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CENTRE FOR INVESTMENT EDUCATION AND LEARNING Training Programme on Banking and Finance CENTRE FOR INVESTMENT EDUCATION AND LEARNING Training Programme on Banking and Finance

The material in this publication is intended to be used only by participants enrolled The material in this publication is intended to be used only by participants enrolled into CIEL’s e-learning and classroom training programmes. All rights reserved. No part of this publication may be reproduced in any form or by any means, without permission in writing from CIEL. The course structure and outline, approach, content, framework and materials, in any form and on any media provided in this publication by CIEL shall be and remain [along with all intellectual property rights therein or related thereto] the exclusive property of CIEL. Course Author: Uma Shashikant Design: Kanchana Sawant © 2009 Centre for Investment Education and Learning Pvt Ltd 106, Sholay Premises, Raheja Complex, Seven Bungalows, Andheri (West), Mumbai - 400 061 India Email: [email protected] co. in Webpage: www. ciel. co. in 2

Lesson 1 Structure of Banks Lesson 1 Structure of Banks

Intermediation § Banks are the biggest financial intermediaries in any economy. They aggregate money Intermediation § Banks are the biggest financial intermediaries in any economy. They aggregate money from those who have it, and make it available to those who need it. § Those who have money may not have the ability or willingness to lend to those who need it. § § § A person with funds to spare for a month is not able to lend to someone who needs it for six months. A person with funds may not be willing to risk lending to someone who is a stranger. Banks intermediate between borrowers and lenders in the system. They borrow from the lenders, and lend to the borrowers, earning a spread (NIM) from such intermediation. 4

Intermediation - Example § Anand is able to save Rs. 2000 every month from Intermediation - Example § Anand is able to save Rs. 2000 every month from his salary. He is happy to earn 3. 5% as interest on his saving deposit from the bank. § ABC Corporation typically receives its payments by the 10 th of a month, but needs to pay salaries by the 1 st of the month. § A bank would use the deposits of Anand to make a working capital loan to ABC corporation. § If ABC pays 6% on the borrowing, the bank makes a 2. 5% spread. § Anand does not know ABC and may be unwilling to lend to them. ABC does not know Anand, and may find it tough to borrow. 5

Types of Intermediation § The bank stands between the borrower and lender and enables Types of Intermediation § The bank stands between the borrower and lender and enables the transfer of funds. In doing so, it lends important services: § § § Liquidity intermediation: The lender can ask for his deposits to be returned. The bank will service this request, without recourse to the lender. Credit intermediation: The borrower may be able to raise loans only at a higher rate, if he went directly to the depositor. The depositor cares only for the bank’s creditworthiness, which is always better. Maturity intermediation : The borrower and lender may have different time horizons for their needs. The bank takes on the risk of differences in maturity periods of the deposits and loans. 6

Risks in Banking § The primary function of the bank is to borrow from Risks in Banking § The primary function of the bank is to borrow from the depositors and make loans to borrowers from such money. § The risk in this business, arises from the intermediation roles § Borrowers may default or delay their payments. § Deposits may be short term; loans may be long term. § Adequate funds may not be available when depositor asks for cash § Banks therefore have to be structured such that these risks are adequately addressed. § Setting up a bank and seeking deposits from the public, is strictly regulated across the world to ensure that the deposits of the public are not under risk from the kind of loans made by banks. 7

Reserve Requirements and Capital Adequacy § Risks are managed through two mechanisms: § Reserve Reserve Requirements and Capital Adequacy § Risks are managed through two mechanisms: § Reserve requirements § Risk-weighted capital adequacy § Banks are required to maintain a percentage of their deposits in cash (CRR). § Banks have to utilise a part of their deposits to buy safe government securities (SLR). Not all deposits can be lent as loans. § Every loan is assigned a risk-weighting. Banks should have equity capital to support any loss in value of loans. This is called capital adequacy (RCAR). 8

Primary Functions of Banks § We broadly look at banking functions as fund-based and Primary Functions of Banks § We broadly look at banking functions as fund-based and fee-based. The broad functions and objectives are as under: § Accepting deposits § Making advances and loans § Enabling third-party payment and collection mechanisms § Managing capital in sync with loans § Maintaining CRR, SLR and other regulatory limits § Advising clients on fund raising, investments, and management of their portfolios § Managing the treasury funds keeping interest rate and credit risks in mind § Enhancing the NIM and return on capital 9

Exercise § You need a loan of Rs. 20, 000 to buy a house. Exercise § You need a loan of Rs. 20, 000 to buy a house. Your savings from monthly salary is Rs. 20, 000, or 1% of your need. Assume there are no banks. § Discuss the following choices and figure what the advantages and disadvantages would be: § Borrowing from the PF account § Borrowing from friends and relatives § Waiting until the required sum is accumulated § Making a bond issue and inviting subscriptions from investors § Borrowing from the money lender § Selling the family jewellery to raise money 10

Lesson 2 Liability-side Products Lesson 2 Liability-side Products

Product Portfolio § Banks offer two broad kinds of products to their customers: § Product Portfolio § Banks offer two broad kinds of products to their customers: § Liability-side products § Asset-side products § Liability side products are in the nature of loans made by customers to banks. They are popularly called deposits. § Asset-side products are in the nature of loans made by banks to customers. These can either be in the following forms: § § § Transactional loans between banks and borrowers Securities issued by borrowers and bought by banks Banks also offer fee-based services which do not involve giving or taking a loan, but offering a service, such as advisory, for a fee. 12

