MANAGEMENT OF COMMERCIAL BANKING

PROF. JITENDRA MAHAKUD

DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 01 : Importance and Forms of Commercial Banks
 What is Commercial Bank?
 Importance of commercial bank
 Special role of banks
 What is Commercial Bank?

It is an institution whose current operations consist in granting loans

and receiving deposits

Types of commercial banks in India: (i) Public Sector banks (ii)

Private sector banks and (iii) Foreign banks
Commercial Banks and Aggregate Economy

• Payment gateway for all transactions

• Important part of monetary transmission mechanism

• Major source of finance for corporate sector

 Bank Based Economy Versus Market Based Economy

• Bank based economy (BBE) is good in dealing with non‐

diversifiable risk
• In market oriented economy, investments in equity are more than
the bank based economy
• BBE is better in inter‐temporal risk sharing
• BBE is NOT good at financing the new technologies
 Why Banks Are Special Among Intermediaries?

• Deal with financial contracts (deposits and loans) which cannot

be easily resold like equity and bonds
• Good in reduction of transaction cost due to different
transformation
• Economies of scope exists between deposits and credit activities
 Sources of Economies of Scope and Scale

• Large number of products

• Expertise in managing liquidity risk
• Proper diversification
 Major Factors Affecting Banking Activities

• Inflation
• Interest rate changes
• Technology
• Consumer
• Globalization
• Competition
 Leading Competitors with Bank

• Mutual Funds: Sells shares to the public representing an interest in

a professionally managed pool of stocks, bonds and other securities
• Hedge Funds: Sell shares mainly to high net‐worth investors in a
broad group of different kind of assets including the non‐traditional
investments
• Investment Banks: Provide financial consultancy, merchant banking
services, services for acquisition
• Finance Companies: Offer loans to commercial enterprises,
individuals and families using funds borrowed in the open
market or loans from other financial institutions
• There are three types of commercial banks operating in
India
• Commercial banks play a significant role in economic
growth process
• Banks are special among all the financial intermediaries
• Other financial institutions like mutual funds, finance
companies are the major competitors of commercial
banks
• Interest rate, inflation, consumer preference, technology
etc are the major factors affecting banking activities
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
• Microeconomics of Banking 2e. By Xavier F and Jean C Rochet, The MIT Press, 2008.
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 02 : Functions, Goals and Constraints of Commercial Banks
 Functions of commercial banks
 Major goals of commercial banks
 Constraints faced by the commercial banks
 Broad Classification of Banking Functions

• Offering liquidity and payment services

• Transformation of assets
• Management of risk
• Processing information and monitoring borrowing
 Liquidity and Payment Services

• Shifting from commodity money to fiat money

• Commodity Money: Medium of exchange is commodity itself
• Fiat Money: A system in which medium of exchange is
intrinsically useless but its value is guaranteed by some
institution so generally accepted as means of payment
• Bank and fiat money management
• Money change( exchange between currencies)
• Provision of payment services
• Payment services include management of clients accounts
and guarantee by the bank
 Asset Transformation

• Convenience of Denomination
 Fiat money is available in different denominations
• Quality Transformation
 Bank deposits offer better risk‐return characteristics than
direct investments to diversify portfolio
 Banks have more information than depositors for better
investment
• Maturity Transformation
 Short maturity deposits to long maturity loans
 Risk Management

• Credit Risk:
Probability of default in lending activities
• Interest Rate Risk:
Change in the value of assets and liabilities of banks due to change
in interest rate
• Liquidity risk:
Not able to fulfill the requirements of depositors
 Off Balance Sheet Operations

• Loan commitments, guarantee etc

• Offer of derivative investments like swap hedging contracts and
underwriting
• Objectives of off balance sheet operations
 Increase in non‐interest income
 Decreasing leverage
 Tax relaxation
 Monitoring and Information Processing

• Long‐term relationship
• Mitigation of the effect of the moral hazard
 Bank Goals and Constraints
• Maximization of shareholder wealth
 Maximization of market value if bank’s stock and cash
dividend paid
 Factors affecting market value:
i. Amount of cash flow
ii. Timing of cash flow
iii. Risk of cash flow
• Constraints
i. Competition
ii. Social
iii. Regulatory: (a) Investment Constraints (b) Consumer
Protection
• Commercial Banks Provide liquidity and plays a significant
role in payment mechanism, good in management of risk
• Major objective of the commercial banks is to maximize
shareholder’s value
• The constraints of commercial banks include social,
regulatory and market structure
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
• Microeconomics of Banking 2e. By Xavier F and Jean C Rochet, The MIT Press, 2008.
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 03 : Regulation of Commercial Banks
 Why commercial banks are regulated?
 Reasons for failure of commercial banks
 Regulation of commercial banks in India
 Reasons for Regulation of Banks

• To reduce the risk of large‐scale failure in the economic system

• To avoid systematic risk and contagious effect in global economy
• To guard against deposit insurance losses
• To achieve the desired social goal
• To promote an efficient and effective banking system that
finances economic growth, impartially allocates credit and meets
the customer needs
 Why Banks Fail?

