A A STUDY ON THE COST AND STUDY ON THE COST AND PROFITABILITY 14 OF BANKS IN INDIA. PROFITABILITY OF BANKS IN H.R.

Bachelor of CommerceCOLLEGE OF Banking & Insurance Bachelor of Commerce Semester V Banking & Insurance Semester V In Partial Fulfillment of the requirements (2012-13) For the Award of Degree of Bachelor of Commerce Banking & Insurance Submitted by DANISH PHIROZ DUBASH Submitted by COMMERCE & ECONOMICS MS. DANISH PHIROZ DUBASH 123, D.W. Road, Churchgate, Mumbai 400 020. Roll No.14 H.R. COLLEGE OF COMMERCE & ECONOMICS 123, D.W. Road, Churchgate, Mumbai 400 020.
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INDIA.

DECLARATION
H.R. COLLEGE OF COMMERCE & ECONOMICS 123, D.W. Road, Churchgate, Mumbai 400 020. External Examiner I Miss DANISH PHIROZ DUBASH the student of B.Com.- Banking & Insurance Semester V (20 12 - 2013) hereby declare that I have completed the Project on A Study on the Cost And Profitabilty Of Banks in India This is to certify that Shri / Miss DANISH PHIROZ DUBASH of B.Com.-Banking & Insurance Semester V (2012 - 2013 ) has successfully completed the and original to the on the my And The information submitted is true project on A Studybest of Costknowledge. Profitabilty Of Banks in India under the guidance of Prof. Meena Desai. Signature Course Co-ordinator DANISH PHIROZ DUBASH Roll No. 14 Project Guide / Internal Examiner Principal

CERTIFICATE

ACKNOWLEDGEMENT

I would like to express my gratitude to the professor in charge and my guide Prof. Meena Desai for her extensive support and guidance and also for providing the relevant information. I would like to thank our head Prof Heena Thakkar for providing us with the opportunity of such a unique learning experience.

EXECUTIVE SUMMARY.
The term 'profit' is an accounting concept which shows the excess of income over expenditure viewed during a specified period of time. Profit is the main reason for the continued existence of every commercial organisation. On the other hand, the term profitability is a relative measure where profit is expressed as a ratio, generally as a percentage. Profitability depicts the relationship of the absolute amount of profit with various other factors. Profitability is the most important and reliable indicator as it gives a broad indicator of the ability of a bank to raise its income level. Profitability of banks is affected by a number of factors. Some of these are endogenous, some are exogenous. Changes in policies made by RBI are exogenous to the system. These include changes in monetary policy, changes in quantitative credit control like changes in cash reserve ratio, statutory liquidity ratio, manipulation of bank rates, qualitative credit controls like selective credit control measures, credit deposit ratio, regionwise guidelines on lending to priority sector, changes in interest rates on deposits and advances, levy of tax on interest income etc. Various other factors like careful control of expenditure, timely recovery of loans are endogenous. In practice executives define profits in banks as the difference between total earnings from all earning assets and total expenditure on managing entire assetliabilities portfolio. In case of banks, the main source of income is interest earned and discount on bills discounted. Since banks accept various types of deposits from people so interest paid to customer is an important expenditure of the banks. The difference between interest earned and interest paid is known as spread and is a goodindicator of bank's efficiency. Establishment expenses covering salaries, provident fund, allowances, bonus and so on, form another important component of expenditure.Profit is the very reason for the continued existence of every commercial organisation.The rate of profitability and volume of profits are

therefore rightfully considered as indicators of efficiency in the deployment of resources of banks.

INDEX
Serial No.

Topic
Introduction to the Banking Sector Classification Of Banking Industry Need of Banks. Regulations for Indian Banks. Need For Cost And Profitabilty Of Banks. Cost And Profitabilty In Banks Assets & Liabilties of Banks. Reforms on Banking Systems Liquidity & Profitabilty . Performance and Profitability of Indian Banks in the Post Liberalization Period. Cost Determining Factors. FACTORS AFFECTING THE PROFITABILITY OF BANKS . FACTORS DETERMINING THE LIQUIDITY OF BANKS . Liquidity Risk Management Assessment of Liquidity Management in Banks. Data Envelopment Analysis for Assesment of Costs and Profitabilty. Rising Interest Rates & Banks Profit Service Charges: Major Costs of the Banks in India ANALYSIS OF FINANCIAL STATEMENTS OF BANKS : PROFIT, PROFITABILITY AND BREAK EVEN LEVEL

Page No.

9-14

2 3 4 5 6 7 8 9 10 11 12 13 14 15

15-16 17-23 24-27 28-29 30-32 33 34-35 36-37 38-40 41-42 43-46 47-48 49-51 52-60

16 17 18

Challeneges before Mangements of Banks. Articles relating to Cost and Profitability of Banks. Bibliography & References.

61-62 63-70 71

Introduction to the Banking Sector in INDIA.

A bank is a financial institution that provides banking and other financial services to their customers. A bank is generally understood as an institution which provides fundamental banking services such as accepting deposits and providing loans. There are also nonbanking institutions that provide certain banking services without meeting the legal definition of a bank. Banks are a subset of the financial services industry. A banking system also referred as a system provided by the bank which offers cash management services for customers, reporting the transactions of their accounts and portfolios, through out the day. The banking system in India, should not only be hassle free but it should be able to meet the new challenges posed by the technology and any other external and internal factors. For the past three decades, Indias banking system has several outstanding achievements to its credit. The Banks are the main participants of the financial system in India. The Banking sector offers several facilities and opportunities to their customers. All the banks safeguards the money and valuables and provide loans, credit, and payment services, such as checking accounts, money orders, and cashiers cheques. The banks also offer investment and insurance products. As a variety of models for cooperation and integration among finance industries have emerged, some of the traditional distinctions between banks, insurance companies, and securities firms have diminished. In spite of these changes, banks continue to maintain and perform their primary roleaccepting deposits and lending funds from these deposits.
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Classification of Banking Industry in India

Indian banking industry has been divided into two parts, organized and unorganized sectors. The organized sector consists of Reserve Bank of India, Commercial Banks and Co-operative Banks, and Specialized Financial Institutions (IDBI, ICICI, IFC etc). The former two have since become full fledged Banks.The unorganized sector, which is not homogeneous, is largely made up of money lenders and indigenous bankers. An outline of the Indian Banking structure may be presented as follows:1. Reserve banks of India. 2. Indian Scheduled Commercial Banks. a) State Bank of India and its associate banks. b) Twenty nationalized banks. c) Regional rural banks. d) Other scheduled commercial banks. 3. Foreign Banks 4. Non-scheduled banks. 5. Co-operative banks.

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Need of the Banks.

Before the establishment of banks, the financial activities were handled by money lenders and individuals. At that time the interest rates were very high. Again there were no security of public savings and no uniformity regarding loans. So as to overcome such problems the organized banking sector was established, which was fully regulated by the government. The organized banking sector works within the financial system to provide loans, accept deposits and provide other services to their customers. The following functions of the bank explain the need of the bank and its importance: To provide the security to the savings of customers. To control the supply of money and credit To encourage public confidence in the working of the financial system, increase savings speedily and efficiently. To avoid focus of financial powers in the hands of a few individuals and institutions. To set equal norms and conditions (i.e. rate of interest, period of lending etc) to all types of customers.

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Regulations for Indian banks

Currently in most jurisdictions commercial banks are regulated by government entities and require a special bank license to operate. Usually the definition of the business of banking for the purposes of regulation is extended to include acceptance of deposits, even if they are not repayable to the customer's orderalthough money lending, by itself, is generally not included in the definition. Unlike most other regulated industries, the regulator is typically also a participant in the market, i.e. a government-owned (central) bank. Central banks also typically have a monopoly on the business of issuing banknotes. However, in some countries this is not the case. In UK, for example, the Financial Services Authority licenses banks, and some commercial banks (such as the Bank of Scotland) issue their own banknotes in addition to those issued by the Bank of England, the UK government's central bank. Some types of financial institutions, such as building societies and credit unions, may be partly or wholly exempted from bank license requirements, and therefore regulated under separate rules. The requirements for the issue of a bank license vary between jurisdictions but typically include: Minimum capital & Minimum capital ratio 'Fit and Proper' requirements for the bank's controllers, owners, directors, and/or senior officers

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 Approval of the bank's business plan as being sufficiently prudent and plausible. Indian Scheduled Commercial Banks The commercial banking structure in India consists of scheduled commercial banks, and unscheduled banks.

Scheduled Banks: Scheduled Banks in India constitute those banks which have been included in the second schedule of RBI act 1934. RBI in turn includes only those banks in this schedule which satisfy the criteria laid down vide section 42(6a) of the Act. Scheduled banks in India means the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the s State Bank of India (subsidiary banks) Act, 1959 (38 of 1959), a corresponding new bank constituted under section 3 of the Banking companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the Second Schedule to the Reserve bank of India Act, 1934 (2 of 1934), but does not include a co-operative bank. For the purpose of assessment of performance of banks, the Reserve Bank of India categories those banks as public sector banks, old private sector banks, new private sector banks and foreign banks, i.e. private sector, public sector, and foreign banks come under the umbrella of scheduled commercial banks.

Regional Rural Bank: The government of India set up Regional Rural Banks (RRBs) on October 2, 1975 . The banks provide credit to the
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weaker sections of the rural areas, particularly the small and marginal farmers, agricultural labourers, and small enterpreneurs. Initially, five RRBs were set up on October 2, 1975 which was sponsored by Syndicate Bank, State Bank of India, Punjab National Bank, United Commercial Bank and United Bank of India. The total authorized capital was fixed at Rs. 1 Crore which has since been raised to Rs. 5 Crores. There are several concessions enjoyed by the RRBs by Reserve Bank of India such as lower interest rates and refinancing facilities from NABARD like lower cash ratio, lower statutory liquidity ratio, lower rate of interest on loans taken from sponsoring banks, managerial and staff assistance from the sponsoring bank and reimbursement of the expenses on staff training. The RRBs are under the control of NABARD. NABARD has the responsibility of laying down the policies for the RRBs, to oversee their operations, provide refinance facilities, to monitor their performance and to attend their problems.

Unscheduled Banks: Unscheduled Bank in India means a banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled bank.

There are several types of banks, which differ in the number of services they provide and the clientele (Customers) they serve. Although some of the differences between these types of banks have lessened as they have begun to expand the range of products and services they offer, there are still key distinguishing traits. These banks are as follows:

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Commercial banks, which dominate this industry, offer a full range of services for individuals, businesses, and governments. These banks come in a wide range of sizes, from large global banks to regional and community banks.

Global banks are involved in international lending and foreign currency trading, in addition to the more typical banking services.

Regional banks have numerous branches and automated teller machine (ATM) locations throughout a multi-state area that provide banking services to individuals. Banks have become more oriented toward marketing and sales. As a result, employees need to know about all types of products and services offered by banks.

Community banks are based locally and offer more personal attention, which many individuals and small businesses prefer. In recent years, online bankswhich provide all services entirely over the Internethave entered the market, with some success.

However, many traditional banks have also expanded to offer online banking, and some formerly Internet-only banks are opting to open branches.

Savings banks and savings and loan associations, sometimes called thrift institutions, are the second largest group of depository institutions. They were first established as community-based institutions to finance mortgages for people to buy homes and still cater mostly to the savings and lending needs of individuals.

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Credit unions are another kind of depository institution. Most credit unions are formed by people with a common bond, such as those who work for the same company or belong to the same labour union or church. Members pool their savings and, when they need

money, they may borrow from the credit union, often at a lower interest rate than that demanded by other financial institutions.

Need for Cost management & Profitability in Banks.

Banks earn profit when its business costs and expenses are less than its revenues through its services and investments. Any business for that matter survives only if it earns profits. Although Banking is considered as a bloodline of economy of a nation, to provide a reasonable return for the above-cited huge capital expenditures and to remain servicing any economy, profitability of the banks is a must. To remain profitable, 'efficient & effective cost management' of its entire operations is the need of the day for the banking sector. Besides this basic need of earning profit for survival, contrary to other business activities, the banks are uniquely positioned to face many constraints to earn even normal profits for its services. The following are some of the bottlenecks the banks have to circumvent to earn profits. 1. The worlds over most of the Banks are predominantly regulated by respective Governments to serve their national objectives like food production, rural development, health, education etc. Banks lend their borrowed funds to other borrowers with needs spread across different time periods. Since banks rely on borrowed money, they need to raise resources in a matching manner to avoid the risk of asset-liability mismatch. At the systemic level often banks face small gaps in their
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matching maturity profiles of their resources due to frequent change in regulatory provisions. 2. Banking business involves greater risk than many other businesses owing to its nature of commodity of transactions-money. 3. The increased range and complexity of bank operations calls for Sophisticated risk management systems and techniques, planning tools and processes that demands additional capital. 4. Business expansion and implementation of Basel-II accord are forcing Banks to shore up capital resources. 5.Burgeoning NPAs in the books of Banks drain the precious resources of the Banks by way of prudential provisioning for bad assets that is the banks chief scourge. 6. Customer driven competitive environment- Customers are less loyal and demand immaculate service delivery. 7. Competition from post offices and non-bank technology companies due to onset of e-commerce with extensive intermediation. 8. Growing interest rates strain the interest spreads. 9. Economies of scale to support new products and services.

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Cost & Profitability in Banks.

According to a Credit Rating and Information Services of India (Crisil) study, Lower operating expenses including rationalisation of employee costs have improved the profitability of banks, contrary to the popular perception that only trading profits helped the banking sector shore up their bottomlines. The reduction in operating expenses was achieved through large-scale voluntary retirement schemes implemented by public sector banks. Since this reduction in operating expenses seems sustainable, it promises a brighter future for the banking sector. Although the non-interest income of banks did increase by 0.3% during this period, it was more than offset by a 0.21% increase in provisions and an identical decline in spreads. Compared to the relatively volatile treasury income, the reduction in operating expenses imparts a greater level of comfort in terms of the banking sector's ability to sustain its profitability in the future. The banking sectors overall profitability as measured by the return on average assets (RoAA) has improved to 0.84 per cent in 2001-02 from 0.53 per cent in 2000-01. An analysis of the incremental change in the various profitability components shows that: * In 2001-02, the sectors non-interest income rose by 32 basis points (bps) over the previous year, primarily due to an increase in treasury profits. On
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the other hand, the net interest income or interest spread declined by 21 bps in the same period. This was in line with the declining interest rate regime and increasing competition in the sector. At the same time, provision and contingency charges rose by 21 bps. Together, the two more than offset the incremental contribution from the non-interest income. * Operating expenses, however, declined significantly by 41 bps in 2001-02 over 2000-01 and this enabled the banking sector to report an overall increase in profitability by 31 bps. The reduction in operating expenses can be attributed to the large-scale voluntary retirement schemes (VRS) being implemented across all public sector banks as well as other cost-cutting measures. A closer analysis of the different banking groups (public sector banks, old private sector banks, new private sector banks and foreign banks) also shows that the reduction in operating expenses was only experienced by the public sector and foreign banks. For private sector banks, the profitability improvement was mainly because of the increase in treasury income and not due to any material reduction in operating expenses. But since public sector and foreign banks account for over 80 per cent of the total assets of all scheduled commercial banks, a reduction in their core operating expenses contributes significantly in improving the profitability of the entire Indian banking sector. Crisil believes that the banking sector is now reaping the benefits of rationalising its employee costs and undertaking other cost-reduction initiatives, which is a welcome sign in terms of the banks financial performance. Crisil, however, pointed out that banks ability to repeat and sustain such efforts would be critical in maintaining their profitability, given the increasing pressure on interest spreads and rising provisioning levels.

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SOURCES OF BANKS INCOME

A bank is a business organisation engaged in the business of borrowing and lending money. A bank can earn income only if it borrows at a lower rate and lends at a higher rate. The difference between the two rates will represent the costs incurred by the bank and the prot. Bank also provides a number of services to its customers for which it charges commission.

This is also an important source of income. The followings are the various sources of a banks prot: 1. Interest on Loans: The main function of a commercial bank is to borrow money for the purpose of lending at a higher rate of interest. Bank grants various types of loans to the industrialists and traders. The yields from loans constitute the major portion of the income of a bank. The banks grant loans generally for short periods. But now the banks also advance call loans which can be called at a very short notice. Such loans are grantedto share brokers and other banks. These assets are highly liquid because they can be called at any time. Moreover, they are source of income to the bank. 2. Interest on Investments: Banks also invest an important portion of their resources in government and other rst class industrial securities. The interest and dividend received from time to time on these investments is a source of income for the banks. Bank also earn some income when the market prices of these securities rise.
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3. Discounts: Commercial banks invest a part of their funds in bills of exchange by discounting them. Banks discount both foreign and inland bills of exchange, or in other words, they purchase the bills at discount and receive the full amount at the date of maturity. For instance, if a bill of Rs. 1000 is discounted for Rs. 975, the bank earns a discount of Rs. 25 because bank pays Rs. 975 today, but will get Rs. 1000 on the due date. Discount, as a matter of fact, is the interest on the amount paid for the remaining period of the bill. The rate of discount on bills of exchange is slightly lower than the interest rate charged on loans and advances because bills are considered to be highly liquid assets. 4. Commission, Brokerage, etc.: Banks perform numerous services to their customers and charge commission, etc., for such services. Banks collect cheques, rents, dividends, etc., accepts bills of exchange, issue drafts and letters of credit and collect pensions and salaries on behalf of their customers. They pay insurance premiums, rents, taxes etc., on behalf of their customers. For all these services banks charge their commission. They also earn locker rents for providing safety vaults to their customers. Recently the banks have also started underwriting the shares and debentures issued by the joint stock companies for which they receive underwriting commission. Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of credit and help remittance of funds in foreign countries. They also act as brokers in foreign exchange. Banks earn income out of these operations. INVESTMENT POLICY OF BANKS The nancial position of a commercial bank is reected in its balance sheet. The balance sheet is a statement of the assets and liabilities of the bank. The assets of the bank are distributed in accordance with certain guiding principles. These principles underline the investment policy of the bank. They are discussed below: 1. Liquidity: In the context of the balance sheet of a bank the term liquidity has two interpretations. First, it refers to the ability of the bank to honour
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the claims of the depositors. Second, it connotes the ability of the bank to convert its non-cash assets into cash easily and without loss. It is a well known fact that a bank deals in funds belonging to the public. Hence, the bank should always be on its guard in handling these funds. The bank should always have enough cash to meet the demands of the depositors. In fact, the success of a bank depends to a considerable extent upon the degree of condence it can instill in the minds of its depositors. If the depositors lose condence in the integrity of their bank, the very existence of the bank will be at stake. So, the bank should always be prepared to meet the claims of the depositors by having enough cash. Among the various items on the assets side of the balance sheet, cash on hand represents the most liquid asset. Next comes cash with other banks and the central bank. The order of liquidity goes on descending. Liquidity also means the ability of the bank to convert its non-cash assets into cash easily and without loss. The bank cannot have all its assets in the form of cash because each is an idle asset which does not fetch any return to the bank. So some of the assets of the bank, money at call and short notice, bills discounted, etc. could be made liquid easily and without loss. 2. Protability: A commercial bank by denition, is a prot hunting institution. The bank has to earn prot to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and to meet the day-to-day expenditure. Since cash is the least protable asset to the bank, there is no point in keeping all the assets in the form of cash on hand. The bank has got to earn income. Hence, some of the items on the assets side are prot yielding assets. They include money at call and short notice, bills discounted, investments, loans and advances, etc. Loans and advances, though the least liquid asset, constitute the most protable asset to the bank. Much of the income of the bank accrues by way of interest charged on loans and advances. But, the bank has to be highly discreet while advancing loans. 3. Safety or Security: Apart from liquidity and protability, the bank should look to the principle of safety of its funds also for its smooth working. While
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advancing loans, it is necessary that the bank should consider the three C s of credit character, capacity and the collateral of the borrower. The bank cannot afford to invest its funds recklessly without considering the principle of safety. The loans and investments made by the bank should be adequately secured. For this purpose, the bank should always insist on security of the borrower. Of late, somehow or other the banks have not been paying adequate importance to safety, particularly in India. 4. Diversity: The bank should invest its funds in such a way as to secure for itself an adequate and permanent return. And while investing its funds, the bank should not keep all its eggs in the same basket. Diversication of investment is necessary to avoid the dangerous consequences of investing in one or two channels. If the bank invest its funds in different types of securities or makes loans and advances to different objectives and enterprises, it shall ensure for itself a regular ow of income. 5. Saleability of Securities: Further, the bank should invest its funds in such types of securities as can be easily marketed at a time of emergency. The bank cannot afford to invest its funds in very long term securities or those securities which are unsaleable. It is necessary for the bank to invest its funds in government or in rst class securities or in debentures of reputed rms. It should also advance loans against stocks which can be easily sold. 6. Stability in the Value of Investments: The bank should invest its funds in those stocks and securities the prices of which are more or less stable. The bank cannot afford to invest its funds in securities, the prices of which are subject to frequent uctuations. 7. Principles of Tax-Exemption of Investments: Finally, the investment policy of a bank should be based on the principle of tax exemption of investments. The bank should invest in those government securities which are exempted from income and other taxes. This will help the bank to increase its prots. Of late, there has been a controversy regarding the relative importance of the various principles inuencing the investment

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policy of a bank particularly between liquidity and protability. It is interesting to examine this controversy. The bank should have adequate cash to meet the claims of the depositors. It is true that a successful banking business calls for installing condence in the minds of the depositors. But, it should be noted that accepting deposits is not the only function of a bank. Moreover, the bank cannot afford to forget the fact that it has to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and meet the day-to-day expenditure. If the bank keeps all its resources in liquid form, it will not be able to earn even a rupee. But protability is a must for the bank. Though cash on hand is the most liquid asset, it is the least protable asset as well. Cash is an idle asset. Hence, the banker cannot concentrate on liquidity only. If the bank attaches importance to protability only, it would be equally disastrous to the very survival of a bank. It is true that a bank needs income to meet its expenditure and pay returns to the depositors and shareholders. The bank cannot undermine the interests of the depositors. If the bank lends out all its funds it will be left with no cash at all to meet the claims of the depositors. It should be noted that the bank should have cash to honour the obligations of the depositors. Otherwise, there will be a run on the bank. A run on the bank would be suicidal to the very existence of the bank. Loans and advances, though the most protable asset, constitute the least liquid asset. It follows from the above that the choice is between liquidity and protability. The constant tug of war between liquidity and protability is the feature of the assets side. According to Crowther, liquidity and protability are opposing or conicting considerations. The secret of successful banking lies in striking a balance between the two.

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Assets & Liabilties of Banks.

According to Crowther, the assets side of the balance sheet is more complicated and interesting. Assets are the claims of the bank on others. In the distribution of its assets, the bank is governed by certain well dened principles. These principles constitute the principles of the investment policy of the bank or the principles underlying the distribution of the assets of the bank. The most important guiding principles of the distribution of assets of the bank are liquidity, protability and safety or security. In fact, the various items on the assets side are distributed according to the descending order of liquidity and the ascending order of protability. 1. Cash: Here we can distinguish cash on hand from cash with central bank and other banks cash on hand refers to cash in the vaults of the bank. It constitutes the most liquid asset which can be immediately used to meet the obligations of the depositors. Cash on hand is called the rst line of defence to the bank. In addition to cash on hand, the bank also keeps some money with the central bank or other commercial banks. This represents the second line of defence to the bank. 2. Money at Call and Short Notice: Money at call and short notice includes loans to the brokers in the stock market, dealers in the discount market and to other banks. These loans could be quickly converted into cash and without loss, as and when the bank requires. At the same time, this item yields income to the bank. The signicance of money at call and short notice is that it is used by the banks to effect desirable adjustments in

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the balance sheet. This process is called Window Dressing. This item constitutes the third line of defence to the bank. 3. Bills Discounted: The commercial banks invest in short term bills consisting of bills of exchange and treasury bills which are self-liquidating in character. These short term bills are highly negotiable and they satisfy the twin objectives of liquidity and protability. If a commercial bank requires additional funds, it can easily rediscount the bills in the bill market and it can also rediscount the bills with the central bank. 4. Bills for Collection: As mentioned earlier, this item appears on both sides of the balance sheet. 5. Investments: This item includes the total amount of the prot yielding assets of the bank. The bank invests a part of its funds in government and non-government securities. 6. Loans and Advances: Loans and advances constitute the most protable asset to the bank. The very survival of the bank depends upon the extent of income it can earn by advancing loans. But, this item is the least liquid asset as well. The bank earns quite a sizeable interest from the loans and advances it gives to the private individuals and commercial rms.

Liabilities
Liabilities are those items on account of which the bank is liable to pay others. They denote others claims on the bank. Now we have to analyse the various items on the liabilities side. 1. Capital: The bank has to raise capital before commencing its business. Authorised capital is the maximum capital upto which the bank is empowered to raise capital by the Memorandum of Association. Generally, the entire authorised capital is not raised from the public. That part of authorised capital which is issued in the form of shares for public subscription is called the issued capital. Subscribed capital represents that part of issued capital which is actually subscribed by the public. Finally, paid-up capital is that part of the subscribed capital which the subscribers are actually called upon to pay.
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2. Reserve Fund: Reserve fund is the accumulated undistributed prots of the bank. The bank maintains reserve fund to tide over any crisis. But, it belongs to the shareholders and hence a liability on the bank. In India, the commercial bank is required by law to transfer 20 per cent of its annual prots to the Reserve fund. 3. Deposits: The deposits of the public like demand deposits, savings deposits and xed deposits constitute an important item on the liabilities side of the balance sheet. The success of any banking business depends to a large extent upon the degree of condence it can instill in the minds of the depositors. The bank can never afford to forget the claims of the depositors. Hence, the bank should always have enough cash to honour the obligations of the depositors. 4. Borrowings from Other Banks: Under this head, the bank shows those loans it has taken from other banks. The bank takes loans from other banks, especially the central bank, in certain extraordinary circumstances. 5. Bills Payable: These include the unpaid bank drafts and telegraphic transfers issued by the bank. These drafts and telegraphic transfers are paid to the holders thereof by the banks branches, agents and correspondents who are reimbursed by the bank. 6. Acceptances and Endorsements: This item appears as a contra item on both the sides of the balance sheet. It represents the liability of the bank in respect of bills accepted or endorsed on behalf of its customers and also letters of credit issued and guarantees given on their behalf. For rendering this service, a commission is charged and the customers to whom this service is extended are liable to the bank for full payment of the bills. Hence, this item is shown on both sides of the balance sheet. 7. Contingent Liabilities: Contingent liabilities comprise of those liabilities which are not known in advance and are unforeseeable. Every bank makes some provision for contingent liabilities.

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8. Prot and Loss Account: The prot earned by the bank in the course of the year is shown under this head. Since the prot is payable to the shareholders it represents a liability on the bank. 9. Bills for Collection: This item also appears on both the sides of the balance sheet. It consists of drafts and hundies drawn by sellers of goods on their customers and are sent to the bank for collection, against delivery documents like railway receipt, bill of lading, etc., attached thereto. All such bills in hand at the date of the balance sheet are shown on both the sides of the balance sheet because they form an asset of the bank, since the bank will receive payment in due course, it is also a liability because the bank will have to account for them to its customers.

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Reforms on Banking Systems Liquidity & Profitabilty .

The liberalization of the Indian banking system dates back to the 1990s when the government began to implement the recommendations of the Narasimham Committee (1992, 1997). The principal features of the steps taken to liberalize and reform the system include: 1. Increase in competition via more liberal rules for the entry of new domestic andforeign banks, raising the number of banks from 70 to over 90 by March 2004. Recent consolidation in the industry has reduced the number of total number of banks to 80 with number of foreign banks declining from a peak of 40 to 29 and private banks shrinking to 27 by end March 2007. Since 1993, twelve new private sector banks were set up but some of them have already either merged with other PSBs or private banks or have gone out of business. Foreign direct investment in private sector banks is allowed up to 74%. 2. Infusion of Government capital in PSBs followed by Injection of private equity. PSBs are allowed to increase the share of private capital upto 49% of which 20% can be foreign equity. As a result, the share of wholly
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Government-owned public sector banks in total system assets fell from 90% in 1991 to 10% in 2004 3. Deregulation on interest rates except for certain specific classes such as savings deposit accounts, NRI deposits, small loans up to Rs. 2 lakh, and exports credits. 4. Cuts in Statutory Liquidity Requirements (SLR) and Cash Reserve Requirements (CRR) to reduce pre-emption of bank lending and lower financial repression. 5. Reduction in credit controls to 40% from 80% of total credit. 6. Introduction of a broader definition of priority sector lending. 7. Incentives to increase consumer loans including long term home mortgages. 8. Implementation of micro-prudential measures including Basle-based capital adequacy requirements, income recognition, asset classification and provisioning norms for loans, exposure norms and accounting norms. 9. Emphasis on performance, transparency and accountability.

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Performance and Profitability of Indian Banks in the Post Liberalization Period.

While inputs and outputs are easily identified in most businesses, that is hardly the case in banking. At the heart is the question of whether deposits are input or output. A typical financial intermediation role for banks involves the use of deposits together with physical inputs of land, labor and capital to make loans and earn interest income. Banks also recognize the importance of generating non-interest income as an anti-dote to the variability in interest income. This approach suggests that we should treat the number of bank branches, total operating expenses and deposits as inputs and loans (advances) and non-interest income as outputs. In this formulation, deposits are not coveted as an independent output; instead they are treated only as a conduit to generating loans. In most banking systems, bank investments (in addition to loans) are also considered as a legitimate output. But such investments in India are mostly in government securities which are often thought of as reflections of lazy banking. According to this line of thinking, higher investments simply imply that banks are not pushing loans adequately. In view of this, we do not use investments as banks output. But the treatment of deposits as an input is far from a universally accepted framework. Indeed, deposit generation is thought of as a legitimate
31

objective of banking by many analysts. The promotion of banking in India was partly motivated by the desire to inculcate banking habits among the masses and generate deposits. Hence, state-owned 4banks were encouraged to expand branch networks everywhere, including rural areas. Equally relevant is the observation that people demand deposits for the services of recordkeeping and safe-keeping, and that these services render deposits as outputs of banking activity. (Srivastava, 1999). Thus, it is not unreasonable to specify deposits as an output that is produced together with loans and non-interest income using physical inputs such as the number of bank branches and operating expenses. TABLE 1 Branches ( % Total)
Banks State1997* 26.9 2004 25.7 6.29 8.3 2.7 0.3 2007 24.6 62.4 8.1 4.4 0.5
ATMS (% Total)

Deposits (% Total) Advances (% Total)

2007 1997 23.5 50.4 5.1 31.7 52.5 7.2 2.7 6.0 2004 2007 25.7 48 6.8 13.1 6.5 24.3 48.4 4.7 16.2 6.4

2007* 1997 2004 * 23.8 36.5 5.9 30.2 3.5 28.2 58.6 6.4 2.0 4.8 27.6 50.7 7.0

owned Nationalized 65.0 Private-Old Private-New Foreign 7.7 6.2 0.1

101.1 15.3 4.5 5.6

*End March Partly in response to these measures and partly as a result of the economys improved performance, the Indian banking sectors characteristics have changed and its health has improved. Old and new private banks have increased their market share in terms of number of branches and ATMs as well as share in deposits and loans at the expense
32

of state-owned and nationalized banks (Table 1). Since 1997, net interest margins have declined in every segment of the banking system save nationalized banks and profit margins with and without taxes have improved acrossthe-board save new private banks upto 2004 but private banks net interest margins and profits started improving from 2005 and outstripped overall industry margins. All in all, industry-wide net interest and profit margins peaked in 2004 and have not recovered from their downward spiral to date.

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COST DETERMINING FACTORS.

Role of equity capital has become more significant since the adoption of Basel Accords I and II by all banks in India under guidance from the Reserve Bank of India. Under Basel Accord II, all banks have achieved risk weighted capital adequacy ratio of 10% by 2006 or so. The number of branches is a very important factor in providing banking products and services, especially in a country like India where a majority of a banks customers are likely to have only limited ability to travel. An extensive bank branch network should cut the shoe-leather costs of banking and allow a bank to generate more deposits and more loans with the same level of operating expenses. In recent years, banks have been moving towards automation and computerization of operations, adding ATMs across the country and encouraging their customers to use internet banking. As a result of transition to automation and computerization as well as ATMs and internet banking, operating costs are likely to decline while fixed costs increase but we would still expect an overall improvement in bank efficiency and profitability.

34

FACTORS AFFECTING THE PROFITABILITY OF BANKS .

1) Amount of Working Funds : Funds deployed by a bank in profitable assets are the working funds of the bank. Profitability of a business is directly proportionate to the amount of working funds dePloyed by the bank. 2) Cost of Funds : Cost of funds are the expenses incurred on obtaining funds from various sources in the form of share capital, reserves, deposits, and borrowings. Thus, it generally refers to interest expenses. Lower the cost of funds, higher the profitability. 3) Yield on Funds : The funds raised by the bank through various sources are deployed in various assets. These assets yield income in the form of interest. So, higher the interest, greater the profitability. 4) Spread : Spread is defined as the difference between the interest received (interest income ) and the interest paid (interest expense ).
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Higher spread indicates more efficient financial intermediation and higher net income. Thus, higher spread leads to higher profitability.

5) Operating Costs : Operating costs are the expenses incurred in the functioning of the bank Excluding cost of funds, all other expenses are operating costs. Lower operating costs give rise to greater profitability of the banks. 6) Risk Cost : This cost is associated to the probable annual loss on assets. They include provisions made towards bad debts and doubtful debts. Lower risk costs increase the profitability of banks. 7) Non interest income : It is the income derived from non financial assets and services It includes commission & brokerage on rencittance facility, rent of locker facility, fees for underwriting and financial guarantees, etc. This income adds to the profitability of banks. 8) Level of Technology : Use of upgraded technology normally leads to decline in the operating costs of banks. This improves the profitability of banks. 9) Level of Non performing assets (NPAs): The profitability of a bank is inversely related to the level of NPAs. Hence, over the years, the NPAs of commercial banks have greatly declined.
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10) Level of competition : Increase in competition generally leads to higher operating costs. This leads to lower profitability.

FACTORS DETERMINING THE LIQUIDITY OF BANKS .

1)

STATUTORY REQUIREMENTS : The extent of liquid reserves held by banks depends on the statutory requirements of the Central Bank (i.e. the RBI) According to RBI, commercial banks have to maintain a certain CRR(cash Reserve Ratio ) and SLR (statutory liquid ratio) Higher CRR and SLR result in lower liquidity.

2) Banking Habits of the People : The nature of the economy has an impact on the banking habits of the people. In developing countries, cheque transactions are confined to business. Individuals depend more on cash transactions Hence, the need for liquidity is comparatively higher.

3) Monetary Transactions : The number and magnitude of monetary transactions determine the liquidity of banks. Higher monetary transaction leads to higher liquidity.

37

4) Nature of Money Market : In case of fully developed money markets, banks buy and sell securities easily. Therefore, liquidity requirement is lower. 5) Structure of Banking System : Branch banking system requires lower liquidity since cash reserves can be centralized in the head office. Unit Banking System requires higher degree of liquidity.

6) Number and Size of Deposits : The number and sized of deposits influence the liquidity of banks. Increase in the number & size of deposits will require higher liquidity. 7) Nature of Deposits : Deposits trade with the banks are of various types like time deposits, demand deposits, short term deposits, etc. larger demand deposits /short term deposits need higher liquidity.

8) Liquidity Policies of other Banks : Various banks may function in the same area So, liquidity policies of other banks also have an impact on the liquidity of a bank to build goodwill among depositors.

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Liquidity Risk Management

What is Liquidity Risk : Liquidity risk is the potential inability to meet the liabilities as they become due. It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities. Importance of Liquidity Risk : Measuring and managing liquidity needs are vital for effective operation of commercial banks. By assuring a banks ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. Liquidity Risk Management Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also examining how funding requirements are likely to be affected under crisis scenarios. Net funding requirements are determined by analyzing the banks future cash flows based on assumptions of the future behavior of assets and liabilities that are classified into specified time buckets and then calculating the cumulative net flows over the time frame for liquidity assessment. Future cash flows are to be analysed under what if scenarios so as to assess any significant positive / negative liquidity swings that could occur on a day-to-day basis and under bank specific and general market crisis scenarios. Factors to be taken into consideration while determining liquidity of the banks future stock of assets and liabilities include:

their potential marketability, the extent to which maturing assets /liability will be renewed, the acquisition of new assets / liability and the normal growth in asset / liability accounts.
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Factors affecting the liquidity of assets and liabilities of the bank cannot always be forecast with precision. Hence they need to be reviewed frequently to determine their continuing validity, especially given the rapidity of change in financial markets. The liquidity risk in banks manifest in different dimensions: (a) Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);
(b) Time

Risk need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

(c) Call Risk due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

Measurement of Liquidity:
Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are Loans to Total Assets, Loans to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans, However, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money marketinstruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The following prudential limits are considered by Banks to put in place to avoid liquidity crisis:(i) Cap on inter-bank borrowings, especially call borrowings;
40

(ii) Purchased funds vis--vis liquid assets; (iii) Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans; (iv) Duration of liabilities and investment portfolio; (v) Maximum Cumulative Outflows across all time bands; (vi) Commitment Ratio track the total commitments given to corporates / banks and other financial institutions to limit the off-balance sheet exposure; (vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

41

Assessment of Liquidity Management in Banks.

Developing a Structure for Managing Liquidity Each bank should have an agreed strategy for the day-to-day management of liquidity. This strategy should be communicated throughout the organisation. A banks board of directors should approve the strategy and significant policies related to the management of liquidity. The board should also ensure that senior management takes the steps necessary to monitor and control liquidity risk. The board should be informed regularly of the liquidity situation of the bank and immediately if there are any material changes in the banks current or prospective liquidity position. Each bank should have a management structure in place to execute effectively the liquidity strategy. This structure should include the ongoing involvement of members of senior management. Senior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are established to control and limit liquidity risk. Banks should set and regularly review limits on the size of their liquidity positions over particular time horizons. A bank must have adequate information systems for measuring, monitoring, controlling and reporting liquidity risk. Reports should be provided on a timely basis to the banks board of directors, senior management and other appropriate personnel. Measuring and Monitoring Net Funding Requirements Each bank should establish a process for the ongoing measurement and monitoring of net funding requirements. A bank should analyse liquidity utilising a variety of what if scenarios. A bank should review frequently the assumptions utilised in managing liquidity to determine that they continue to be valid. Managing Market Access
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Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets.

Contingency Planning A bank should have contingency plans in place that address the strategy for handling liquidity crises and include procedures for making up cash flow shortfalls in emergency situations. Foreign Currency Liquidity Management Each bank should have a measurement, monitoring and control system for its liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually. Subject to the analysis undertaken according to Principle 10, a bank should, where appropriate, set and regularly review limits on the size of its cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which the bank operates. Internal Controls for Liquidity Risk Management Each bank must have an adequate system of internal controls over its liquidity risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to supervisory authorities. Role of Public Disclosure in Improving Liquidity Each bank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information about the bank in order to manage public perception of the organisation and its soundness.

43

Data Envelopment Analysis for Assesment of Costs and Profitabilty.

Data Envelopment Analysis (DEA), developed by Charnes, Cooper and Rhodes (1978), uses principles of linear programming to examine how a particular decisionmaking unit (DMU) like a bank in our exercise operates relative to other DMUs in the sample. Efficiency is defined by the ratio of output to input. This is straight forward when there is only one output and one input. But the task becomes complex where multiple of outputs and inputs are involved. DEA gets around this problem by constructing an efficiency frontier from weighted outputs (virtual output) and weighted inputs (virtual input). DMUs on the frontier are assigned an efficiency score of 1 while those inside receive scores of between zero and one. The further away a bank is from the frontier, the lower its efficiency score. While inputs and outputs are easily identified in most industries, it is not so in the banking industry. The DEA studies of bank efficiency have typically used either the intermediation approach or the production approach in selecting outputs and inputs. The former considers banks as ntermediaries that use deposits together with other inputs such as labor and capital to produce outputs like loans. Hence, the intermediation approach views
44

deposits as an input. In the production approach, however, banks are thought of as service providers and deposits are considered as an output. Thus, the production approach postulates that banks produce deposits, and loans using labor and capital as inputs. In using the two approaches, we also consider non-interest income earned by each banks as a distinct output in view of the emphasis banks themselves place on it as a stable source of income. As our subsequent quantitative analysis shows, whether deposits are treated as an input or an output does not appear to make any difference to the efficiency scores of various banks. A few DEA-based studies of efficiency in the Indian banking system have appeared in recent years. They have used a variety of specifications for inputs and outputs as evident from the Table below.

Author(s)
Bhattacharyya A. C.A.K. Lovell & P. Sahay Saha & Ravisankar

Inputs
Interest Expense, Operating Expense No. of Branches, No. of Employees, Nonestablishment

Outputs
Advances, Deposits Investments

Period
1986-91

Advances, Deposits, Investments, Spread, Total Income, Interest Income

1991-92 1994-95

Establishment & & Non-interest

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Expenditures Ketkar & Noulas Capital, No. Employees Deposits

Investments Advances

1993

Author(s)
Ketkar, Noulas & Agarwal

Inputs
Capital No. of Employees Deposits Operating

Outputs

Period

InvestmentsAdvances 1990-1995

Rammohan &

Investments, Loans & 1992-2000 Non-interest Income Investments, Performing Loans , Equity Non-interest Income 1997-2003

Ray Costs, Deposits Das A. A. Nag & Borrowed S. Ray Funds, No. of Employees, Fixed Assets,

Inputs vary from purely financial such as interest and non-interest expenses to purely physical like number of branches and employees. Outputs are either income related -- interest and non-interest income or product/service related loans, investments and non-interest income. Deposits appear as inputs or outputs depending upon whether the authors work with the intermediation or production interpretation of banking business. The efficiency scores are found to be relatively sensitive to the specification in terms of inputs and outputs, which makes it difficult to reach generalized conclusions on how bank efficiencies stack up by ownership.

46

In a few studies that use a large number of inputs, not surprisingly many more banks are found to be on the efficiency frontier (Das, Nag and Ray). In earlier papers Ketkar etc. used deposits as well as physical inputs such as number of full time employees as a proxy for labor and number of branches as a proxy for capital, and loans and investments as outputs. The efficiency scores of most domestic banks were found to be quite low in that specification of inputs and outputs. On reflection, we conclude that this was due to a shift away from banks traditional intermediation function of mobilizing deposits and making loans. The financial market reforms of the 1990s increased competition for banks from non-bank intermediaries in the capital markets. Companies were increasingly able to obtain financing via equity issuance, which reduced their captivity to bank lending. Banks recognized this and over time started focusing on earning non-interest income.

47

Rising Interest Rates & Banks Profit

The Reserve Bank of India (RBI) today cautioned rising interest rate and high cost of funds could hurt the profitability of the banking sector. "Going ahead, with hardening interest rates and the imminent increase in cost of funds, the credit growth is expected to slow down, which could adversely affect the profitability," the RBI said in Financial Stability Report released today.

The hike in savings account interest rate, amortisations of pension liabilities and potentially enhanced provisioning requirements for NPAs may also impact profitability, it said. The report noted that banks' profitability improved, buoyed by increased net interest income (NII) though non-interest income remained stagnant. An increase in NII facilitated growth of around 20% in aggregate net profit of the banking system, even with an almost stagnant non-interest income and increase in risk provisions, it said. Interest income increased by 18.6% over 7.5% last year and interest expense increased by 10.1% as against 4.0% last year, it said. There was improvement of 34.9% in the NII of the banks during 2010-11 despite little change in non-interest income, increase of 49% in risk provisions and 24% increase in operating expenses. The growth in interest income by 18.6% was, however, not in tandem with the growth in loans and advances which grew by 22.6% during 2010-11, it said.
48

However, it said, the public sector banks registered a lower growth in profits mainly due to reduction in trading profits, increase in provisions towards staff expenses (including those for pension liabilities) and towards impaired assets. Under stress conditions based on NPA shocks, it said, the profitability of the banks was seen to be affected significantly though the capital adequacy position appeared to be reasonably resilient. The study indicates that some banks may face extreme liquidity constraints, under severe stress scenario. Overall, the results of the macrostress tests using different scenarios, suggested that the banking sector would be able to withstand macroeconomic shocks though the prevailing inflation and interest rate situation is expected to have an adverse effect on the asset quality of banks, it said

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Service Charges: Major Costs of the Banks in India

In 1999, the practice of Indian Banks' Association (IBA) fixing the benchmark service charges on behalf of the member banks was discontinued and the decision to prescribe the service charges was left to the discretion of the Boards of individual banks. Banks were then advised that they should ensure that the charges were reasonable and not out of line with the average cost of providing the services and that the customers with low volume of activities were not penalized. It was expected that, with time, market pressure would force the banks to price their services competitively ensuring services at a fair price. However, the Reserve Bank continued to receive representations from the public regarding Unreasonable and nontransparent service charges. The plethora of complaints received indicated that the issue of fairness in fixing the service charges by the banks needed to be examined. Accordingly, in order to ensure fair practices in banking services, in terms of the Annual Policy Statement 2006-07, Reserve Bank constituted a Working Group having in it a nominee of the IBA and a representative of customers to formulate a scheme for ensuring reasonableness of bank charges, and to incorporate the same in the Fair Practices Code, the compliance of which would be monitored by the Banking Codes and Standards Board of India (BCSBI). (A)Nature of transactions: a. Banking services that are ordinarily availed by individuals in the middle and lower segments will be the first parameter. These will comprise services related to deposit/loan accounts, remittance services and collection services.
50

b. When the above transactions occur in different delivery channels, for the purpose ofpricing, they may be treated on separate footing.

(B) Value of transactions: Low value of transactions with customers/public upto the ceiling as given below will be the second Parameter: i. Remittances up to Rs. 10,000/- in each instance. ii. Collections below Rs. 10,000/- in each instance. (Foreign exchange transactions valued upto US $ 500/-). As per extant RBI instructions the banks service charges should not be out of line with the average costs of providing the services. Basic Services. There are 27 basic service charges that should be taken into account while analyzing the service charges. These are Service relating to deposit accounts 1 Cheque book facility 2 Issue of Pass Book (or Statement) / Issue of Balance Certificate 3 Issue of duplicate pass book or statement 4 ATM cards 5 Debit cards (electronic cheque) 6 Stop Payment 7 Balance enquiry
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8 Account closure 9* Cheque Return - Inward (cheque received for payment) 10* Signature verification

Relating to Loan Accounts 11* No dues certificate

Remittance Facilities (Rupee or foreign exchange) Demand Draft Issue Demand Draft Cancellation Demand Draft Revalidation Demand Draft Duplicate issuance Payment Order Issue Payment Order- Cancellation Payment Order Revalidation

12 13 14 15 16 17 18

19 Payment Order-Duplicate issuance 20* Telegraphic Transfer Issue 21* 22* 23* Telegraphic Transfer Cancellation Telegraphic Transfer- Duplicate issuance Payment by Electronic Clearing Services (ECS)

24* Transfer by National Electronic Fund Transfer (NEFT) and Electronic Funds Transfer (EFT). Collection facilities 25* Collection of Local Cheques
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26* 27*

Collection of Outstation Cheques Cheque Return-Outward (cheque deposited for collection)

ANALYSIS OF FINANCIAL STATEMENTS OF BANKS : PROFIT, PROFITABILITY AND BREAK EVEN LEVEL
The banks, acting as financial intermediaries, mobilize savings of the society and supplement their resources through borrowings for providing credit to the needy sectors. They have to pay interest on their deposits and borrowings. They have to pay salaries to their staff and incur other overhead expenses in the course of their business operations. They are also required to make provisions for any potential erosion in their assets. After all this, they may have to pay a reasonable divided to their shareholders. The banks will, therefore, have to earn profit. Only a profit earning bank inspires confidence in its customers. FACTORS AFFECTING PROFITABILITY While profit is excess of income over expenditure during any accounting period, profitability is a relative term expressed as a percentage to average working funds. The following five important factors determine the profitability of a bank. i) Amount of working funds deployed ii) Cost of funds iii) Yield on funds

53

iv) Burden Management cost, and v) Risk cost

i)Working funds
Working Funds are the funds deployed by a bank in its business. The amount of working funds so deployed is usually arrived at by subtracting the aggregate amount of contra items from the total liabilities of the balance sheet. However, for analyzing the profitability, the balance sheet showing balance based on weekly/monthly average should prepared. Based on this balance sheet, the average working funds should be ascertained by netting the total of contra items from the total of the balance sheet.

ii)Cost of funds
The sources of funds for a bank comprise share capital and reserves (owned funds), deposits, borrowings and other liabilities. These are briefly discussed in the following paragraphs. a)Share capital and reserves Share capital is contributed by the shareholders in case of CBs and RRBs and by the members in Cooperative banks for the business of the bank and may, therefore, be treated as cost free for the purpose of profitability. However, for a more stringent and conservative analysis of profitability, the dividend paid by a bank may be taken as cost of owned funds. b)Reserves being past profits retained in the business are cost free. Provisions and credit balance in the profit and loss account which are not in the nature of outside liabilities may be equated with the reserves first, share capital and further from deposits for the purpose of profitability analysis.

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ILLUSTRATION: If the share capital of a bank is Rs.50,00 lakh out of the total owned funds of Rs.75.00 lakh, and if the bank had declared a dividend of 15% on its share capital. The average cost of owned funds can be calculated as under:

Amount of dividend Average cost of owned funds = ----------------------- X Average owned funds 7,50,000 = ------------------------ X 100 75,00,000 = 10% 100

It may be observed from the above that although the bank had declared a dividend of 15% the cost of its owned funds works out to only 10% due to the build up cost free reserves. c)Deposits The banks pay different rates of interest depending upon the nature and term of the deposit. The cost of deposits, therefore, depends upon the deposit-mix of the bank. We have to find out the average cost of these deposits for comparing with the average yield on funds deployed. The average cost of deposits is worked out per Rs.100/- of deposits as in the following example: If the amount of interest paid and payable on the deposits of Rs.200.00 lakhs is Rs.14,22,600/-the average cost of deposits is worked out as follows: Interest paid/payable (As per P & L A/c) = ------------------------ X Average deposits
55

100

14,22,600 = ------------------------ X 200,00,000 = 7.113% d)Borrowings These may be by way of borrowings from higher financing agencies, interbank borrowings or refinance from RBI, NABARD, SIDBI, IDBI, NHB etc. The average cost of borrowings and the weighted average cost of each type of borrowing have to be worked out as in the case of deposits. e)Other liabilities The other liabilities include bills pauyable, drafts payable, etc. and represents cost free funds. f)Average cost of funds The average cost of funds for the bank can be worked out as under : Total interest/dividend paid (as per P & L A/c.) Average cost of funds (k)= ------------------------------Average working funds X 100 100

iii)Deployment of funds and yield on funds The funds mobilized by a bank through different sources are utilized for a. Compliance with the statutory requirements relating to CRR and SLR; b. investments in non-SLR avenue; c. granting loans and advances; and d. deploying in other assets such as land & buildings, furniture and fixtures, etc.
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Cash on hand As cash on hand yields no returns, banks should maintain only minimum cash balance required for day to day business. This will also reduce the security risk for the bank. Balance in Current Account Amount kept in CA with other bank and if no interest is paid income/yield on this balance will be nil. Some of the sponsor banks pay interest on CA balance with them to their sponsor RRBs. Interest received on such Investments Investments, for the purposes of profitability analysis, include all deposits with banks including current account balance, and other investments in Government and other securities, shares and debentures, etc. The banks have to maintain these investments for the purposes of CRR and / or SLR. The return on these investments comprises interest and divided actually received. As in the case of liabilities, the average yield on investment and the weighted average yield on each type of investment have to be worked out to select the optimum investmentsmix.

Loans and advances The loans and advances port-folio provides the most profitable avenue for deployment of funds by a bank. The weighted average yield on advances of 100 is worked out as follows :

Interest received on advances (as per P&L A/c.) Average yield on advances = ---------------------------------X 100

Average advances (including NPAs)

57

Other assets The bank should limit its investments in land and buildings, furniture and fixtures, etc. only to the extent required for its business as they do not either earn any return or earn comparatively low returns.

iv)Other factorsWe have so far discussed the average cost of funds and average yield on funds. The profitability, however, ultimately depends upon the overhead costs, risk cost and the miscellaneous income. These are discussed briefly hereunder: Transaction costs (Operating cost) These are also called management costs and include all costs other than cost of funds and provisions. Thus, they consist of staff cost, i.e., salaries and other payments such as bonus, gratuity, etc. made to staff (s) and overheads such as expenses on stationery and printing, postages, rents, depreciation on assets, etc. (o). Transaction costs should be computed as a percentage of working funds as under: Total transaction costs Transaction costs (s+o) = ------------------------- X 100 Average working funds Risk cost The risk cost is worked out to estimate the likely annual loss on assets as a ratio of Rs.100/- of average funds deployed. Provisions made towards bad and doubtful debts, loss assets should be included under risk cost. The risk cost can be qualified as : Total of provisions made in P & L A/c. towards NPA, etc. Risk cost (pc) = ---------------------------------- X 100

58

Average working funds In order to ensure a realistic projection of the risk cost banks should systematically estimate bad and doubtful assets each year. Calculation of risk cost can be made on the basis of asset classification and provisioning norms. Non-interest income This is the income derived from non-financial assets and services and includes commission and brokerage on remittance facilities, LCs, guarantees, underwriting contracts etc., locker rentals and other service charges. However, items of non-recurring nature such as profit from sale of non-banking assets, when significant should not be included. For the purpose of profitability analysis, noninterest income also is to be worked out per Rs.100 of working funds as follows: Total non-interest income Non-interest income (n) = ------------------------------------- X 100 Average working funds Financial margin Just as a trading or manufacturing organization arrives at its gross profit to assess its trading or manufacturing activities, banks also ascertain their gross profit. This is also called "Spread" and is computed as a difference between weighted average yield on assets and weighted average cost of funds.

Burden The total non-interest expenses representing the transactions costs will generally be more than miscellaneous income. The difference between the two is called burden, as while making a cost plus pricing of loans this difference has to be loaded onto the rate of interest. The concept of burden also illustrates the importance of non-interest or service income of the bank. A high level of noninterest income can not only recover the entire operating cost, it can enable a bank to pay high level of compensation to its employees, as in the case of foreign banks. If the non-

59

interest income of bank is high enough to leave surplus after paying for operating cost, the same can recover a part of the interest cost as well. This means a negative loading in a cost plus pricing scenario. Such strategy is surely highly aggressive and may even prove to be unnecessarily risky.

Tools of Financial Analysis in Banks.

There are some widely popular tools of financial analysis. Some of these are discussed hereunder:Trend analysis This is done through comparison of two or more successive balance-sheets and profit and loss accounts, and studying the changes in the various components of assets and liabilities and income and expenditure. Break Even Level Business (BEL) This is the level of business (in terms of working funds) at which the total income of the bank is just adequate to meet all its costs. It is calculated as follows: (Transaction costs + Risk costs) -Non-interest income BEL = ------------------------------------- X 100 Net Margin In case the present level of working funds is more than BEL, the bank would be in profit and the actual profit can be arrived at as follows: Profit = (Actual working funds BEL working funds) X Net margin

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The amount of dividend taken to calculate the average cost of funds, has to be added to the above figure to arrive at the net profit shown in the profit and loss account. Sometimes break-even level is calculated in relation to core business, that is, without considering non-interest income. For this BEL is arrived at by dividing the total operating costs by financial margin (or net interest margin).

Challenges before Managements of Banks.

1. Banks need to retain their existing customers and widen their base developing a retail strategy and geographical capabilities to focus on the customer satisfaction, improve product sales and delivery qualitatively adhering to regulatory frame work. 2. Banks have to develop an effective strategy and management tools to ensure cost effective straight through processing and seamless end-to-end business processing by leveraging technology for real time performance management capabilities enabling link between actual business performance and business plans. 3.After the recent melt down of the western economies like USA which saw some of the biggest and supposedly safest names in international banking like Bear Sterns, Lehman Brothers, Merrill Lynch and HBOS on both sides of Atlantic keel over, the confidence level of investing public in banking is at low ebb. It's reported that 74 banks in USA were closed their shutters this year alone till September 2009. Therefore earning legitimate profits in a transparent and fair manner managing inherent risk factors for
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ultimate survival is a big challenge. 4. The range of banking products is ever changing with lesser and lesser margins; but cost of infrastructure and operating costs are growing exponentially. 5. Developing new revenue streams and pricing competitively. It is easier said than done. It all again depends upon the level of organizational maturity, management skills, resource strength and business plans of each bank to evolve their own cost management and profit making strategies carefully prioritizing each step of their activity. A study conducted by the Virginia Bankers association and researchers from Virginia Commonwealth University examining the relationship between bank financial performance and the emphasis on operational practices touted as critical success factors. This survey gets importance for the reason that 64 Banks were analyzed with an average business existence of 62 years to their credit (29 percent had been in business for at least 100 years). More than 90% of the response came from the highest level of Bank Management, President, CEO, CFO or COO. The results are clear. In the current economic environment, one clear critical success factor for Banks is a strong emphasis on expense management throughout the Banks. Although other critical success factors- such as quality, dependability, relationship building and convenience- are always worthy of attention, an emphasis on controlling expenses trumped all other factors.

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RECENT ARTICLES RELATING TO COST & PROFITABILTY OF BANKS.

Bank profitability set to fall- Gourav Gupta (Manager, Financial sector ratings, CRISIL)
Higher salaries, declining spreads and lower fee incomes will ensure this. Macroeconomic headwinds in 2006-07 and 2007-08 have resulted in substantial fluctuations in banks' profitability. Rising interest rates in 200607 and the first half of 2008-09 raised banks' overall cost of borrowings; as yields on advances and investments did not keep pace, banks' profitability suffered. Moreover, the RBI's use of reserve ratios, statutory liquidity ratio and cash reserve ratio as monetary policy tools affected banks' profitability: No interest is paid on CRR balances, and the interest yield on SLR securities is far lower than the yields on advances. By the time the RBI relaxed reserve requirements in October 2008, reducing CRR and SLR to 5 per cent and 24 per cent respectively -- from 9 per cent and 25 per cent -- the effect on banks' profitability was already apparent. For these reasons, after 2004-05, when banks' net profitability margin peaked at 1.63 per cent, their core profitability has been on a declining trend; by 2007-08, it had reached 1.40 per cent. CRISIL believes that banks' core profitability remained under stress in 2008-09, with the system NPM estimated to have reduced to 1.26 per cent; a further drop to 1.19 per cent is projected for 2009-10.
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Rising Cost Of Deposits For Banks The hardening of interest rates, acting in combination with a steady increase in CRR between 2004-05 and 2007-08 resulted in an across-theboard increase in banks' overall cost of resources. Further, strong credit growth, and a shift in the deposit-mix towards expensive term-deposits, added to the pressure on banks' CoB. The Indian banking system experienced credit growth averaging 28 per cent annually between 2002-03 and 2006-07. To fund credit growth, banks started vying for big-ticket term-deposits. In addition, the tenure of term deposits started shrinking. Because interest rates were increasing, banks were forced to re-price deposits at renewal. Pricing pressure and a paucity of retail deposits compelled banks to offer higher interest rates on retail term-deposits. The double impact of business-led upward pressure on cost of deposits, and tighter monetary policies, saw banks' cost of deposits rise to 6.1 per cent in 2007-08, from 5.1 per cent in 2006-07. CRISIL estimates that the cost of deposits has further increased by about 50 basis points (bps; 100 bps equals 1 percentage point) in 2008-09, to around 6.6 per cent. Yields Fail to Play Catch-Up RBI's liquidity-tightening measures, especially the increase in CRR, left no option for banks but to increase prime lending rates. Between 2005-06 and 2007-08, banks increased their PLRs by 150 to 200 bps, causing yields on advances to increase to 8.56 per cent in 2007-08 from 7.92 per cent in 2006-07. Although yields did increase to some extent, they did not keep pace with the sharp increase in CoB. Banks also suffered because of the negative carry on SLR portfolios, as term-deposit rates rose faster than yields on incremental SLR portfolios (yield on 10-year government securities moved in the range of 7.48-8.32 per cent during 2007-08). The combined effect of increasing CoB, negative carry on SLR portfolios, and zero interest on CRR, was to severely constrain banks' spreads. The system average interest spread declined by 32 bps, to 2.31 per cent in 2007-08, from 2.63 per cent in 2006-07.

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CRISIL estimates that the yield on advances has increased by 63 bps in 2008-09, driven by higher yields on corporate and retail advances, but overall interest yields are estimated to have increased by only 49 bps, because of the braking effect of SLR and CRR. CRISIL estimates that interest spreads declined to 2.22 per cent in 2008-09.

Fee-Income Growth to Moderate Since 2003-04, banks have reported strong growth in fee revenues, a trend primarily led by private banks' focus on retail credit, distribution of thirdparty products such as insurance and mutual funds, and provision of wealth management services. After 2004-05, public sector banks also focused increasingly on fee-income generation as the contribution from treasury operations declined. Sustained growth in retail credit (where banks charge up-front processing fees), and buoyant capital markets, enabled the banking sector to increase the proportion of fee-based income (as a percentage of average funds deployed) to 1.14 per cent in 2007-08, from 1 per cent in 2005-06. CRISIL expects the contribution of fee-based income to banks' total income to reduce to around 1.09 per cent in 2008-09, and further to 1.05 per cent in 2009-10, on account of the slowdown in retail credit growth, and weaker distribution income because of sluggish capital market conditions. Opex Unlikely to Reduce Most public sector banks have sought to rein in their operating expenditure (Opex) by investing substantially in the implementation of core banking solutions which will allow banks to reduce their operating expenses over the medium-term - because of greater operational integration and real-time processing of transactions. However, public sector banks' operating expenses may increase over the next 18 months, on account of wage revisions due from November 2007. Core profitability to decline

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Equities: Between 2005-06 and 2007-08, banks recorded a significant growth in profits on sale of investments on account of buoyant equity markets. However, equity prices have declined sharply since January 2008. CRISIL believes that equity prices will remain subdued over the near- to medium-term, and that banks are unlikely to book the levels of POSI that they enjoyed between 2005-06 and 2007-08. Debt: In the past, banks also booked huge gains on their large bond portfolios when yields were falling. However, banks had to provide for mark-to-market losses in 2007-08 and the first quarter of 2008-09 as yields increased. A sharp fall in yields on government securities during the third quarter of 2008-09, after the repo rate cuts by RBI, helped Indian banks register a high level of income from POSI on debt. CRISIL, however, believes that these treasury gains were driven by shortterm swings in interest rates, which were the result of several macroeconomic and demand-supply factors. The subsequent increase in the interest rates during the fourth quarter of 2008-09 could negate the benefit of treasury gains booked in the previous quarter, and significantly affect profits for 2008-09. The economic slowdown, declining spreads, and lower fee-income, are expected to result in weakening profitability for Indian banks over the next two years. CRISIL expects the system average NPM to reduce to 1.19 per cent in 2009-10, from 1.40 per cent in 2007-08. Banks' profits will also be affected by lower POSI, and higher provisioning costs.

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Malini Bhupta & Abhijit Lele: The hidden truth to PSB profitability State-owned banks may be sitting on a powder-keg of inadequately provisioned loans. Malini Bhupta & Abhijit Lele / Mumbai Sep 06, 2012, 00:47 IST The banking sectors June quarter earnings pleasantly surprised the market. The countrys largest lender, State Bank of India (SBI), has seen its net profit grow 137 per cent in the quarter, which has helped push up the profitability of the benchmark indices. On the back of such a stellar performance, the bank has been trying to convince analysts to give its shares a better rating, since its profitability puts it in league with companies like Oil and Natural Gas Corporation, Reliance Industries and Tata Consultancy Services. The Street, however, is in no hurry to re-rate either SBI or the larger universe of public sector banks (PSBs), even though shares of these banks are available at throwaway prices. This is not surprising because stateowned banks have seen a pile-up of bad loans at a faster pace, compared to their private sector peers. For PSBs, the fresh inflow of non-performing loans (NPLs) in the quarter, also known as slippages, has sharply moved up in the opening quarter of FY13. For instance, SBIs slippage ratio or share of impaired assets in Q1 has more than doubled to 4.59 per cent.

This sharp deterioration in asset quality of PSBs implies two things. First, the accretion of bad debt and loan restructuring signal financial stress. Second, the sharp rise in bad debt calls for a review of the lending process
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of state-owned banks, considering the borrower profile of private sector banks is no different and yet their non-performing assets are lower. Kotak Institutional Equities says it is intrigued by the low levels of NPLs of certain private banks versus the high levels of restructured loans and NPLs of state-owned banks. The brokerage notes that the loan profile of both is not very different. What makes the situation worrisome for state-owned banks is the inadequate provisioning for these bad loans. In 2009, the Reserve Bank of India (RBI) had made it mandatory for banks to put aside Rs 70 for every Rs 100 that had become an NPL. Last April, the central bank unexpectedly relaxed the norms on this provisioning coverage ratio (PCR), under which banks were not required to maintain a PCR of 70 per cent for bad loans after September 2010. The consequence of this relaxation is visible in the earnings of PSBs this fiscal. SBIs PCR is down from 68 per cent in Q4FY12 to 64 per cent in Q1. Had SBI provided adequately for its bad loans, its profits would have been lower. BRICS Securities says while the profitability of the sector seems reasonable, its debatable if one adjusts for higher provisioning. Anish Tawakley of Barclays explains: The balance sheets of PSBs have been deteriorating. If the PCRs had been maintained, the reported profits would have been lower. However, a liquidity crisis is not imminent here. Since most of the banking system is government-owned, depositors dont get concerned about the safety of their deposits. For the top 10 PSBs, the average PCR has come down to 50.64 per cent from 53.63 per cent year-on-year. In contrast, the large private sector banks have a PCR of 80 per cent. According to analyst estimates, incremental provisioning (for the fresh accretion of bad loans every quarter) has come down sharply from the prudential 70 per cent levels for many PSBs. Investors and analysts believe that these banks are only deferring pain. Emkay Globals analysis shows that the PCR of 10 PSBs has come down to 50.64 per cent from 53.63 per cent compared to last year. SBIs Managing Director and Chief Financial Officer Diwakar Gupta says: The first priority is to ensure that the balance sheet is robust and we will improve the PCR.

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PROVISIONAL PROFITS Bank Net Adjusted Provision Incremental slippages PAT (Rs coverage provisioning in Gross crore) ratio coverage Q1Fy13 NPA in in ratio (%) (Rs in Q1FY13 Q1FY13 Q1Fy13 in Q1FY13* crore) (%) Andhra 362 691 60.38 22.77 2.7 Bank Bank of 888 1,193 60.86 47.71 2.6 India Canara 775 840 66.53 56.79 2.0 Bank Corp Bank 370 510 61.02 46.86 1.7 Punjab National 1,246 1,040 62.81 86.54 3.3 Bank Union Bank 512 1,170 59.00 37.35 3.8 of India State Bank 3,752 7,562 64.29 36.90 5.0 of India * Incremental provisioning ratio is calculated by emkays analysts Source: Emkay Global

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Even as most PSBs are confident that the trend in asset quality deterioration will reverse soon, this optimism is questionable. The trend in asset quality deterioration suggests that currently medium and small corporations are stressed. In the June quarter, SBIs reported net slippages were to the tune of Rs 7,500 crore, of which Rs 3,400 crore has come from medium and small companies. This is expected to spread to large corporate and retail borrowers in the coming quarters. Bad loans have increased to 9.5 per cent of gross assets for PSBs in the June quarter, while it has held steady for private banks at 3.2 per cent of gross advances, explains BRICS Securities. Given that PSBs account for 70 per cent of the banking sector, the sharp pile-up in bad debts is not good news. Over the last few quarters, both restructured assets and fresh slippages have been high. In the fourth quarter of FY12, slippages for the 10 PSBs stood at Rs 12,631 crore, and loans worth Rs 37,435 crore were restructured. In the first quarter of FY13, the value of restructured loans is down to Rs 22,105 crore but slippages have doubled to Rs 22,926 crore. Although banks could improve their PCR, it could come at the cost of lower net profit. It will hit the capital adequacy at a time when they are preparing for the roll-out of Basel III norms, for which the RBI governor has indicated the government will need to infuse Rs 90,000 crore over the next six years. Prabhakar said setting aside higher amounts (as provisions) will impact the bottom line and capital adequacy. Raising extra capital in the current market situation then becomes a challenge. Going by the nature of companies headed for corporate debt restructuring, analysts believe that PSBs will have to write off at least 20 per cent of their restructured portfolio. Late last year, a consortium of 25 lenders agreed to restructure the Rs 16,000-crore debt of GTL Group. Similarly, 27 lenders have agreed to recast the Rs 3,300-crore debt of Hindustan Construction Company. Says one analyst, knock-offs will be high for these banks a few quarters down the line. Anish Damania, co-head equities at Emkay Global, says: Asset quality woes will haunt PSU banks, thereby increasing credit cost requirement and eventually lowering return on assets. If slippages stay elevated, then revenue visibility will be lower and net interest income will decline. With growth slowing and interest rates high, companies are finding it increasingly difficult to service loans. The quarterly numbers of banks show
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that corporate borrowers are either defaulting on payments or seeking easier repayment terms along with lower interest rates. Not only has the fresh accretion of bad loans increased but the queue of companies outside the corporate debt restructuring (CDR) cell has grown longer. According to an analysis by Emkay Global, over FY09 and Q1FY13, the CDR cell has cumulatively restructured 309 cases amounting to Rs 160,000 crore. Either way, banks have to take a hit on their books.

BIBLIOGRAPHY & REFERENCES. Book References Indian Management Studies Journal:Profitability Analysis of

Public Sector Banks in India- Narinder Kaur and Reetu Kapoor

Committees and Commissions in India, 1947-73: 1971-73 The Performance of Indian Banks During Financial

Liberalization By Petya Koeva Brooks

Banking Sector Reforms in India and Performance Evaluation of Commercial Banks By Debaprosanna Nandy Online References:

RESERVE BANK OF INDIA COLLEGE OF AGRICULTURAL

BANKING ANALYSIS OF FINANCIAL STATEMENTS OF BANKS PROFIT, PROFITABILITY : http://www.cab.org.in/Lists/Knowledge

%20Bank/Attachments/47/Analysis%20of%20Financial%20Statement%20of %20Banks-Updated.pdf

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Performance and Profitability of Indian Banks in the Post

liberalization Period* Kusum W. Ketkar & Suhas L. Ketkar : (DEA ANALYSIS): http://www.indexmeasures.ca/dc2008/papers/ketkar17940.pdf

http://www.studymode.com/subjects/customer-profitability-analysis-infinity-bankpage3.html

Customer Profitability Analysis Infinity Bank Essays and Term Papers

DESSERTATION WORK ONASSET LIABILITY MANAGEMENT BY AMBREEN KAUSAR :

http://www.scribd.com/doc/53326587/11/PROFITABILITY-ANALYSIS-OF-BANKS

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