Deposits § Bank deposits are of two types: § § § Demand deposits Time Deposits § Bank deposits are of two types: § § § Demand deposits Time deposits Demand deposits are transactional balances kept by customers with banks. § § § They can be withdrawn on demand. They are not maintained for any specific time period with the bank. Time deposits are kept with the bank for a specific period of time. § Tenors of time deposits can range from 14 days to 5 years § Regulations limit the maximum tenor for which banks may offer time deposits. 13

Demand Deposits § Demand deposits are of the following types: § § § Savings Demand Deposits § Demand deposits are of the following types: § § § Savings bank accounts of retail customers Current accounts of institutional customers Savings accounts facilitate routine transactions of retail investors § § They facilitate self and third-party transactions through cheques and fund transfers. § § They are designed to keep transactional balances, e. g. salaries Saving accounts usually offer a low rate of interest on balances or none at all. Current accounts facilitate business transactions of institutional clients § They are transaction-intensive and usually offer no interest on balances. 14

Opening an Account § Most banking relationships begin with the opening of a demand Opening an Account § Most banking relationships begin with the opening of a demand deposit account. § § To offer certain facilities such as business or investment advisory services, banks insist on a basic demand deposit relationship. Banks are required under Regulations to verify the customer credentials before opening demand deposit accounts. § PMLA and Anti-money laundering laws § KYC requirements § Banks may also carry out customer reference checks and seek introductions before opening an account. § Extension of business relationship into retail relationships are also done, e. g. salary accounts the employees of large customers. 15

Demand Deposits: Risks and Reward § Demand deposits represent the lowest-cost funds available to Demand Deposits: Risks and Reward § Demand deposits represent the lowest-cost funds available to banks. § Since they can be withdrawn on demand, deploying them is a tricky business § § Regulators impose conditions for accepting demand deposits, to ensure that there is no systemic risk for run on banks § § Run on banks and liquidity risks CRR and SLR stipulations and reporting requirements In reality, a good amount of demand deposits may be available with banks, for deployment, depending on transactional pattern of customers § Instances of ‘float’ 16

Pricing of Demand Deposits § Banks do not offer an interest on transactional balances Pricing of Demand Deposits § Banks do not offer an interest on transactional balances of current accounts. § § § They incur costs in servicing the transactions of large customers They may restrict the number of transactions depending on the size of operations The interest rate offered on savings deposits may be subject to regulation (min 3. 5% in India) § § § Services offered to customers may vary depending on actual transactional balance (QAB) Classification of customers with differential service standards is a common practice Banks try to balance the interest earned on demand deposit balances with the cost of services provided. 17

Services on Savings Bank Accounts § Regulations require mandatory provision of the facility to Services on Savings Bank Accounts § Regulations require mandatory provision of the facility to withdraw demand deposits, at zero cost. § § Banks fulfill this requirement by offering withdrawal slips at branches Other transactional services on savings bank accounts are: § § ATM and debit cards § Passbook or Statement of Account § Internet/Mobile /Phone banking § § Cheque books Issuance of demand drafts and pay orders The range of services and costs of the services, depend on the type of account, as classified by the average balances. 18

Quarterly Average Balance (QAB) § QAB refers to the average balance maintained by a Quarterly Average Balance (QAB) § QAB refers to the average balance maintained by a savings bank account holder over a quarter. § The daily closing balance in the savings account is taken for a quarter and added up. § This number is then divided by the number of days in the quarter. § The resulting number is the QAB, or the daily average balance in the account during that quarter. § If the balance in a savings account, for each day, for the months of April, May and June adds up to Rs. 610, 000, the QAB would be Rs. 6703 (610000/91). 19

Third-party Payments and Fund Transfer § Customers use payment instruments to pay third-parties using Third-party Payments and Fund Transfer § Customers use payment instruments to pay third-parties using the balances in their demand deposit accounts. § Every payment instrument has 4 parties – payer, beneficiary, paying bank and collecting bank. § A cheque or demand draft is an instruction by the payer to his bank (paying bank) to pay a given amount to the beneficiary. § The cheque or DD is handed over to the beneficiary, who deposits it in his bank (collecting bank). § The collecting bank collects the cheque from the paying bank, through the clearing process. 20

Clearing § The investor draws a cheque on his bank account. The beneficiary may Clearing § The investor draws a cheque on his bank account. The beneficiary may have his collecting bank account with another bank. § § The process through which banks transfer funds between one another is called ‘clearing’. § § The collection of investors’ funds depends on where the two banks are located. When funds are transferred from the payer’s bank account to the beneficiary’s bank account, they are said to have been ‘cleared’. Banks use the ‘Clearing house’ for such inter-bank transactions. § A clearing house is an association of banks located in a certain geographical area. § There are over 1000 clearing houses across India. 21

Clearing Process - Example § Customer draws a cheque on his account and gives Clearing Process - Example § Customer draws a cheque on his account and gives it to the beneficiary, whose bank is Deutsche Bank. § The cheque travels through the service branch to the clearing house and onward to the payer’s bank, HDFC Bank. § Unless placed in return clearing, the cheque is deemed to have cleared. 22

Electronic Clearing § Modern banks have adopted technological solutions, that do not require physical Electronic Clearing § Modern banks have adopted technological solutions, that do not require physical travel of cheques. § Cheques have MICR codes/ISC codes that are electronically captured with a scan, and verified on the system for customer signature match. § Entries in the clearing house and between bank branches are also made electronically. § See a sample MICR code below: 23

