Commercial Banking 12

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Bank is an institution which collects money from

those who have in spare or who are saving it out of

their income; and lend this money out to those who

require it.

All those institutions which are in thebusiness of banking are called financial institutions.


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Banking Systemin India

Scheduled Banks

State Coop.Banks

CommercialBanks

Non-ScheduledBanks

Central Coop.Banks and

primary credit

societies


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CommercialBanks

Public Sector

Banks

SBI &

Associate

Banks(7)

Other

Nationalized

Banks

Foreign BanksPrivate Sector

Banks


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Scheduled banks :- Banks which have been included in

the Second Schedule of RBI Act 1934. They arecategorized as follows:

Public Sector Banks :- E.g.. SBI, PNB, Syndicate

Bank, Union Bank of India etc.

Private Sector Banks :- E.g.. ICICI Bank, IDBIBank, HDFC Bank, AXIS Bank etc.

Foreign Banks :- E.g.. Citi Bank, Standard

Chartered Bank, Bank of Tokyo Ltd. etc.

Non scheduled banks :- Banks which are not included

in the Second Schedule of RBI Act 1934.


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Commercial Banks are those profit seeking institutionswhich accept deposits from general public and advance

money to individuals like household, entrepreneurs,

businessmen etc. with the prime objective of earning

profit in the form of interest, commission etc. Examples of commercial banks ICICI Bank, State

Bank of India, Axis Bank, and HDFC Bank


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Commercial banks are an organisation which

normally performs certain financial transactions. Itperforms the twin task of accepting deposits from

members of public and make advances to needy and

worthy people form the society. When banks accept

deposits its liabilities increase and it becomes a

debtor, but when it makes advances its assets

increases and it becomes a creditor. Banking

transactions are socially and legally approved. It isresponsible in maintaining the deposits of its account

holders.


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A. Accepting deposits

1. Demand or current account deposits- a depositorcan withdraw it in part or in full at any time he

likes without notice. It carries no interest.

2. Fixed deposits- it can be done from 15 days to

few years with high rate of interest which can be

withdrawn at expiry of term.

3. Saving deposits- it is for the purpose of small

saving deposits by salaried people. These depositscarry less rate of interest and money can be

withdrawn through cheques.


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B. Advancing loans

1. Overdraft facility- this facility is provided to thebusinessmen only even if the deposits are less, thetransaction can be done . Banks charge interest on thisfacility.

2. Loans by creating deposits- it can be done in

following ways Cash credit

Demand loans

Short term loans


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The tendency of the commercial banks to make loans

several times of the excess cash reserves kept by the

bank is called creation ofcredit.

Creation of credit means that the commercial banks bytaking in deposits and making loans expand the money

supply.


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The process of 'Credit Creation' begins with bankslending money out of primary deposits. Primary

deposits are those deposits which are deposited in

banks.

In fact banks cannot lend the entire primary deposits

as they are required to maintain a certain proportion of

primary deposits in the form of reserves with the RBI

under RBI & Banking Regulation Act.


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Bank M receives a cash deposit of $2000. This is the cash inhand with the bank which is its assets and this amount is also

the liability of the bank by way of deposits it holds.

Given the reserve ratio of 10 % the bank holds $200 in

reserves and lends $1800 to one of its customers.


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Commercial bank's balance sheet has two main sides

i.e. the liabilities and the assets. From the study of thebalance sheet of a bank we come to know about a

system which a bank has followed for raising funds

and allocation of these funds in different asset

categories. Bank can have others money with it. Itcan be in terms of shareholders share capital or

depositors deposits. This money is the bank's

liabilities. On the other hand bank's own sources of

income leads to generation of assets for bank.


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Liabilities Assets

a. Share Capital a. i. Cash in Hand

b. Reserve Funds ii. Cash with the Central Bank (RBI)

c. Deposits iii. Cash with the other banks

i. Fixed Deposits b. Money at short

ii. Saving Deposits c. Bills and securities discounted

iii.Current Deposits d. Investment of bank

iv. Other Deposits e. Loans and Advances given

d. Borrowings f. Other Assetse. Other liabilities


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Capital Adequacy Ratio (CAR) is a ratio that

regulators in the banking system use to watch bank'shealth, specifically bank's capital to its risk.

Regulators in the banking system track a bank's CAR

to ensure that it can absorb a reasonable amount of

loss.

Regulators in most countries define and monitor

CAR to protect depositors, thereby maintaining

confidence in the banking system.


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Capital adequacy ratio is the ratio which determines

the capacity of a bank in terms of meeting the time

liabilities and other risk such as credit risk, market

risk, operational risk, and others. It is a measure of

how much capital is used to support the banks' risk

assets.


