BA4003 - BANKING AND FINANCIAL SERVICES

UNIT II
MANAGING BANK FUNDS/ PRODUCTS & RISK MANAGEMENT

Capital Adequacy – Deposit and Non-deposit sources – Designing deposit schemes and pricing
of deposit sources – loan management – Investment Management – Asset and Liability Management –
Financial Distress –Signal to borrowers – Prediction Models – Risk Management – Interest rate – Forex –
Credit market –operational and solvency risks – NPA’s – Current issues on NPA’s – M&A’s of banks into
securities market

1. CAPITAL ADEQUACY

The capital adequacy ratio (CAR) is an indicator of how well a bank can meet its obligations. Also
known as the capital-to-risk weighted assets ratio (CRAR), the ratio compares capital to risk-weighted
assets and is watched by regulators to determine a bank's risk of failure.

Capital Adequacy Norms, often referred to in the context of banking regulations, set the
standards and requirements for the amount of capital that financial institutions, particularly banks, are
required to maintain. Adequate capital is essential for banks to absorb losses, mitigate risks, and ensure
the stability of the financial system. The capital adequacy norms are typically established and enforced
by regulatory authorities, and they aim to protect depositors and maintain the overall health of the
banking sector.

As of my last knowledge update in January 2022, the Basel Committee on Banking Supervision
has been a key driver in developing international standards for capital adequacy. The Basel Accords,
particularly Basel III, outline the regulatory framework for capital adequacy norms.

1.1. Deposit & Non Deposit Sources

1.1.1 Deposit:

A deposit generally refers to the placement of funds into an account held at a financial
institution, such as a bank. Deposits are a fundamental aspect of the banking system and play a crucial
role in the financial transactions and services provided by banks. Here are some key points about
deposits:

1.1.2 Types of Deposits:

Savings Deposits: Accounts designed for individuals to save money while earning a modest interest
rate. These accounts often have restrictions on the number of withdrawals.

Current or Checking Deposits: Transactional accounts that allow frequent withdrawals and deposits.
These accounts are suitable for day-to-day financial activities and often come with checks and debit
cards.

Fixed Deposits (Time Deposits): Accounts where funds are deposited for a fixed period at a specified
interest rate. Withdrawals before maturity may incur penalties.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

Recurring Deposits: Accounts where individuals make regular, fixed payments into the account, typically
monthly. The accumulated amount earns interest and is payable at maturity.

Demand Deposits: Funds that can be withdrawn on demand by the account holder. Current accounts
and some savings accounts fall into this category.

1.1.3 Designing Deposit Schemes:

Designing deposit schemes involves creating various types of deposit products that cater to the
diverse needs of customers. This process takes into consideration factors such as interest rates,
accessibility, and the specific requirements of different customer segments.

Savings Deposits: Designed for customers who want to save money while earning modest interest.
Often come with limited transaction capabilities.

Current or Checking Deposits: Suited for customers who need frequent access to their funds for day-to-
day transactions. May come with checks and debit cards.

Fixed Deposits: Targeted at customers looking for higher interest rates with a fixed maturity period.
Generally, withdrawals before maturity may result in penalties.

Recurring Deposits: Tailored for customers who want to make regular, fixed payments into the account.
Interest is earned, and the accumulated amount is payable at maturity.

Online Savings Accounts: Geared toward customers who prefer digital banking. Typically offer higher
interest rates than traditional savings accounts.

Senior Citizen Deposits: Designed to meet the financial needs of senior citizens, often providing higher
interest rates and additional benefits.

1.1.4 Pricing of Deposit Sources:

Pricing deposit sources involves determining the interest rates and terms associated with
various deposit products. It's a strategic decision that considers market conditions, regulatory
requirements, and the bank's overall business strategy.

Interest Rates: Determined based on market rates, competition, and the bank's own cost of funds, may
vary across different deposit products.

Maturity and Lock-in Periods: Fixed deposits often have varying maturity periods, and longer-term
deposits may offer higher interest rates.

Relationship Pricing: Banks may offer preferential interest rates to customers with multiple accounts or
those who use additional banking services.

Promotional Rates: Banks may introduce promotional rates for specific deposit products to attract new
customers or encourage existing ones to shift funds.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

Tiered Interest Rates: Some accounts offer tiered interest rates based on the account balance,
encouraging customers to maintain higher balances.

