Unit III: Financial

Institutions
• COMMERCIAL BANKING: INTRODUCTION, CLASSIFICATION, ITS ROLE IN FINANCING- COMMERCIAL AND
CONSUMER,
• RECENT DEVELOPMENTS LIKE MUDRA FINANCING, PROBLEMS OF NPAS, BANKRUPTCY AND INSOLVENCY ACT,
FINANCIAL INCLUSION
Banking

 Sec. 5 (1)(b) of the Banking Regulation Act defines banking as “ the accepting,
for lending or investment, of deposits of money from the public, repayable on
demand or otherwise and withdrawable by cheque, draft, order or otherwise.”

 Sec. 5 (1)(c) defines a banking company as “any company which transacts the
business of banking in India”

 However, Accepting deposits by companies to finance their own business is not

regarded as banking within the meaning of the act.
Functions of Banks in India

Functions
of Bank

Primary Function Secondary Function

Accepting
Agency Functions
Deposit

Granting Advances Utility Functions

Primary Function: Deposits

•Current Account
•Saving Account
•Non-Resident External (NRE)
Account
Demand Deposits
•Non- Resident Ordinary (NRO)
Account
•Foreign Currency Non-Resident
(FCNR) Account

Deposits

•Fixed Deposit (FD) or Fixed

Account
Time Deposits

•Recurring Deposit (RD)

Primary Function: Lending

Cash Credits

Overdraft
Lending/Advances
Loans

Discounting of Bills of Exchange

Secondary Functions: Agency Functions

 Collection of Cheques, Dividends, Interests etc.

 Payment of Subscription, Rent, Insurance Premium etc.
 Conduct of Stock Exchange Transactions
 Acting as Executor, Trustees, Attorneys etc.
 Preparation of Income Tax Returns
 Remittance of Funds
 Conduction Foreign Exchange Transactions
 Bankers acts as an agent to the Customer
Secondary Functions: Utility Functions

 Safekeeping of Valuables
 Traveller’s Cheques
 Letter of Credit
 Underwriting Securities
 ATM Facilities
 Gift Cheque
 Accepting Bills
 Merchant Banking
 Wealth Management and Investment Advisory
 Government Transactions
 Internet and Mobile banking
 Payment Services
Role of Banking in the Economic Development

 Mobilising and Allocating Savings

 Providing Financial Intermediation
 Facilitating Capital Formation
 Supporting Small and Medium Enterprises (SMEs)
 Promoting Financial Inclusion
 Facilitating International Trade and Foreign Exchange Transactions
 Monetary Policy Implementation
 Innovation and Technological Advancements
 Evaluation of Banking in India

1921 1935 1936-1955 1956-2000 2000-2020 2020 Onwards

•Closed market •Establishment of RBI •Imperial Bank •Nationalization of 14 •In 2003 Kotak •Recent
•State-owned Imperial Bank as the central Bank expanded its network large commercial Mahindra Finance technological
of India was the only Existing •Quasi central to 480 branches banks in 1969 & six Ltd. received a innovations,
Bank banking role of •In order to increase more banks in 1980 banking licence from especially in the area
Imperial Bank came penetration in rural •Entry of private RBI and became the of digital lending
to an end areas, imperial bank players such as ICICI first NBFC to be •Digitalization of Agri-
was converted into intensifying the converted into a finance was
State Bank of India competition Bank conceptualized
•Gradual technology •In 2009, the jointly by the Reserve
upgradation in PSU government Bank and the
banks. removed the Banking Reserve Bank
cash transaction tax innovation Hub. This
which was will enable delivery of
introduced in 2005 Kisan Credit card
(KCC) loans in a fully
digital and hassle-
free manner.
•In November 2022,
RBI launched a pilot
project on central
bank digital currency
(CBDC)
Structure of the Indian Banking Sector

Scheduled Commercial banks (SCBs)

as of 2022:
# Public Sector Banks (12)
# Private Sector Banks (21)
# Foreign Banks (46)
# Regional Rural Banks (43)
Banks

Cooperative Credit Institutions:

# Urban Cooperative Banks (1534)
# Rural Cooperative Banks (96, 508)
Reserve Bank of India

#All India Financial Institutions

Financial Institutions #State-level Institutions
#Other Institutions
Risk Management in Banks

 Financial and Non Financial risks (credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputational, operational etc.)
 Risk Management involves identification, measurement, monitoring and controlling
risk to optimise the risk-reward trade-off.
Different Types of Risk

 Credit Risk or Default Risk

 Market Risk:
a) Foreign Exchange (Forex) Risk
b) Interest Rate Risk/Price Risk
 Operational Risk
a) Internal Fraud
b) External Fraud
c) Employment Practices and Workplace Safety
d) Damage to Physical Assets
e) Business Disruption and System Failures
f) Execution, Delivery and Process Management
 Liquidity Risk
a) Funding Liquidity Risk
b) Time Risk
 Other Risks
a) Strategic Risk
b) Reputation Risk
c) Systematic Risk
d) Unsystematic Risk
Evaluation of Financial Soundness of
Banks