Modes of Speedy Transfer § Transfer cheques are used to transfer funds when the Modes of Speedy Transfer § Transfer cheques are used to transfer funds when the payer has an account with the same bank as the beneficiary and knows the account number. § High value clearing enables same-day fund transfer between select branches in the same city, for amounts higher than a specified amount. § Standing instructions enable periodic transfers across branches within the same bank. § Electronic clearing services enable transfer of funds across banks on specific dates. § EFT, NEFT and RTGS enable same-day electronic transfer across branches. 24

Exercise § Anand lives in Mumbai and is a travelling salesman. He likes to Exercise § Anand lives in Mumbai and is a travelling salesman. He likes to ensure that his dad who lives in Trichy receives a fixed monthly allowance, from his salary. What are Anand’s choices? Which one is efficient? Why? § Anuradha has to deal with several monthly payments, such as electricity, phone, water and gas bills, and credit card payments. She often forgets to deposit the cheques in the drop box. What is an efficient solution for her? Why? § ABC International School receives at least one lakh applications for its various courses. It is a bother for its office to deposit low value DDs of Rs. 500 that comes with each application. Can ABC do better? How? 25

Operational Aspects of Demand Deposits § The most critical facility to the customer is Operational Aspects of Demand Deposits § The most critical facility to the customer is the ability to conduct transactions and make third-party payments using the balances in the demand deposit account. § Banks offer efficient processes to facilitate transactions: § Internet, phone and mobile banking to enable balance enquiry, fund transfer and most transactions except deposit and cash withdrawal. § Bill-pay facilities that enable ECS mandates to be given for routine periodic payments. § Linked-accounts to enable timely payment for securities transactions. § Facilities to block balances for participation in IPOs (ASBA) 26

Operational Aspects - 2 § Savings bank accounts can be operated by a maximum Operational Aspects - 2 § Savings bank accounts can be operated by a maximum number of two joint account holders. § Both joint account holders have to complete the KYC formalities. § The account can be operated by either one of them, or by both of them jointly. § Account holders can delegate the operation of their bank accounts to another person, by executing a power of attorney (Po. A). The signature of the Po. A holder is kept in the bank records and verified against transactions. § Institutional investors appoint authorised signatories who sign the cheques. The list along with approvals from the Board are maintained by the bank. 27

Float in Current Accounts § There are occasions when customers of banks have to Float in Current Accounts § There are occasions when customers of banks have to keep large balances, even if for a short period, in their current accounts: § Subscriptions moneys for IPOs, security issuances. § Bulk credits for payment of bond and fund redemptions, or interest and dividend payments. § Grants and loans from governments and international bodies § Banks are active participants in money markets and are therefore able to earn a return on every rupee they hold for every day. § Banks pass on some of the benefits from ‘float’ through value added services to clients § Collecting banks and CMS § Arranging banks and issue management § Bridge loans and funding-gap facilities. 28

Time Deposits § Time deposits are saving products, intended to earn an interest income Time Deposits § Time deposits are saving products, intended to earn an interest income to the customer, as distinct from demand deposits that primarily enable transactions. § Time deposits also represent an important source of funds to the bank, to help them build a loan portfolio of longer tenor. § Time deposits are issued in two forms: § As certificates of deposits to large customers, for durations less than one year. § As fixed deposit receipts (FDRs) to all customers, for durations ranging from 14 days to 5 years. 29

Product Structure § Time deposits can be created from balances in the savings bank Product Structure § Time deposits can be created from balances in the savings bank account through a facility called ‘sweep’. § Customers can also sweep balances into time deposits using phone/mobile/internet banking. § Time deposits are created for a specific maturity date, at the end of a given tenor. Customers can choose from the following options: § § § Interest payout Cumulative Time deposits can be transferred to an identified saving account on maturity, or can be rolled over for a identical tenor, as instructed by the customer. 30

Product Pricing § Interest on time deposits are indicated either for a full year, Product Pricing § Interest on time deposits are indicated either for a full year, or for parts of the year – quarterly or half yearly. § Banks offer a higher effective rate by allowing the reinvestment of quarterly or half yearly interest rates. § For example, if a bank offers 2% quarterly, it amounts to an effective annual interest on Rs. 100 of deposits of: § § Q 2: 102 x (1. 02) = 104. 04 § Q 3: 104. 04 x (1. 02) = 106. 12 § § Q 1: 100 x (1. 02) = 102 Q 4: 106. 12 x (1. 02) = 108. 24 Thus 2% quarterly interest amounts to an effective rate of 8. 24% per annum. 31

Pre-mature Termination § Time deposits have to be bought or booked for a specific Pre-mature Termination § Time deposits have to be bought or booked for a specific period. If a customer needs the money before the maturity of the deposit, there are two options: § § § The bank may offer a loan against the deposit, at a rate higher than the deposit rate. The bank may agree to terminate the deposit before maturity. If a time deposit is terminated before maturity, the bank may agree to pay broken period interest, at current rates, only for the period for which the funds have been with the bank. § § A 3 -year deposit, terminated at the end of 1 -year, will earn only the 1 -year rate as on the date of termination. Some banks agree to pay proportionate interest for the broken period, at the contracted rate. 32

Operational Features of Time Deposits § Time deposits can be held by two joint Operational Features of Time Deposits § Time deposits can be held by two joint holders. § The FDR may be issued as a physical instrument with a serial number, in which case it has to be discharged and returned to the bank on maturity. § FDRs can also be issued in electronic form, which is easier to create and cancel. § CDs are usually issued to wholesale investors and have a higher face value. (for example Rs. 25 lakh each) § CDs can be transferred from one buyer to another; the bank makes the maturity payment to the registered holder on maturity date. 33

