial institution license.
2. What are the purposes of offshore banking?
License applications must be accompanied by the information
specified in the offshore bank guidelines. If the application 3. What are the benefits of offshore banking?

i
satisfies the guidelines then a license will be issued promptly. 4. Discuss offshore banking locations.

com Tr
Normally the application is a confidential document and may be 5. Discuss operational aspects of offshore banking.
subject to the secrecy provisions of the relevant corporate
6. What are the advantages of offshore banking?
legislation.
Banks with a solid international standing get preferential Notes:

rd. F
treatment and certainly can obtain offshore banking licenses in
any jurisdiction in the world. However, Eastern European

iza D
banks for example, even the largest ones, could face some
difficulties. It’s much easier for them to obtain a limited
offshore banking license. Not only large but medium or small
dfw P
sized banks, non-banking companies and even individuals are
eligible for an offshore banking license in more liberal
jurisdictions like Nauru and Vanuatu in the South Pacific.
Usually recommendations from other banks, as well as lawyers
w.p m

and auditors are required to register an offshore bank. Proof of


the applicants’ solvency and, in some cases, business plan of
proposed offshore bank is required.
ww Co

An off-shore bank must have a registered office, minimum


number of Directors and shareholders. A Registered Agent is a
must in all offshore banking locations. Management and the
accounting department are usually located in the place of the
owners’ domicile. In some offshore banking locations the
cu

management of the offshore bank must actually be located


within the jurisdiction.
Management
Do

Business activities of an off-shore bank are often conducted via


its representations (registered or non-registered) around the
world, through which business partners and clients can be
contacted. The management and administration of the
offshore bank should not be conducted in the domestic
jurisdictions of the corporate group and care must be taken to
ensure that offshore deposit-taking activities do not breach
domestic banking laws. If too many of the management
activities of the offshore bank are effected in the domestic
locations the offshore bank may be deemed to be carrying on
business there through a branch, with adverse consequences
under both tax and banking legislation. The management
functions should therefore be carried out by the offshore bank.

© Copy Right: Rai University


11.621.6 157
MANAGEMENT OF FINANCIAL INSTITUTION

LESSON 36:
E-BANKING

Learning Objectives Common E-Banking Services


After reading this lesson, you will understand 1. Internet Banking
• Definition of e-banking 2. Electronic Bill Payment
• Internet banking 3. Online Brokerages
• Electronic bill payment 4. Online Delivery of Financial Products like Mortgages
• Online brokerage Internet Banking

al
• Online delivery of financial products Two distinct trends can be discerned in the realm of Internet
• E-banking components Banking. On one hand, Banks and Financial Institutions are
trying to enter into new areas and consolidate their hold on the

i
• E-banking support services

com Tr
entire financial sector. On the other hand, new Dot Coms are
• Security challenges in e-banking entering the financing business and challenging the banks. It
Definition of E-banking could be said that two opposite things are happening at the
E-banking is defined as the automated delivery of new and same time. The banks, via their consolidation moves are trying
traditional banking products and services directly to customers to preserve their strongholds, while the Dot Coms are trying to

rd. F
through electronic, interactive communication channels. E- fragment the market by providing superior services. Banks and
banking includes the systems that enable financial institution Financial Institutions are trying to leverage their Brands and

iza D
customers, individuals or businesses, to access accounts, transact
business, or obtain information on financial products and
services through a public or private network, including the
their position in the industry. While, the Dot Coms are using
their competency in superior service design and experience of
competing in this highly unstable environment. All the players
dfw P
Internet. Customers access e-banking services using an share the same objectives: acquiring customers, providing them
intelligent electronic device, such as a personal computer (PC), with new financial information, services, and products, and
personal digital assistant (PDA), automated teller machine doing so in a way that enhances the value proposition of their
(ATM), kiosk, or Touch Tone telephone. While the risks and products and services.
w.p m

controls are similar for the various e-banking access channels, Internet Banking allows the Banks (and other Financial Service
this booklet focuses specifically on Internet-based services due providers) to overcome the tradeoff between content and reach.
to the Internet’s widely accessible public network. Accordingly, With the use of Internet, banks can provide their services to a
ww Co

this booklet begins with a discussion of the two primary types much wider audience then they could do without it. Even
of Internet websites: informational and transactional. before the coming of Internet, competition had shifted from
Introduction products to services. This was due, in large part, to the advent
Internet has touched almost all aspects of our lives. The of Private Sector Banks.
cu

emergence of e-commerce has revolutionized the way we live, Before the entry of these banks, the retail banking was more of
shop, entertain and interact. Therefore, it should not come as a a commodity with hardly any differentiation on the basis of
surprise if it tries to influence the way we save and the way we products or services. Banks offered similar products and similar
invest. service. But the new private sector banks changed the scenario
Do