 The components of CAMELS are:

• (C)apital adequacy
• (A)ssets
• (M)anagement capability
• (E)arnings
• (L)iquidity
• (S)ensitivity
• The CAMELS rating system assesses the strength of a bank through six categories.
• CAMELS is an acronym for capital adequacy, assets, management capability, earnings, liquidity, sensitivity.
• The rating system is on a scale of one to five, with one being the best rating and five being the worst rating. (Just
keep in mind that a lower rating is better, indicating a more financially stable, less at-risk bank.)
 Capital Adequacy
 Capital adequacy assesses an institution’s compliance with regulations on the minimum capital reserve amount. Regulators establish the
rating by assessing the financial institution’s capital position currently and over several years.
 Future capital position is predicted based on the institution’s plans for the future, such as whether they are planning to give out dividends
or acquire another company. The CAMELS examiner would also look at trend analysis, the composition of capital, and liquidity of the
capital.

 Assets
 This category assesses the quality of a bank’s assets. Asset quality is important, as the value of assets can decrease rapidly if they are high
risk. For example, loans are a type of asset that can become impaired if money is lent to a high-risk individual.
 The examiner looks at the bank’s investment policies and loan practices, along with credit risks such as interest rate risk and liquidity risk.
The quality and trends of major assets are considered. If a financial institution has a trend of major assets losing value due to credit risk,
then they would receive a lower rating.
 Management Capability
Management capability measures the ability of an institution’s management team to identify and then react to financial stress. The category depends on the quality of a bank’s
business strategy, financial performance, and internal controls. In the business strategy and financial performance area, theCAMELS examiner looks at the institution’s plans for
the next few years. It includes the capital accumulation rate, growth rate, and identification of the major risks.
 Earnings
Earnings help to evaluate an institution’s long term viability. A bank needs an appropriate return to be able to grow its operations and maintain its competitiveness. The examiner
specifically looks at the stability of earnings, return on assets (ROA), net interest margin (NIM), and future earning prospects under harsh economic conditions. While assessing
earnings, the core earnings are the most important. The core earnings are the long term and stable earnings of an institutionthat is affected by the expense of one-time items.

 Liquidity
For banks, liquidity is especially important, as the lack of liquid capital can lead to a bank run. This category of CAMELS examines the interest rate risk and liquidity risk. Interest
rates affect the earnings from a bank’s capital markets business segment. If the exposure to interest rate risk is large, then the institution’s investment and loan portfolio value will
be volatile. Liquidity risk is defined as the risk of not being able to meet present or future cash flow needs without affecting day-to-day operations.
 Sensitivity
Sensitivity is the last category and measures an institution’s sensitivity to market risks. For example, assessment can be made on energy sector lending, medical lending, and
agricultural lending. Sensitivity reflects the degree to which earnings are affected by interest rates, exchange rates, and commodity prices, all of which can be expressed by Beta.
Asset Liability Management

• Asset and liability management (ALM) is a practice used by financial institutions to mitigate
financial risks resulting from a mismatch of assets and liabilities.
• By strategically matching of assets and liabilities, financial institutions can achieve greater
efficiency and profitability while also reducing risk.
• Some of the most common risks addressed by ALM are interest rate risk and liquidity risk.
 A full ALM framework focuses on long-term stability and profitability by maintaining liquidity
requirements, managing credit quality, and ensuring enough operating capital. Unlike other risk
management practices, ALM is a coordinated process that uses frameworks to oversee an
organization’s entire balance sheet. it ensures that assets are invested most optimally, and
liabilities are mitigated over the long-term.
 Traditionally, financial institutions managed risks separately based on the type of risk involved. Yet,
with the evolution of the financial landscape, it is now seen as an outdated approach. ALM practices
focus on asset management and risk mitigation on a macro level, addressing areas such as
market, liquidity, and credit risks.
Non Performing Assets

