ACAD-EDGE

EDITION 5
Banking
Table of Contents
Types of Banks ..............................................................................................................................................3
Functions of a Commercial Bank ..................................................................................................................5
Corporate Banking……………………………………………………………………………………………………………………………….13
Types of Interest Rates…………………………………………………………………………………………………………………………15
Types of Charges........................................................................................................................................ 15
Liquidity Adjustment Facility ..................................................................................................................... 16
CAMELS approach...................................................................................................................................... 20
Other Terms used in Banking .................................................................................................................... 22

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 Types of Banks

Commercial Banks: Commercial banks are the banks that accept money in the form of
deposits from the public and give loans and advances to its customers by charging interest.
They mobilize small savings and promote the growth of trade and commerce. Generally,
commercial banks lend money for a short period only. They only provide working capital to
the organizations. But in recent times commercial banks are providing long-term capital also to
the organizations.
There are several types of deposits which are accepted by the commercial banks like
• Savings Deposits
• Current Deposits
• Fixed Deposits
• Seasonal Deposits
• Recurring Deposits, etc.

The Commercial banks give different types of loans and advances to the businessmen like
• Cash Credits
• Overdrafts
• Loans
• Discounting Bills

Co-operative Banks: Co-operative Banks are the banks that usually provide short term,
medium term and long-term credit to agricultural purposes. Co-operative Banks also provides
loans to small-scale artisans. Co-operative Banks usually provide credit facilities to farmers,
small-scale industries, etc. at a cheaper rate of interest. Co-operative Banks are mainly situated
in rural areas and can also be seen in urban areas.

Central Bank: Every country has its own Central Bank. The Central bank aims at non-profit
functioning. It regulates the monetary and credit system of the country. Central Bank acts as
controller, supervisor, and regulator of the activities of commercial banks and other financial
institutions in the country. The Central bank is considered as the apex institution of the
country’s money market.

Functions of Central Bank

• Note issue
• Credit control
• It acts as a banker to the banks
• It acts as a banker to the government
• It maintains the foreign exchange reserves of the country
• It maintains the gold reserves of the country

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Industrial Banks: Industrial banks are also called as Investment Banks. Industrial banks
provide long-term loans to the industries. Industries require long-term capital for buying
machinery, construction of buildings, expansion of operations, etc. This capital required by
industries is provided by industrial banks for industrialists to grow their businesses. Industrial
banks accept long-term deposits from the public. They secure capital by issuing shares and
debentures.

Agricultural Banks: Agricultural Banks are the banks which provide agricultural credit to the
farmers. The Agricultural Development Banks provide medium term and long-term credit.
Some examples of Agricultural Banks in India are Agricultural Finance Corporation,
Agricultural Refinance and Development Corporation, National Bank for Agricultural and
Rural Development (NABARD). Agricultural Banks are established by the government to
promote agricultural credit in the country.

Savings Bank: Savings Banks mainly concentrates on the mobilization of savings of the
people. In India Post offices run by Postal department act as savings banks. Since Commercial
banks are providing these facilities of savings banks to the public, the need for separate
savings bank is fading.

Foreign Exchange Banks: Foreign Exchange Banks are the banks which provide finance for
foreign trade. These banks accept deposits from the public. Foreign Exchange Banks are
specialized banks in providing credit for the foreign trade. These banks usually have their
branches in foreign countries for uninterrupted functioning of their services. But in recent
times commercial banks are also financing foreign trade.

Exchange Banks: Exchange Banks are the banks which operate by financing the imports and
exports of the country. These banks are mainly concerned with providing foreign exchange to
their customers and help to promote international trade. They also offer to discount of foreign
bills of exchange to their customers.

Private Bankers: Private Bankers are the individuals who do banking business individually or
as a partnership. It is purely an unorganized sector. Most of the private bankers do not receive
or accept any deposits from the public, they do banking business with their own capital. They
lend money to the people for high-interest rates.

Chit Funds: There are chit funds in India. They provide finance to trade and commerce.
However, they cannot be called as banks in the regular sense. The Chit fund business is very
large in a country like India. It is also an unorganized sector in India.

Note: Thus, banks are classified based on their functions in which they are specialized. But it
must be noted that Commercial Banks are now providing services of agricultural banks, they
are providing loans for industries as industrial banks, and they are even expanding their
services into foreign exchange replacing the foreign exchange banks.
Therefore, the commercial banks are raising their capabilities for attracting a large number of
customers.
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Q. Is there a difference between Public Sector and Nationalized banks?

Nationalization is an act of taking an industry or assets into the public ownership of a national
government. Nationalization refers to private assets being transferred to the public sector to be
operated by or owned by the state. So, there is no difference between a nationalized bank and a
public sector bank. The Banks which were earlier in private sector were transferred to the
public Sector by the act of nationalization. The first nationalized bank was Imperial Bank of
India (under the SBI Act of 1955) and re-christened as State Bank of India (SBI) in July 1955.
In 1969, 14 banks were nationalized and in 1980, the second phase of nationalization of Indian
banks took place, in which 7 more banks were nationalized.