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The ratio is calculated by dividing Tier1 + Tier2capital by the risk weighted assets.

Capital

Capital Adequacy Ratio = ------------

Risk

Tier1 + Tier2 capital

= -----------------------------Risk Weighted Assets

* 8%


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Tier 1 Capital: This is the bank's core capital

comprising of share capital, disclosed reserves and

minority interests. Some institutions expand this

definition to include restricted forms of "equity-like"

capital instruments.

Tier 2 Capital: This includes supplementary Capital

consisting of general loan loss reserves andrevaluation reserves on investments and properties

held for investment purposes.


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Risk-Weighted Assets: This includes the total assets owned.

The value of each asset is assigned a risk weight (for

example 100% for corporate loans and 50% for mortgageloans) and the credit equivalent amount of all off-balance sheet

activities. Each credit equivalent amount is also assigned a risk

weight.


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Takes risk into account.

Since different types of assets have different risk profiles,

CAR primarily adjusts for assets that are less risky by

allowing banks to "discount" lower-risk assets.


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RISKS

FINANCIAL RISK NON FINANCIAL RISK

CREDIT RISK MARKET RISK

TRANSACTION RISK

PORTFOLIO RISK

INTEREST RATE RISK

LIQUIDITY RISK

FOREX RISK

OPERATING RISK

SYSTEMATIC RISK

POLITICAL RISK

HUMAN RISK

TECHNOLOGY RISK

Classification of Risk


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Risks Faced by Banks

Credit Risk

Market RiskLiquidity Risk

Interest Rate Risk

Foreign Exchange RiskOperational Risk

Solvency Risk


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Credit default riskoccurs when a borrower cannot

repay the loan. Eventually, usually after a period of90 days of nonpayment, the loan is written off. Banks

are required by law to maintain an account for loan

loss reserves to cover these losses.

Banks reduce credit risk by screening loan applicants,requiring collateral for a loan, credit risk analysis,

and by diversification.

A bank can also reduce credit risk by diversifying

making loans to businesses in different industries or

to borrowers in different locations.


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Transaction Risk

Risk relating to specific trade transactions, sectors or

groups.

Portfolio RiskRisk arising from lending to sectors non related to

the core competencies of the Bank / concentrated

credits to a particular sector / lending to a few big

borrowers.


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Market risk is the risk to a banks financial condition thatcould result from adverse movements in market price. The

risk that an un-expected happening ,which is extreme

sudden or dramatic will cause an all-round fall in market

prices. It signifies the adverse movement in the market

value of trading portfolio during period required to

liquidate the transaction


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TYPES OF MARKET RISK

Interest Rate Risk

Risk felt, when changes in the interest rate structure putpressure on the net interest margin of the Bank. This riskis the possibility that assets or liabilities have to berepriced on account of changes in the market rates andits impact on the income of the bank.


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For instance, if a bank has a loan for $100 for whichit receives $7 annually in interest, and a deposit of

$100 for which it pays $3 per year in interest, that is a

net interest margin of $4. But if current market

interest rates for deposits rises to 4%, then the bank

will have to start paying $4 for the $100 deposit

while still receiving 7% on the long-term loan,

decreasing its profit in this scenario by $1.


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Liquidity Risk: Risk arising due to the potential forliabilities to drain from the Bank at a faster rate thanassets. Liquidity risk is when the bank is unable to meet a

financial commitment arising out of a variety ofsituations. However, there are times when an FI can facea liquidity crisis. When all or many FIs are facingsimilar abnormally large cash demands, the cost of

additional funds rises as their supply becomes restrictedor unavailable. Such serious liquidity problems mayeventually result in a run in which all liabilityclaimholders seek to withdraw their funds simultaneously

from the FI. This turns theFIs

liquidity problem into asolvency problem and could cause it to fail.


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Forex Risk:

To the extent that the returns on domestic and foreigninvestments are imperfectly correlated, there are

potential gains for an FI that expands its asset holdingsand liability funding beyond the domestic frontier.


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NON-FINANCIAL RISKSOperational Risk :arises as a result of failure of operating

system in the bank due to certain reasons like fraudulent

activities, natural disaster, human error, omission etc.Systemic Risk: is seen when the failure of one financial

institution spreads as chain reaction to threaten thefinancial stability of the financial system as a whole.

Political Risk arises due to introduction of Service tax or

increase in income tax, freezing the assets of the bankby the legal authority etc.

Human Risk: Labour unrest, lack of motivation, inadequateskills, etc

Technology Risk: Obsolescence, mismatches, breakdowns,adoption of latest technology by competitors, etc, comeunder technology risk


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THANK YOU

Commercial Banking 12

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