 In India are defined as any advance or loan overdue for more than 90
days as per RBI.
 In other word, where the borrower has failed to make payments on the
principal and interest of the loan for at least 90 days.
 Asset Classification (as per RBI)
 Standard Assets
Standard Asset is one which does not disclose any problems and which does not carry more than normal risk attached to the business. Such an asset should not be an
NPA.
 Sub-standard Assets
(i) With effect from March 31, 2005 an asset would be classified as sub-standard if it remained NPA for a period less than or equal to 12 months. In such cases, the
current net worth of the borrowers / guarantors or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full. In other
words, such assets will have well defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the banks will
sustain some loss, if deficiencies are not corrected.
(ii) An asset where the terms of the loan agreement regarding interest and principal have been re-negotiated or rescheduled after commencement of production, should
be classified as sub-standard and should remain in such category for at least 12 months of satisfactory performance under the re-negotiated or rescheduled terms. In other
words, the classification of an asset should not be upgraded merely as a result of rescheduling, unless there is satisfactory compliance of this condition.
 Doubtful Assets
 With effect from March 31, 2005, an asset is required to be classified as doubtful, if it has remained NPA for more than 12 months. For Tier I banks, the 12-month period of
classification of a substandard asset in doubtful category is effective from April 1, 2009. As in the case of sub-standard assets, rescheduling does not entitle the bank to
upgrade the quality of an advance automatically. A loan classified as doubtful has all the weaknesses inherent as that classified as sub-standard, with the added
characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.
 Loss Assets
A loss asset is one where loss has been identified by the bank or internal or external auditors or by the Co-operation Department or by the Reserve Bank of India
inspection but the amount has not been written off, wholly or partly. In other words, such an asset is considered un-collectible and of such little value that its continuance as
a bankable asset is not warranted although there may be some salvage or recovery value.
'Prudential Framework for Resolution of Stressed Assets', lenders will recognize incipient stress in borrower accounts,
immediately on default, by classifying them as special mention accounts (SMA)

Basis for classification -

Principal or interest payment
SMA Sub-categories
or any other amount wholly
or partly overdue
SMA-0 Upto 30 days
More than 30 days and upto
SMA-1
60 days
More than 60 days and upto
SMA-2
90 days
 Problems with NPAs

• Provisioning

• The bad loans lead to banks having to save a part of their operating revenue to account for bad loans which is called Provisioning.

• The technical term used for provisioning is Capital Adequacy Ratio (CAR) or Capital to Risk (weighted) Assets Ratio (CRAR).

• Less profitable

• The banks are required to provision for bad loans out of their operating income.

• The concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans.

• Risk-averse

• The officials of such banks hesitate from extending loans to business ventures that may remotely appear risky for the fear of aggravating an already
high level of non-performing assets (or NPAs).

• Downfall in the share markets

• Any reduction in the perceived valuation of the banks might lead to loss of share value of the banks, leading to general downfall in the share markets.
This could result in wiping out shareholders’ wealth from the financial markets.

• Rising Bad Loans

• In spite of various efforts, a substantial amount of NPAs continue on the balance sheets of banks primarily because the stock of bad loans as revealed by
the Asset Quality Review is not only large but fragmented across various lenders.
 NPA Provisioning
It means an amount that the banks set aside from their profits or income in a particular
quarter for non-performing assets, such as assets that may turn into losses in the future.
It is a method by which banks provide for bad assets and maintain a healthy book of
accounts.
Provisioning is done according the category the asset belongs.
Provisioning Coverage Ratio= (Provision to NPA/Gross NPA)*100
To improve the provisioning cover and enhance the bank’s soundness, the total
provisioning ratio of the banks should not be less than 70%.
Debt Restructuring

 Process where the terms of the existing debt obligations are modified to make
them more manageable or sustainable.
 To address financial distress faced by the borrowers and to prevent a large
number of NPAs or bad loans
 Loans can be restructured by changing various parameters like:
a. Repayment Period
b. Repayable amount
c. Number of instalments
d. Interest rate
e. Additional loans
Schemes to address NPAs

 Corporate Debt Restructuring (CDR)

 Strategic Debt Restructuring (SDR)
 Joint Lender’s Forum (JLF)
 5/25 Scheme
 Sustainable Structuring of Stressed Assets (S4A) Scheme
The Insolvency and Bankruptcy Code,
2016

 In 2018, the RBI scrapped numerous loan recasting schemes like CDR, S4A, SDR, Flexible
Structuring of Existing Long-Term Project Loans, and the Joint Lenders Forums Scheme.
 It made The Insolvency and Bankruptcy Code, 2016 (IBC), the primary tool to deal with the
defaulters.
 RBI harmonises stressed assets resolution framework in view of enactment of IBC
 Resolution plans for the stressed cases of over 2000 crore, must be completed within 180
days.
 If resolution plan is not implemented, then account to be referred to IBC in 15 days
 For restructuring outside IBC, account should not be in default
 Banks will now have to report credit information to Central Repository of Information on
Large Credits (CRILC) on Special Mention accounts every month
 Default with exposure of more than 5 crore have to be reported weekly
MUDRA (Micro Units Development &
Refinance Agency Ltd) Financing

Mudra Offerings

Refinance for micro units to

commercial Credit Guarantee Development and
Technology Enabler
Banks/NBFCs/RRBs/SFBs/MFIs for Mudra Loan Promotional Support
(under PMMY)