Today, when the customer is king and the service providers are by differentiating on the basis of service. They started providing
rushing to pay obeisance to the king, financial service providers Telephone based banking and introduced the concept of home
cannot be left behind. In their quest to differentiate their banking. The superior service being provided by these banks
services and gain competitive advantage over their competitors, was the main reason for their rapid growth. But their reach was
the financial service providers are trying to provide their services limited due to logistics of setting up branches and increasing
to the customers in the comfort of their homes. The Internet the reach of their service. Any attempt to increase the branch
has emerged as a convenient channel for these service providers. network would have increased their overheads and any attempt
to widen the areas being served by a branch was likely to lead to
Living in India, we might find these ideas too far fetched but deterioration in the service levels. In other words, these banks
the truth is that Internet has changed the way these services are were caught in a dilemma as they faced the Reach and content
delivered, particularly in countries where the Internet tradeoff. With the advent of Internet these banks have been
penetration is high. The different ways in which Internet is able to overcome this tradeoff.
trying to revolutionize the delivery of the financial services and
products are given below: - By using the Internet, these banks can expand their reach as well
as maintain the standards of their services.

© Copy Right: Rai University


158 11.621.6
Electronic Bill Payment The Banks have entered the e-trading business. Since many

MANAGEMENT OF FINANCIAL INSTITUTION


From the point of view of Banks, Electronic Bill Payment banks are also Depositary participants, they have tied up with e-
(EBP) represents something of a threat, in that it could lead to traders so that a customer is able to buy or sell shares online
customer attrition and reduce revenue. Among other revenue and make and receive payments through the Net.
streams, the following sources of funds for the banks could be In India, HDFC Bank has tied up with Investsmart.com and is
affected: offering its services to all the clients of the brokerage. ICICI
• Float associated with processing in the physical form, Bank has gone a step ahead and launched ICICIDirect.com.
• Cash Management Services These banks have become exclusive providers of banking and
depositary/custodial services to the clients of these online
The Banks can protect itself by providing this service to their
brokerages.
customers. But EBP also has an important strategic dimension,
as it can become an integral part of a bank’s portfolio of Online Delivery of Financial Products
services. EBP can attract customers to the bank by making The Banks have started offering banking services like checking
transactions more efficient and enabling customers to access your account status fund transfer, ordering demand drafts and

al
their financial information more easily. Moreover, online writing out cheques, via the net. Soon these will form only a
interactions allow use of such tools as e-CRM to create a more small part of the total array of services being offered by them.
intimate relationship with the customer and promote and These Banks have embarked on a number of new initiatives to

i
deliver other online products and services. protect their stronghold and to leverage the net. They are

com Tr
If the Banks do not establish control on EBP, they are likely to offering value-added services to their customers and at the same
loose customers to the new providers of financial services, thus time are trying to get into B2C and B2B e-commerce. They are
affecting other sources of revenue. even trying to get their finger into various transactions between
the Government on one side and the business and the
In India, HDFC Bank, ICICI Bank and Citibank are trying

rd. F
customer on the other. Banks are trying to become a part of the
setup an EBP portal. ICICI has already started a portal called
online value chain. For example, they are trying to tie up with
BillJunction.com. Banks are planning to use the Net for
corporates so as to become a part of their supply chain and

iza D
payment of utility bills. They are entering into tie-ups with
utilities like MTNL, Airtel, Orange, and BPL Mobile etc. Right
now, a customer who’s received a bill in the physical form logs
enable electronic transfer of funds between the different
components of the Supply Chain. They are doing this by acting
dfw P
as an intermediary between the corporations and their vendors
into the network in order to make an online payment. In the
by enabling online transactions at one place.
future, these bills will be sent to customers through the Net.
Some Banks are trying to setup portals for routing payments
Consumers and Businesses can derive economic benefit on
like Excise Duty and Sales Tax. Not content with that Banks are
w.p m

account of reduction in transaction costs and a reduction in the


setting up secure payment gateways to tap the B2C online
float resulting from physical processing of the Bills. In
market.
addition, many are likely to adopt it mainly for the convenience.
Banks have taken the application process for personal loans, car
ww Co