• Credit Risk
 Banks keep reserves for expected losses
 If losses > reserves then the excess amount of losses are
deducted from bank capital
 Importance of bank capital
• Maximization of the utility of all the stakeholders; i.e.
shareholders, managers, employees, customers, communities
• Changes in macro economic conditions
• Financial repression: excess government intervention
• Inadequate diversification of loans
 Why Banks Fail? Contd…

• Bank Runs
 It occurs when depositors and other creditors fear for the
safety or availability of their funds and large number of
depositors try to withdraw their funds at the same time
 It reflects the heard behavior of depositors to obtain the
limited amount of cash that is available
• Silent Run
 It occurs when large creditors such as banks and investment
companies withdraw their funds in order to protect them
Example A: Credit Risk

Asset (Million) Liabilities (Million)

Loans 102 Deposits 90
Interest Rate 8% Interest Rate 6%
Loan loss reserve ‐2 Stockholder’s equity: 10
Net loans 100 Total 100

Net Income: 8.16 ‐ 5.4 = INR 2.76

Return on Assets: 2.76/100 = 2.76%
Equity/total Assets = 10/100 = 10%
(Bank is well capitalised)
Example B: Credit Risk
Bank raises additional INR 10 million in deposits and invests in two loans of
INR 5 million each. No additional loan losses required
Asset (Million) Liabilities (Million)
Loans 102 Deposits 100
Interest Rate 8% Interest Rate 6%
Loan 5 Stockholder’s equity: 10
Loan 5
Loan reserve ‐2
Net loans 110 Total 110
Net Income: 8.96 ‐ 6 = INR 2.96
Return on Assets: 2.96/110 = 2.69%
Equity/total Assets = 10/110 = 9.09%
(Bank is adequately capitalised)
Example C: Credit Risk
One of INR 5 million loan goes into default
Asset (Million) Liabilities (Million)
Loans 102 Deposits 100
Interest Rate 8% Interest Rate 6%
Loan 5 Stockholder’s equity: 7
Loan default ‐5
Loan reserve 2
Net loans 107 Total 107
Default loan of INR 5MM exceeds loan loss reserve by INR 3MM, which is
deducted from shareholder’s equity
Net Income: 8.56 ‐ 6 = INR 2.56
Return on Assets: 2.56/107 = 2.39%
Equity/total Assets = 7/107 = 6.54%
(Bank not adequately capitalised (<8%))
Bank Regulations in India
• Banking Regulation Act (1949)
• Disclosure norms: Annual report, asset quality, liquidity, earning
• KYC norms
• Anti Money Laundering Act (AML) & Countering Financing of Terrorism (CFT)
• Protection of small investors (Deposit insurance and credit guarantee
corporation)
• Prudential Norms: income recognition, asset classification and provisioning,
capital adequacy, investment and capital market exposure
• Licensing: Branch authorization policy
• Regulation of Interest Rate: Deposits of NRIs, small loans upto 2 lakh, export
credit
• Statutory Pre‐emptions: CRR and SLR
• Corporate Governance: Fit and proper criteria; director should have knowledge
about banking
• Banks are regulated to make an efficient and sound
banking system.
• Credit risk, macroeconomic condition, inadequate
diversification, bank run are the major reasons for bank
failure.
• Many regulatory reforms have been taken to make the
Indian banking sector stable and efficient.
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
• Reserve Bank of India, Various Publications.
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 04 : Financial Statements of Commercial Banks‐I
 Balance Sheet
 Assets of Commercial Banks
 Approaches to Bank Lending
 Balance Sheet

• The Balance sheet of commercial bank shows the financial

position ( assets, liabilities, equity etc ) at a given point of time
usually the last day of the quarter or year
• It is also viewed as a list of financial inputs (i.e. sources of funds)
and outputs (i.e. uses of funds) at a point of time
 Assets in Commercial Banks

• Cash
• Security holdings/ Investments
• Loans
• Miscellaneous Assets
 Cash Assets

• It includes cash and deposits due from banks

• Items include:
 Cash in treasury or vault cash
 Deposits with other banks
 Cash in process of collection
 Reserve account with Central Bank
• It is called Primary Reserves
 Securities or Investments

• Short term Securities (Liquidity Position and Secondary Reserves)

 Short term government securities
 Money market securities i.e. (i) interest bearing time deposits
& (ii) commercial papers
• Securities for Investment (Income generating position of
Securities)
 Government dated securities
 Corporate bonds and other holdings
 Investments Contd…

Trading Account Assets

• Securities purchased to provide short term profits from short
term price movements
• Amount recorded in the trading account is valued in market
Government funds and Reverse Repurchase Agreement
• It is one type of loan account
• Generally overnight loan
• Government fund sold : funds come from the deposits at central
bank
• Reverse Repo
 Loan Accounts