Special Types of Deposit Accounts - NRs § Banks may offer the facility of Special Types of Deposit Accounts - NRs § Banks may offer the facility of creating deposits for non-residents (NR). § These deposits are usually received in foreign currency and are subject to foreign exchange regulations of the country where the bank operates. § Repatriation and joint holding facilities on NR deposits are subject to exchange control regulations and limits imposed therein. § NR deposits are subject to specific tax concessions as well. In India interest on NR deposits is free from tax. § Non-residents usually seek facilities for inward and outward remittances from their bank accounts. 34

Special Types of Deposits - Minors § Minors are children who have not attained Special Types of Deposits - Minors § Minors are children who have not attained 18 years of age. § As per regulations in most countries, minors are not authorised to enter into contractual obligations. Such contracts are null and void. § § Bank accounts can be opened in the name of minor children, and operated by guardians. § § Guardians conduct the financial transactions of minor children. Parents are natural guardians of minor children. Minor children have limited facilities such as debit cards with specific limits. They cannot issue third party cheques. Once the child turns 18, the account is converted into a normal account and operated by the minor-turned-major customer. § KYC formalities have to be completed for such customers. 35

Lesson 3 Asset-side Products Lesson 3 Asset-side Products

Loans and Advances § The primary asset-side product of banks are loans and advances. Loans and Advances § The primary asset-side product of banks are loans and advances. § These are transactions based on a credit-assessment process, and are arrangements between the bank and the borrower, bound by an agreement § Loans are not securities and are therefore not traded § Loans can be secured by an asset or can be unsecured. § Loans are made to retail and institutional borrowers: § § Retail loans include personal loans, vehicle loans, home loans, loan against securities and credit cards. Institutional loans include over drafts, working capital loans, loan against trade receivables and lines of credit. 37

Base Rate § With effect from July 1, 2010 the all loans and advances Base Rate § With effect from July 1, 2010 the all loans and advances of bank will be priced with reference to a base rate § Will be calculated considering cost of funds, negative carry on CRR and SLR, overhead costs and return on networth § Banks can use their own methodology for calculation § Will be reviewed at least once a quarter § Banks cannot lend at rates lower than the base rate § Loans for which base rate will not be applicable § Loans to banks’ own employees § Loans against deposits of depositors 38

Corporate Loans § Fund-based working capital loans § cash credit § packing credit § Corporate Loans § Fund-based working capital loans § cash credit § packing credit § short-term loans payable on demand § inland/export bills discounting § export and import financing § § § cash-flow gap financing subscription to commercial paper Non-fund based working capital products § Documentary credit and bank guarantees 39

Retail Loans § Retail loans are of two types: § Secured loans against assets Retail Loans § Retail loans are of two types: § Secured loans against assets § Unsecured loans § Loans can also be secured with third-party guarantees. § Retail loans are usually made only to existing customers. Opening a deposit account is mandatory before applying for a loan. § Loans can be disbursed in tranches (home loans), in a lump sum (personal loans) or on an on-going basis (overdrafts and credit cards) § Repayment of loans can be in equated monthly installments (EMIs), or in tranches or as a lump sum. 40

Personal Loans § Personal loans are unsecured loans sanctioned against the known sources of Personal Loans § Personal loans are unsecured loans sanctioned against the known sources of income of the borrower. § The purpose for which the loan is used is not monitored by the bank. § Borrower is expected to produce proof of income, to establish the ability to repay. No collateral or guarantees are sought. § The rate of interest on personal loans can vary across borrowers based on their credit scores. § Personal loans may also be pre-approved based on credit history. § Usually personal loans are processed faster to existing customers with an acceptable credit history. 41

Loan Against Securities § Customers may be willing to offer securities, such as shares, Loan Against Securities § Customers may be willing to offer securities, such as shares, mutual funds and bonds that they hold, as collateral. § Loans with collateral tend to be cheaper than unsecured loans. § Banks ascertain the value of the securities and are willing to offer a loan that is somewhat lower than the value of the securities (the difference is called margin or haircut). § The securities that are offered as collateral are taken on lien by the bank. The registrar who maintains the investor records, is notified about the lien. § Securities marked under lien cannot be sold, transferred or redeemed by the borrower. 42

Invoking and Revoking the Lien § The bank can invoke the lien and sell Invoking and Revoking the Lien § The bank can invoke the lien and sell of the securities offered as collateral, if the borrower fails to repay the loan. § The bank may ask for part payment, or additional collateral if the value of the securities falls and breaches the margin. § Banks may allow additional loans against the collateral if the value of securities has moved up. § The bank will revoke the lien if the amount of loan has been repaid and notify the registrars. § The borrower is entitled to corporate benefits like dividends and interest on the securities. However, bonus shares where issued will be automatically included in the lien. 43

Home Loan § Banks offer loans for buying houses, which include purchase of land, Home Loan § Banks offer loans for buying houses, which include purchase of land, constructed houses and home-improvement. § Loans are offered against mortgage of the property and are usually long-term in nature. Tenors of home loans can vary from 10 to 20 years. § Home loans are usually repaid in equated monthly installments (EMIs) by the borrower. § Borrowers can pre-pay the loan before the end of the tenor. Banks may impose penalties on pre-payment. § If borrowers fail to repay the loan, banks may foreclose the property and offer it for sale to recover the dues. 44

Home Equity Loans § Sometimes the value of the homes that customers hold could Home Equity Loans § Sometimes the value of the homes that customers hold could have moved up steeply, resulting in the value of the asset being much higher than the loan due on it. § The difference between the value of the asset and the loan outstanding is called equity. § Banks may offer additional loans against home equity, which are available at a finer rate than a personal loan, since they are secured by the value of the house. § Home equity loans can be used for business and other purposes as desired by the borrower. 45

