MANAGING BANK FUNDS/

PRODUCTS & RISK

MANAGEMENT
Unit - 2
Learning Points

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
Capital Adequacy

• a measure of a bank's or other financial institution's ability to pay its

debts if people or organizations are unable to pay back the money
they have borrowed from the bank
Capital Funding

• refers to the money that a business raises to finance its operations,

growth, or investments. This funding can come from various sources,
such as personal savings, loans, or investments from others (like
venture capitalists or shareholders).
Deposits

“a savings product that customers can use to

hold an amount of money at a bank

for a specified length of time”

In return, the financial institution will pay the customer the relevant amount of
interest, based on how much they choose to deposit and for how long.
Features of Deposits
• Maturity date - length of time the customer and bank agree to keep the money on deposit

• Early repayment - withdrawal of money before the maturity date, on paying penalty.

• Return - interest rate for deposits.

• Interest payment - customer can choose to receive interest payments periodically or at maturity.

• Taxation - customer may have to pay a tax

• Liquidity - Fixed deposits has high liquidity

• Flexibility - Flexibility in investment amount, tenure, and interest payout options.

• Guaranteed returns - Fixed deposits offer guaranteed returns

Deposit Schemes
Non-Deposit Sources
• Funding gap – difference b/w current & projected credits & deposits

• Borrowing from central Bank

• Certificate of deposits
• a savings account has fixed amount of money for a fixed period of time & in exchange, the issuing
bank pays interest.

• Foreign funds

• Commercial papers – Promissory notes

• Other money market borrowings – financial institutions

Pricing of deposit sources
• Cost plus pricing strategy
• Cost-plus pricing typically calls for a bank to charge deposit service fees
enough to cover all the costs of providing the service in addition to a small
margin for profit.

• Promotional pricing strategy

• In order to retain customers
• Relationship pricing strategy
• Depository institution prices deposits according to the number of services purchased
or utilized.
• The depositor may be given lower fees or have a part of the cost waived if they have
used two or more services

• Time based pricing strategy

• Time based pricing refers to a pricing strategy linking prices to a particular time.

• In contrast to value based pricing, the practice is directed toward determining the
price of a service based on the period used by a client.
Loan Management

“a type of credit vehicle in which

a sum of money is lent to another party

in exchange for future repayment

of the value or principal amount”

Types of
Loans
Components of loan document
• Statement of lending – loan type • Guidelines – how to avail loan?

• Lending authority - whether authorized to • Policies & Procedures – interest rates, tenure
lend • Quality standards – issue if meeting standards
• Lines of responsibility – reporting all
• Upper limit to loans – max. limit
information
• Define Community – what is banks principal
• Operating procedure
trade area?
• Required documents
• Trouble loan – analyzing problems
• Lines of authority - review banks credit files
Types of Lending

• Fund based lending

• direct transfer of funds from the lender to the borrower - loans, overdrafts

• Non-Fund based lending

• a financial guarantee for a borrower

• Asset based Lending

• a business financing method that uses an asset owned by a business as security
against a business loan
Loan management in Issues faced & Trends in
Indian Banks loan management

• Customer perspective • Digital platform

• Service provider perspective • Drastic change in lending system

• Macro market perspective • Hike in small ticket loans

Pricing of loans
• Fixed & floating rate loans
• the rate of interest is subject to revision every quarter.

• The interest will be pegged by the RBI based on various economic factors.

• Cost-Benefit loan pricing

• Whether bank charges enough for a loan to fully compensate

• Customer profitability analysis

• a management accounting and credit underwriting method that measures how profitable a

customer or customer segment is.

• Cost plus pricing
• a common loan pricing strategy that considers four components to determine the interest rate
on a loan

• Funding cost, Servicing costs, Risk premium, Profit margin

• Relationship based pricing

• a banking pricing and billing model that considers a customer's overall purchases and
circumstances, rather than individual products, to determine pricing

• Risk based pricing

• a strategy that lenders use to offer different interest rates and loan terms to borrowers based
on their creditworthiness
Investment Management

“The handling of financial assets

and other investments

by professionals for clients”

Forms of Bank Investment Policy

• SLR Investment
• Statutory Liquidity Ratio popularly called SLR is the minimum percentage of
deposits that the commercial bank maintains through gold, cash and other
securities
• Cash: Physical cash held by the bank.

• Gold: Investments in gold, which can be liquidated easily.

• Government Securities: Bonds and treasury bills issued by the government.

• Non-SLR Investments
• refer to those investments that do not qualify under the SLR requirements.

These may include a wider range of assets and financial instruments.

• Corporate Bonds: Debt securities issued by corporations.

• Equity Shares: Investments in stocks of companies.

• Mutual Funds: Investments in various mutual fund schemes that do not fall under SLR

guidelines

• Debentures: Long-term securities yielding a fixed rate of interest.

