A Study on Cost and Profitabilty of Banks

7/29/2019 A Study on Cost and Profitabilty of Banks.

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H.R.

COLLEGE

OF

COMMERCE & ECONOMICS

123, D.W. Road, Churchgate, Mumbai 400 020.

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A STUDY ON THE COST AND

PROFITABILITY OF BANKS IN

INDIA.

Bachelor of Commerce

Banking & Insurance

Semester V

(2012-13)

Submitted by

DANISH PHIROZ DUBASH

A STUDY ON THE COST AND PROFITABILITY

OF BANKS IN INDIA.

Bachelor of Commerce

Banking & Insurance

Semester V

In Partial Fulfillment of the requirements

For the Award of Degree of Bachelor of

Commerce Banking & Insurance

Submitted by

MS. DANISH PHIROZ DUBASH

Roll No.14

H.R. COLLEGE OF COMMERCE & ECONOMICS123, D.W. Road, Churchgate, Mumbai 400 020.


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H.R. COLLEGE OF COMMERCE & ECONOMICS

123, D.W. Road, Churchgate, Mumbai 400 020.

CERTIFICATE

This is to certify that Shri / Miss DANISH PHIROZ DUBASH of

B.Com.-Banking & Insurance Semester V (2012 - 2013 ) has

successfully completed the project on A Study on the Cost And

Profitabilty Of Banks in India under the guidance of Prof. Meena

Desai.

Course Co-ordinator Principal

Project Guide / Internal Examiner

External Examiner

DECLARATION

I Miss DANISH PHIROZ DUBASH the student of B.Com.- Banking & Insura

Semester V (20 12 - 2013) hereby declare that I have completed the Project o

Study on the Cost And Profitabilty Of Banks in India

The information submitted is true and original to the best of my knowledge.

Signature

DANISH PHIROZ DUBASH

Roll No. 14


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ACKNOWLEDGEMENT

I would like to express my gratitude to the professor in charge and my

guide Prof. Meena Desai for her extensive support and guidance and also

for providing the relevant information.

I would like to thank our head Prof Heena Thakkarfor providing us withthe opportunity of such a unique learning experience.

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EXECUTIVE SUMMARY.

The term 'profit' is an accounting concept which shows the excess ofincome over expenditure viewed during a specified period of time. Profit is

the main reason for the continued existence of every commercial

organisation. On the other hand, the term profitability is a relative measure

where profit is expressed as a ratio, generally as a percentage. Profitability

depicts the relationship of the absolute amount of profit with various other

factors. Profitability is the most important and reliable indicator as it gives a

broad indicator of the ability of a bank to raise its income level. Profitability

of banks is affected by a number of factors. Some of these areendogenous, some are exogenous. Changes in policies made by RBI are

exogenous to the system. These include changes in monetary policy,

changes in quantitative credit control like changes in cash reserve ratio,

statutory liquidity ratio, manipulation of bank rates, qualitative credit

controls like selective credit control measures, credit deposit ratio, region-

wise guidelines on lending to priority sector, changes in interest rates on

deposits and advances, levy of tax on interest income etc. Various other

factors like careful control of expenditure, timely recovery of loans are

endogenous.

In practice executives define profits in banks as the difference between

total earnings from all earning assets and total expenditure on managing

entire assetliabilities portfolio. In case of banks, the main source of income

is interest earned and discount on bills discounted. Since banks accept

various types of deposits from people so interest paid to customer is an

important expenditure of the banks. The difference between interest earned

and interest paid is known as spread and is a goodindicator of bank'sefficiency. Establishment expenses covering salaries, provident fund,

allowances, bonus and so on, form another important component of

expenditure.Profit is the very reason for the continued existence of every

commercial organisation.The rate of profitability and volume of profits are

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therefore rightfully considered as indicators of efficiency in the deployment

of resources of banks.

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INDEX

SerialNo.

Topic PageNo.

1 Introduction to the Banking Sector

Classification Of Banking Industry

Need of Banks.

Regulations for Indian Banks.

9-14

2 Need For Cost And Profitabilty Of Banks. 15-16

3 Cost And Profitabilty In Banks 17-23

4 Assets & Liabilties of Banks. 24-27

5 Reforms on Banking Systems Liquidity & Profitabilty . 28-29

6 Performance and Profitability of Indian Banks in the Post

Liberalization Period.

30-32

7 Cost Determining Factors. 33

8FACTORS AFFECTING THE PROFITABILITY OF BANKS. 34-35

9 FACTORS DETERMINING THE LIQUIDITY OF BANKS. 36-37

10 Liquidity Risk Management 38-40

11 Assessment of Liquidity Management in Banks. 41-42

12 Data Envelopment Analysis for Assesment of Costs and

Profitabilty.

43-46

13 Rising Interest Rates & Banks Profit 47-48

14 Service Charges: Major Costs of the Banks in India 49-51

15 ANALYSIS OF FINANCIAL STATEMENTS OF BANKS :

PROFIT, PROFITABILITY AND BREAK EVEN LEVEL

52-60

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16 Challeneges before Mangements of Banks. 61-62

17 Articles relating to Cost and Profitability of Banks. 63-70

18Bibliography & References.

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Introduction to the Banking Sector in INDIA.

A bank is a financial institution that provides banking and other financial

services to their customers. A bank is generally understood as an

institution which provides fundamental banking services such as accepting

deposits and providing loans. There are also nonbanking institutions that

provide certain banking services without meeting the legal definition of a

bank. Banks are a subset of the financial services industry. A banking

system also referred as a system provided by the bank which offers cash

management services for customers, reporting the transactions of their

accounts and portfolios, through out the day. The banking system in India,

should not only be hassle free but it should be able to meet the new

challenges posed by the technology and any other external and internal

factors. For the past three decades, Indias banking system has several

outstanding achievements to its credit. The Banks are the main participantsof the financial system in India. The Banking sector offers several facilities

and opportunities to their customers. All the banks safeguards the money

and valuables and provide loans, credit, and payment services, such as

checking accounts, money orders, and cashiers cheques. The banks also

offer investment and insurance products. As a variety of models for

cooperation and integration among finance industries have emerged, some

of the traditional distinctions between banks, insurance companies, and

securities firms have diminished. In spite of these changes, banks continue

to maintain and perform their primary roleaccepting deposits and lending

funds from these deposits.

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Classification of Banking Industry in India

Indian banking industry has been divided into two parts, organized and

unorganized sectors. The organized sector consists of Reserve Bank of

India, Commercial Banks and Co-operative Banks, and Specialized

Financial Institutions (IDBI, ICICI, IFC etc). The former two have since

become full fledged Banks.The unorganized sector, which is not

homogeneous, is largely made up of money lenders and indigenous

bankers. An outline of the Indian Banking structure may be presented asfollows:-

1. Reserve banks of India.

2. Indian Scheduled Commercial Banks.

a) State Bank of India and its associate banks.

b) Twenty nationalized banks.

c) Regional rural banks.

d) Other scheduled commercial banks.

3. Foreign Banks

4. Non-scheduled banks.

5. Co-operative banks.

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Need of the Banks.

Before the establishment of banks, the financial activities were handled by

money lenders and individuals. At that time the interest rates were very

high. Again there were no security of public savings and no uniformity

regarding loans. So as to overcome such problems the organized banking

sector was established, which was fully regulated by the government. The

organized banking sector works within the financial system to provide

loans, accept deposits and provide other services to their customers. Thefollowing functions of the bank explain the need of the bank and its

importance:

To provide the security to the savings of customers.

To control the supply of money and credit

To encourage public confidence in the working of the financial system,increase savings speedily and efficiently.

To avoid focus of financial powers in the hands of a few individuals and

institutions.

To set equal norms and conditions (i.e. rate of interest, period of lending

etc) to all types of customers.

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Regulations for Indian banks

Currently in most jurisdictions commercial banks are regulated by

government entities and require a special bank license to operate. Usually

the definition of the business of banking for the purposes of regulation is

extended to include acceptance of deposits, even if they are not repayable

to the customer's orderalthough money lending, by itself, is generally not

included in the definition.