• Commercial and industrial loans

• Consumer loans
• Real estate loans
• Financial institution loans
• Priority Sector Lending
 Approaches to Bank Lending

• Liquidation Approach:
It considers the assets of the borrower as security for a loan. It
implies a short‐term rather than a long term view of the
borrower’s prospects

• Going Concern Approach:

It gives greater emphasis on the borrower’s ability to repay the
loan out of future cash flow rather than his ability to offer some
tangible assets as security for the loan
 Specific and General Reserves

• Specific Reserves: Set aside to cover a particular loan

• Remaining are called General Reserves
• Determined by management, taxes and government regulations
 Miscellaneous Assets

• Fixed Assets
• Indirect and direct investment in real estate
• Goodwill and other intangibles
• The balance sheet represents the financial position of
commercial banks at a particular point of time
• Loans, Investments, cash are the major assets of
commercial banks
• There are two approaches of bank lending: Liquidation
and Going concern
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 05 : Financial Statements of Commercial Banks‐II
 Commercial Bank Liabilities
 Factors affecting bank deposits
 Income Statement
 Balance sheet and Income statement variations across the size
 Liabilities of Commercial Banks

• Deposits
• Borrowings from non‐deposit sources
• Equity Capital
• Off‐balance sheet items
 Bank Deposits

• Demand Deposits
Current Deposits: These are chequable accounts, there are no
restrictions on the amount or the number of withdrawals
from these accounts and does not carry any interest
Savings Deposit: Cheques can be drawn, withdrawn from an
account without previous notice are restricted
• Call Deposits : they are accepted from fellow bankers and are
repayable on demand. These deposits carry am interest charge
 Bank Deposits Contd….

• Time Deposits: Usually carry a fixed maturity and stipulated

interest rate

• Recurring Deposits: Fixed amount of money deposited in an

uniform interval for a stipulated fixed period and carry a
stipulated interest rate
 Factors Affecting Bank Deposits

• Increase in per capita income

• Expansion of banking facilities
• Increase in banking habit
• Increase in relative rate of return on deposits
• Increase in bank credit
• Inflow of deposits for NRIs
• Growth of substitutes
 Borrowings for Non Deposit Resources

• Borrowing from money market

• Borrowing from Central Bank through repo operations
• Borrowings from other banks apart from regular money market
• Subordinate debts
• It has grown due to lesser cost
• These are highly volatile
 Equity Capital

• Preferred Stock: It gives its holder an fixed annual dividend

before common shareholders receive any dividend payment. It is
not tax deductible (less preferred)
• Common Stock Outstanding
• Retained Earnings
 Balance Sheet Variations Across Size

• Relative importance of balance sheet varies across the size

• Larger banks tend to trade securities for short‐term profits than
smaller banks
• Smaller banks hold more investment securities and loan relative
to their assets
• Smaller banks rely more on deposits
• Larger banks make more use of money market instruments
 Off‐Balance Sheet Items in Banking

• Unused Commitments: In this case a lender receives a fee to lend

upto a certain amount of money over a defined period of time,
but these funds have not yet been transferred from lender to
borrower
• Standby Credit Agreements: Banks receive a fee to guarantee
repayment of a loan that a customer has received from another
lender
• Derivative Contracts: Future Contracts, Options, Swaps to hedge
credit risk, interest rate risk and foreign exchange risk
 Income Statement

• It indicates the amount of revenue received and expenses

incurred over a specific period of time
• Close correlation between the balance sheet items and income
statement
• Assets usually account for the majority of operating revenues and
liabilities generate bank’s operating expenses
 Revenue and Expenditure Items

• Interest Income: Interest earned from loans and security

investments
• Non‐Interest income: fees, commissions etc
• Interest expenses: Interest on deposits, interest owed on short
term borrowings in the money market, long term borrowings
• Non‐ Interest Expenses: Cost of equity capital, salary, wages,
benefits paid to employees, overhead expenses, funds set aside
for possible loan losses and taxes owed.
 Revenue and Expenditure Items Cont…

• Net interest income = Interest income – Interest expenses

• Net Income = Total Revenue – Total Expenses
• Pre tax Net Operating Income= Net interest income + Net Non‐
interest Income
• Pre tax Net Operating Income – Tax + Securities gains or losses +
Extraordinary Income = Net Income
 Income Statement Ratios and Bank Size

• Large banks receive more income from non‐interest income

• Small banks rely more on deposits than money market
instruments.
• Deposits, borrowings, equity shares are the major sources
of liability of the commercial banks
• Unused commitments, standby credit agreements and
derivatives contracts are the major off‐balance sheet
items
• Relative importance of balance sheet varies across the size
of the bank
• The income statement is correlated with the balance sheet
• Interest income is the major source of revenue of
commercial banks
• Importance of non‐interest income has been increasing
over the years
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007