Bank Management

Class One

For

PGDM

Indian Institute of Management , Calcutta

By

Praloy Majumder

(For Classroom discussion only)

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 Class One

Role of Financial System

Financial system is one of the most important inventions of the modern society. Its
primary task is to move scarce loanable funds from those who save to those who
borrow to buy goods and services and to make investments in new equipment and
facilities so that the overall economy can grow and increase the standard of living
enjoyed by the citizens. Without the financial system and the funds it supplies, each
of us would lead a much less enjoyable life.
The financial system determines both the cost of credit and how much credit will be
available to pay for the thousands of different goods and services we purchase daily.
The happening in this system has a powerful impact in the health of the overall
economy. For example, when credit becomes more costly and less available, total
spending for goods and services falls resulting in the increase in unemployment. This
will in turn reduce the growth and which will force the business houses to cut back
the production and lay off workers. In contrast, when the cost of credit declines the
loanable funds become more readily available and this will increase the total
spending in the economy. This will in turn creates more jobs and the economy
growth accelerates. In fact, the financial system is an integral part of the economy
system and we cannot be able to comprehend the economy system without knowing
the financial system.
Flows within the economic system
The basic function of any economy is to allocate scarce resources--- land, labor,
management skill and capital to produce the goods and services needed by the
society. The economy system must combine inputs--- land, labor and management
skills, capital to produce out put in the form of goods and services. The economy
generates a flow of production in return for a flow of payments.

Flow of Production
Land & other natural
resources Goods and services sold
Flow of payments to the public.
Labor and managerial
skills

Capital equipment

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 Figure 1.1 : The Economic System

The flows of payments and production within the economic system can be depicted
as a circular flow between producing unit (mainly business and government)
and consuming unit (principally households). In modern economy,
household provides labor, management skill, and natural resources to
business firms and governments in return for income in the form of wages
and other payments. Most of the income received by the household is spent
to purchase goods and services from business and governments. This is
shown below in Fig 1.2:

Flow of expenditure for consumption and taxes

Flow of production of goods and service

Producing units
(mainly business Consuming units
firms and govt) (mainly
households)

Flow of productive services

Flow of income

Fig 1.2: Flow of income, payments and production in the economic

system

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The Evolution of Financial Transaction
All financial transactions perform at least one basic function- movement of scarce
fund from those who save and lend to those who wish to borrow and invest.
However, the transfer of funds from savers to borrowers can be accomplished in at
least three different ways . We label these methods of fund transfer as
Direct Finance
Semi direct Finance
Indirect Finance
Direct Finance : In the direct finance, borrower and lender meet each other and
exchange funds in return for financial assets. One such example is the borrowal of
money from one individual from another in exchange of promissory notes ( signed by
the borrower) against money ( given by the lender) . The process is explained below
with the help of the following diagram:

Flow of funds
Borrowers Lenders
(deficit budget unit) (surplus budget unit)

Primary Securities

Fig: 1.3 Direct Finance (Direct lending gives rise to direct claims against
borrowers)

Limitation of this type of finance:

Both borrower and lender must meet each other to carry out the transaction.
So cost of searching/information is high.
Both borrower and lender must agree to exchange exactly identical amount of
money that is difficult.
Lender must have faith on the security issued by the borrower, which is also
difficult to achieve.
Semi direct Finance: In this type of finance , some individuals and business houses
become security brokers and dealers whose essential function is to bring surplus and

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deficit budget units together, thereby reducing information costs. This is explained
below:

Primarysecurities Primary
Borrowers Security brokers, Lenders
Securities
(deficit budget dealers and (surplus budget
unit) investment unit)
Flow of funds bankers Flow of funds

Fig 1.4 Semi direct Finance (Direct lending with the aid of market makers
who assist in the sale of direct claims against borrowers)
Semi direct finance is an improvement over the direct finance in the following
manner:
Information cost for participants is reduced to a great extent
The requirement of exact amount of money involved is eliminated as dealers
can split up securities and sale in smaller lots
Both dealers and brokers help in the development of the secondary market
Still semi direct finance has limitations. The most important of them is:
In this process also , the lender has to accept the security offered by the
borrower as an acceptable security.

Indirect Finance: The limitations of both direct and semi direct finance can be
removed in the Indirect Finance . In this form of finance, one financial intermediary
comes in between lenders and borrowers. The financial intermediaries performs the
following functions:
The financial intermediary accepts money from the surplus budget unit in the
form of deposits. In return of the money deposited, the financial intermediary
issues secondary security. Since most of the financial intermediaries are
regulated by financial regulations in terms of financial strength, lenders are
more willing to accept this secondary security as gains the primary securities
issued by the borrower himself.

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 The financial intermediary finds out the deficit budget units for giving loans
and collects money from the borrowing unit. The information and searching
cost are reduced.
The entire mechanism of indirect financing is shown below :

Primary Security Secondary Security

Ultimate Financial Ultimate lenders
borrowers Intermediaries ( surplus budget
(deficit budget (banks, Financial unit)
units) Institutions)

Flow of funds Flow of funds

Fig 1.5: Indirect Finance (The financial intermediation of funds)

Financial disintermediation : In the process of financial disintermediation , the

role of financial intermediary has been eliminated and the borrowers can raise the
fund directly from the lender with the help of either public issue or private placement
of securities. This can be performed with the help of stock exchanges. Though the
financial disintermediation has been progressing rapidly in the developed and
matured financial markets like USA , UK etc, it is yet to take momentum in Indian
market. This is due to the fact that to work financial disintermediation, stock market
has to perform to the satisfaction of the lenders. Considering the maturity stage of
our stock market, it is yet a long road to go for establishing financial
disintermediation as an established procedure.