Unlike most other regulated industries, the regulator is typically also a

participant in the market, i.e. a government-owned (central) bank. Central

banks also typically have a monopoly on the business of issuing

banknotes. However, in some countries this is not the case. In UK, for

example, the Financial Services Authority licenses banks, and some

commercial banks (such as the Bank of Scotland) issue their own

banknotes in addition to those issued by the Bank of England, the UK

government's central bank.

Some types of financial institutions, such as building societies and credit

unions, may be partly or wholly exempted from bank license requirements,

and therefore regulated under separate rules. The requirements for the

issue of a bank license vary between jurisdictions but typically include:

Minimum capital & Minimum capital ratio

'Fit and Proper' requirements for the bank's controllers, owners, directors,

and/or senior officers

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Approval of the bank's business plan as being sufficiently prudent and

plausible.

Indian Scheduled Commercial Banks

The commercial banking structure in India consists of scheduled

commercial banks, and unscheduled banks.

Scheduled Banks: Scheduled Banks in India constitute those banks

which have been included in the second schedule of RBI act 1934.

RBI in turn includes only those banks in this schedule which satisfy

the criteria laid down vide section 42(6a) of the Act. Scheduledbanks in India means the State Bank of India constituted under the

State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as

defined in the s State Bank of India (subsidiary banks) Act, 1959 (38

of 1959), a corresponding new bank constituted under section 3 of

the Banking companies (Acquisition and Transfer of Undertakings)

Act, 1980 (40 of 1980), or any other bank being a bank included in

the Second Schedule to the Reserve bank of India Act, 1934 (2 of

1934), but does not include a co-operative bank. For the purpose of

assessment of performance of banks, the Reserve Bank of India

categories those banks as public sector banks, old private sector

banks, new private sector banks and foreign banks, i.e. private

sector, public sector, and foreign banks come under the umbrella of

scheduled commercial banks.

Regional Rural Bank: The government of India set up Regional Rural

Banks (RRBs) on October 2, 1975 . The banks provide credit to the

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weaker sections of the rural areas, particularly the small and marginal

farmers, agricultural labourers, and small enterpreneurs. Initially, five

RRBs were set up on October 2, 1975 which was sponsored by

Syndicate Bank, State Bank of India, Punjab National Bank, United

Commercial Bank and United Bank of India. The total authorized

capital was fixed at Rs. 1 Crore which has since been raised to Rs. 5

Crores. There are several concessions enjoyed by the RRBs by

Reserve Bank of India such as lower interest rates and refinancing

facilities from NABARD like lower cash ratio, lower statutory liquidity

ratio, lower rate of interest on loans taken from sponsoring banks,

managerial and staff assistance from the sponsoring bank and

reimbursement of the expenses on staff training. The RRBs are

under the control ofNABARD. NABARD has the responsibility of

laying down the policies for the RRBs, to oversee their operations,

provide refinance facilities, to monitor their performance and to

attend their problems.

Unscheduled Banks: Unscheduled Bank in India means a banking

company as defined in clause (c) of section 5 of the Banking

Regulation Act, 1949 (10 of 1949), which is not a scheduled bank.

There are several types of banks, which differ in the number of services

they provide and the clientele (Customers) they serve. Although some of

the differences between these types of banks have lessened as they havebegun to expand the range of products and services they offer, there are

still key distinguishing traits. These banks are as follows:

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Commercial banks, which dominate this industry, offer a full range of

services for individuals, businesses, and governments. These banks

come in a wide range of sizes, from large global banks to regional

and community banks.

Global banks are involved in international lending and foreign

currency trading, in addition to the more typical banking services.

Regional banks have numerous branches and automated teller

machine (ATM) locations throughout a multi-state area that provide

banking services to individuals. Banks have become more oriented

toward marketing and sales. As a result, employees need to know

about all types of products and services offered by banks.

Community banks are based locally and offer more personal

attention, which many individuals and small businesses prefer. In

recent years, online bankswhich provide all services entirely over

the Internethave entered the market, with some success.

However, many traditional banks have also expanded to offer online

banking, and some formerly Internet-only banks are opting to open

branches.

Savings banks and savings and loan associations, sometimes called

thrift institutions, are the second largest group of depository

institutions. They were first established as community-based

institutions to finance mortgages for people to buy homes and still

cater mostly to the savings and lending needs of individuals.

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Credit unions are another kind of depository institution. Most credit

unions are formed by people with a common bond, such as those

who work for the same company or belong to the same labour union

or church. Members pool their savings and, when they need

money, they may borrow from the credit union, often at a lower interest

rate than that demanded by other financial institutions.

Need for Cost management & Profitability inBanks.

Banks earn profit when its business costs and expenses are less than its

revenues through its services and investments. Any business for that

matter survives only if it earns profits. Although Banking is considered as a

bloodline of economy of a nation, to provide a reasonable return for the

above-cited huge capital expenditures and to remain servicing any

economy, profitability of the banks is a must. To remain profitable, 'efficient

& effective cost management' of its entire operations is the need of the day

for the banking sector.

Besides this basic need of earning profit for survival, contrary to other

business activities, the banks are uniquely positioned to face many

constraints to earn even normal profits for its services. The following are

some of the bottlenecks the banks have to circumvent to earn profits.

1. The worlds over most of the Banks are predominantly regulated by

respective Governments to serve their national objectives like food

production, rural development, health, education etc. Banks lend their

borrowed funds to other borrowers with needs spread across different time

periods. Since banks rely on borrowed money, they need to raise

resources in a matching manner to avoid the risk of asset-liability

mismatch. At the systemic level often banks face small gaps in their

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matching maturity profiles of their resources due to frequent change in

regulatory provisions.

2. Banking business involves greater risk than many other businesses

owing to its nature of commodity of transactions-money.

3. The increased range and complexity of bank operations calls for

Sophisticated risk management systems and techniques, planning tools

and processes that demands additional capital.

4. Business expansion and implementation of Basel-II accord are forcing

Banks to shore up capital resources.

5.Burgeoning NPAs in the books of Banks drain the precious resources of

the Banks by way of prudential provisioning for bad assets that is the banks

chief scourge.

6. Customer driven competitive environment- Customers are less loyal and

demand immaculate service delivery.

7. Competition from post offices and non-bank technology companies due

to onset of e-commerce with extensive intermediation.

8. Growing interest rates strain the interest spreads.

9. Economies of scale to support new products and services.

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Cost & Profitability in Banks.

According to a Credit Rating and Information Services of India (Crisil)

study, Lower operating expenses including rationalisation of employee

costs have improved the profitability of banks, contrary to the popular

perception that only trading profits helped the banking sector shore up their

bottomlines. The reduction in operating expenses was achieved through

large-scale voluntary retirement schemes implemented by public sector

banks. Since this reduction in operating expenses seems sustainable, it

promises a brighter future for the banking sector.

Although the non-interest income of banks did increase by 0.3% during thisperiod, it was more than offset by a 0.21% increase in provisions and an

identical decline in spreads. Compared to the relatively volatile treasury

income, the reduction in operating expenses imparts a greater level of

comfort in terms of the banking sector's ability to sustain its profitability in

the future.

The banking sectors overall profitability as measured by the return on

average assets (RoAA) has improved to 0.84 per cent in 2001-02 from 0.53per cent in 2000-01. An analysis of the incremental change in the various

profitability components shows that:

* In 2001-02, the sectors non-interest income rose by 32 basis points (bps)

over the previous year, primarily due to an increase in treasury profits. On

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the other hand, the net interest income or interest spread declined by 21

bps in the same period. This was in line with the declining interest rate

regime and increasing competition in the sector. At the same time,

provision and contingency charges rose by 21 bps. Together, the two more

than offset the incremental contribution from the non-interest income.