Assets & Liabilities Management

“a financial accounting practice that involves managing

financial risks that arise from mismatches between assets
and liabilities”

ALM is concerned with risks caused by changes in interest

rates, exchange rates, credit risk, and liquidity positions.
Components of ALM
Bank assets Bank liabilities

• Retail personal loans • Retail checking & savings accounts

• May be fixed or floating
• Retail fixed deposits
• Retail mortgages

• Credit-card receivables • Deposits from commercial

• Commercial loans customers

• Long-Term investments • Bonds issued by the bank

• Traded bonds & derivatives
Organizational structure of ALM
• Under the CEO/ Managing Director
• Head of Consumer Banking

• Head of Treasury
• Head of ALM

• Money Market Dealers

• Head of Corporate Banking

• Head of Finance

• Head of Credit

• Head of Operations
Asset - Liability Committee (ALCO)

• A supervisory group that manages a company's assets and liabilities.

• Responsible for
• evaluating risk

• managing liquidity and

• ensuring the company earns adequate returns

ALM Procedure

• Step 1: Reviewing the bank/Financial Statements & Reports

• Step 2: Assess whether bank plans its liquidity needs

• Step 3: Future development of banks & plans

• Step 4: Examining bank’s internal audit

• Step 5: Reviewing on bank’s plan of unanticipated liquidity needs

• Step 6: Preparing an ALM internal control questionnaire

Financial Distress

• Occurs when a bank's cash flow is insufficient to pay its immediate obligations.

• This can be caused by a number of factors, including:

• Board structure

• Unsustainable macroeconomic policies

• large current account deficits

• unsustainable public debt

• and excessive credit booms.

Prediction Models of Financial
Distress
• Altman’s Z-Score Model
“a numerical measurement used to predict
the chances of a business going bankrupt in
the next two years”
• The model was developed by American
finance professor Edward Altman in 1968
as a measure of the financial stability of
companies.
• using multiple balance sheet values and
corporate income.
• Hazard Model
• a firm's risk for bankruptcy changes through time, and its health is a function
of its latest financial data and its age.
• The bankruptcy probability that a static model assigns to a firm does not vary
with time.
Methods for
Rehabilitatio
n of Financial
Distress
Signals to Borrowers

“Late or missed payments to the Bank or you are

concerned about meeting scheduled repayments”
Risk Management

“the process of identifying, assessing, and mitigating

risks that a bank may face in its daily operations”
- a critical function that helps ensure a bank's stability and sustainability, and

protects the interests of depositors and investors.

Types of RISK’s
• Credit

• Interest Rate

• Liquidity

• Price

• Foreign Exchange

• Transaction

• Compliance

• Strategic and Reputation

Strategies for Risk Management

• Business Plan • Securitization

• Statement of business goals & objectives
• Removal of related assets
for the next 2 years
reduces risk
• Strategy for controlling risk inherent
• Internal control/asset review system
• Expected Loss
• Loss expected in a year
• Adequate capital
• Minimum regulatory capital requirement
Risk Measurement & Management
Process
• Risk identification

• Risk measurement

• Risk pricing

• Risk monitoring & Control

• Risk mitigation
Interest Rate Risk

• the probability of a decline in the value of an asset resulting from

unexpected fluctuations in interest rates.

• As interest rates rise bond prices fall, and vice versa. This means that
the market price of existing bonds drops to offset the more attractive
rates of new bond issues.
Types of Interest Rate Risk
• Gap or mismatch risk
• Gaps over different time intervals as at a given date

• Basis risk
• variation in future values

• Embedded option risk

• due to pre payment of cash

• Yield curve risk

• shift in interest rates will negatively impact the returns from fixed-income investments, like

bonds
• Price risk
• the value of an investment or security will decline in the future. It can apply to any financial

instrument, foreign exchange position, or commodity.

• Reinvestment risk
• the possibility that an investor will not be able to reinvest cash flows from an investment at the

same rate of return as the original investment.

• Net interest position risk

• a risk that banks face when market interest rates fall and the bank has more earning assets than

paying liabilities.
How to manage Interest Rate Risk

• Earnings perspective
• considers how interest rate changes will affect a bank's reported earnings

• Economic value perspective

• focuses on the value of a bank's net cash flows.
FOREX Risk

• The risk occurs when a company engages in financial transactions or

maintains financial statements in a currency other than where it is
headquartered.
Types of FOREX Risk
• Transaction risk
• Transaction risk is the risk faced by a company when making financial
transactions between jurisdictions. The risk is the change in the exchange rate
before transaction settlement. Essentially, the time delay between transaction
and settlement is the source of transaction risk.
• Translation risk
• also known as translation exposure, refers to the risk faced by a company
headquartered domestically but conducting business in a foreign jurisdiction,
and of which the company’s financial performance is denoted in its domestic
currency.
Managing FOREX RISK
• Managing transaction risk
• Forward market hedge
• agreements to trade an asset at a specified price and date in the future

• Money market hedge

• a technique used to lock in the value of a foreign currency transaction in a company's
domestic currency.