They can pay bills electronically in the same way they do today,
but by consolidating their bills, they can reduce the effort loans, and mortgage, online. They plan to offer other financial
involved in the whole process. They can also access their account products like Bonds and Mutual Funds through their financial
at the same time. They can conveniently access all billers from a service portal. This strategy is aimed by pre-empting the entry
single portal that also provides them banking facilities. This of new startups into this business.
cu

would enable them to view their account balance while paying Another bit of the Net strategy, involves providing
bills. For portals or the intermediaries that consolidate bills infrastructure for B2C as well as B2B e-commerce. Banks are
from multiple billers at a single online location EBP is a tool to setting up secure payment gateways that will allow online retail
acquire customers and provide them other financial services also. shops to obtain instant credit card verifications. Once the buyer
Do

Dominance of the EBP market can lead to an entry into other hits the pay button at a B2C portal, the buyer’s credit card details
financial services markets such as credit or debit card payments, will get encrypted and travel securely to the Visa or MasterCard
or indeed into a much broader range of e-commerce markets, approval system through the bank’s payment gateway.
such as payments gateways. The banks are also setting up their own shopping portals.
Online Brokerage HDFC has a stake in a portal called easy2buy.com where HDFC
Online Broking is emerging as another field where traditional bank customers can buy using their bank account number.
service providers are likely to face tough competition from the Federal Bank has similar arrangements with Rediff.com and
Dot Coms. In Taiwan and Korea, 30% of the stock trading has Fabmart.com. ICICI has setup Magiccart.com, an e-tailing site.
already moved online. This is posing a threat to the traditional At the B2B end, Banks are offering Net Banking service that
Full-Service Brokerages. By leveraging the power of the web, allows electronic fund transfers among a company, its vendors
Charles Schwab has emerged as a major threat to Full-Service and dealers. Another service being targeted at this segment is
brokers like Merrill Lynch. In order to preempt the moves into cash management. This will reduce the float, which is present in
these areas by new players, many Banks have already tied up physical processing of the payments.
with Online Brokerages.

© Copy Right: Rai University


11.621.6 159
The Banks are also trying to integrate their systems with the Website design and hosting,
MANAGEMENT OF FINANCIAL INSTITUTION

ERP/Supply Chain system of their clients. This will enable the Firewall configuration and management,
bank to benefit from the movement towards e-procurement.
Intrusion detection system or IDS (network and host-based),
E-Procurement involves making transactions online and
processing the payment electronically. Network administration,
Security management,
Security Controls for Safeguarding Customer
Internet banking server,
Information;
Authentication processes necessary to initially verify the identity E-commerce applications (e.g., bill payment, lending,
of new customers and authenticate existing customers who brokerage),
access e-banking services; Internal network servers,
Liability for unauthorized transactions; Core processing system,
Losses from fraud if the institution fails to verify the identity Programming support, and

al
of individuals or businesses applying for new accounts or credit Automated decision support systems.
on-line;
These components work together to deliver e-banking services.
Possible violations of laws or regulations pertaining to Each component represents a control point to consider.

i
consumer privacy, anti-money laundering, anti-terrorism, or the

com Tr
Through a combination of internal and outsourced solutions,
content, timing, or delivery of required consumer disclosures;
management has many alternatives when determining the
and
overall system configuration for the various components of an
Negative public perception, customer dissatisfaction, and e-banking system. However, for the sake of simplicity, this
potential liability resulting from failure to process third-party booklet presents only two basic variations. First, one or more

rd. F
payments as directed or within specified time frames, lack of technology service providers can host the e-banking application
availability of on-line services, or unauthorized access to and numerous network components as illustrated in the

storage.
E-banking Components
iza D
confidential customer information during transmission or following diagram. In this configuration, the institution’s
service provider hosts the institution’s website, Internet
banking server, firewall, and intrusion detection system. While
dfw P
the institution does not have to manage the daily
E-banking systems can vary significantly in their configuration
administration of these component systems, its management
depending on a number of factors. Financial institutions
and board remain responsible for the content, performance, and
should choose their e-banking system configuration, including
security of the e-banking system.
w.p m

outsourcing relationships, based on four factors:


1 Strategic objectives for e-banking; E-banking Support Services
In addition to traditional banking products and services,
2 Scope, scale, and complexity of equipment, systems, and
ww Co

financial institutions can provide a variety of services that have


activities;
been designed or adapted to support e-commerce. Management
3 Technology expertise; and should understand these services and the risks they pose to the
4 Security and internal control requirements. institution. This section discusses some of the most common
Financial institutions may choose to support their e-banking support services: weblinking, account aggregation, electronic
cu

services internally. Alternatively, financial institutions can authentication, website hosting, payments for e-commerce, and
outsource any aspect of their e-banking systems to third parties. wireless banking activities.
The following entities could provide or host (i.e., allow Weblinking
applications to reside on their servers) e-banking-related services A large number of financial institutions maintain sites on the
Do

for financial institutions: World Wide Web. Some websites are strictly informational,
Another financial institution, while others also offer customers the ability to perform financial
Internet service provider, transactions, such as paying bills or transferring funds between
accounts.
Internet banking software vendor or processor,
Virtually every website contains “weblinks.” A weblink is a
Core banking vendor or processor, word, phrase, or image on a webpage that contains coding that
Managed security service provider, will transport the viewer to a different part of the website or a
Bill payment provider, completely different website by just clicking the mouse. While
Credit bureau, and weblinks are a convenient and accepted tool in website design,
their use can present certain risks. Generally, the primary risk
Credit scoring company. posed by weblinking is that viewers can become confused about
E-banking systems rely on a number of common components whose website they are viewing and who is responsible for the
or processes. The following list includes many of the potential information, products, and services available through that
components and processes seen in a typical institution: website. There are a variety of risk management techniques
institutions should consider using to mitigate these risks. These

© Copy Right: Rai University


160 11.621.6
risk management techniques are for those institutions that Biometric identifiers.

MANAGEMENT OF FINANCIAL INSTITUTION


develop and maintain their own websites, as well as institutions The authentication methods listed above vary in the level of
that use third-party service providers for this function. The security and reliability they provide and in the cost and
agencies have issued guidance on weblinking that provides complexity of their underlying infrastructures. As such, the
details on risks and risk management techniques financial choice of which technique(s) to use should be commensurate
institutions should consider. with the risks in the products and services for which they
Account Aggregation control access. Additional information on customer
Account aggregation is a service that gathers information from authentication techniques can be found in this booklet under
many websites, presents that information to the customer in a the heading “Authenticating E-Banking Customers.”
consolidated format, and, in some cases, may allow the The Electronic Signatures in Global and National Commerce
customer to initiate activity on the aggregated accounts. The (E-Sign) Act establishes some uniform federal rules concerning
information gathered or aggregated can range from publicly the legal status of electronic signatures and records in
available information to personal account information (e.g., commercial and consumer transactions so as to provide more

al
credit card, brokerage, and banking data). Aggregation services legal certainty and promote the growth of electronic commerce.
can improve customer convenience by avoiding multiple log-ins The development of secure digital signatures continues to
and providing access to tools that help customers analyze and evolve with some financial institutions either acting as the

i
manage their various account portfolios. Some aggregators use certification authority for digital signatures or providing

com Tr
the customer-provided user IDs and passwords to sign in as repository services for digital certificates.
the customer. Once the customer’s account is accessed, the
Website Hosting
aggregator copies the personal account information from the
Some financial institutions host websites for both themselves
website for representation on the aggregator’s site (i.e., “screen
as well as for other businesses. Financial institutions that host a
scraping”). Other aggregators use direct data-feed arrangements

rd. F
business customer’s website usually store, or arrange for the
with website operators or other firms to obtain the customer’s
storage of, the electronic files that make up the website. These
information. Generally, direct data feeds are thought to provide

scraping. iza D
greater legal protection to the aggregator than does screen
files are stored on one or more servers that may be located on
the hosting financial institution’s premises. Website hosting
services require strong skills in networking, security, and
dfw P
Financial institutions are involved in account aggregation both programming. The technology and software change rapidly.
as aggregators and as aggregation targets. Risk management Institutions developing websites should monitor the need to
issues examiners should consider when reviewing aggregation adopt new interoperability standards and protocols such as
services include: Extensible Mark-Up Language (XML) to facilitate data exchange
w.p m

Protection of customer passwords and user IDs – both those among the diverse population of Internet users.
used to access the institution’s aggregation services and those Risk issues examiners should consider when reviewing website
the aggregator uses to retrieve customer information from hosting services include damage to reputation, loss of
ww Co

aggregated third parties – to assure the confidentiality of customers, or potential liability resulting from:
customer information and to prevent unauthorized activity,
Downtime (i.e., times when website is not available) or inability
Disclosure of potential customer liability if customers share to meet service levels specified in the contract,
their authentication information (i.e., IDs and passwords) with
Inaccurate website content (e.g., products, pricing) resulting
third parties, and
cu

from actions of the institution’s staff or unauthorized changes


Assurance of the accuracy and completeness of information by third parties (e.g., hackers),
retrieved from the aggregated parties’ sites, including required
Unauthorized disclosure of confidential information stemming
disclosures
from security breaches, and
Do