* Operating expenses, however, declined significantly by 41 bps in 2001-02

over 2000-01 and this enabled the banking sector to report an overall

increase in profitability by 31 bps. The reduction in operating expenses can

be attributed to the large-scale voluntary retirement schemes (VRS) being

implemented across all public sector banks as well as other cost-cutting

measures.

A closer analysis of the different banking groups (public sector banks, old

private sector banks, new private sector banks and foreign banks) also

shows that the reduction in operating expenses was only experienced by

the public sector and foreign banks.

For private sector banks, the profitability improvement was mainly because

of the increase in treasury income and not due to any material reduction in

operating expenses. But since public sector and foreign banks account for

over 80 per cent of the total assets of all scheduled commercial banks, a

reduction in their core operating expenses contributes significantly in

improving the profitability of the entire Indian banking sector.

Crisil believes that the banking sector is now reaping the benefits of

rationalising its employee costs and undertaking other cost-reduction

initiatives, which is a welcome sign in terms of the banks financial

performance. Crisil, however, pointed out that banks ability to repeat and

sustain such efforts would be critical in maintaining their profitability, given

the increasing pressure on interest spreads and rising provisioning levels.

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SOURCES OF BANKS INCOME

A bank is a business organisation engaged in the business of borrowing

and lending money.

A bank can earn income only if it borrows at a lower rate and lends at a

higher rate. The difference between the two rates will represent the costsincurred by the bank and the profit. Bank also provides a number of

services to its customers for which it charges commission.

This is also an important source of income. The followings are the various

sources of a banks profit:

1. Interest on Loans: The main function of a commercial bank is to borrow

money for the purpose of lending at a higher rate of interest. Bank grantsvarious types of loans to the industrialists and traders. The yields from

loans constitute the major portion of the income of a bank. The banks grant

loans generally for short periods. But now the banks also advance call

loans which can be called at a very short notice. Such loans are grantedto

share brokers and other banks. These assets are highly liquid because

they can be called at any time. Moreover, they are source of income to the

bank.

2. Interest on Investments: Banks also invest an important portion of their

resources in government and other first class industrial securities. The

interest and dividend received from time to time on these investments is a

source of income for the banks. Bank also earn some income when the

market prices of these securities rise.

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3. Discounts: Commercial banks invest a part of their funds in bills of

exchange by discounting them. Banks discount both foreign and inland bills

of exchange, or in other words, they purchase the bills at discount and

receive the full amount at the date of maturity. For instance, if a bill of Rs.

1000 is discounted for Rs. 975, the bank earns a discount of Rs. 25because bank pays Rs. 975 today, but will get Rs. 1000 on the due date.

Discount, as a matter of fact, is the interest on the amount paid for the

remaining period of the bill. The rate of discount on bills of exchange is

slightly lower than the interest rate charged on loans and advances

because bills are considered to be highly liquid assets.

4. Commission, Brokerage, etc.: Banks perform numerous services to their

customers and charge commission, etc., for such services. Banks collect

cheques, rents, dividends, etc., accepts bills of exchange, issue drafts and

letters of credit and collect pensions and salaries on behalf of their

customers. They pay insurance premiums, rents, taxes etc., on behalf of

their customers. For all these services banks charge their commission.

They also earn locker rents for providing safety vaults to their customers.

Recently the banks have also started underwriting the shares and

debentures issued by the joint stock companies for which they receive

underwriting commission.

Commercial banks also deal in foreign exchange. They sell demand drafts,

issue letters of credit and help remittance of funds in foreign countries.

They also act as brokers in foreign exchange. Banks earn income out of

these operations.

INVESTMENT POLICY OF BANKS

The financial position of a commercial bank is reflected in its balance sheet.

The balance sheet is a statement of the assets and liabilities of the bank.

The assets of the bank are distributed in accordance with certain guiding

principles. These principles underline the investment policy of the bank.

They are discussed below:

1. Liquidity: In the context of the balance sheet of a bank the term liquidity

has two interpretations. First, it refers to the ability of the bank to honour

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the claims of the depositors. Second, it connotes the ability of the bank to

convert its non-cash assets into cash easily and without loss.

It is a well known fact that a bank deals in funds belonging to the public.

Hence, the bank should always be on its guard in handling these funds.The bank should always have enough cash to meet the demands of the

depositors. In fact, the success of a bank depends to a considerable extent

upon the degree of confidence it can instill in the minds of its depositors. If

the depositors lose confidence in the integrity of their bank, the very

existence of the bank will be at stake. So, the bank should always be

prepared to meet the claims of the depositors by having enough cash.

Among the various items on the assets side of the balance sheet, cash on

hand represents the most liquid asset. Next comes cash with other banks

and the central bank. The order of liquidity goes on descending.

Liquidity also means the ability of the bank to convert its non-cash assets

into cash easily and without loss. The bank cannot have all its assets in the

form of cash because each is an idle asset which does not fetch any return

to the bank. So some of the assets of the bank, money at call and short

notice, bills discounted, etc. could be made liquid easily and without loss.

2. Profitability: A commercial bank by definition, is a profit hunting

institution. The bank has to earn profit to earn income to pay salaries to thestaff, interest to the depositors, dividend to the shareholders and to meet

the day-to-day expenditure. Since cash is the least profitable asset to the

bank, there is no point in keeping all the assets in the form of cash on

hand. The bank has got to earn income. Hence, some of the items on the

assets side are profit yielding assets. They include money at call and short

notice, bills discounted, investments, loans and advances, etc. Loans and

advances, though the least liquid asset, constitute the most profitable asset

to the bank. Much of the income of the bank accrues by way of interestcharged on loans and advances. But, the bank has to be highly discreet

while advancing loans.

3. Safety or Security: Apart from liquidity and profitability, the bank should

look to the principle of safety of its funds also for its smooth working. While

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advancing loans, it is necessary that the bank should consider the three C

s of credit character, capacity and the collateral of the borrower. The bank

cannot afford to invest its funds recklessly without considering the principle

of safety. The loans and investments made by the bank should be

adequately secured. For this purpose, the bank should always insist onsecurity of the borrower. Of late, somehow or other the banks have

not been paying adequate importance to safety, particularly in India.

4. Diversity: The bank should invest its funds in such a way as to secure

for itself an adequate and permanent return. And while investing its funds,

the bank should not keep all its eggs in the same basket. Diversification of

investment is necessary to avoid the dangerous consequences of investing

in one or two channels. If the bank invest its funds in different types ofsecurities or makes loans and advances to different objectives and

enterprises, it shall ensure for itself a regular flow of income.

5. Saleability of Securities: Further, the bank should invest its funds in

such types of securities as can be easily marketed at a time of emergency.

The bank cannot afford to invest its funds in very long term securities or

those securities which are unsaleable. It is necessary for the bank to invest

its funds in government or in first class securities or in debentures of

reputed firms. It should also advance loans against stocks which can beeasily sold.

6. Stability in the Value of Investments: The bank should invest its funds

in those stocks and securities the prices of which are more or less stable.

The bank cannot afford to invest its funds in securities, the prices of which

are subject to frequent fluctuations.

7. Principles of Tax-Exemption of Investments: Finally, the investment

policy of a bank should be based on the principle of tax exemption ofinvestments. The bank should invest in those government securities which

are exempted from income and other taxes. This will help the bank to

increase its profits. Of late, there has been a controversy regarding the

relative importance of the various principles influencing the investment

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policy of a bank particularly between liquidity and profitability. It is

interesting to examine this controversy.

The bank should have adequate cash to meet the claims of the depositors.

It is true that a successful banking business calls for installing confidence inthe minds of the depositors. But, it should be noted that accepting deposits

is not the only function of a bank. Moreover, the bank cannot afford to

forget the fact that it has to earn income to pay salaries to the staff, interest

to the depositors, dividend to the shareholders and meet the day-to-day

expenditure. If the bank keeps all its resources in liquid form, it will not be

able to earn even a rupee. But profitability is a must for the bank. Though

cash on hand is the most liquid asset, it is the least profitable asset as well.