Flexible Withdrawal Options: Accounts with more flexible withdrawal options may offer lower interest
rates compared to those with restrictions.

Market Conditions: Banks need to adapt their deposit pricing based on changes in interest rates,
inflation, and other economic factors.

1.2.1 Non - Deposit:

"Non-deposit" typically refers to financial instruments and services that are not classified as
traditional deposits in banking. Non-deposit products and services play a crucial role in the broader
financial landscape, providing various ways for individuals and businesses to manage their money,
invest, and access financial services.

2. Loan Management

Loan Management is a common business requirement in today’s competitive world. Loan

management helps to design a loan and manage the day to day operations related to it. Loan
management can also be used by companies which deal in the products which are most expensive.

2.1 Benefits of Loan Management:

 Offer flexible payment schedules to customer

 Create loans with amortization schedule with the breakup of principal, interest, tax, due date
etc.
 Manage bad debt provision for each loan
 Receive loan payment partially or in full
 Refinance a loan by selling the loan to an external institute

2.2 Major components of a typical loan policy documents

The documents required for each loan application and all the necessary papers and records to
be kept in the lender's files like financial statements, pass book details, security agreements, etc. Lines
of authority and accountability for maintaining, monitoring, updating and reviewing the institution's
credit files.

 Statement of Lending
 Establish a lending authority
 Establish lines of responsibility
 Operating procedure
 Required documents
 Lines of authority
 Guidelines
 Policies & Procedures

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

 Quality statements
 Upper limit of loan

2.3 Pricing of Loans in banks

Loan pricing is the process of determining the interest rate for granting a loan, typically as an
interest spread (margin) over the base rate, conducted by the book runners. The pricing of syndicated
loans requires arrangers to evaluate the credit risk inherent in the loans and to gauge lender appetite
for that risk.

 Fixed & Floating rate loan

 Cost benefit loan pricing
 Customer profitability analysis
 Cost plus pricing
 Relationship based pricing
 Risk based pricing

2.4 Benefits of Loan Management Systems

Calability: Allows lenders to scale their businesses up and down to react quickly to changing economic
circumstances.

Security: Provides regular maintenance and automatic updates to fix bugs and install security patches
and stores customer data in secure cloud servers.

Analytics: Enables lenders to check on applicants’ creditworthiness using analytics modeling.

Artificial Intelligence: Employs AI to prevent the approval of loans to applicants who intentionally
provide false information and flags changes in the creditworthiness of borrowers that could affect
repayment.

Lower Upfront Cost: Enable lenders access to advanced technology without a large upfront investment.

Automation: Automates loan application and management processes, saving time, reducing human-
based errors, and increasing revenue.

Accessibility: Provides a better customer experience by enabling customers to use dashboards to keep
them better informed about their accounts.

Integration: Streamlines loan management processes by integrating with other lending and enterprise
software, as well as third-party applications.

2.5 Types of loans that you can easily manage through a loan management system

Automated lending solutions can manage a variety of loans ranging from simple unsecured
loans to business fundings. Here are the different types of loans that you can streamline with loan
management systems.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

1. Personal Loans: These are loans that are for personal or non-commercial use. Organizations look up
the individual’s credit history before giving out the loan. Loans can either be secured or unsecured. For
instance, a car loan is a secured loan, where the borrower will have to offer something as collateral,
whereas a student loan is an unsecured loan where money can be borrowed outright.

2. Commercial Loans: Commercial loans are intended for business purposes only and are offered by
financial organizations to startups and established businesses. These loans are designed to cover
expenses that an organization cannot afford on its own. Typically, companies and startups utilize this
funding to support their growth or expansion endeavors.

3. Student Loans: Student loans are funds provided for educational expenses, such as tuition fees and
accommodation, by government and private organizations.

4. Syndicated Loans: A syndicated loan is a loan where multiple lenders provide a loan to several
borrowers under the same term. A group of lenders gives out this type of loan when the credit amount
is too large for one lender to manage. Usually, larger organizations and banks give out such loans. This
process is usually facilitated by a middleman who coordinates the entire transaction.

5. Mortgage Loans: Both individuals and businesses can obtain this type of loan from lenders to finance
the purchase of real estate. These loans are secured by the property being purchased and generally
have longer repayment periods. In the event of non-payment, the lender has the right to take ownership
of the property.

6. Payday loans: These are short-term loans with high-interest rates. Individuals often avail payday loans
to cover for certain until the upcoming payday.