Loans for Consumer Durables and Vehicles § Household durables and personal vehicles may also Loans for Consumer Durables and Vehicles § Household durables and personal vehicles may also require funding for their purchase. But these assets do not appreciate in value over time. § Loans for depreciating assets are made at a higher margin, against simple hypothecation of the underlying asset. § If the loan is not repaid, the banker holds the right to seize possession of the asset and dispose the same in the second-hand market to recover the dues. § Such loans are also repaid in EMIs. § The tenor of such consumer loans is usually not over 5 years. 46

Credit Cards § Credit cards are unsecured loans made by banks to customers. § Credit Cards § Credit cards are unsecured loans made by banks to customers. § The unpaid balances on credit card usage represent the loan, and are subject to interest. § If customers pay the balances in full on or before the due date, the credit card represents a payment facility to the customer. § If customers roll-over the balances by paying only the minimum amount due, there is a revolving loan on the card, increasing by the purchases made, and reducing to the extend of payment made. § Debit cards do not represent loans, as the payment is made by directly debiting the bank account, without any credit period. 47

Structure of Credit Card Loans § Credit cards involve three parties: § Card issuing Structure of Credit Card Loans § Credit cards involve three parties: § Card issuing entity (Visa, Master. Card or Amex), § Merchant establishments that accept the card, and § Issuing banks that deal with the customer. § The acceptance of the cards and the payment to the merchant is managed by the card issuing entity; the issuance of cards to customers and recovery of dues is managed by the bank. § Card issuance is a credit activity, subject to checking the customer’s credit history and scores, and placing limits on usage. § Credit card loans are among the most expensive priced at 24% to 36% per annum. 48

Educational Loans § Offered to fund professional education in well known institutions of higher Educational Loans § Offered to fund professional education in well known institutions of higher learning. § Loan is sanctioned based on the expense estimates provided by the borrower and vetted by the institution of study. § Disbursal is directly to the educational institution. § Educational loans enjoy a moratorium on interest and repayment of principal, during the course of study and for a period of 1 -2 years after completion. § Banks require financial guarantees or joint application with earning members of the family, to sanction educational loans. 49

Pricing of Retail Loans § Most retail loans are structured to be repaid in Pricing of Retail Loans § Most retail loans are structured to be repaid in equated monthly installments (EMI). § EMIs include both interest and principal. § The sum of the present value of the EMIs, discounted by the interest rate, is the value of the home loan. § The formula for calculation of EMI given the loan, term and interest rate is: § EMI = ((p*r) (1+r)n) /(1+r)(n – 1) § Where p = amount of loan, § r = rate of interest per installment period, § n = no. of installments in the tenure. 50

Using Excel to Compute EMI § Click on the function icon ‘fx’ or go Using Excel to Compute EMI § Click on the function icon ‘fx’ or go to Insert> function in a spreadsheet. § Select ‘Financial’ under the head ‘or select a category’. Under the list of functions, select ‘PMT. ’ § A window which requires the variables to be keyed in, opens. § Key in the interest rate say ‘ 8%/12’ if 8% is the interest and the repayment is monthly. § Key in the nper as ‘ 15*12’ since monthly instalments are payable for 15 years. § Key in PV as the value of the loan say, 100, 000. § The formula result at the bottom of the window is the EMI – Rs. 9557. 51

Splitting the EMI § To know how much of the EMI is interest and Splitting the EMI § To know how much of the EMI is interest and how much is principal, we can use a function called IPMT. § § Key in the interest rate as ‘ 8%/12’ since the repayment is monthly. ‘Per’ is the specific instalment, for which you want to find out the interest component. If it is for example, the 10 th EMI, key in ‘ 10’. § Key in the nper as ‘ 15*12’ since monthly instalments are payable for 15 years. § Key in PV as the value of the loan -100000. § The formula result at the bottom of the window is the interest component – Rs. 6489. § § The 10 th instalment of EMI of Rs 9557 is split into Rs. 6489 towards interest, and Rs. 3068 (9557 minus 6489) towards principal. 52

Exercise § Arun likes to borrow Rs. 2, 000 for his house. If he Exercise § Arun likes to borrow Rs. 2, 000 for his house. If he is offered a fixed interest of 11% by his bank, what is the EMI if he chooses to repay the loan in 15 years? How does the EMI change if he chooses to pay in 20 years? § Split the EMI Arun pays in month 24, and in month 48. What do you see? Why does the interest and principal component in his EMI change? 53

Structure of Personal and Durable Loans § Most loans from banks, except for overdrafts Structure of Personal and Durable Loans § Most loans from banks, except for overdrafts and revolving credit on a card, are repaid in EMIs. § In case of consumer durable loans, there is many a times a clever packaging of the loan, to create an impression of lower rate, sometimes zero rate! § Consider this example: § § You agree to an EMI of Rs 1500 for 36 months § The bank imposes a administrative fee of Rs. 3000 to process your loan. § § Your loan amount is Rs. 50, 000 You are asked to pay 3 advance EMIs. Your actual repayment is 1500 x 33 =49500. No Interest? 54

The Zero-Interest Puzzle § Since you paid Rs. 3000 charges plus Rs 4500 as The Zero-Interest Puzzle § Since you paid Rs. 3000 charges plus Rs 4500 as advance EMI, your actual loan amount is only Rs. 42, 500. § Since you pay Rs 49, 500 through the remaining 33 EMIs, the interest you have paid is Rs. 7000. § If we use the PMT formula, § Nper = 36 § Pmt = 1500 § PV = (42500) § we will find that the interest rate on the loan is 1. 355 per month or 16. 28% p. a. § There is no free lunch in finance! 55