Cash is an idle asset.

Hence, the banker cannot concentrate on liquidity only.

If the bank attaches importance to profitability only, it would be equally

disastrous to the very survival of a bank. It is true that a bank needs income

to meet its expenditure and pay returns to the depositors and shareholders.

The bank cannot undermine the interests of the depositors. If the bank

lends out all its funds it will be left with no cash at all to meet the claims of

the depositors. It should be noted that the bank should have cash to honour

the obligations of the depositors. Otherwise, there will be a run on thebank. A run on the bank would be suicidal to the very existence of the

bank. Loans and advances, though the most profitable asset, constitute the

least liquid asset.

It follows from the above that the choice is between liquidity and

profitability. The constant tug of war between liquidity and profitability is the

feature of the assets side. According to Crowther, liquidity and profitability

are opposing or conflicting considerations. The secret of successful

banking lies in striking a balance between the two.

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Assets & Liabilties of Banks.

According to Crowther, the assets side of the balance sheet is more

complicated and interesting. Assets are the claims of the bank on others. In

the distribution of its assets, the bank is governed by certain well defined

principles. These principles constitute the principles of the investment

policy of the bank or the principles underlying the distribution

of the assets of the bank. The most important guiding principles of the

distribution of assets of the bank are liquidity, profitability and safety or

security. In fact, the various items on the assets side are distributed

according to the descending order of liquidity and the ascending order of

profitability.

1. Cash: Here we can distinguish cash on hand from cash with central

bank and other banks cash on hand refers to cash in the vaults of the bank.

It constitutes the most liquid asset which can be immediately used to meetthe obligations of the depositors. Cash on hand is called the first line of

defence to the bank.

In addition to cash on hand, the bank also keeps some money with the

central bank or other commercial banks. This represents the second line of

defence to the bank.

2. Money at Call and Short Notice: Money at call and short notice

includes loans to the brokers in the stock market, dealers in the discountmarket and to other banks. These loans could be quickly converted into

cash and without loss, as and when the bank requires. At the same time,

this item yields income to the bank. The significance of money at call and

short notice is that it is used by the banks to effect desirable adjustments in

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the balance sheet. This process is called Window Dressing. This item

constitutes the third line of defence to the bank.

3. Bills Discounted: The commercial banks invest in short term bills

consisting of bills of exchange and treasury bills which are self-liquidating incharacter. These short term bills are highly negotiable and they satisfy the

twin objectives of liquidity and profitability. If a commercial bank requires

additional funds, it can easily rediscount the bills in the bill market and it

can also rediscount the bills with the central bank.

4. Bills for Collection: As mentioned earlier, this item appears on both

sides of the balance sheet.

5. Investments: This item includes the total amount of the profit yielding

assets of the bank. The bank invests a part of its funds in government and

non-government securities.

6. Loans and Advances: Loans and advances constitute the most

profitable asset to the bank. The very survival of the bank depends upon

the extent of income it can earn by advancing loans. But, this item is the

least liquid asset as well. The bank earns quite a sizeable interest from the

loans and advances it gives to the private individuals and commercial firms.

Liabilities

Liabilities are those items on account of which the bank is liable to pay

others. They denote others claims on the bank. Now we have to analyse

the various items on the liabilities side.

1. Capital: The bank has to raise capital before commencing its business.

Authorised capital is the maximum capital upto which the bank is

empowered to raise capital by the Memorandum of Association. Generally,

the entire authorised capital is not raised from the public. That part ofauthorised capital which is issued in the form of shares for public

subscription is called the issued capital. Subscribed capital represents that

part of issued capital which is actually subscribed by the public. Finally,

paid-up capital is that part of the subscribed capital which the subscribers

are actually called upon to pay.

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2. Reserve Fund: Reserve fund is the accumulated undistributed profits of

the bank. The bank maintains reserve fund to tide over any crisis. But, it

belongs to the shareholders and hence a liability on the bank. In India, the

commercial bank is required by law to transfer 20 per cent of its annual

profits to the Reserve fund.

3. Deposits: The deposits of the public like demand deposits, savings

deposits and fixed deposits constitute an important item on the liabilities

side of the balance sheet. The success of any banking business depends

to a large extent upon the degree of confidence it can instill in the minds of

the depositors. The bank can never afford to forget the claims of the

depositors. Hence, the bank should always have enough cash to honour

the obligations of the depositors.

4. Borrowings from Other Banks: Under this head, the bank shows

those loans it has taken from other banks. The bank takes loans from other

banks, especially the central bank, in certain extraordinary circumstances.

5. Bills Payable: These include the unpaid bank drafts and telegraphic

transfers issued by the bank. These drafts and telegraphic transfers are

paid to the holders thereof by the banks branches, agents and

correspondents who are reimbursed by the bank.

6. Acceptances and Endorsements: This item appears as a contra item

on both the sides of the balance sheet. It represents the liability of the bank

in respect of bills accepted or endorsed on behalf of its customers and also

letters of credit issued and guarantees given on their behalf. For rendering

this service, a commission is charged and the customers to whom this

service is extended are liable to the bank for full payment of the bills.

Hence, this item is shown on both sides of the balance sheet.

7. Contingent Liabilities: Contingent liabilities comprise of thoseliabilities which are not known in advance and are unforeseeable. Every

bank makes some provision for contingent liabilities.

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8. Profit and Loss Account: The profit earned by the bank in the course of

the year is shown under this head. Since the profit is payable to the

shareholders it represents a liability on the bank.

9. Bills for Collection: This item also appears on both the sides of thebalance sheet. It consists of drafts and hundies drawn by sellers of goods

on their customers and are sent to the bank for collection, against delivery

documents like railway receipt, bill of lading, etc., attached thereto. All such

bills in hand at the date of the balance sheet are shown on both the sides

of the balance sheet because they form an asset of the bank, since the

bank will receive payment in due course, it is also a liability because the

bank will have to account for them to its customers.

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Reforms on Banking Systems Liquidity &

Profitabilty .

The liberalization of the Indian banking system dates back to the 1990s

when the government began to implement the recommendations of theNarasimham Committee (1992, 1997). The principal features of the steps

taken to liberalize and reform the system include:

1. Increase in competition via more liberal rules for the entry of new

domestic andforeign banks, raising the number of banks from 70 to over 90

by March 2004.

Recent consolidation in the industry has reduced the number of total

number of banks to 80 with number of foreign banks declining from a peak

of 40 to 29 and private banks shrinking to 27 by end March 2007. Since

1993, twelve new private sector banks were set up but some of them have

already either merged with other PSBs or private banks or have gone out of

business. Foreign direct investment in private sector banks is allowed up

to 74%.

2. Infusion of Government capital in PSBs followed by Injection of private

equity. PSBs are allowed to increase the share of private capital upto 49%

of which 20% can be foreign equity. As a result, the share of wholly

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Government-owned public sector banks in total system assets fell from

90% in 1991 to 10% in 2004

3. Deregulation on interest rates except for certain specific classes such as

savings deposit accounts, NRI deposits, small loans up to Rs. 2 lakh, and

exports credits.

4. Cuts in Statutory Liquidity Requirements (SLR) and Cash Reserve

Requirements (CRR) to reduce pre-emption of bank lending and lower

financial repression.

5. Reduction in credit controls to 40% from 80% of total credit.

6. Introduction of a broader definition of priority sector lending.

7. Incentives to increase consumer loans including long term home

mortgages.

8. Implementation of micro-prudential measures including Basle-based

capital adequacy requirements, income recognition, asset classification andprovisioning norms for loans, exposure norms and accounting norms.

9. Emphasis on performance, transparency and accountability.

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Performance and Profitability of Indian Banks in

the Post Liberalization Period.