Additional information regarding management of risks in


Damage to computer systems of website visitors due to
aggregation services can be found in appendix D.
malicious code (e.g., virus, worm, active content) spread
Electronic Authentication through institution-hosted sites.
Verifying the identities of customers and authorizing e-banking
Payments for E-commerce
activities are integral parts of e-banking financial services. Since
Many businesses accept various forms of electronic payments
traditional paper-based and in-person identity authentication
for their products and services. Financial institutions play an
methods reduce the speed and efficiency of electronic
important role in electronic payment systems by creating and
transactions, financial institutions have adopted alternative
distributing a variety of electronic payment instruments,
authentication methods, including:
accepting a similar variety of instruments, processing those
Passwords and personal identification numbers (PINs), payments, and participating in clearing and settlement systems.
Digital certificates using a public key infrastructure (PKI), However, increasingly, financial institutions are competing with
Microchip-based devices such as smart cards or other types of third parties to provide support services for e-commerce
tokens, payment systems. Among the electronic payments mechanisms
that financial institutions provide for e-commerce are
Database comparisons (e.g., fraud-screening applications), and

© Copy Right: Rai University


11.621.6 161
automated clearing house (ACH) debits and credits through the Gain independent audit assurance over the bill payment
MANAGEMENT OF FINANCIAL INSTITUTION

Internet, electronic bill payment and presentment, electronic provider’s processing controls.
checks, e-mail money, and electronic credit card payments. Restrict employees’ administrative access to ensure that the
Additional information on payments systems can be found in internal controls limiting their capabilities to originate, modify,
other sections of the IT Handbook. or delete bill payment transactions are at least as strong as those
Most financial institutions permit intrabank transfers between a applicable to the underlying retail payment system ultimately
customer’s accounts as part of their basic transactional e- transmitting the transaction.
banking services. However, third-party transfers – with their Restrict by vendor contract and identify the use of any
heightened risk for fraud – often require additional security subcontractors associated with the bill payment application to
safeguards in the form of additional authentication and ensure adequate oversight of underlying bill payment system
payment confirmation. performance and availability.
Bill Payment and Presentment Evaluate the adequacy of authentication methods given the
Bill payment services permit customers to electronically instruct higher risk associated with funds transfer capabilities rather than

al
their financial institution to transfer funds to a business’s with basic account access.
account at some future specified date. Customers can make Consider the additional guidance contained in the IT
payments on a one-time or recurring basis, with fees typically

i
Handbook’s “Information Security,” “Retail Payment Systems,”
assessed as a “per item” or monthly charge. In response to the

com Tr
and “Outsourcing Technology Services” booklets.
customer’s electronic payment instructions, the financial
Financial institutions that use third-party software to host a bill
institution (or its bill payment provider) generates an electronic
payment application internally.
transaction – usually an automated clearinghouse (ACH) credit
– or mails a paper check to the business on the customer’s Determine the extent of any independent assessments or

rd. F
behalf. To allow for the possibility of a paper-based transfer, certification of the security of application source code.
financial institutions typically advise customers to make Ensure software is adequately tested prior to installation on the
payments effective 3–7 days before the bill’s due date. live system.

iza D
Internet-based cash management is the commercial version of
retail bill payment. Business customers use the system to
Ensure vendor access for software maintenance is controlled
and monitored.
dfw P
initiate third-party payments or to transfer money between Financial institutions that develop, maintain, and host their
company accounts. Cash management services also include own bill payment system.
minimum balance maintenance, recurring transfers between
Financial institutions can offer bill payment as a stand-alone
accounts and on-line account reconciliation. Businesses typically
w.p m

service or in combination with bill presentment. Bill


require stronger controls, including the ability to administer
presentment arrangements permit a business to submit a
security and transaction controls among several users within the
customer’s bill in electronic form to the customer’s financial
business.
ww Co

institution. Customers can view their bills by clicking on links


This booklet discusses the front-end controls related to the on their account’s e-banking screen or menu. After viewing a
initiation, storage, and transmission of bill payment bill, the customer can initiate bill payment instructions or elect
transactions prior to their entry into the industry’s retail to pay the bill through a different payment channel.
payment systems (e.g., ACH, check processing, etc.). The IT
In addition, some businesses have begun offering electronic bill
cu