Fixed vs. Floating Rates § Banks offer a choice of fixed or floating rates Fixed vs. Floating Rates § Banks offer a choice of fixed or floating rates to borrowers. § A fixed rate is one that is contracted at the time of the loan and remains unchanged until maturity. § A floating rate loan is one where the rate of interest is reviewed periodically, with reference to a benchmark, and reset to reflect the current market rates. § For example a 5 -year Libor+50 bps loan, reset six-monthly, means: § The rate of interest will be reset every six months. § On reset date the prevailing Libor will be referred to. § To the benchmark rate, a spread of 0. 50% will be added. § The resultant value is the interest on the loan, until the next reset. 56

Fixed Rate Loans § The interest rate on a fixed rate loan in unaltered Fixed Rate Loans § The interest rate on a fixed rate loan in unaltered through the tenure of the loan. § Usually the EMI of a fixed rate loan is the cash outflow a borrower needs to plan for through the tenure. § As incomes and inflation move up over the years, a fixed EMI is attractively stagnant. The real cost of the loan actually drops. § With a fixed EMI, any reduction in interest rates in the market, will not benefit the borrower. § A fixed rate borrower chooses to ignore market swings and focus on the fixed EMI. Therefore there are no gains from falling rates or losses from rising rates, that occur subsequent to the start of the loan. 57

Floating Rate Loans § Floating rate loans are a deceptive attraction. When the rates Floating Rate Loans § Floating rate loans are a deceptive attraction. When the rates fall they look like a bargain, and when rates go up they look unfair. § In a loan cycle of 15 to 20 years, the borrower would have paid market rates, and that is the advantage of a floating rate loan. § The EMI of a floating rate loan should change with changes in interest rates. § § § Borrowers may be reluctant to risk a fluctuating EMI, as it impacts their monthly cash flows. Banks provide the option to change the number of EMIs instead. In a floating rate loan, the borrowers trade-off a changing EMI or tenure for the ability to pay market-adjusted rates. 58

Mixed Choices § There are loans that feature both fixed and floating rates. § Mixed Choices § There are loans that feature both fixed and floating rates. § § There are loans where the EMI is fixed for an initial period, after which it floats. § § One part of the loan is set on a fixed rate basis and another is set on a floating rate basis. These are for borrowers who want to have the best of both. There are loans where the EMI for an initial period is low and increases over time. § These are for young borrowers, who like to keep the initial commitment low and can enhance their payment as their incomes grow. § There are choices that feature higher EMIs for an initial period and lower EMI for the remaining period. § These are for older borrowers, wanting to pay more earlier and at the peak of their income cycle, and like lower EMIs close to retirement. 59

Exercise § You have taken a floating rate home loan at 7. 5% when Exercise § You have taken a floating rate home loan at 7. 5% when the fixed rate was 9%, four years ago. § In the last four years, your EMIs on the floating rate loan have been increased every time the interest rates went up. You now worry about servicing a 20 -year loan, now become 30 -year loan. § Currently, the fixed rate is 9. 5% and the floating rate is 11%. § What should you do? § Switch to a fixed rate loan? Why not? § Stay with the floating rate loan? Why? § What should you consider when you choose a fixed or a floating rate? And does it make sense to switch m id-course? 60

Credit Card Terms § Billing Cycle § § Customers periodically (once a month) receive Credit Card Terms § Billing Cycle § § Customers periodically (once a month) receive a listing of their credit card transactions. They get about 15 -20 days to make the payment. Free Credit Period § If they pay the total amount due on or before the due date, no interest will be charged. They enjoy a free credit period for their transactions in a billing cycle. § Minimum Amount Due § Paying the minimum amount due indicates that the customer is willing to pay interest on his dues. The minimum amount is usually 5% of the total amount due on a card, or Rs. 100 whichever is higher. 61

Interest on Revolving Credit § Interest rate on a credit card is quoted as Interest on Revolving Credit § Interest rate on a credit card is quoted as a monthly rate. But it applies on a per day basis. § For example, if the quoted rate is 3. 15% per month, the rate per day is 3. 15 x 12/365= 0. 1036%. § If the customer does not pay in full on or before the due date, interest calculation is triggered. § When the next bill is raised, interest is computed for each transaction from the date of the transaction to the date of the bill. § By not paying in full, the customer no longer enjoys a free credit period. § 62

Interest Computations § The number of days from each transaction to the statement date Interest Computations § The number of days from each transaction to the statement date is calculated. § Each transaction amount is multiplied by the number of days and the per day interest. § The total of all such dues appears on the next billing statement. § If the minimum amount is also not paid, 30% of this amount is charged as late payment fee, and added to the next billing statement. § Credit card companies may also charge an annual fee. In competitive markets like India this fee has since been waived. 63

Example Statement date Payment due date Total Amount due Minimum amount due 15 -Mar-10 Example Statement date Payment due date Total Amount due Minimum amount due 15 -Mar-10 22 -Mar-10 29 -Mar-10 • • • 15 -Apr-10 4 -May-10 6500 325 Opening balance Good Lifestyle Stores Quality Restaurant 0 4500 2000 This is a sample credit card statement. The spends for the period 16 March 2010 to 15 April 2010 have been covered. The payment due date is May 4, 2010 The minimum amount due is 5% of the amount total amount due. 64