While inputs and outputs are easily identified in most businesses, that is

hardly the case in banking. At the heart is the question of whether deposits

are input or output. A typical financial intermediation role for banks

involves the use of deposits together with physical inputs of land, labor and

capital to make loans and earn interest income. Banks also recognize the

importance of generating non-interest income as an anti-dote to the

variability in interest income. This approach suggests that we should treat

the number of bank branches, total operating expenses and deposits as

inputs and loans (advances) and non-interest income as outputs. In thisformulation, deposits are not coveted as an independent output; instead

they are treated only as a conduit to generating loans. In most banking

systems, bank investments (in addition to loans) are also considered as a

legitimate output. But such investments in India are mostly in government

securities which are often thought of as reflections of lazy banking.

According to this line of thinking, higher investments simply imply that

banks are not pushing loans adequately. In view of this, we do not use

investments as banks output.

But the treatment of deposits as an input is far from a universally accepted

framework. Indeed, deposit generation is thought of as a legitimate

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objective of banking by many analysts. The promotion of banking in India

was partly motivated by the desire to inculcate banking habits among the

masses and generate deposits. Hence, state-owned 4banks were

encouraged to expand branch networks everywhere, including rural areas.

Equally relevant is the observation that people demand deposits for the

services of recordkeeping and safe-keeping, and that these services

renderdeposits as outputs of banking activity. (Srivastava, 1999). Thus, it

is not unreasonable to specify deposits as an output that is produced

together with loans and non-interest income using physical inputs such as

the number of bank branches and operating expenses.

TABLE 1

Branches ( % Total) ATMS( %

Total)

Deposits (% Total) Advances (%

Total)

Banks 1997* 2004 2007 2007*

*

1997 2004 2007 1997 2004 2007

State-

owned

26.9 25.7 24.6 23.8 28.2 27.6 23.5 31.7 25.7 24.3

Nationalized 65.0 6.29 62.4 36.5 58.6 50.7 50.4 52.5 48 48.4

Private-Old 7.7 8.3 8.1 5.9 6.4 7.0 5.1 7.2 6.8 4.7

Private-New 6.2 2.7 4.4 30.2 2.0 101.1 15.3 2.7 13.1 16.2

Foreign 0.1 0.3 0.5 3.5 4.8 4.5 5.6 6.0 6.5 6.4

*End March

Partly in response to these measures and partly as a result of theeconomys improved performance, the Indian banking sectors

characteristics have changed and its health has improved. Old and new

private banks have increased their market share in terms of number of

branches and ATMs as well as share in deposits and loans at the expense

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of state-owned and nationalized banks (Table 1). Since 1997, net interest

margins have declined in every segment of the banking system save

nationalized banks and profit margins with and without taxes have

improved acrossthe-board save new private banks upto 2004 but private

banks net interest margins and profits started improving from 2005 and

outstripped overall industry margins. All in all, industry-wide net interest and

profit margins peaked in 2004 and have not recovered from their downward

spiral to date.

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COST DETERMINING FACTORS.

Role of equity capital has become more significant since the adoption of

Basel Accords I and II by all banks in India under guidance from the

Reserve Bank of India. Under Basel Accord II, all banks have achieved risk

weighted capital adequacy ratio of 10% by 2006 or so.

The number of branches is a very important factorin providing banking

products and services, especially in a country like India where a majority of

a banks customers are likely to have only limited ability to travel.

An extensive bank branch network should cut the shoe-leather costs of

banking and allow a bank to generate more deposits and more

loans with the same level of operating expenses.

In recent years, banks have been moving towards automation and

computerization of operations, adding ATMs across the country and

encouraging their customers to use internet banking.

As a result of transition to automation and computerization as well as

ATMs and internet banking, operating costs are likely to decline while

fixed costs increase but we would still expect an overall improvement in

bank efficiency and profitability.

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FACTORS AFFECTING THE PROFITABILITY OF

BANKS .

1) Amount of Working Funds :

Funds deployed by a bank in profitable assets are the working funds of the

bank.

Profitability of a business is directly proportionate to the amount of working

funds dePloyed by the bank.

2) Cost of Funds :

Cost of funds are the expenses incurred on obtaining funds from various

sources in the form of share capital, reserves, deposits, and borrowings.

Thus, it generally refers to interest expenses.Lower the cost of funds, higher the profitability.

3) Yield on Funds :

The funds raised by the bank through various sources are deployed in

various assets.

These assets yield income in the form of interest.

So, higher the interest, greater the profitability.

4) Spread :

Spread is defined as the difference between the interest received

(interest income ) and the interest paid (interest expense ).

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Higher spread indicates more efficient financial intermediation and higher

net income.

Thus, higher spread leads to higher profitability.

5) Operating Costs :

Operating costs are the expenses incurred in the functioning of the bank

Excluding cost of funds, all other expenses are operating costs.

Lower operating costs give rise to greater profitability of the banks.

6) Risk Cost :

This cost is associated to the probable annual loss on assets.

They include provisions made towards bad debts and doubtful debts.

Lower risk costs increase the profitability of banks.

7) Non interest income :

It is the income derived from non financial assets and services

It includes commission & brokerage on rencittance facility, rent of locker

facility, fees for underwriting and financial guarantees, etc.

This income adds to the profitability of banks.

8) Level of Technology :

Use of upgraded technology normally leads to decline in the operating

costs of banks.

This improves the profitability of banks.

9) Level of Non performing assets (NPAs):

The profitability of a bank is inversely related to the level of NPAs.

Hence, over the years, the NPAs of commercial banks have greatly

declined.

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10) Level of competition :

Increase in competition generally leads to higher operating costs.

This leads to lower profitability.

FACTORS DETERMINING THE LIQUIDITY OF

BANKS .

1) STATUTORY REQUIREMENTS :

The extent of liquid reserves held by banks depends on the statutory

requirements of the Central Bank (i.e. the RBI)

According to RBI, commercial banks have to maintain a certain

CRR(cash Reserve Ratio ) and SLR (statutory liquid ratio)

Higher CRR and SLR result in lower liquidity.

2) Banking Habits of the People :

The nature of the economy has an impact on the banking habits of the

people.

In developing countries, cheque transactions are confined to business.

Individuals depend more on cash transactions

Hence, the need for liquidity is comparatively higher.

3) Monetary Transactions :

The number and magnitude of monetary transactions determine the

liquidity of banks.

Higher monetary transaction leads to higher liquidity.

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4) Nature of Money Market :

In case of fully developed money markets, banks buy and sell securities

easily.

Therefore, liquidity requirement is lower.

5) Structure of Banking System :

Branch banking system requires lower liquidity since cash reserves can

be centralized in the head office.

Unit Banking System requires higher degree of liquidity.

6) Number and Size of Deposits :

The number and sized of deposits influence the liquidity of banks.

Increase in the number & size of deposits will require higher liquidity.

7) Nature of Deposits :

Deposits trade with the banks are of various types like time deposits,

demand deposits, short term deposits, etc. larger demand deposits

/short term deposits need higher liquidity.

8) Liquidity Policies of other Banks :

Various banks may function in the same area

So, liquidity policies of other banks also have an impact on the liquidity

of a bank to build goodwill among depositors.

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Liquidity Risk Management

What is Liquidity Risk :Liquidity risk is the potential inability to meet the liabilities as they becomedue. It arises when the banks are unable to generate cash to cope with adecline in deposits or increase in assets. It originates from the mismatchesin the maturity pattern of assets and liabilities.

Importance of Liquidity Risk :Measuring and managing liquidity needs are vital for effective operation ofcommercial banks. By assuring a banks ability to meet its liabilities as theybecome due, liquidity management can reduce the probability of anadverse situation developing.Liquidity Risk Management

Analysis of liquidity risk involves the measurement of not only the liquidity

position of the bank on an ongoing basis but also examining how fundingrequirements are likely to be affected under crisis scenarios. Net fundingrequirements are determined by analyzing the banks future cash flowsbased on assumptions of the future behavior of assets and liabilities thatare classified into specified time buckets and then calculating thecumulative net flows over the time frame for liquidity assessment.Future cash flows are to be analysed under what if scenarios so as toassess any significant positive / negative liquidity swings that could occuron a day-to-day basis and under bank specific and general market crisisscenarios. Factors to be taken into consideration while determining liquidity

of the banks future stock of assets and liabilities include:

their potential marketability, the extent to which maturing assets /liability will be renewed, the acquisition of new assets / liability and the normal growth in asset / liability accounts.