• Options market hedge

• a risk mitigation technique employed to safeguard investments from adverse market
fluctuations.
• Swaps
• an agreement or a derivative contract between two parties for a financial exchange so that they
can exchange cash flows or liabilities.

• Exposure netting and offsetting

• Exposure netting is achieved within a firm where it can find offsetting position in two or more
currencies or other risk factors within various segments of the firm.

• Leading & Lagging

• Leading indicators help predict future performance, whereas lagging indicators give insight into
past outcomes.

• Invoicing
• a means by which companies borrow money from investors through unpaid or overdue invoices
• Managing translation risk
• Balance sheet hedge

• Contractual and natural hedge

Credit Risk

• the possibility that a borrower will not repay a debt, which can result
in a loss for the lender.
• This risk can include:
• Lost interest and principal

• Cash flow disruption

• Increased collection costs

Types of Credit Risk
• Fraud risk
• Check for applicants identity and verify

• Default risk
• whether the borrower will be able to meet their loan obligations and pay the agreed-upon
amount in the loan contract

• Credit spread risk

• typically caused by changing interest and risk-free return rates

• Concentration risk
• a significant portion of a bank’s portfolio is concentrated on a single sector or asset class
Market risk

“the possibility of

losing money on an
investment”
Types of Market risk
• Interest rate risk
• The risk that interest rate will change

• Equity risk
• The risk that the price of a stock will increase or decrease

• Commodity risk
• The price of the commodities like oil, gold or agricultural items will change

• Currency risk
• Relative prices of different currencies will change

• Margining risk
• Uncertain future cash outflows due to margin calls covering adverse value changes
Operational risk

• the possibility of losses that can result from failed or flawed systems, processes,
policies, or events that disrupt business operations.

• caused by
• Employee errors

• Criminal activity, like fraud

• Physical events

• Poor computer systems

• Failure to comply with regulation

Solvency risk

“the risk that the business cannot meet its financial

obligations as they come due for full value even after
disposal of its assets”
Non Performing Assets - NPA

• Non-Performing Assets (NPAs) are loans or advances issued by banks

or financial institutions that no longer bring in money for the lender
since the borrower has failed to make payments on the principal and
interest of the loan for at least 90 days
Types of Non Performing Assets
(NPA)
• Sub-Standard Assets
• if it remains as an NPA for a period less than or equal to 12 months.

• Doubtful Assets
• if it remains as an NPA for more than 12 months.

• Loss Assets
• 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.
NPA Provisioning

• means an amount that the banks set aside from their profits or
income in a particular quarter for non-performing assets, such as
assets that may turn into losses in the future.

• a method by which banks provide for bad assets and maintain a

healthy book of accounts.
GNPA and NNPA

• GNPA stands for gross non-performing assets. GNPA is an absolute

amount. It tells you the total value of gross non-performing assets for
the bank in a particular quarter or financial year, as the case may be.

• NNPA stands for net non-performing assets. NNPA subtracts the

provisions made by the bank from the gross NPA. Therefore net NPA
gives you the exact value of non-performing assets after the bank has
made specific provisions.
NPA Ratios

• NPAs can also be expressed as a percentage of total advances. It gives

us an idea of how much of the total advances are not recoverable.
The calculation is:
• GNPA ratio is the ratio of the total GNPA of the total advances.

• NNPA ratio uses net NPA to determine the ratio to the total advances.
Mergers of Banks

“when two or more banks combine or one bank takes over

another, which can result in a number of changes for
customers and the banking industry”
To diversify risk, reduce cost and to increase efficiency

PNB – Oriental bank of Commerce

Bank of Baroda – Vijaya bank, Dena bank

Types of Merger
• Vertical merger
• A merger between companies that operate at different stages of the same
supply chain or production process

• Horizontal merger
• A merger between companies that deal in the same product or service.

• Conglomerate merger
• A merger between companies that have different products and/or services.
• Product extension merger
• A merger between companies that deal with related products or services.

• Reverse takeover
• An acquisition that makes a private company public without the need for an IPO

• Congeneric merger
• Also known as a concentric merger, this is a merger between companies that
serve the same industry but have different product and service lines.
• Consolidation
• The merger of many smaller companies.

• Management acquisition
• Also known as a management buyout (MBO), this is when a group led by the
current management of a company acquires a majority of the company's
shares
Acquisitions of Banks

“when one bank buys another, usually a smaller bank”

for a variety of reasons

Cost

Efficiency

Control

Customer reach
Types of Acquisition

• Friendly takeover

• Hostile takeover

• Reverse takeover

• Back-flip takeover