Next Statement with Interest § The opening balance is the due of the last Next Statement with Interest § The opening balance is the due of the last month, that is fully unpaid. § The new spend is Rs. 2500. § Both interest and late payment fees have been imposed. Statement date Payment due date Total Amount due Minimum amount due 15 -Apr-10 22 -Apr-10 15 -May-10 Opening balance Novelty Gifts Interest on outstanding dues Late payment fee 15 -May-10 4 -Jun-10 9486 474 6500 2500 389 98 65

Interest Computation No. of Amount Days Date Spend Rate per day Interest 22 -Mar-10 Interest Computation No. of Amount Days Date Spend Rate per day Interest 22 -Mar-10 Gold Lifestyle Stores 4500 54 0. 09863% 240 29 -Mar-10 Quality Restaurant 2000 47 0. 09863% 93 22 -Apr-10 Novelty Gifts 2500 23 0. 09863% 57 Interest 389 Late fee 98 § Interest is 3% per month or 3 x 12/365 per day. § Interest is computed from the date of spend to the date of statement. § Late fee is 30% of minimum amount due and not paid (30% of Rs. 325). 66

Operational Aspects of Retail Loans § Retail loans, except for personal loan and credit Operational Aspects of Retail Loans § Retail loans, except for personal loan and credit card loans, are secured by assets. § The bank executes a hypothecation or mortgage of the asset being funded by the loan. § The papers pertaining to the ownership of the assets is with the bank. § The bank will require proof of income (income tax returns), guarantees, references and deposits, as it deems necessary to assure itself that the loan would be good. § Loan documents are legal documents and will have to be executed on stamp paper, and signed along with witnesses. 67

Repayment Processes § Borrowers can repay loans using post-dated cheques, standing instructions, electronic transfer, Repayment Processes § Borrowers can repay loans using post-dated cheques, standing instructions, electronic transfer, or cheque deposit. § Loans can be pre-paid by borrowers. Pre-payment is subject to conditions that banks may impose on minimum service period, number of pre-payments, administrative charges and pre-payment penalties if any. § Loans have to be paid on or before the due date in order to not trigger default provisions. § Loans or interest on loans that are unpaid for 90 days from the due date are classified as non-performing assets. § Banks have to provide for and write-off NPAs as per regulation before declaring their profits for the year. 68

Lesson 4 Advisory and Other Services Lesson 4 Advisory and Other Services

Investment Services - Corporate § Treasury Management § § Banks offer treasury management services Investment Services - Corporate § Treasury Management § § Banks offer treasury management services for small businesses, to help them efficiently deploy short-term surpluses. International Assets § Banks manage foreign currency assets for companies, advising them on currency and derivative markets. § Derivatives and Forwards § Banks offer derivative products like swaps and forwards to enable clients manage their interest, commodity and currency exposures. 70

Investment Services - Retail § Banks function as point of sales (Po. S) for Investment Services - Retail § Banks function as point of sales (Po. S) for a range of investment products: § Mutual funds These are products offering portfolios of equity, debt and money market securities. § Tax Saving Bonds These are bonds issued by specific institutions eligible for tax concessions. § Government of India Bonds These are treasury bonds issued by the RBI on behalf of the government. § Initial Public Offers These are equity and debt issues made by companies. § Gold Banks sell gold of highest purity to customers. § § Senior Citizens Savings Scheme, 2004. New Pension Scheme, 2009. 71

Government Bonds and Bills § The central bank issues treasury bonds and bills to Government Bonds and Bills § The central bank issues treasury bonds and bills to fund the deficit of the government. § These instruments carry the guarantee of the government and therefore have no default risk. § Investors have to open a CSGL account with the bank to buy G-secs. Banks can buy Gsecs in an auction on behalf of the customer. § The secondary markets for G-secs is dominated by large investors. Retail investors may have to buy and hold the bonds that they subscribe to through their banks. 72

Corporate Bonds § Bonds represent borrowings of a company, on which a periodic interest Corporate Bonds § Bonds represent borrowings of a company, on which a periodic interest is paid. § Interest can be fixed rate or floating rate. § Secured debt is called debenture; unsecured debt instruments are called bonds. § Credit worthiness of borrower is important in choosing a debt instrument. Credit rating is used for this purpose. § § Higher the rating, lower the interest rate and vice versa Debt instruments can be offered to public, or privately placed. 73

Bonds of Financial Institutions § Financial institutions like Nabard, NHB, NHAI issue bonds regularly. Bonds of Financial Institutions § Financial institutions like Nabard, NHB, NHAI issue bonds regularly. § These are credit-rated and listed on stock exchanges. § Some are classified as infrastructure bonds and eligible for tax concessions § 80 C benefit on infrastructure bonds § 54 EC benefit for specific bonds, to save capital gains. § Interest income from bonds is taxable § Can be issued as coupon paying bonds or as zero coupon bonds. § Institutional bonds are issued to retail investors. 74

Public Provident Fund § Some banks are authorised to operate PPF accounts on behalf Public Provident Fund § Some banks are authorised to operate PPF accounts on behalf of their customers. § PPF is a risk-free deposit made with the government § § 15 years tenure § § Can be opened with banks Yearly deposit mandatory, else penalty is levied. Contributions can be between Rs 500 to Rs 70000 per year. § Eligible for deduction under Section 80 C § Interest is accrued end of the year and reinvested at 8%. § Interest and redemption proceeds are completely exempt from tax. 75

Range of Mutual Fund Products Mutual fund products can be classified as follows: § Range of Mutual Fund Products Mutual fund products can be classified as follows: § Based on Life Span § § Open and closed end funds Based on Asset Class § § § Equity, debt, money markets, gilts and the like Funds may also invest in a combination of asset classes Based on Management Style § Passive and active funds 76