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Factors affecting the liquidity of assets and liabilities of the bank cannotalways be forecast with precision. Hence they need to be reviewedfrequently to determine their continuing validity, especially given the rapidityof change in financial markets.

The liquidity risk in banks manifest in different dimensions:(a) Funding Risk need to replace net outflows due to unanticipated

withdrawal/non-renewal of deposits (wholesale and retail);

(b)Time Risk need to compensate for non-receipt of expected inflows offunds, i.e. performing assets turning into non-performing assets; and

(c) Call Risk due to crystallisation of contingent liabilities and unable to

undertake profitable business opportunities when desirable.

Measurement of Liquidity:

Liquidity measurement is quite a difficult task and can be measuredthrough stock or cash flow approaches. The key ratios, adopted across thebanking system are

Loans to Total Assets, Loans to Core Deposits,

Large Liabilities (minus) Temporary Investments to Earning Assets(minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans,

However, the ratios do not reveal the intrinsic liquidity profile of Indianbanks which are operating generally in an illiquid market. Experiencesshow that assets commonly considered as liquid like Governmentsecurities, other money marketinstruments, etc. have limited liquidity as themarket and players are unidirectional.Thus, analysis of liquidity involves tracking of cash flow mismatches. For

measuring and managing net funding requirements, the use of maturityladder and calculation of cumulative surplus or deficit of funds at selectedmaturity dates is recommended as a standard tool.

The following prudential limits are considered by Banks to put in place toavoid liquidity crisis:-

(i) Cap on inter-bank borrowings, especially call borrowings;

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(ii) Purchased funds vis--vis liquid assets;(iii) Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio,

Statutory Liquidity Ratio and Loans;(iv) Duration of liabilities and investment portfolio;(v)Maximum Cumulative Outflows across all time bands;(vi) Commitment Ratio track the total commitments given to corporates /

banks and other financial institutions to limit the off-balance sheetexposure;

(vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreigncurrency sources.

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Assessment of Liquidity Management in Banks.

Developing a Structure for Managing LiquidityEach bank should have an agreed strategyfor the day-to-daymanagement of liquidity. This strategy should be communicated throughoutthe organisation.

A banks board of directors should approve the strategy and significant

policies related to the management of liquidity. The board should alsoensure that senior management takes the steps necessary to monitorand control liquidity risk. The board should be informed regularly of theliquidity situation of the bank and immediately if there are any materialchanges in the banks current or prospective liquidity position.Each bank should have a management structure in place to executeeffectively the liquidity strategy. This structure should include the ongoinginvolvement of members of senior management. Senior management mustensure that liquidity is effectively managed, and that appropriate policiesand procedures are established to control and limit liquidity risk. Banksshould set and regularly review limits on the size of their liquidity positionsover particular time horizons.

A bank must have adequate information systems for measuring,monitoring, controlling and reporting liquidity risk. Reports should beprovided on a timely basis to the banks board of directors, seniormanagement and other appropriate personnel.

Measuring and Monitoring Net Funding RequirementsEach bank should establish a process for the ongoing measurement and

monitoring of net funding requirements.A bank should analyse liquidity utilising a variety of what if scenarios.A bank should review frequently the assumptions utilised in managingliquidity to determine that they continue to be valid.Managing Market Access

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Each bank should periodically review its efforts to establish and maintainrelationships with liability holders, to maintain the diversification of liabilities,and aim to ensure its capacity to sell assets.

Contingency PlanningA bank should have contingency plans in place that address the strategyfor handling liquidity crises and include procedures for making up cash flowshortfalls in emergency situations.

Foreign Currency Liquidity ManagementEach bank should have a measurement, monitoring and control system for

its liquidity positions in the major currencies in which it is active. In additionto assessing its aggregate foreign currency liquidity needs and theacceptable mismatch in combination with its domestic currencycommitments, a bank should also undertake separate analysis of itsstrategy for each currency individually.Subject to the analysis undertaken according to Principle 10, a bankshould, where appropriate, set and regularly review limits on the size of itscash flow mismatches over particular time horizons for foreign currencies inaggregate and for each significant individual currency in which the bank

operates.Internal Controls for Liquidity Risk ManagementEach bank must have an adequate system of internal controls overits liquidity risk management process. A fundamental component of theinternal control system involves regular independent reviews andevaluations of the effectiveness of the system and, where necessary,ensuring that appropriate revisions or enhancements to internal controlsare made. The results of such reviews should be available to supervisoryauthorities.

Role of Public Disclosure in Improving LiquidityEach bank should have in place a mechanism for ensuring that there is anadequate level of disclosure of information about the bank in order tomanage public perception of the organisation and its soundness.

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Data Envelopment Analysis for Assesment of

Costs and Profitabilty.

Data Envelopment Analysis (DEA), developed by Charnes, Cooper and

Rhodes (1978), uses principles of linear programming to examine how a

particular decisionmaking unit (DMU) like a bank in our exercise

operates relative to other DMUs in the sample. Efficiency is defined by the

ratio of output to input. This is straight forward when there is only one

output and one input. But the task becomes complex where multiple of

outputs and inputs are involved. DEA gets around this problem by

constructing an efficiency frontier from weighted outputs (virtual output) andweighted inputs (virtual input). DMUs on the frontier are assigned an

efficiency score of 1 while those inside receive scores of between zero and

one. The further away a bank is from the frontier, the lower its efficiency

score.

While inputs and outputs are easily identified in most industries, it is not so

in the banking industry. The DEA studies of bank efficiency have typically

used either the intermediation approach or the production approach in

selecting outputs and inputs. The former considers banks as ntermediaries

that use deposits together with other inputs such as labor and capital to

produce outputs like loans. Hence, the intermediation approach views

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deposits as an input. In theproduction approach, however, banks are

thought of as service providers and deposits are considered as an output.

Thus, the production approach postulates that banks produce deposits, and

loans using labor and capital as inputs.

In using the two approaches, we also consider non-interest income earned

by each banks as a distinct output in view of the emphasis banks

themselves place on it as a stable source of income. As our subsequent

quantitative analysis shows, whether deposits are treated as an input or an

output does not appear to make any difference to the efficiency scores of

various banks.

A few DEA-based studies of efficiency in the Indian banking system have

appeared in recent years. They have used a variety of specifications for

inputs and outputs as evident from the Table below.

Author(s) Inputs Outputs PeriodBhattacharyya

A. C.A.K. Lovell

&

P. Sahay

Interest

Expense,

Operating

Expense

Advances, Deposits

Investments

1986-91

Saha &

Ravisankar

No. of

Branches, No.

of Employees,

Establishment &

Non-

establishment

Advances, Deposits,

Investments, Spread,

Total Income, Interest

& Non-interest

Income

1991-92

1994-95

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ExpendituresKetkar & Noulas Capital, No.

Employees

Deposits

Investments

Advances

1993

Author(s) Inputs Outputs PeriodKetkar, Noulas

& Agarwal

Capital

No. of

Employees

Deposits

InvestmentsAdvances 1990-1995

Rammohan &

Ray

Operating

Costs, Deposits

Investments, Loans &

Non-interest Income

1992-2000

Das A. A. Nag &

S. Ray

Borrowed

Funds, No. of

Employees,

Fixed Assets,

Investments,

Performing Loans ,

Equity Non-interest

Income

1997-2003

Inputs vary from purely financial such as interest and non-interest

expenses to purely physical like number of branches and employees.

Outputs are either income related -- interest and non-interest income or

product/service related loans, investments and non-interest income.

Deposits appear as inputs or outputs depending upon whether the authors

work with the intermediation or production interpretation of banking

business.