Handbook’s “Retail Payments Systems Booklet” provides


presentment directly from their own websites rather than
additional information regarding the various electronic
through links on the e-banking screens of a financial
transactions that comprise the back end for bill payment
institution. Under such arrangements, customers can log on to
processing. The extent of front-end operating controls directly
the business’s website to view their periodic bills. Then, if so
under the financial institution’s control varies with the system
Do

desired, they can electronically authorize the business to “take”


configuration. Some examples of typical configurations are
the payment from their account. The payment then occurs as an
listed below in order of increasing complexity, along with
ACH debit originated by the business’s financial institution as
potential control considerations.
compared to the ACH credit originated by the customer’s
Financial institutions that do not provide bill payment services, financial institution in the bill payment scenario described
but may direct customers to select from several unaffiliated bill above. Institutions should ensure proper approval of
payment providers. businesses allowed to use ACH payment technology to initiate
Caution customers regarding security and privacy issues through payments from customer accounts.
the use of on-line disclosures or, more conservatively, e- Cash management applications would include the same control
banking agreements. considerations described above, but the institution should
Financial institutions that rely on a third-party bill payment consider additional controls because of the higher risk
provider including Internet banking providers that subcontract associated with commercial transactions. The adequacy of
to third parties. authentication methods becomes a higher priority and requires
Set dollar and volume thresholds and review bill payment greater assurance due to the larger average dollar size of
transactions for suspicious activity. transactions. Institutions should also establish additional

© Copy Right: Rai University


162 11.621.6
controls to ensure binding agreements – consistent with any common language standards for developing wireless device

MANAGEMENT OF FINANCIAL INSTITUTION


existing ACH or wire transfer agreements – exist with content. Wireless Application Protocol (WAP) has emerged as a
commercial customers. Additionally, cash management systems data transmission standard to deliver WML content.
should provide adequate security administration capabilities to Manufacturers of wireless devices are working to improve device
enable the business owners to restrict access rights and dollar usability and to take advantage of enhanced “third-generation”
limits associated with multiple-user access to their accounts. (3G) services. Device improvements are anticipated to include
Person-to-Person Payments bigger screens, color displays, voice recognition applications,
Electronic person-to-person payments, also known as e-mail location identification technology (e.g., Federal Communications
money, permit consumers to send “money” to any person or Commission (FCC) Enhanced 911), and increased battery
business with an e-mail address. Under this scenario, a capacity. These improvements are geared towards increasing
consumer electronically instructs the person-to-person payment customer acceptance and usage. Increased communication
service to transfer funds to another individual. The payment speeds and improvements in devices during the next few years
service then sends an e-mail notifying the individual that the should lead to continued increases in wireless subscriptions.

al
funds are available and informs him or her of the methods As institutions begin to offer wireless banking services to
available to access the funds including requesting a check, customers, they should consider the risks and necessary risk
transferring the funds to an account at an insured financial management controls to address security, authentication, and

i
institution, or retransmitting the funds to someone else. compliance issues. Some of the unique risk factors associated

com Tr
Person-to-person payments are typically funded by credit card with wireless banking that may increase a financial institution’s
charges or by an ACH transfer from the consumer’s account at a strategic, transaction, reputation, and compliance risks are
financial institution. Since neither the payee nor the payer in the discussed in appendix E.
transaction has to have an account with the payment service,
Security Challenges in E-banking

rd. F
such services may be offered by an insured financial institution,
Establishment of a comprehensive security control process
but are frequently offered by other businesses as well.
A comprehensive set of security policies and procedures should
Some of the risk issues examiners should consider when

iza D
reviewing bill payment, presentment, and e-mail money services
include:
be developed based on a threat and vulnerability analysis of e-
banking assets.
dfw P
The Following are Key Elements of an Effective E-
Potential liability for late payments due to service disruptions,
Liability for bill payment instructions originating from banking
someone other than the deposit account holder, Security Process:
w.p m

Losses from person-to-person payments funded by transfers Explicit responsibility should be assigned for establishing and
from credit cards or deposit accounts over which the payee does maintaining corporate security policies
not have signature authority, Sufficient physical controls should be established to provide a
ww Co