Open-Ended Funds § They have no fixed maturity date and can be bought or Open-Ended Funds § They have no fixed maturity date and can be bought or sold at any time. § Open-ended funds are offered during a new fund offer (NFO) for the first time. § Investors can buy redeem on a continuous basis after the fund re-opens for transactions. § On-going transactions are done at NAV-based prices. § Unit capital is not fixed but changes with purchase and redemption. § Transactions can be restricted by the fund under special situations. 77

Closed-end Funds § Closed-end funds have a specified maturity date. § They are offered Closed-end Funds § Closed-end funds have a specified maturity date. § They are offered during the NFO for the first time and redeemed on maturity date § Closed-end fund are closed for further purchase and redemption after NFO. § § Some funds may offer redemption at NAV-based prices They have to be compulsorily listed on stock exchanges. § § § Prices determined by liquidity in the market Can be at premium or discount to NAV Unit capital of a closed-end fund does not increase after the NFO. 78

Equity Funds § These funds invest pre-dominantly in equity markets. § § § They Equity Funds § These funds invest pre-dominantly in equity markets. § § § They may hold a diversified portfolio of equity shares They may hold a select set of equity shares based on a selection criterion. Equity funds can also specify their investment styles: § Sector or thematic funds invest in one or more specific sectors. § Growth funds invest in aggressive stocks with high valuation. § Value funds invest in less-sought after stocks, at low prices. § Mid & small stock funds invest in stocks with lower liquidity and potential for higher return. § Index funds invest in the same stocks as in the index. 79

Debt Funds § Debt funds predominantly invest in the debt markets, made up of Debt Funds § Debt funds predominantly invest in the debt markets, made up of long and short term bonds issued by government and corporate sector. § Income funds or diversified debt funds invest across the bond market spectrum. § Gilt funds can be short or long term and invest in securities issued by the government. They have no default risk. § Liquid and money market funds invest in money market instruments. § Serial plans or fixed maturity plans are closed end funds, investing such that the fund and the bonds it holds mature simultaneously. 80

Hybrid Funds § Hybrid funds invest in more than one asset class. They may Hybrid Funds § Hybrid funds invest in more than one asset class. They may invest in debt and equity in varying proportions. § Pre-dominantly debt-oriented hybrids hold debt securities with some exposure to equity: Monthly income plans Education plans and children’s plans § Pre-dominantly equity-oriented hybrids hold equity shares with some exposure to debt Balanced funds Retirement plans Growth & Income funds 81

Other Funds § Commodity funds § § Real estate funds § § Invest in Other Funds § Commodity funds § § Real estate funds § § Invest in real estate linked products and in property International funds § § Invest in commodity stocks and futures Invest in global ETFs, funds and securities Fund of funds § § § Invest in other funds Impose two layers of management fees ETFs § Passive funds linked to an index § Bought and sold on the exchange 82

Basis for Classification § Risk § § Sector funds are most risky; money market Basis for Classification § Risk § § Sector funds are most risky; money market funds are least risky Tenor § Equity funds require a long investment horizon; liquid funds are for the short term liquidity needs § Investment objective § Equity funds suit growth objectives; debt funds suit income objectives

Classification-Asset Class Fund type Securities held Equity Funds - Shares Income Funds - Bonds Classification-Asset Class Fund type Securities held Equity Funds - Shares Income Funds - Bonds / Government securities Money Market Funds (Liquid) - Short maturity fixed income instruments Hybrid Funds - Shares & fixed income instruments Commodity Funds - Gold, commodity stocks and futures Real Estate Funds - Real estate Fund of Funds - Other funds Gilt Funds - Government securities High Yield Debt Funds - Debt instruments with lower credit rating 84

Advisory Services - Retail § Wealth Management Services § § Offering investment products to Advisory Services - Retail § Wealth Management Services § § Offering investment products to match the asset allocation needs of investors. § § Risk profiling, financial planning and model portfolios for retail investors. Distribution of third-party and white-labeled products. Asset search and selection services § Home search, accreditation and documentation advice. § Tie-up for offering truck, cars and two-wheelers in new and second hand markets. Protection assets Po. S for insurance products for life, health and general insurance. 85

Advisory Services - Institutional § Structured products and risk solutions for operations, transactions, and Advisory Services - Institutional § Structured products and risk solutions for operations, transactions, and assets. § Global trade finance and currency advisory solutions. § Securitisation of mortgage and other assets. § Market analysis and deal structuring for capital market offerings. § Market reach advisory for SMEs and rural sectors. § Investment advisory for international investors. 86

Value-added Services § Issue Management § § Letter of credit and guarantees § § Value-added Services § Issue Management § § Letter of credit and guarantees § § Enabling trade credit and remittances Cash Management Services § § Managing the collection of proceeds in a NFO and IPO or other public offerings across Collection and payment from multiple centres through electronic upload of pay-in and pay-out instructions. Forex remittances § Inter-bank international clearing through nostro and vostro accounts as correspondent banks. 87

Value-added Services § Depository account opening and servicing of demat and remat requests. § Value-added Services § Depository account opening and servicing of demat and remat requests. § Internet trading accounts linked to demat and bank account to enable electronic trading and settlement. § Custody accounts for straight through processing of securities and cash. § Fund accounting services for marking portfolios to market. § Clearing accounts for settlement of securities transactions § Investment banking services including product structuring, white labeling, distribution, and portfolio management. § Arrangement and syndication of loans in domestic and international markets. 88