The efficiency scores are found to be relatively sensitive to the

specification in terms of inputs and outputs, which makes it difficult to reach

generalized conclusions on how bank efficiencies stack up by ownership.

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In a few studies that use a large number of inputs, not surprisingly many

more banks are found to be on the efficiency frontier (Das, Nag and

Ray). In earlier papers Ketkar etc. used deposits as well as physical inputs

such asnumber of full time employees as a proxy for labor and number of

branches as a proxy for capital, and loans and investments as outputs. The

efficiency scores of most domestic banks were found to be quite low in that

specification of inputs and outputs. On reflection, we conclude that this

was due to a shift away from banks traditional intermediation function of

mobilizing deposits and making loans. The financial market reforms of the

1990s increased competition for banks from non-bank intermediaries in the

capital markets.

Companies were increasingly able to obtain financing via equity issuance,

which reduced their captivity to bank lending. Banks recognized this and

over time started focusing on earning non-interest income.

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Rising Interest Rates & Banks Profit

The Reserve Bank of India (RBI) today cautioned rising interest rate andhigh cost of funds could hurt the profitability of the banking sector.

"Going ahead, with hardening interest rates and the imminent increase incost of funds, the credit growth is expected to slow down, which couldadversely affect the profitability," the RBI said in Financial Stability Reportreleased today.

The hike in savings account interest rate, amortisations of pension liabilities

and potentially enhanced provisioning requirements for NPAs may also

impact profitability, it said.

The report noted that banks' profitability improved, buoyed by increased netinterest income (NII) though non-interest income remained stagnant.

An increase in NII facilitated growth of around 20% in aggregate net profitof the banking system, even with an almost stagnant non-interest incomeand increase in risk provisions, it said.

Interest income increased by 18.6% over 7.5% last year and interestexpense increased by 10.1% as against 4.0% last year, it said.

There was improvement of 34.9% in the NII of the banks during 2010-11despite little change in non-interest income, increase of 49% in riskprovisions and 24% increase in operating expenses.

The growth in interest income by 18.6% was, however, not in tandem withthe growth in loans and advances which grew by 22.6% during 2010-11, itsaid.

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However, it said, the public sector banks registered a lower growth inprofits mainly due to reduction in trading profits, increase in provisionstowards staff expenses (including those for pension liabilities) and towardsimpaired assets.

Under stress conditions based on NPA shocks, it said, the profitability ofthe banks was seen to be affected significantly though the capital adequacyposition appeared to be reasonably resilient.

The study indicates that some banks may face extreme liquidity

constraints, under severe stress scenario. Overall, the results of the macro-

stress tests using different scenarios, suggested that the banking sector

would be able to withstand macroeconomic shocks though the prevailing

inflation and interest rate situation is expected to have an adverse effect on

the asset quality of banks, it said

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Service Charges: Major Costs of the Banks in

India

In 1999, the practice of Indian Banks' Association (IBA) fixing the

benchmark service charges on behalf of the member banks was

discontinued and the decision to prescribe the service charges was left to

the discretion of the Boards of individual banks. Banks were then advisedthat they should ensure that the charges were reasonable and not out of

line with the average cost of providing the services and that the customers

with low volume of activities were not penalized. It was expected that, with

time, market pressure would force the banks to price their services

competitively ensuring services at a fair price. However, the Reserve Bank

continued to receive representations from the public regarding

Unreasonable and nontransparent service charges. The plethora of

complaints received indicated that the issue of fairness in fixing the service

charges by the banks needed to be examined. Accordingly, in order to

ensure fair practices in banking services, in terms of the Annual Policy

Statement 2006-07, Reserve Bank constituted a Working Group having in it

a nominee of the IBA and a representative of customers to formulate a

scheme for ensuring reasonableness of bank charges, and to incorporate

the same in the Fair Practices Code, the compliance of which would be

monitored by the Banking Codes and Standards Board of India (BCSBI).

(A)Nature of transactions:

a. Banking services that are ordinarily availed by individuals in the middle

and lower

segments will be the first parameter. These will comprise services related

to deposit/loan accounts, remittance services and collection services.

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b. When the above transactions occur in different delivery channels, for the

purpose ofpricing, they may be treated on separate footing.

(B) Value of transactions:

Low value of transactions with customers/public upto the ceiling as given

below will be the

second Parameter:

i. Remittances up to Rs. 10,000/- in each instance.

ii. Collections below Rs. 10,000/- in each instance.

(Foreign exchange transactions valued upto US $ 500/-).

As per extant RBI instructions the banks service charges should not be out

of line with the average costs of providing the services.

Basic Services.

There are 27 basic service charges that should be taken into account while

analyzing the service charges. These are

Service relating to deposit accounts

1 Cheque book facility

2 Issue of Pass Book (or Statement) / Issue of Balance Certificate

3 Issue of duplicate pass book or statement

4 ATM cards

5 Debit cards (electronic cheque)

6 Stop Payment

7 Balance enquiry

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8 Account closure

9* Cheque Return - Inward (cheque received for payment)

10* Signature verification

Relating to Loan Accounts

11* No dues certificate

Remittance Facilities (Rupee or foreign exchange)

12 Demand Draft Issue

13 Demand Draft Cancellation

14 Demand Draft Revalidation

15 Demand Draft Duplicate issuance

16 Payment Order Issue

17 Payment Order- Cancellation

18 Payment Order Revalidation19 Payment Order-Duplicate issuance

20* Telegraphic Transfer Issue

21* Telegraphic Transfer Cancellation

22* Telegraphic Transfer- Duplicate issuance

23* Payment by Electronic Clearing Services (ECS)

24* Transfer by National Electronic Fund Transfer (NEFT) and Electronic

Funds Transfer (EFT).

Collection facilities

25* Collection of Local Cheques

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26* Collection of Outstation Cheques

27* Cheque Return-Outward (cheque deposited for collection)

ANALYSIS OF FINANCIAL STATEMENTS OFBANKS :

PROFIT, PROFITABILITY AND BREAK EVENLEVEL

The banks, acting as financial intermediaries, mobilize savings of the

society and supplement their resources through borrowings for providingcredit to the needy sectors.

They have to pay interest on their deposits and borrowings. They have to

pay salaries to their staff and incur other overhead expenses in the course

of their business operations.

They are also required to make provisions for any potential erosion in their

assets. After all this, they may have to pay a reasonable divided to their

shareholders. The banks will, therefore, have to earn profit. Only a profitearning bank inspires confidence in its customers.

FACTORS AFFECTING PROFITABILITY

While profit is excess of income over expenditure during any accounting

period, profitability is a relative term expressed as a percentage to average

working funds.

The following five important factors determine the profitability of a bank.

i) Amount of working funds deployed

ii) Cost of funds

iii) Yield on funds

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iv) Burden Management cost, and

v) Risk cost

i)Working funds

Working Funds are the funds deployed by a bank in its business. The

amount of working funds so deployed is usually arrived at by subtracting

the aggregate amount of contra items from the total liabilities of the balance

sheet. However, for analyzing the profitability, the balance sheet showing

balance based on weekly/monthly average should prepared. Based on thisbalance sheet, the average working funds should be ascertained by netting

the total of contra items from the total of the balance sheet.

ii)Cost of funds

The sources of funds for a bank comprise share capital and reserves

(owned funds), deposits, borrowings and other liabilities. These are briefly

discussed in the following paragraphs.

a)Share capital and reserves Share capital is contributed by theshareholders in case of CBs and RRBs and by the members in

Cooperative banks for the business of the bank and may, therefore, be

treated as cost free for the purpose of profitability. However, for a more

stringent and conservative analysis of profitability, the dividend paid by a

bank may be taken as cost of owned funds.

b)Reserves being past profits retained in the business are cost free.

Provisions and credit balance in the profit and loss account which are not in

the nature of outside liabilities may be equated with the reserves first,

share capital and further from deposits for the purpose of profitability

analysis.