Losses from employee misappropriation of funds held secure area to house the e-banking systems including armed
pending access instructions from the payer, and guards, CCTV with motion sensors, smoke and fire alarm
Potential liability directing payment availability information to systems, and biometric authentication like fingerprint or retina
the wrong e-mail or for releasing funds in response to e-mail scan
from someone other than the intended payee. Security profiles should be created and specific authorization
cu

privileges assigned to all users of e-banking systems including


Wireless E-banking
customers, internal users, and system administrators and
Wireless banking is a delivery channel that can extend the reach
outsourced service providers. LDAP-based directory solutions
and enhance the convenience of Internet banking products and
or Identity management solutions can be used for an effective
Do

services. Wireless banking occurs when customers access a


implementation of this requirement.
financial institution’s network(s) using cellular phones, pagers,
and personal digital assistants (or similar devices) through Storage of sensitive data on organization’s desktop and laptop
telecommunication companies’ wireless networks. Wireless systems should be minimized and properly protected by
banking services in the United States typically supplement a encryption, access control and data recovery plans
financial institution’s e-banking products and services. Appropriate techniques should be employed to mitigate
Wireless devices have limitations that increase the security risks external threats, including the use of:
of wireless-based transactions and that may adversely affect Firewalls to separate all DMZs, internal networks and external
customer acceptance rates. Device limitations include reduced untrusted networks
processing speeds, limited battery life, smaller screen sizes, Virus-scanning software at all critical entry points (like firewalls,
different data entry formats, and limited capabilities to transfer remote access servers, e-mail servers) and on each desktop
stored records. These limitations combine to make the most system
recognized Internet language, Hypertext Markup Language
Host- and network-based intrusion detection systems to detect
(HTML), ineffective for delivering content to wireless devices.
violations of security polices and controls
Wireless Markup Language (WML) has emerged as one of a few
Periodic penetration testing of internal and external networks

© Copy Right: Rai University


11.621.6 163
Regular monitoring and correlation of access and activity logs transactions, records and information that is either transmitted
MANAGEMENT OF FINANCIAL INSTITUTION

should be performed for all perimeter devices, intrusion over public networks or stored in internal bank databases.
detection systems, applications and databases Banks can use one-way hash functions to compute and verify
Current industry security developments should be continuously checksums for in-transit or stored data. File integrity checkers are
tracked and appropriate software upgrades and service packs also useful tools to ascertain any modified files and restore last
should be installed known good copies, if required.
A rigorous background check should be performed for all Establishment of Clear audit Trails for E-banking
employees, service providers and contractors
Transactions
Authentication of e-banking customers Banks are not only challenged to ensure that effective internal
To ensure legitimate access and reduce the risk of identity theft, controls can be provided in highly automated environments,
banks should use reliable methods for verifying the identity and but also that controls can be independently audited, particularly
authorization of new and existing customers. for all e-banking events and applications. The following should

al
Banks can use a variety of authentication mechanisms, including be considered, to determine if clear audit trails are maintained:
PINs, passwords, smart cards, biometrics and digital certificates. Opening, modification or closing of a customer account
Multi-factor authentication systems generally provide greater Any transaction with financial consequences

i
assurance, although they may pose greater implementation

com Tr
Any authorization granted to a customer to exceed a limit
complexities. The selection of an authentication method
should be based on careful risk analysis of the e-banking Any modification in access rights and privileges of e-banking
system’s transactional capabilities, the sensitivity and value of systems
the stored e-banking data and customer’s ease of usage. Sufficient logs should be maintained for all e-banking
transactions to help establish a clear audit trail and assist in

rd. F
Measures to Ensure Segregation of Duties
By their very nature, e-banking systems and applications require dispute resolution. Also, it should be ensured that audit trails
that traditional controls should be reviewed and adapted to are not tampered with and can be used as evidence in a court of

iza D
ensure effectiveness. To establish and maintain segregation of
duties in an e-banking environment, banks should take into
law.
Confidentiality of Bank Information
dfw P
consideration the following issues: To preserve confidentiality of key e-banking information, banks
Transaction processes and systems should be designed to should ensure that:
ensure that no single employee can enter, authorize and Data is classified into different groups and are only accessed by
complete a transaction duly authorized and authenticated individuals, agents or
w.p m

Segregation should be maintained between those initiating systems


static data (including web page content) and those responsible During transmission over public or private networks, all
for verifying its integrity confidential bank data are protected from unauthorized viewing
ww Co

Segregation should be maintained between those developing or modification using industry standard encryption algorithms
and those administrating e-banking systems and technologies
Internal authorization controls within e-banking systems, All access to restricted data is logged and efforts are made to
applications and databases ensure that access logs are resistant to tampering
cu