3. Investment Management

Investment management refers to the handling of financial assets and other investments not
only buying and selling them. Management includes devising a short- or long-term strategy for acquiring
and disposing of portfolio holdings. It can also include banking, budgeting, and tax services and duties,
as well.

3.1. Investment Management Objectives

1. Assess and manage risk: Investment managers must assess the amount of risk they’re willing to take
and how to manage it on an ongoing basis.

2. Establish goals: An investment manager will help you determine your financial objectives and create a
strategy to reach them.

3. Select investments: With a deep understanding of different asset classes, the manager will choose
appropriate investments for the investor’s needs.

4. Monitor progress: The manager will track market conditions and adjust the portfolio accordingly to
maximise returns while mitigating risks when necessary.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

5. Maximise returns: Through careful portfolio management, investment managers strive to maximise
gains while minimising losses over time, with attention given to tax efficiency and liquidity.

3.2. Types of Investment Management

1. Traditional Investment: This is the most basic form of investing, in which a portfolio manager invests
in stocks, bonds, and other assets according to an investor’s goals.

2. Hedge Fund Investing: Hedge funds are investment vehicles that use alternative strategies such as
leveraging debt and using derivatives to maximise returns.

3. Private Equity Investing: Private equity investments involve buying stakes in private companies that
may not be publicly traded on stock exchanges.

4. Real Estate Investing: It involves purchasing properties to generate rental income or capital
appreciation over time.

5. Mutual Fund Investing: Mutual funds are investment vehicles that pool money from many investors
and invest in a wide range of assets.

6. Portfolio Management: This umbrella term encompasses all the other forms of investment
management, where portfolio managers oversee the entire investment process, from selecting
investments to monitoring performance and taking action when necessary.

7. Quantitative Investing: This type of investing involves creating algorithms or models to identify
trends and uncover potential market trading opportunities based on sophisticated data analysis
techniques.

8. Crypto currency Investing: This type involves buying and selling digital currencies, such as Bitcoin and
Ethereum, to capitalise on price fluctuations in a highly volatile market.

4. Asset and Liability Management

Asset and liability management (ALM) is a practice used by financial institutions to mitigate
financial risks resulting from a mismatch of assets and liabilities. ALM strategies employ a combination
of risk management and financial planning and are often used by organizations to manage long-term
risks that can arise due to changing circumstances.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

4.1 Assets & Liability Management Cycle

4.2 ALM process

 Liquidity risk Management

 Management of risk market
 Funding and capital planning
 Profit planning and growth projection
 Trading risk management

4.3. ALM objective

 Liquidity Risk Management

 Interest Rate Risk Management
 Currency Risks Management
 Profit Planning and Growth Projection

5. Financial distress

Financial distress is a term commonly used in corporate finance that describes any situation
where an individual's or company's financial condition leaves them struggling to pay their bills,
especially loan payments due to creditors. Severe, prolonged financial distress may eventually lead to
bankruptcy.

Financial distress is a situation in which the company cannot pay off its fixed costs as salaries to
employees, loan installment, payment to raw materials, etc., because of improper planning of working
capital, mismanagement at the top level, fraud, change in government policies, etc. A company needs to
recognize signs early and take necessary preventive measures not to go into a period of financial
distress. Else, it becomes very difficult to find solutions for the same.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

Financial Distress

5.1 Causes of Financial Distress

5.2 Indicators

Factors that cause such situations fall into two categories – internal and external.

Internal Factors are-

 Improper and ineffective demand forecast

 Poor cash management
 The high rate of employee layovers
 Unsuitable product mix
 Inaccurate estimation of working capital requirement
 Ill-utilization of Assets

External Factors are-

 Weak contracts with suppliers

 Dependency on a single supplier for raw materials
 Exceptionally hike in the price of Raw material
 Change in Government policy in terms of excess import duty, stringent trade practices, etc.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

6. Risk Management

Risk management is the continuing process to identify, analyze, evaluate, and treat loss
exposures and monitor risk control and financial resources to mitigate the adverse effects of loss. Loss
may result from the following: financial risks such as cost of claims and liability judgments.