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ILLUSTRATION: If the share capital of a bank is Rs.50,00 lakh out of the

total owned funds of Rs.75.00 lakh, and if the bank had declared a dividend

of 15% on its share capital. The average cost of owned funds can be

calculated as under:

Amount of dividend

Average cost of owned funds = ----------------------- X 100

Average owned funds

7,50,000

= ------------------------ X 100

75,00,000

= 10%

It may be observed from the above that although the bank had declared a

dividend of 15% the cost of its owned funds works out to only 10% due to

the build up cost free reserves.

c)Deposits The banks pay different rates of interest depending upon thenature and term of the deposit. The cost of deposits, therefore, depends

upon the deposit-mix of the bank. We have to find out the average cost of

these deposits for comparing with the average yield on funds deployed.

The average cost of deposits is worked out per Rs.100/- of deposits as in

the following example: If the amount of interest paid and payable on the

deposits of Rs.200.00 lakhs is Rs.14,22,600/-the average cost of deposits

is worked out as follows:

Interest paid/payable

(As per P & L A/c)

= ------------------------ X 100

Average deposits

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14,22,600

= ------------------------ X 100

200,00,000

= 7.113%

d)Borrowings These may be by way of borrowings from higher financing

agencies, interbank borrowings or refinance from RBI, NABARD, SIDBI,

IDBI, NHB etc. The average cost of borrowings and the weighted average

cost of each type of borrowing have to be worked out as in the case of

deposits.

e)Other liabilities The other liabilities include bills pauyable, drafts

payable, etc. and represents cost free funds.

f)Average cost of funds The average cost of funds for the bank can be

worked out as under :

Total interest/dividend paid

(as per P & L A/c.)

Average cost of funds (k)= ------------------------------- X 100

Average working funds

iii)Deployment of funds and yield on funds

The funds mobilized by a bank through different sources are utilized for

a. Compliance with the statutory requirements relating to CRR and SLR;

b. investments in non-SLR avenue;

c. granting loans and advances; and

d. deploying in other assets such as land & buildings, furniture and fixtures,

etc.

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Cash on hand As cash on hand yields no returns, banks should

maintain only minimum cash balance required for day to day business.

This will also reduce the security risk for the bank.

Balance in Current Account Amount kept in CA with other bank and ifno interest is paid income/yield on this balance will be nil. Some of the

sponsor banks pay interest on CA balance with them to their sponsor

RRBs. Interest received on such

Investments Investments, for the purposes of profitability analysis,

include all deposits with banks including current account balance, and other

investments in Government and other securities, shares and debentures,

etc. The banks have to maintain these investments for the purposes of

CRR and / or SLR. The return on these investments comprises interestand divided actually received. As in the case of liabilities, the average yield

on investment and the weighted average yield on each type of investment

have to be worked out to select the optimum investmentsmix.

Loans and advances The loans and advances port-folio provides the

most profitable avenue for deployment of funds by a bank. The weighted

average yield on advances of 100 is worked out as follows :

Interest received on advances

(as per P&L A/c.)

Average yield on advances = ---------------------------------- X 100

Average advances (including NPAs)

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Other assets The bank should limit its investments in land and buildings,

furniture and fixtures, etc. only to the extent required for its business as

they do not either earn any return or earn comparatively low returns.

iv)Other factors-

We have so far discussed the average cost of funds and average yield on

funds. The profitability, however, ultimately depends upon the overhead

costs, risk cost and the miscellaneous income. These are discussed briefly

hereunder:

Transaction costs (Operating cost) These are also called management

costs and include all costs other than cost of funds and provisions. Thus,

they consist of staff cost, i.e., salaries and other payments such as bonus,

gratuity, etc. made to staff (s) and overheads such as expenses on

stationery and printing, postages, rents, depreciation on assets, etc. (o).

Transaction costs should be computed as a percentage of working funds

as under:

Total transaction costs

Transaction costs (s+o) = ------------------------- X 100


Risk cost The risk cost is worked out to estimate the likely annual loss

on assets as a ratio of Rs.100/- of average funds deployed. Provisions

made towards bad and doubtful debts, loss assets should be included

under risk cost. The risk cost can be qualified as :

Total of provisions made in

P & L A/c. towards NPA, etc.

Risk cost (pc) = ---------------------------------- X 100

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In order to ensure a realistic projection of the risk cost banks should

systematically estimate bad and doubtful assets each year. Calculation of

risk cost can be made on the basis of asset classification and provisioningnorms.

Non-interest income This is the income derived from non-financial

assets and services and includes commission and brokerage on remittance

facilities, LCs, guarantees, underwriting contracts etc., locker rentals and

other service charges. However, items of non-recurring nature such as

profit from sale of non-banking assets, when significant should not be

included. For the purpose of profitability analysis, noninterest income also

is to be worked out per Rs.100 of working funds as follows:

Total non-interest income

Non-interest income (n) = ------------------------------------- X 100


Financial margin Just as a trading or manufacturing organization arrives

at its gross profit to assess its trading or manufacturing activities, banks

also ascertain their gross profit. This is also called "Spread" and iscomputed as a difference between weighted average yield on assets and

weighted average cost of funds.

Burden The total non-interest expenses representing the transactions

costs will generally be more than miscellaneous income. The difference

between the two is called burden, as while making a cost plus pricing of

loans this difference has to be loaded onto the rate of interest. The conceptof burden also illustrates the importance of non-interest or service income

of the bank. A high level of noninterest income can not only recover the

entire operating cost, it can enable a bank to pay high level of

compensation to its employees, as in the case of foreign banks. If the non-

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interest income of bank is high enough to leave surplus after paying for

operating cost, the same can recover a part of the interest cost as well.

This means a negative loading in a cost plus pricing scenario. Such

strategy is surely highly aggressive and may even prove to beunnecessarily risky.

Tools of Financial Analysis in Banks.

There are some widely popular tools of financial analysis. Some of these

are discussed hereunder:-

Trend analysis

This is done through comparison of two or more successive balance-sheets

and profit and loss accounts, and studying the changes in the various

components of assets and liabilities and income and expenditure.

Break Even Level Business (BEL)

This is the level of business (in terms of working funds) at which the total

income of the bank is just adequate to meet all its costs. It is calculated as

follows:

(Transaction costs + Risk costs)

-Non-interest income

BEL = ------------------------------------- X 100

Net Margin

In case the present level of working funds is more than BEL, the bankwould be in profit and the actual profit can be arrived at as follows:

Profit = (Actual working funds BEL working funds) X Net margin

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The amount of dividend taken to calculate the average cost of funds, has to

be added to the above figure to arrive at the net profit shown in the profit

and loss account.

Sometimes break-even level is calculated in relation to core business, thatis, without considering non-interest income. For this BEL is arrived at by

dividing the total operating costs by financial margin (or net interest

margin).

Challenges before Managements of Banks.

1. Banks need to retain their existing customers and widen their base

developing a retail strategy and geographical capabilities to focus on thecustomer satisfaction, improve product sales and delivery qualitatively

adhering to regulatory frame work.

2. Banks have to develop an effective strategy and management tools to

ensure cost effective straight through processing and seamless end-to-end

business processing by leveraging technology for real time performance

management capabilities enabling link between actual business

performance and business plans.

3.After the recent melt down of the western economies like USA which saw

some of the biggest and supposedly safest names in international

banking like Bear Sterns, Lehman Brothers, Merrill Lynch and HBOS on

both sides of Atlantic keel over, the confidence level of investing public in

banking is at low ebb. It's reported that 74 banks in USA were closed their

shutters this year alone till September 2009. Therefore earning legitimate

profits in a transparent and fair manner managing inherent risk factors for

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ultimate survival is a big challenge.

4. The range of banking products is ever changing with lesser and lesser

margins; but cost of infrastructure and operating costs are growing

exponentially.

5. Developing new revenue streams and pricing comp

Documents

A Study on Cost and Profitabilty of Banks