Sectoral Development
Shishu (Upto Rs. Kishore (Rs. 50000 to
50000) Rs. 5 lakh)
Financial Literacy
Institution Development

Tarun (Rs. 5 lakh to

Rs. 10 lakh)
Financial Exclusion
 Exclusion may also have resulted from a variety of structural factors such as unavailability
of products suiting their requirements, stringent documentation and collateral
requirements and increased competition in financial services.
 There has also been particular emphasis on socio-cultural factors that matter for an
individual to access financial services (United Nations, 2006b).
 Substantial proportion of households, especially those with low income and those living in
rural and remote areas, is at present outside the ambit of the formal financial system in
many countries.
Financial Inclusion

 Financial Inclusion is the process of ensuring access to appropriate financial products

and services needed by vulnerable groups such as weaker section and low income
groups at an affordable cost in fair and transparent manner by mainstream institutional
players. (Reserve Bank of India)

 In other words refers to universal access to a wide range of financial services at the
reasonable cost.

 Not only banking products but also other financial services such as insurance and
equity products.
 Household Access to Financial Services

Access

Contingency Planning Credit Wealth Creation

Savings & Investments

based on household’s
Insurable
Retirement Savings Buffer Savings Business Livelihood Emergency Loans Housing Loans Consumption Loans level of financial
Contingencies
literacy and risk
perception
Financial Inclusion leads to:

 Broadening the resource base of financial system

 Developing a culture of savings among large segments of the rural
population
 Facilitating easy access for all individuals and businesses to formal credit
 Increasing the rate of economic development
 Protecting low-income groups’ financial wealth and other resources under
challenging circumstances
 Mitigating the exploitation of vulnerable sections by usurious money
lenders.
National Strategy for Financial Inclusion for
India 2019-2024

 Prepared under the aegis of the Financial Inclusion Advisory Committee

 Based on the inputs from Government of India, other Financial Sector Regulators, viz,
Securities Exchange Board of India (SEBI), Insurance Regulatory and Development
Authority of India (IRDA) and Pension Fund Regulatory and Development Authority of
India (PFRDA), other stakeholders and market players, including NABARD, National
Payments Corporation of India (NCPI), Commercial Banks and Corporate Business
Correspondents.
 It sets forth the vision and key objectives of financial inclusion policies in India,
emphasising enhancing digital financial inclusion, promoting financial literacy and
strengthening the grievance redressal mechanism in the country.
Initiatives for Financial Inclusion

 India Stack (four layered system offering multiple services:

Unique Identification Authority of India (UIDAI) to issue Unique identification
numbers named Aadhar , E-KYC, Digital Locker (DigiLocker), Unified Payment
Interface (UPI)
 Pradhan Mantri Jan Dhan Yojna
Launched on 28 Aug 2014
Universal access to banking facilities with at least one banking account for
every household, financial literacy, and access to credit and insurance.
 Initiatives for Micro Small & Medium Enterprise (MSME)
Considered as the engines of growth of the Indian economy, contributing nearly 31 % to
India’s GDP and 45 % to exports and providing employment opportunities to more than
11.1 crore skilled and semi-skilled people.
There are approximately 6.33 crore MSMEs in the country.
Web portals like the ‘Udyami Mitra’ and psbloanin59minutes’ have been launched to
provide easy access to credit.
Pradhan Mantri Mudra Yojna (PMMY), a scheme to finance small business enterprises was
launched in 2015, whereby lending institutions would finance micro-entrepreneurs up to Rs.
10 lakh
An exclusive fund, viz, Financial Inclusion Fund (FIF) has been created to support the
adoption of technology and capacity building with an initial corpus of Rs. 2000 crore.
Financial Inclusion Index

 India’a first financial inclusion index, i.e, CRISIL(Credit Rating Information Services of
India ltd.) inclusix was launched in 2013.
 It is based on four dimensions: Branch penetration, deposit penetration, credit
penetration and insurance penetration.
 It measures progress on financial inclusion down to the level of each of the 666
districts in the country, and is based on data provided by the RBI, the Micro Finance
Institution Network, and the Insurance Information Bureau of India.
Role of Technology

 Enhanced convenience and accessibility

 Improved efficiency and operational processes
 Enhanced security and fraud prevention
 Financial Inclusion
 Innovation and Enhanced Customer Experience
Recent Notable Technological Changes

 Cheque Truncation System (CTS) and Magnetic Ink Character Recognition (MICR)
 Automated Teller Machines (ATMs)
 Internet Banking and Mobile Banking
 Electronic Funds Transfer (EFT) and Real-Time Gross Settlement (RTGS)
 Aadhar Enabled Services
 Unified Payment Interface (UPI)
 Electronic Know Your Customer (e-KYC)
 Biometric Authentication and Security
 Artificial Intelligence and Chatbots
 Robotic Process Automation