Strategies / Tools for Risk Management in Banks

 Realistic Operating or Business Plan

 Strategy for Assessing and Controlling the Risk Inherent in the Plan
 Adequate capital
 Securitization
 Expected loss
 Value at risk
 Financial derivatives

Risk measurement and management process in risk management

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

6.1 Types of Risk in Bank

1. Interest Rate Risk: Interest rate risk is the exposure of a bank's current or future earnings and
capital to adverse changes in market rates

Types of Interest Rate Risk

 Gap or Mismatch Risk
 Basis Risk
 Embedded Option Risk
 Yield Curve Risk
 Price Risk
 Reinvestment Risk
 Net Interest Position Risk
2. FOREX Risk: Foreign exchange risk is the chance that a company will lose money on
international trade because of currency fluctuations. Also known as currency risk, FX risk and
exchange rate risk, it describes the possibility that an investment's value may decrease due to
changes in the relative value of the involved currencies.
3. Credit Risk: Credit risk is the probability of a financial loss resulting from a borrower's failure to
repay a loan. Essentially, credit risk refers to the risk that a lender may not receive the owed
principal and interest, which results in an interruption of cash flows and increased costs for
collection
4. Market Risk: Market risk is the possibility that an individual or other entity will experience losses
due to factors that affect the overall performance of investments in the financial markets.
5. Operational Risk: Operational risk is the risk of losses caused by flawed or failed processes,
policies, systems or events that disrupt business operations. Employee errors, criminal activity
such as fraud, and physical events are among the factors that can trigger operational risk.
6. Solvency Risk: Solvency risk is the risk that the business cannot meet its financial obligations as
they come due for full value even after disposal of its assets. A business that is completely
insolvent is unable to pay its debts and will be forced into bankruptcy.

7. Non-Performing Asset (NPA)

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

NPA expands to non-performing assets (NPA). Reserve Bank of India defines Non Performing
Assets in India as any advance or loan that is overdue for more than 90 days.

“An asset becomes non-performing when it ceases to generate income for the bank,” said RBI in
a circular form 2007.

7.1 Types of Non-Performing Assets (NPA)

a) Sub-Standard Assets: An asset is classified as a sub-standard asset if it remains as an NPA for a period
less than or equal to 12 months.

b) Doubtful Assets: An asset is classified as a doubtful asset if it remains as an NPA for more than 12
months.

c) Loss Assets: An asset is considered a loss asset when it is “uncollectible” or has such little value that
its continuance as a bankable asset is not suggested. However, some recovery value may be left in it as
the asset has not been written off wholly or in parts.

8. Mergers of Banks

The focus on the economy, profitability and cost-effectiveness is what brought in the bank
merger in India. The growing competition among the key players in the same industry had a great
impact on the economy and profitability. One other goal was to reduce and avert financial distress that
arose out of bad loans. Restructuring of the banking industry with mergers was done for improving the
performance both in terms of profitability as well as customer service.

Acquirer Bank Merged Bank

Canara Bank Syndicate Bank
Oriental Bank of Commerce
Punjab National Bank
United Bank of India
Indian Bank Allahabad Bank
Andhra Bank
Union Bank of India
Corporation Bank
Vijaya Bank
Bank of Baroda
Dena Bank
State Bank of Travancore
State Bank of Hyderabad
State Bank of Bikaner and Jaipur
State Bank of India
State Bank of Patiala
State Bank of Mysore
Bharatiya Mahila Bank

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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8.1 Merits of Bank Merger

The following are the merits of a Bank Merger in India:

 Reduction in operational costs.

 Increase in financial inclusion.
 The range of banking operations in the country will increase as the services can reach the nook
and corner of the country with the increase in the network.
 Availability of technical expertise will improve, and there will be reduced scope of inefficiency,
which was happening in small branches all this while.
 Wage disparity will be eliminated.
 The need for infusion of funds by the Government to improve capital in PSUs time and gain will
reduce.
 Removal of unnecessary posts, as well as designation, will reduce administrative expenses.
 The product range will improve and will give the customers a wider choice.

8.2 Demerits of Bank Merger in India

 Most of the banks are region-centric, and mergers will defeat the purpose of decentralisation.
 The larger banks are impacted greatly by the global economic crisis, while the smaller banks can
escape the impact.
 The larger banks will have greater pressure on performance because of the increased NPA
volume owing to the pooling of NPA of weaker banks.
 Bad loans and bad governance are inherent issues, and the larger banks cannot get away from
them by virtue of mergers.
 Face staff issues due to changes in the mode of working and the internal guidelines.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul