Liquidity Management

The Commercial Loan

Theory
• Originated in England during the 18th century
•The theory states ;
 A Commercial Bank must provide short
term liquidating loans to meet working
capital requirements.
The bank should refrain from long term
loans
•Logical basis of the theory
Commercial bank deposits are near
demand liabilities and should have short term
self liquidating obligations.
The bank holds a Principle that when money is
lent against self liquidating papers, it is known as
Real Bills Doctrine.
The doctrine had some criticisms. They were;
 A new loan was not granted unless the previous
loan was repaid.
Banks should provide loans before the maturity of
the previous bills
Due to Economic Condition the liquidity character
of the self liquidating loans are affected.
• During Economic depression
goods do not move fast through normal channels
 Prices fall
Losses to sellers
• No guarantee , even the transaction for which loan provided is
genuine and whether debtor will be able to repay the debt.

Another criticism was that

It failed to take cognizance of the fact that the bank can
ensure liquidity of its assets only when they are readily
convertible into cash without any loss.
Thus the Commercial loan theory was ignored because of the
criticisms of the DOCRINE.
 Shiftability Theory
• Originated in USA in 1918 by H.G.Moulton

• According to this theory, the problem of liquidity is not a

problem but shifting of assets without any material loss.

• Moulton specified, ‘ to attain minimum reserves, relying

on maturing bills is not needed but maintaining quantity
of assets which can be shifted to other banks whenever
necessary
• According to this theory ;

 It must fulfill the attributes of immediate transferability

to others without loss

• In case of general liquidity crisis, bank should maintain

liquidity by possessing assets which can be shifted to the
Central Bank.

Eligibility of Shifting of assets

 Soundness of assets
 Acceptability are distinct

Thus, as development took place the Commercial Loan

theory lost ground in favor of Shiftability Theory
• Blue chip securities which possess high degree of
shiftability, the commercial banks were ready to buy
them as a collateral security for lending purposes.

• During depression, the whole industry would be in crisis.

The shares and debentures of well reputed companies
would fail to attract buyers and cost of shifting of assets
would be high.

• Blue chip Securities will also lose their shiftability

character.

Thus, both Commercial loan as well as Shiftability theory

failed to distingish liquidity if an individual bank as well as
the banking industry.
 Anticipated Income Theory
• Developed in 1948 by Herbert V.Prochnov

• Most striking Developments of commercial banks that

took place was in participation of term lending.

• The banker plans the liquidation of the term loans from

anticipated earnings of the borrower.

• Loan repayment schedules have to be adapted to

anticipated income

• Estimation of future earnings should be made.

The liability Management
Theory
 Introduction

• It emerged in the year 1960.

• This is one of the important liquidity
management theory.
• Says that there is no need to follow
old liquidity norms like maintaining
liquid assets , liquid investments etc.
Proposes many alternatives
Certificate of deposits
• Is a negotiable instrument.
• Maturity date.
Limitations
• Interest rates.
• Commercial banks compete with
each other for it.
Borrowing from other banks
• Short term
• Sensitive to market condition
Limitation
• Every bank mostly faces shortage
Borrowing from the central bank
• Available in the form of discounting
and day to day and seasonal liquidity
needs.
Limitations
• Costlier
• Restrictions
Raising of capital funds
• By issue of shares
• Depends on public response ,
dividend and growth rate.
using Reserve profit
 Potentiality of liability
management theory in India
• Inter bank participation certificate
1.with risk sharing
2.without risk sharing
• RBI may not be a dependable source.
• Raising capital funds is not easy.
Conclusion
• This theory makes a limited
contribution.
Thank
you !!
BASEL COMMITTE
INTRODUCTION
 FEATURES OF BASLE
COMMITTEE - I:
MINIMUM CAPITAL REQUIREMENT
DIVIDED THE CAPITAL
INTO TWO
STEPS IN COMPUTING CRAR
CLASSIFY THE ASSETS

OFF BALANCE EXPOSURE

RISK WEIGHTED ASSETS

ARRIVE CRAR
CONTINNUED…
NewBasel NormsonCapital Adequacy(Basel

Committee– ΙΙ Norms)
 Soamendment intheaccord–during1966Basel committeeII (BCBS) brought out

consultative paper on newcapital adequacy framework in june 1999 and a second

revisioninjanuary2001thenewaccordrestsonthreepillars:

Minimumcapitalrequirement
•
Supervisoryreviewprocess.
•
Market discipline.
•
 1. MinimumCapital Requirement

Primarily concerned with minimum capital requirements to

cover credit risk

Banks be required to measure and apply capital charges in

respect of their market risks in addition to their credit risks

Incaseofstandardisedapproach–riskmeasurementwouldbethesame–there
wouldbe4categoriesforclaimsoncorporate20%,50%,100%and150%ofrisk
weightageasagainst thepresentsingleuniformriskweight of100%.
• Thus besides the earlier tier i and tier
ii a new category of capital tier 3 has
been created. As such eligible capital
to cover market risks includes equity
and retained earnings
• 1 Supplementary capital
• 2 A third tier of capital.
 SupervisoryReviewof Process

This piller would seek to ensure that each bank

has sound internal process in place to assess the
adequacy of financial modelling techniques to the
prescription of capital adequacy.
This is to be achieved through;
• Supervisors would be responsible for evaluating
how well banks are assessing the capital adequacy
needs relative to their risks.
The 4 basic and complimentary principles
on which the piller 2 rests are;
• Assessing bank overall capital adequacy in relation to risk profile as
well as strategy for maintaining capital levels

• Review and evaluate internal adequacy assessment

• Supervisors expect bank to operate above minimum capital ratio

• Prevent capital from dipping below prudential levels

 3. Market Discipline

Blostering market discipline

through enhanced disclosure by
banks. This is essential to ensure
that market participants can better
understand bank risk profile and the
adequacy of their capital position
BCBS 3rd Consultative paper
2003
• Fully secured lending will now receive a 35% risk weighting
instead of the erlier 40%.
• A minimum loss given defaults value 10% is propsed for
retail exposures secured by mortgages
• Advanced and foundation internal rating based approaches
are presently available for high volatility commercial real
estate lending.
• An alternative standard operational risk approach has been
developed
THANK YOU
Management of Secondary
Reserve in Commercial
Banks
 Nature of Secondary
• Consists ofReserve:
the aggregate of “highly
liquid earning assets”.
• Principal objective - ‘To impart
adequate liquidity to funds without
adversely affecting the profitability’
• Therefore assets which:
yield some income + highly liquid
(quickly converted into cash without
any material loss).
• Three Conditions:
“Shiftability, Low Risk and Yield”
- Shiftability:
-For quick liquidation of assets (ready market
should be there)
- Low Risk:
-Asset should be free from money rate risk (risk arising
out of fluctuations in security price due to
variations in interest rates)
- Contractual rate of interest would remain the same
• Market price of Fixed Interest bearing securities
closely related to their maturity period
• Short period securities less vulnerable to interest
rates fluctuations and hence Low Risk
• For the purpose of income, liquidity attribute
should not be forgone
• Emphasis: Liquidity- Primary
Income- Secondary
 Type of Assets:
• Call loans to stock brokers and commercial
banks.
• Short-term loans to commercial banks.
• Short-term loans secured against self-liquidating
assets or blue chips.
• Investments in treasury bills.
• Promissory notes of short period maturity.
• Discounting of Usance bills eligible for
rediscounting from RBI.
• Short period Debentures of companies with an
faultless credit standing.
 Functions of Secondary Reserve:
• Principal function is to Replenish Primary
Reserve.
• Subsidiary function is to earn a moderate
income.
• Helps the banker to trade off successfully
between liquidity and profitability.
• “Push Button Fashion”
• “Reservoir whose gates are opened or closed
as the need for fund arises”
• To strengthen the bank liquidity
• The core of bank liquidity
 Factors influencing the
level of Secondary
Reserve:
• EXTERNAL FACTORS

• INTERNAL FACTORS
 External Factors:
1. National Factors:
- General State of Economy
# Prosperity
# Recession
- Political Condition- stable
- Taxation Policy- exemption=liquidity + earnings
- Monetary Policy
# Rise/ Fall in minimum reserve
# Liquid assets ratio & Rediscounting policy
2. Local Factors:
- Character of the Local Economy
# Agriculturist
# Industrialist
- Character of Local Population
# Illiterate- rumours
- Movement of Local Population
# Bigger employment opportunities
# Natural Calamities
 Internal Factors
• Deposit structure
• Ownerships of deposit accounts
• Average size of bank accounts
• Access to money market
• Nature of bank loans
• Maturities and diversification of
investment portfolio
 Management of secondary
reserve in a commercial bank
1. Estimating liquidity needs for secondary reserve
a) Rough method
Loan-increase by 300000 to reach 1000000
Deposits-Decrease by 300000 from level of deposits
1300000.
Bank would sum up excess of loans & shortfall of
deposits i.e 600000(secondary reserves)
b) Statistical method
• Find percentage variation in the level of loans & deposits.
• Reduce percentage change into absolute figures using
figures from capital, deposits, loans.
• Add the net increase/subtract the net decrease in loans &
deposits.
• Sum up the estimated amounts of loans & deposits.
2. Estimating secondary reserve
requirements for possible changes in
reserve requirements.

3. Estimating secondary reserve

requirements for unstable deposit
accounts
Conclusion
Bank should manage secondary
reserve to impart adequate liquidity
without adversly affecting the
profitability.
 III. Expansion Phase(1968-
1984)
This phase witnessed socialization of
banking sector(viewed as change agent &
social control emphz.)
Nationalization took place (14-1969, 6-
1980)
Birth & growth of directed lending
programme
Poverty alleviation & employment
generating schemes
Dominance of social banking over
commercial banking.
 1975 -Birth of RRB, 1982 –NABARD
 Commercial banks declined &
scheduled banks shot up due to the
emergence of RRBs
 branch expansion given importance
 50,000 new branches were set up
(3/4th in rural & semi urban areas)
 Banking industry achieved unparallel
growth but no consideration given to
other issues such as support systems
required for efficient services, control
mechanism etc.
 Thus with growth came inefficiency & loss
of control
 As lending was given to risk prone areas
at concessional rate(asset quality &
profitability declined)
 IV. Consolidation
Phase(1985-1990)
 Thrust was given in consolidation of
the banking sector
 Thus policy initiatives were taken
with the objective of consolidating
gains of branch expansion
 Branch expansion was slowed down
& hardly 7000 branches were set up
 Attention was paid in:
- improving housekeeping,
-customer services
-credit management
-staff productivity &
profitability
 Steps taken to increase rate of bank
deposits & lending
 Measures initiated to reduce structural
constraints in devloping money market
 90% of commercial banks were in public sector
& were closely regulated
 There was no autonomy given for taking vital
decisions:
prices of asset & liability-fixed by RBI
prices of services –fixed by IBA
63.5% of bank funds mopped up by CRR,SLR
remaining funds directed to priority sector
 Thus banks ended up consolidating their losses
instead of gains
V. Reformatory Phase(1991-
2000)
 The need for reform was emphasized
as the country faced grave economic
crisis in 1991
• Due to the crisis:
- India defaulted on its international
commitments
- External access to commercial credit
denied
- International credit rating
downgraded
- International confidence erroded
- Economy suffered from serious
inflationary pressure
 And thus various economic structural
reformatory measure became
necessary so as to improve the
strength of economy & ensure
against future crisis & also to ensure
growth with equity
 For this purpose Narsimham
Committee was set up
THANK YOU
 Introduction
• The past four and half decades and
particularly the last two and half
decades witnessed cataclysmic
change in the sphere of commercial
banking all over the world. Indian
banking system has also followed the
same trend. As a matter of fact,
changes here have been far more
pronounced than anywhere else
 Phases in Banking sector
In over six decades since independence banking
system in India in has passed through distinct
phases, viz.,
• Evolutionary phase- prior to 1948
• Foundation phase- 1948-1967
• Expansion phase- 1968-1984
• Consolidation phase- 1985-1990
• Reformatory phase- 1991-2000
• Mergers and Acquisition phase-2001 and onwards
Evolution phase (prior to 1950)
 Enactment of the RBI Act 1935 gave birth
to scheduled banks in India
 The prominent among the scheduled banks
is the Allahabad Bank, which was set up in
1865 with European management
 while as many as twenty scheduled banks
came into existence after independence-
two in the public sector and one in the
private sector
 Conti…

 The United Bank of India was formed in 1950 by

the merger of four existing commercial banks
 the numbers of scheduled banks rise to 81. Out
of 81 Indian scheduled banks, as many as 23
were either liquidated or merged into or
amalgamated with other scheduled banks in
1968, leaving 58 Indian scheduled banks.
 Conti……

Established during No of bank’s

19th Century 2
Pre- first war world 14
Inter war- period 21
Second World War 3
Post- Second World War 18
Total 58
 Conti..
• It may be emphasized at this stage
that banking system in India came to
be recognized in the beginning of 20th
century as powerful instrument to
influence the pace and pattern of
economic development of the
country
• .
 Conti…
• Until 1935 when RBI came into
existence to play the role of Central
Bank of the country and regulatory
authority for the banks , Imperial
Bank of India played the role of a
quasi central bank
 Foundation Phase 1948-1967
• The banking scenario prevalent in the country
during the period 1948-1968 presented a strong
focus
• The emphasis of the banking system during this
period was on laying the foundation for a sound
banking system in the country.
• phase witnessed the development of the necessary
legislative framework for facilitating reorganization
and consolidation of the banking system in the
country
 Conti…..
• Banking Regulation Act was passed in 1949
to conduct and control operations of the
commercial banks in India
• Major step taken during this period was the
transformation of Imperial Bank of India into
State Bank of India and a redefinition of its
role in the Indian economy,
• During this period number of commercial
banks declined remarkably.
 Conti..
• Before 1968, only RBI and Associate
Banks of SBI were mainly controlled by
the Government. Some associates
were fully owned subsidiaries of SBI
and in the rest, there as a very small
shareholding by individuals and the
rest by RBI.
•  
 PRIORITY SECTOR
FINANCING BY
COMMERCIAL BANKS IN
INDIA
 Priority Sector Lending
Policies
OBJECTIVE
Aimed at development of agriculture,
small-scale industries, small traders,
artisans, self-employed persons and
other weak sections of society which
had been ignored by the banks.
 Cardinal Features

• The banks would pursue the production

nexus approach instead of asset nexus
approach while dispensing assistance.
• Offer composite finance, it include
provide term lending facilities to
farmers for purchase of inputs,
pesticides, for development of land etc.
• Commercial banks would provide
concessional lending facilities to the
priority sectors.
 In order to align bank credits to the
changing needs of the society the scope
and definition were changed, where the
following are some of measures initiated
in 2003-04
• The ceiling on credit limit to farmers
against pledge/hypothecation of
agriculture produce was increased from
Rs. 5 Lakh to Rs. 10 Lakh.
• Limit on advances for dealers in agricultural
machinery was increased from 20 Lakh to 30
Lakh.
• For distribution of inputs for allied activities
increased to 40 lakhs from 25 Lakhs.
• Investment limit in plant and machinery for 7
items belonging to sports goods was
enhanced from Rs. 1 crore to Rs. 5 crore.
 besides from this,
• RBI was directed not to insist for any
collateral security/ third party guarantees
for all advances under priority sector upto
Rs.25000.
• no service or processing fee is to be
recovered by banks in such a case.
• Time schedule is given to sanction the
advances.
Broad categories of priority sector
for all commercial banks
1. Agriculture (direct and indirect
finance)
2. Small Enterprise (direct and indirect
finance)
3. Retail Trade
4.Micro credit
5.Educationa Loans
6.Housing Loans
Trends in banks advances to
priority sector and Problems
faced by banks in priority
sector lending.
 Bank advances to
priority sector
700000

600000

500000

400000
a m o u n t in c r o r e
300000

200000

100000

0
Ju n -69 Ju n -91 m ach -01 m ach -06 m ach 07
 Priority sector advances in
different banks.

2005

F o r e ig n b a n k s
P r iv a t e s e c t o r
P u b lic s e c t o r

2006

0 5 10 15 20 25 30 35 40 45 50
2007
 RBI norms to improve credit
delivery to priority sector.
• Only SSI units to be included in priority sector.

• Banks to fix self targets for financing SME sector to achieve

higher disbursement.

• Banks to consider credit appraisal and rating tool (CART) risk

assessment model and comprehensive rating model for risk
assessment of proposals for SME.

• Banks to provide credit to atleast 5 SME enterprises per year.

• Banks should formulate liberal policies based on guideline of

specific sectors.

• Banks to adapt cluster based approach for SME financing.

• Banks should start specialized SME branches to have easy

access to bank credit
 Problems faced by banks in
priority sector lending.
The main two problems are
- high volume of overdues
- ever increasing cost of supervision
The recovery of the loans by the
banks from SME sector is difficult.
• So in order to gather the resources of the bank in a
better way recovery camps should be there.

• If the banks have to survive successfully, the banks

have to ensure proper utilization of credit and
recycling of credit. Proper supervision should be
there by banks.

• Large scale priority sector lending have imposed

additional burden to bank as they have to take care
priority sector as well as other weaker sections of the
society.

• So something should be done so as to arrest the

deterioration of profitability trend.