Functions of a Commercial Bank

A commercial bank is a profit-based financial institution that grants loans, accepts deposits,
and offers other financial services, such as overdraft facilities and electronic transfer of funds.
Commercial banks play a significant role in fulfilling the short-term and medium- term
financial requirements of industries. They do not provide, long-term credit, so that liquidity of
assets should be maintained. The funds of commercial banks belong to the public and are
withdrawn at a short notice; therefore, commercial banks prefer to provide credit for a short
period of time backed by tangible and easily marketable securities. Commercial banks, while
providing loans to businesses, consider various factors, such as nature and size of business,
financial status and profitability of the business, and its ability to repay loans.

• Primary Functions: Refer to the basic functions of commercial banks that include the
following:

o Accepting Deposits: Implies that commercial banks are mainly dependent on public
deposits.

There are two types of deposits, which are discussed as follows:

Demand Deposits:
Refer to kind of deposits that can be easily withdrawn by individuals without any
prior notice to the bank. In other words, the owners of these deposits are allowed
to withdraw money anytime by simply writing a check. These deposits are the
part of money supply as they are used as a means for the payment of goods and
services as well as debts. Receiving these deposits is the main function of
commercial banks.

Time Deposits:
Refer to deposits that are for certain period of time. Banks pay higher interest on
time deposits. These deposits can be withdrawn only after a specific period is
completed by providing a written notice to the bank. Commercial bank offers the
following accounts to individuals for depositing their money:

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 • Current Accounts: Refer to accounts that are mainly meant for businesses
and other public accounts are check-operated accounts that are not for saving
purposes as no interest is paid on.
• Savings Accounts: Refer to accounts that promote savings among
individuals while allowing required. Apart from this, individuals get interests
on deposits in savings account.
• Fixed Deposit Accounts: Refer to accounts in which deposits are made for a
fixed period. be withdrawn before the expiry of the period. The profits are
higher, if the period of deposits is.

o Advancing Loans: Refers to one of the important functions of commercial banks.

The public deposits are used by commercial banks for the purpose of granting loans
to individuals and businesses. Commercial banks grant loans in the form of
overdraft, cash credit, and discounting bills of exchange.

Bank Loan:
Bank loan may be defined as the amount of money granted by the bank at a
specified rate of interest for a fixed period of time. The commercial bank needs
to follow certain guidelines to extend bank loans to a client. For example, the
bank requires the copy of identity and income proofs of the client and a
guarantor to sanction bank loan. The banks grant loan to clients against the
security of assets so that, in case of default, they can recover the loan amount.
The securities used against the bank loan may be tangible or intangible, such as
goodwill, assets, inventory, and documents of title of goods.

• The advantages of the bank loan are as follows:

• Grants loan at low rate of interest
• Involves very simple process of loan granting
• Requires minimum document and legal formalities to pass the loan
• Involves good customer relationship management
• Consumes less time because of modern techniques and computerization
• Provides door-to-door facilities

In addition to advantages, the bank loan suffers from various imitations, which
are as follows:
• Imposes heavy penalty and legal action in case of default of loan
• Charges high rate of interest, if the party fails to pay the loan amount in
the allotted time
• Ads extra burden on the borrower, who needs to incur cost in preparing
legal documents for procuring loans
• Affects the goodwill of the organization, in case of delay in payment

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 Cash Credit:
Cash credit can be defined as an arrangement made by the bank for the clients to
withdraw cash exceeding their account limit. The cash credit facility is generally
sanctioned for one year, but it may extend up to three years in some cases. In
case of special request by the client, the time limit can be further extended by the
bank.

The extension of the allotted time depends on the consent of the bank and past
performance of the client. The rate of interest charged by the bank on cash credit
depends on the time duration for which the cash has been withdrawn and the
amount of cash.

The advantages of the cash credit are as follows:

• Involves very less time in the approval of credit
• Involves flexibility as the cash credit can be extended for more time to
fulfil the need of the customers.
• Helps in fulfilling the current liabilities of the organization
• Charges interest only on the amount withdrawn by the customer. The
interest on cash credit is charged only on the amount of cash withdrawn
from the bank, not on the total amount of credit sanctioned.
• The cash credit is one of the most important instruments of short-term
financing, but it has some limitations.

These limitations are mentioned in the following points:

• Requires more security for the approval of cash
• Imposes very high rate of interest
• Depends on the consent of the bank to extend the credit amount and the
time limit

Bank Overdraft:
Bank overdraft is the quickest means of the short-term financing provided by the
bank. It is a facility in which the bank allows the current account holders to
overdraw their current accounts by a specified limit. The clients generally avail
the bank overdraft facility to meet urgent and emergency requirements. Bank
overdraft is the most popular form of borrowing and do not require any written
formalities. The bank charges very low rate of interest on bank overdraft up to a
certain time.

The advantages of the bank overdraft are as follows:

• Involves no documentation for the extension of overdraft amount
• Imposes nominal interest on the overdraft amount
• Charges fee only on the amount exceeding the account limit

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 • The disadvantages of the bank overdraft are as follows:
• Incurs high cost for the clients, if they fail to pay the amount of overdraft
for a longer period of time
• Hampers the reputation of the organization, if it fails to pay the amount
of overdraft on time
• Allows the bank to deduct overdraft amount from the customers’
accounts without their permission

Discounting of Bill:
Discounting of bill is a process of settling the bill of exchange by the bank at a
value less than the face value before maturity date. According to Sec. 126 of
Negotiable Instruments, “a bill of exchange is an unconditional order in writing
addressed by one person to another, signed by the person giving it, requiring the
person to whom it is addressed to pay on demand or at fixed or determinable
future time a sum certain in money to order or to bearer.”
The facility of discounting of bill is used by the organizations to meet their
immediate need of cash for settling down current liabilities.

Conditions laid down by the bank for discounting of bill are as follows:
• Must be intended to specific purpose
• Must be enclosed with the signature of the two persons (company, bank
or reputed person)
• Must be less than the face value
• Must be produced before the maturity period.

• Secondary Functions: These functions are explained as follows:

o Agency Functions: Implies that commercial banks act as agents of customers by

performing various functions, which are as follows:

Collecting Checks: Refer to one of the important functions of commercial

banks. The banks collect checks and bills of exchange on the behalf of their
customers through clearing house facilities provided by the central bank.

Collecting Income: Constitute another major function of commercial banks.

Commercial banks collect dividends, pension, salaries, rents, and interests on
investments on behalf of their customers. A credit voucher is sent to customers
for information when any income is collected by the bank.

Paying Expenses: Implies that commercial banks make the payments of various
obligations of customers, such as telephone bills, insurance premium, school
fees, and rents. Similar to credit voucher, a debit voucher is sent to customers for
information when expenses are paid by the bank.

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 o General Utility Functions: It includes the following:
Providing Locker Facilities: Implies that commercial banks provide locker
facilities to its customers for safe keeping of jewelry, shares, debentures, and
other valuable items. This minimizes the risk of loss due to theft at homes.

Issuing Traveler’s Checks: Implies that banks issue traveler’s checks to

individuals for traveling outside the country. Traveler’s checks are the safe and
easy way to protect money while traveling.

Dealing in Foreign Exchange: Implies that commercial banks help in providing

foreign exchange to businessmen dealing in exports and imports. However,
commercial banks need to take the permission of the central bank for dealing in
foreign exchange.

Transferring Funds: Refers to transferring of funds from one bank to another.

Funds are transferred by means of draft, telephonic transfer, and electronic
transfer.

• Other Functions: It includes the following:

Credit Creation process of the Banks

A central bank is the primary source of money supply in an economy through
circulation of currency.
It ensures the availability of currency for meeting the transaction needs of an
economy and facilitating various economic activities, such as production,
distribution, and consumption.
However, for this purpose, the central bank needs to depend upon the reserves of
commercial banks. These reserves of commercial banks are the secondary source
of money supply in an economy. The most important function of a commercial
bank is the creation of credit.
Therefore, money supplied by commercial banks is called credit money.
Commercial banks create credit by advancing loans and purchasing securities.
They lend money to individuals and businesses out of deposits accepted from the
public. However, commercial banks cannot use the entirety of public deposits for
lending purposes. They are required to keep a certain amount as reserve with the
central bank for serving the cash requirements of depositors. After keeping the
required amount as reserves, commercial banks can lend the remaining portion
of public deposits.
According to Benham’s, “a bank may receive interest simply by permitting
customers to overdraw their accounts or by purchasing securities and paying for
them with its own cheques, thus increasing the total bank deposits.”

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 Let us learn the process of credit creation by commercial banks with the help of
an example.

Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the
bank. The cash reserve requirement of the central bank is 10%. In such a case,
bank A would keep Rs. 1000 as reserve with the central bank and would use
remaining Rs. 9000 for lending purposes.
The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as
demand deposit account. However, this is not actually paid out to Mr. X. The
bank has issued a checkbook to Mr. X to withdraw money. Now, Mr. X writes a
check of Rs. 9000 in favor of Mr. Y to settle his earlier debts.
The check is now deposited by Mr. Y in bank B. Suppose the cash reserve
requirement of the central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000)
will be kept as reserve and the remaining balance, which is Rs. 8550, would be
used for lending purposes by bank B.
Thus, this process of deposits and credit creation continues till the reserves with
commercial banks reduce to zero.

This process is shown in the Table-1

Bank New Deposits / Primary Deposits Demand Deposits Derivative Deposits / Loans
Bank A 10,000 1,000 9,000
Bank B 9,000 450 8,550
Bank C 8,550 855 7,695
Bank N – – –
Total 50,000 10,000 40,000

The process of credit creation can also be learned with the help of following
formulae:

Total Credit Creation = Original Deposit * Credit Multiplier Coefficient

Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called
as Cash Reserve Ratio (CRR)

Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10 Total credit created =

10,000 *10 = 100000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20 Total credit creation =
10000 * 20 = 200000
Thus, it can be inferred that lower the CRR, the higher will be the credit
creation, whereas higher the CRR, lesser will be the credit creation. With the
help of credit creation process, money multiplies in an economy. However, the
credit creation process of commercial banks is not free from limitations.

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Some of the limitations of credit creation by commercial banks are shown in Figure-3:

Amount of Cash: Affects the creation of credit by commercial banks. Higher the cash of
commercial banks in the form of public deposits, more will be the credit creation. However, the
amount of cash to be held by commercial banks is controlled by the central bank.

The central bank may expand or contract cash in commercial banks by purchasing or selling
government securities. Moreover, the credit creation capacity depends on the rate of increase or
decrease in CRR by the central bank.

CRR: Refers to reserve ratio of cash that need to be kept with the central bank by commercial
banks. The main purpose of keeping this reserve is to fulfil the transactions needs of depositors
and to ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation
would be more and vice versa.

Leakages: Imply the outflow of cash. The credit creation process may suffer from leakages of
cash. The different types of leakages are discussed as follows:

o Excess Reserves: Takes place generally when the economy is moving towards
recession. In such a case, banks may decide to maintain reserves instead of utilizing
funds for lending. Therefore, in such situations, credit created by commercial banks
would be small as a large amount of cash is resented.

o Currency Drains: Imply that the public does not deposit all the cash with it. The
customers may hold the cash with them which affects the credit creation by banks.
Thus, the capacity of banks to create credit reduces.

Availability of Borrowers: Affects the credit creation by banks. The credit is created by
lending money in form of loans to the borrowers. There will be no credit creation if there are no
borrowers.

Availability of Securities: Refers to securities against which banks grant loan. Thus,
availability of securities is necessary for granting loan otherwise credit creation will not occur.
According to Crowther, “the bank does not create money out of thin air; it transmutes other
forms of wealth into money.”

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Business Conditions: Imply that credit creation is influenced by cyclical nature of an economy.
For example, credit creation would be small when the economy enters into the depression
phase. This is because in depression phase, businessmen do not prefer to invest in new projects.
In the other hand, in prosperity phase, businessmen approach banks for loans, which lead to
credit creation. In spite of its limitations, we can conclude that credit creation by commercial
banks is a significant source for generating income.

The essential conditions for creation of credit are as follows:

o Accepting the fresh deposits from public
o Willingness of banks to lend money
o Willingness of borrowers to borrow.

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 Corporate Banking

In the realm of financial services, Corporate Banking stands as a pivotal division within a bank. Its
primary function is to orchestrate and provide loans to a diverse clientele, including corporations,
financial institutions, and governments

Often referred to as "institutional banking," this arm of the bank typically operates under the broader
umbrella of Investment Banking. Interestingly, corporate banking is frequently viewed as a "loss
leader." This perception stems from the idea that the direct profits generated from corporate loans might
be modest compared to the substantial fees earned from other, more lucrative investment banking
products. These include high-stakes activities like mergers and acquisitions (M&A) advisory, and the
underwriting of both bond and equity issuances. Essentially, the relationships fostered through corporate
lending can serve as a crucial gateway to securing these more profitable engagements for the investment
bank.

Key Products and Services Offered in India

The suite of products and services offered by corporate banks in India is comprehensive, designed to
meet the diverse and dynamic needs of their corporate clientele. These can be broadly categorized as
follows:

a. Lending Solutions: Working Capital Finance: This includes cash credit, overdraft facilities, and bill
discounting, crucial for managing a company's day-to-day operational liquidity, inventory, and
receivables. Indian banks are adept at structuring these facilities to align with the seasonal and cyclical
needs of various industries.

Term Loans: Provided for capital expenditure, expansion projects, or acquisition financing,
these are typically long-tenor loans with structured repayment schedules. This category also
includes syndicated loans, where multiple banks collaborate to fund large projects, spreading the
risk.

Project Finance: A specialized form of long-term financing for large-scale infrastructure and
industrial projects (e.g., power plants, roads, ports). This is often non-recourse or limited
recourse, meaning repayment is primarily from the project’s cash flows, requiring extensive due
diligence and risk assessment. Indian banks, particularly public sector banks, have been
instrumental in funding national infrastructure development.

b. Trade Finance: Facilitating international and domestic trade, these services include:

Letters of Credit (LCs): Guarantees of payment to exporters, mitigating risk for both buyers
and sellers.

Bank Guarantees: Assurances given by banks on behalf of their clients to third parties, often
required in contracts, tenders, or for performance obligations.

Export/Import Financing: Pre-shipment and post-shipment credit to support trade cycles.

c. Treasury and Foreign Exchange Services: Banks provide sophisticated treasury solutions,
including:

Foreign Exchange (Forex) Services: Spot and forward contracts, currency options, and hedging
solutions to manage foreign exchange risk for companies involved in international trade or with
foreign currency exposures.

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 Interest Rate Risk Management: Derivatives like interest rate swaps to hedge against interest
rate fluctuations.

Cash Management Services: Efficient collection and disbursement of funds, liquidity

management, and reconciliation services, often leveraging digital platforms.

d. Transaction Banking: This encompasses a range of services designed to optimize a company's

financial operations:

Payment and Collection Solutions: Bulk payments, electronic fund transfers (RTGS, NEFT,
IMPS), and cheque processing.

Supply Chain Finance: Solutions that optimize working capital across the entire supply chain,
benefiting both large corporates and their smaller suppliers/distributors.

e. Advisory Services: Beyond traditional banking, many corporate banking divisions offer strategic
advice, particularly for larger clients:

Debt Syndication: Arranging and structuring large debt facilities from a consortium of lenders.

Financial Restructuring: Advising companies on optimizing their capital structure or

navigating financial distress.

Mergers & Acquisitions (M&A) Advisory (often in conjunction with Investment Banking):
While typically an investment banking function, corporate banking relationships often serve as
the entry point for M&A advisory, providing strategic advice on acquisitions, divestitures, and
mergers.

Corporate Banking as “Loss Leader”?

Corporate banking is usually housed within the investment bank part of a financial institution and serves
as the quarterback for broader capital markets business. Corporate banking is closely tied to the M&A
advisory and capital markets divisions within an investment bank.

What this means is that within the investment bank, corporate banking often functions as a “loss leader”
to foster stronger overall investment banking relationships. Banks often give large, sophisticated clients
sweetheart loan offers because they can be cross sold on additional banking services or want to build a
long-term relationship.

Clients regularly require corporate banking products such as term loans, revolving credit facilities, and
cash management solutions to support business operations.

When a big corporation decides to tap into capital markets and needs to allocate distribution (and fees,
or “wallet”) to the capital markets teams of various banks they’ve done business with, they often
consider the prior support corporate bankers gave them when deciding how much to allocate to each
bank.

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 Types of Interest Rates

Fixed Interest These do not change even if there is any fluctuation in the economy.
Rate Preferred
when the interest rates are expected to increase in the future
When the borrower wants to know exactly what he would like to pay in the
future, i.e. without risk of uncertainty
Floating The interest rate is charged by having a certain markup over and above some
Interest Rate benchmark index, like LIBOR/MIBOR.
Preferred when the interest rates are expected to decrease in the near future

There are exchange banks who helps the two customers to swap their obligation from Fixed to
floating interest rates and vice versa. They charge a fee as a percentage of principal amount
generally ranging from 0.10% to 1.00%. The fees may not be lump sum in nature. It could be
taken at every interest payment.

Types of Charges

Pledge Pledger who owns the asset, loses the right to use the asset as the possession is
transferred to the pledgee. It is said to be a form of bailment primarily for taking
the loan
Hypothecation The owner has the right to use the asset, sell and purchase it
Used basically for items with high mobility e.g. inventory or stock
Most common for securing overdraft facility
Mortgage Immovable property
Primary or Secondary mortgage

Pledge: is used when the lender (pledgee) takes actual possession of assets (i.e. certificates,
goods). Such securities or goods are movable securities. In this case the pledgee retains the
possession of the goods until the pledger (i.e. borrower) repays the entire debt amount. In case
there is default by the borrower, the pledgee has a right to sell the goods in his possession and
adjust its proceeds towards the amount due (i.e. principal and interest amount). Some examples
of pledge are Gold / Jeweler Loans, Advance against goods, /stock, Advances against National
Saving Certificates etc.

Hypothecation: It is used for creating charge against the security of movable assets, but here
the possession of the security remains with the borrower itself. Thus, in case of default by the
borrower, the lender (i.e. to whom the goods / security has been hypothecated) will have to first
take possession of the security and then sell the same. The best example of this type of
arrangement are Car Loans. In this case Car / Vehicle remains with the borrower but the same is
hypothecated to the bank / financer. In case the borrower, defaults, banks take possession of the

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vehicle after giving notice and then sell the same and credit the proceeds to the loan account.
Other examples of hypothecation are loans against stock and debtors. [Sometimes, borrowers
cheat the banker by partly selling goods hypothecated to bank and not keeping the desired
amount of stock of goods. In such cases, if bank feels that borrower is trying to cheat, then it
can convert hypothecation to pledge i.e. it takes over possession of the goods and keeps the
same under lock and key of the bank].

Mortgage: It is used for creating charge against immovable property which includes land,
buildings or anything that is attached to the earth or permanently fastened to anything attached
to the earth (However, it does not include growing crops or grass as they can be easily detached
from the earth). The best example when mortgage is created is when someone takes a Housing
Loan / Home Loan. In this case house is mortgaged in favor of the bank / financer but remains
in possession of the borrower, which he uses for himself or even may give on rent.

Note: Any right can be assigned to any other person, and the other person assumes all the
rights and liabilities of the transferor. Assignment is done every time the loan is
transferred from one bank to another or there is securitization of loans taking place.

Note: A lien is a legal right granted by the owner of property, by a law or otherwise acquired by
a creditor. A lien serves to guarantee an underlying obligation, such as the repayment of a loan.
If the underlying obligation is not satisfied, the creditor may be able to seize the asset that is the
subject of the lien. Once executed, a lien becomes the legal right of a creditor to sell the
collateral property of a debtor who fails to meet the obligations of a loan or other contract. The
property that is the subject of a lien cannot be sold by the owner without the consent of the lien
holder.

E.g. A lien is often granted when an individual takes out a loan from a bank to purchase an
automobile. The individual purchases the vehicle and pays the seller using the funds from the
bank but grants the bank a lien on the vehicle. If the individual does not repay the loan, the
bank may execute the lien, seize the vehicle, and sell it to repay the loan. If the individual does
repay the loan in full, the lien holder (the bank) then releases the lien, and the individual owns
the property free and clear of any liens.

Liquidity Adjustment Facility

A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the
Reserve Bank of India (RBI), that allows banks to borrow money through repurchase
agreements (repos) or for banks to make loans to the RBI through reverse repo agreements.
This arrangement manages liquidity pressures and assures basic stability in the financial
markets. In the United States, the Federal Reserve transacts repos and reverse repos under its
open market operations.

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages
during periods of economic instability or from any other form of stress caused by forces beyond
their control. Various banks use eligible securities as collateral through a repo agreement and
use the funds to alleviate their short-term requirements, thus remaining stable.

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The facilities are implemented on a day-to-day basis as banks and other financial institutions
ensure they have enough capital in the overnight market. The transacting of liquidity adjustment
facilities take place via an auction at a set time of the day. An entity wishing to raise capital to
fulfill a shortfall engages in repo agreements, while one with excess capital does the opposite –
executes a reverse repo.

Type Present
Rate Description

1. % of deposits to be deposited to the Reserve

Cash Reserve Ratio 3% Bank
2. Higher the ratio, lower the liquidity, lower the
credit creation
1. Amount to be maintained in the specified
Statutory Liquidity liquid securities.
18%
Ratio 2. Higher the ratio, lower the liquidity, lower the
credit creation
1. RBI lends money to the banks with the help of
Repo Rate 5.5% repurchase agreement
2. The security is purchased back at the amount
including the repo rate
1. Similar to Repo rate but here RBI takes a loan
Reverse Repo Rate 3.35% from the banks
2. Both repo and Reverse Repo rate are for the
short-term money lending
This is the rate at which bank takes a long-term loan
Bank Rate 5.75%
from the RBI
This is the rate at which the scheduled banks can borrow
Marginal Standing funds overnight from RBI against government securities.
5.75%
Facility MSF is a very short-term borrowing scheme for scheduled
commercial banks

Cash Reserve Ratio: Banks in India are required to hold a certain proportion of their deposits
in the form of cash. However, Banks don't hold these as cash with themselves, they deposit such
cash with Reserve Bank of India, which is considered as equivalent to holding cash with
themselves. This minimum ratio (that is the part of the total deposits to be held as cash) is
stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.

When a bank's deposits increase by INR 100, and if the cash reserve ratio is 9%, the banks will
have to hold INR 9 with RBI and the bank will be able to use only INR 91 for investments and
lending, credit purpose. Therefore, higher the ratio, the lower is the amount that banks will be
able to use for lending and investment. This power of Reserve bank of India to reduce the
lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank
through which it can control the amount that banks lend. Thus, it is a tool used by RBI to
control liquidity in the banking system.

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Statutory Liquidity Ratio: Every bank is required to maintain at the close of business every
day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the
form of cash, gold and un- encumbered approved securities. The ratio of liquid assets to
demand and time liabilities is known as Statutory Liquidity Ratio (SLR).
RBI is empowered to increase this ratio up to 40%. An increase in SLR also restricts the bank's
leverage position to pump more money into the economy.

Net Demand Liabilities - Bank accounts from which you can withdraw your money at
any time like your savings accounts and current account

Time Liabilities - Bank accounts where you cannot immediately withdraw your money
but have to wait for certain period. e.g. Fixed deposit accounts
The main objectives for maintaining the Statutory Liquidity Ratio are the following:

• Statutory Liquidity Ratio is maintained in order to control the expansion of Bank

Credit. By changing the level of Statutory Liquidity Ratio, Reserve bank of India
can increase or decrease bank credit expansion.
• Statutory Liquidity Ratio in a way ensures the solvency of commercial banks.
• By determining Statutory Liquidity Ratio, Reserve Bank of India, in a way,
compels the commercial banks to invest in government securities like
government bonds.

Repo Rate: Repo Rate or Repurchase Rate is the rate at which the RBI lends funds to
commercial banks and other financial institutions within the country. Simply put, banks borrow
funds from The Central Bank of India by selling government securities with a legal agreement
to repurchase the securities sold on a given date at a predetermined price. The rate of interest
charged by RBI while they repurchase the securities is called Repo Rate.

Reverse Repo Rate: Reverse Repo Rate: When Reserve Bank of India faces a financial crunch,
they invite commercial banks and other financial institutions to deposit their excess funds into
RBI treasury and offers them excellent interest rates. Similarly, when banks have excess funds,
they voluntarily transfer it to RBI as their money is safe and secure with them. Generally,
Reverse Repo Rate is always lesser than Repo Rate.

Bank Rate: Bank Rate: Bank Rate is the rate of interest charged by The Central Bank of India
against loans offered to commercial banks. Bank rate is usually higher than repo rate. Unlike
repo rate, bank rate directly affects the end user, in this case the customer, as high bank rates
mean high lending rates. When bank pay high interest rate to obtain loan from RBI, they in
return charge the customer high interest rate to break even. Also known as “Discount Rate”,
bank rate is a powerful tool used by the RBI to control liquidity and money supply in the
market.

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Marginal Standing Facility: MSF, being a penal rate, is always fixed above the repo rate. The
MSF would be the last resort for banks once they exhaust all borrowing options including the
liquidity adjustment facility by pledging government securities, where the rates are lower in
comparison with the MSF. The MSF would be a penal rate for banks, and the banks can borrow
funds by pledging government securities within the limits of the statutory liquidity ratio. The
scheme has been introduced by RBI with the main aim of reducing volatility in the overnight
lending rates in the inter-bank market and to enable smooth monetary transmission in the
financial system.

MSF represents the upper band of the interest corridor with repo rate at the middle and reverse
repo as the lower band

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 CAMELS approach

Capital Adequacy Measure of Financial strength.

Capital Adequacy ratio is used to map the Tier-1 and Tier-2 Capital with
that of the Risk weighted assets
Asset Quality This involves considering the factors relating to the loans given by the
bank to the parties
These include checking of the loans, their exposure towards a particular
party, group or beneficial owner.
Management It influences the other parameters of the business
It is measured by metrics like Operating Cost per unit of money and
Earnings per employee
Earnings The major component of it is Net Interest Income (NII) (actual amount of
spread between the deposit and lending rates)
It is measured with the help of Return on Equity, Return on Assets and
Interest Spread
However now other value-added services also contribute to the income of
the banks
Liquidity It is to ensure that the bank is able to clear its dues in time.
More liquidity means less profitability as the amount is not invested in the
proper
This is evaluated by mapping the maturity profile of deposits and loans.
The ILFS crisis is majorly because of this reason
Sensitivity of Market It is related to the risk that the bank may face if the interest rate increases
Risk in the future.
The risk is more prevalent in the fixed interest rate loans that the bank has
given with a longer maturity.

CAMELS is a rating system developed in the US that is used by supervisory authorities to rate
banks and other financial institutions. It applies to every bank in the U.S and is also used by
various financial institutions outside the U.S. This rating system was adopted by National
Credit Union Administration in 1987. In 1988, the Basel Committee on Banking Supervision of
the Bank of International Settlements (BIS) proposed the CAMELS framework for assessing
financial institutions.

Purpose: The ratings are assigned based on the financial statements of the bank or financial
institution. This system helps the supervisory authorities to identify banks that need maximum
amount of regulatory concern. It is used to measure risk and financial stability of a bank. It
determines the banks overall conditions in the areas of financial, managerial and operational
aspects.

Score scale: The rating system consists of a score from one to five with score one considered as
best and score five considered as the worst for each factor. Banks which obtain the score of one are
considered most stable, banks with a score of 2 or 3 are considered average and those with 4 or 5
considered as below average and are subjected to supervisory scrutiny.

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Factors:
CAMELS is an acronym of the following factors on which ratings are given by supervisory
authorities.

C- Capital Adequacy: Capital adequacy refers to the amount of capital the financial
institutions have to hold as required by its financial regulator. It is expressed as the Capital
Adequacy ratio, which can be defined as the ratio of banks capital to risk weighted assets. This
ensures the protection of depositors and investors and financial soundness of the bank. Factors
involved in rating and assessing an institution's capital adequacy are its growth plans, economic
environment, ability to control risk, and loan and investment concentrations.

A- Asset Quality: Asset quality evaluates the quality of asset/loan the bank offers. The assets
of a bank include cash, government securities, investments, real estates and interest earning
loans. Assets such as loans provide returns to the financial institutions in terms of interests and
comprise a majority of banks assets carrying high risk. Asset quality deals with quality of the
loans, investments; and banks effectiveness in controlling and monitoring the credit risk. This
provides the stability of the company when faced with particular risks.

M- Management: Assessment of management determines ability of an institution to diagnose

and react to financial stress. This component rating is reflected by the management's capability
to identify, measure, and control risks of the institution's daily activities. It ensures safe
operation of the institution with effective policies and guidelines. The management has to
address the risk related to credit, rate of interest, transactions etc.

E- Earnings: Ratings on earnings are based on the financial institution's ability to create
returns on its assets. These returns enable the institution to expand, retain competitiveness, and
provide adequate capital. It can be measured as the return on asset ratio. company's growth,
stability, valuation allowances, net interest margin, net worth level and the quality of the
company's existing assets are assessed to rate the Earnings.

L- Liquidity: To meet unexpected withdrawals from depositors without affecting the daily
operations, the bank must maintain liquid cash and assets that can be easily converted into cash.
The ratio of liquid cash to asset ratio can be used as a parameter to measure banks liquidity.

S- Sensitivity: Sensitivity refers to effect on bank due to market changes. In other terms it
refers to market risk. Banks sensitivity to changes in interest rates, foreign exchange rates,
changes in price of commodities, etc. is measured. It primarily evaluates the interest rate risk
and sensitivity to all loans and deposits.

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 Other Terms used in Banking

Tier 1 Capital: A term used to refer to one of the components of regulatory capital. It consists
mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I items are deemed
to be of the highest quality because they are fully available to cover losses Hence it is also
termed as core capital.

Tier 2 Capital: Refers to one of the components of regulatory capital. Also known as
supplementary capital, it consists of certain reserves and certain types of subordinated debt. Tier
II items qualify as regulatory capital to the extent that they can be used to absorb losses arising
from a bank's activities. Tier II's capital loss absorption capacity is lower than that of Tier I
capital.

Frequently Asked Questions

What is the base rate (BR)?

It is the minimum rate of interest that a bank is allowed to charge from its customers. Unless
mandated by the government, RBI rule stipulates that no bank can offer loans at a rate lower
than BR to any of its customers.

How is the base rate calculated?

A host of factors, like the cost of deposits, administrative costs, a bank's profitability in the
previous financial year and a few other parameters, with stipulated weights, are considered
while calculating a lender's BR. The cost of deposits has the highest weight in calculating the
new benchmark. Banks, however, have the leeway to take into account the cost of deposits of
any tenure while calculating their BR.

How is it different from bank prime lending rate?

BR is a more objective reference number than the bank prime lending rate (BPLR) -- the current
benchmark. BPLR is the rate at which a bank is willing to lend to its most trustworthy, low-risk
customer. However, often banks lend at rates below BPLR. For example, most home loan rates
are at sub-BPLR levels. Some large corporates also get loans at rates substantially lower than
BPLR. For all banks, BR will be much lower than their BPLR.

What is an interest rate corridor?

Interest rate corridor refers to the window between the repo rate and the reverse repo rate
wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the
overnight interbank call money market, where lending and borrowing is unsecured, should
move within this corridor. However, when banks are short of funds and the overnight call
money rates are high and above the repo rate, banks approach the RBI to borrow under the repo
window. Therefore, the repo rate becomes an effective policy tool as it would help bring down
the rates in the overnight market. The reverse happens when money market rates fall below the
reverse repo rate. Banks then park surplus funds with the RBI through a reverse repo
transaction. As a result, when there is excess liquidity in the system, the reverse repo is more

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effective. When liquidity is tight and banks need short-term funds from the RBI to manage
mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to
the system the reverse repo would become the operative policy rate as the RBI would be
draining out funds from the system.

What is Capital Adequacy Ratio?

It is the measure of a bank’s financial strength expressed by the ratio of its capital (net worth
and subordinated debt) to its risk-weighted credit exposure (loans). It is also called CRAR-
Capital to Risk-weighted Assets Ratio. Currently, RBI mandates minimum CRAR of 9%, but
the Government of India has mandated total CRAR of 12%, with 8% Tier I capital. Most banks
in India have a capital adequacy of more than 12%. A bank with a higher capital adequacy is
considered safer because if its loans go bad, it can make up for it from its net worth.

Why do banks have to maintain CAR?

India’s bank regulator, RBI, has prescribed a minimum ratio to be maintained by the banking
system. This is done because the depositors are secured about their deposits and banks have a
cushion for their potential losses. In the face of the financial crises seen in the last few years,
maintenance of CAR is mandated by the regulatory authorities to protect the depositors.

Non-Performing Assets

As per RBI’s Income Classification and Asset Recognition (ICAR) guidelines, the loans that
are given by the banks are classified into two categories and based on that the provision for
non-recovery is being made. The two classes being Performing and Non-Performing Assets.
The NPAs are also further classified into three categories being Sub-Standard, Doubtful and
Loss assets.
• Substandard assets: Assets which has remained NPA for a period less than or equal to
12 months.

• Doubtful assets: An asset would be classified as doubtful if it has remained in the

substandard category for a period of 12 months.

• Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value
that its continuance as a bankable asset is not warranted, although there may be some
salvage or recovery value.” The asset is classified as Loss asset when either the
management or the auditor classifies it so.

Banks could not record interest income on NPAs till the time the said amount is received. The
banks are not only impacted by loss of revenue but also have a risk of loss of capital. If the
borrower defaults in repayment of the sums, then the ability of bank to generate credit in the
market is impaired. The bank has to repay the amount to the depositors, but it isn’t able to
recover the sum from the borrower. It also impacts the Capital Adequacy requirements of the
banks, so there is burden from the regulator as well.

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