In order to maintain segregation of duties, banks need to Privacy of Customer Information


strictly control authorization controls and access privileges. The To meet the risk challenges concerning the preservation of
following are sound practices relating to authorization controls: privacy of customer information, banks should ensure that:
Specific authorization and access privileges should be assigned The bank’s customer privacy policies and standards comply with
Do

to all individuals all privacy regulations and laws applicable to the jurisdictions to
No individual, agent or system should have the authority to which it is providing e-banking services
change his own authority or access privileges in an authorization Customers are made aware of the bank’s privacy policies
database concerning use of e-banking services
Any modification to an authorization database should be duly Customers may decline (“opt out”) from permitting the bank
authorized by an authenticated source to share with a third party for cross-marketing purposes any
Authorization databases should be resistant to tampering and information about the customer’s personal needs, interests,
corruption and sufficient audit trails should exist to document financial position or banking activity
any modification or tampering Customer data are not used for purposes beyond which they are
Data integrity of e-banking transactions and information specifically allowed or for purposes beyond which customers
have authorized
Data integrity refers to the assurance that information that is in-
transit or in storage is not altered without authorization. Banks The bank’s standards for customer data use must be met when
should ensure that appropriate measures are in place to ascertain third parties have access to customer data through outsourcing
the accuracy, completeness and reliability of e-banking relationships

© Copy Right: Rai University


164 11.621.6
Availability of e-banking systems Marketing Challenges in E-Banking

MANAGEMENT OF FINANCIAL INSTITUTION


Banks have to maintain high availability and continuity of e- One of the most significant developments in bank marketing
banking systems, considering the potential for high transaction in recent years has been the use of technology in creating new
demand (especially during peak time periods) and high channels through which customers can transact their accounts
customer expectations regarding short transaction processing and interact with their bank. The literature shows how e-
cycle times and constant 24x7 availability. To provide customers banking has developed rapidly and become a mainstream
with the continuity of e-banking services they expect, banks channel, but concerns have been raised about the ability of
should ensure that: banks to manage customer relationships effectively through this
new channel. However, while the need to manage customers far
Current and future capacity of critical e-banking delivery systems
more holistically is recognised ,this has not yet been achieved in
are assessed on an ongoing basis
practice. The reasons for this highlight challenges for marketing
E-banking transaction processing capacity estimates are in the banking sector.
established, stress tested and periodically reviewed
Questions to Discuss:

al
E-banking systems, applications and infrastructure are designed
and implemented keeping in mind the need for high-availability 1. What do you understand by e-banking?
for e.g., multiple redundant Internet links, routers, switches, 2. Discuss the characteristics of Internet Banking.

i
web servers with an external hardware load balancing device, 3. What do you understand by Electronic Bill Payment?

com Tr
high-availability databases with fail-over, etc 4. What are Online Brokerages?
Appropriate processing alternatives for managing demand 5. Discuss Online Delivery of Financial Products.
should be developed when e-banking systems appear to be
reaching defined capacity checkpoints Notes:

rd. F
Appropriate business continuity and disaster recovery plans for
critical e-banking processing and delivery systems are in place
Regular disaster recovery drills are performed to check
effectiveness of disaster
iza D
One of the challenges before a Bank, which is trying to become
dfw P
e - enabled is that the data is scattered across the countries.
Integration of this data is necessary if the banks have to succeed
on the net. The second challenge is related to the move towards
expanding the basket of financial products being offered by
w.p m

Financial Service providers. In developed countries, Financial


Service providers are using the Internet as a media for
expanding into new products. Banks are getting into Mutual
ww Co

funds and vice-versa. However, in India, archaic regulations do


not allow companies to have a close relationship with the Banks
owned by them or to offer products, which are offered by
another category of service providers. As a result, companies
like ICICI are forced to keep their Banking arms separate from
cu

the main company. They are also prevented from offering


products, which fall under the purview of Banks. This is a
serious impediment for innovation in the financial service
sector. Moreover, it prevents Indian Financial Service Providers
Do

from exploiting the power of the web.


Given these challenges, only a Bank (or Financial Service
provider) which moves fast and tries to capture the first mover
advantage can think of succeeding in this sector. Another Key
Success Factor will be the Value, which the online operations of
the Banks will be offering to the consumer. This is what will
differentiate between similar offerings from many providers of
financial products and services. Starting now, will give the
organization an advantage in terms of the networking it will be
able to achieve. This will help it in meeting the first challenge.
Banks (or Financial Service providers) should be ready to launch
their operations within days of the liberalization of the sector.
This will allow them to reach a critical mass and establish
themselves in the e-World.

© Copy Right: Rai University


11.621.6 165

You might also like