Banks Liability and Assets

As can be seen from the previous chapter that bank plays the role of an intermediary
where banks collects money from the depositor against issuance of its security and
then it lends to the corporate. Such system would operate as long as the bank is able
to keep its commitment to the investors. Since bank is an important financial
intermediary , the soundness of the bank is of paramount importance in the stability

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of financial system. Accordingly, we need to know the basic financial structure of
bank and how it is different from normal corporate.

Let us draw a comparison of ICICI bank balance sheet and Tata Steel balance sheet
as on March 31 2007 . The liability comparison of both the entities are given below :

Comparison of Tata Steel and ICICI Bank

Liability
Sl No Particulars Tata Steel ICICI Bank

1 Equity 11.52% 0.37%

Reserves
and
2 Surplus 39.18% 11.35%

3 Loans 33.47% 82.75%

Other
4 Liabilities 3.26% 2.96%

Current
Liabilities
and
5 Provisions 12.57% 2.58%
Total 100.00% 100.00%

Fig : 1.6 Comparison of Tata Steel and ICICI Bank Balance Sheet Liability
Composition

As we see from the above that the capital structure of ICICI Bank is highly levered
compared to Tata Steel balance sheet . This is reflected in lower percentage of equity
and reserves of total liability of ICICI bank compared to that of Tata Steel. Since we
know that a highly levered institution is highly risky entity , ICICI bank is a risky
entity compared to that of Tata Steel. This is true for all other banks . But at the
same time we are telling that banks at any point of time would have to keep its
commitment to its depositors and at the same time have to work within the risky
parameters. So bank will always have to operate under strict risk containing
mechanism as prescribed by central bank of a country. When we shall analyse the

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bank performance , we have to always keep this in our mind. This is the rational
behind prudential norms, exposure norms, investment valuation norms , capital
adequacy norms, risk management and asset liability management systems of
banks.

After comparing the liability side of bank balance sheet we shall

compare the asset side of bank balance sheet with that of Tata Steel:

Comparison of Tata Steel and ICICI Bank

Asset
Sl No Particulars Tata Steel ICICI Bank

1 Net Fixed Assets 23.44% 1.03%

2 Investment 7.62% 27.88%

3 Current Assets 68.65% 65.95%

Misc.expenditure not
4 written off 0.29% 5.15%
Total 100.00% 100.00%

Fig 1.7: Comparison Tata Steel and ICICI Bank Asset Composition
If we see the above , we find that majority of bank assets comprise of investment
and current assets. In the current assets we have included loan and advances given
by the bank to other entities. From the above , we see that net fixed asset is lower in
the bank balance sheet . This would be due to the reason that bank is created to
channelise fund to the productive sector. That is why banks are having restriction in
investment in Fixed assets. Banks are having significantly higher portion in the form
of investments and loans and advances. In India, Investment includes subscription
to Govt of India securities. This is being carried out due to meeting the SLR
requirement . Banks need to invest 25% of its net demand and time liabilities in the
form of SLR securities which consist of GOI securities. Government issues securities
to bridge the fiscal deficit and bank has to invest fund on this instrument in the
form of SLR securities. With the implementation of FRBM act we expect that the SLR
requirement would go down in the near future as the fiscal deficit would go down
with the implementation of FRBM act. If we see, an early indication has been made

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in this regard by lowering the floor of SLR as per Banking Regulation Act where the
floor has been reduced to 20% of NDTL . However, at present banks need to
maintain 25% . The effect of reduction of SLR would be good as more fund would be
available to the commercial sector and this would be used for increasing goods and
services in the country.

While bank raises fund and invest in asset it keeps in mind the following aspects :
1. While borrowing, it is borrowing from the depositor at a particular cost for a
particular period. But it does not mean that if the depositor comes before the
maturity date , it would deny the payment to the investor. In that case faith
on the banking system would be vanished. So Banks should make emergency
provisions while deploying such deposit in the form of different assets.
2. While investing in the form of investment , it has to adhere to certain
investment norms depending on the nature of investment. Since banks are
not permitted to invest freely in the equity securities and in India the
restriction is too high, in India banks are investing majority amount in the
fixed income securities for the reason mentioned above. As we know that
interest rate and price of a fixed income security is inversely proportional ,
banks have to keep this in mind at the time of investment. Investment can be
made under three category i.e. Held to Maturity, Held for Trading and
Available for Sales category and there are benefits and drawbacks under each
method. In the case of Held to Maturity , banks will not be able to derive any
trading profit and at the same time would not incur loss on account of
adverse movement of interest rates. In the case of Held for Trading ,a bank
has to realise the gain or loss within 90 days and depending on its prediction
it can earn profit or incur loss. In the case of Available for sale category, the
bank can incur losses or earn profit for first 90 days but this is notional in
nature. While investing, other important issue is that the bank can borrow
against particular type of investment from dedicated lender in case of
emergency and this would help bank to overcome the emergency payment
requirement. So while investing ,bank would carry out some statistical
analysis of its liability and accordingly it would invest in the investment of a
particular security to this benefit.
3. While giving loans and advances to corporations, bank would keep in mind
the riskiness of the loan . Since different categories of loan are having

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 different risk weight , bank would try to lend to a loan of lower risk weight at
a given rate of interest. Besides, for certain category of loan and advances
like export credit, term loan to SSI , refinance facility would be available and
accordingly bank would be able to overcome sudden liquidity requirement in
case of urgency.

After giving proper consideration in the above mentioned factors, bank raises the
fund from its depositor and accordingly would invest in loans and advances.
However, bank has been permitted to borrow and lend its temporary surpluses in
certain other market due to its nature of operation to ensure liquidity. Banks can
lend and borrow from inter bank call money market and repurchase market.

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