Dear Readers,
In our previous article, we had a quick
overview of the Banking sector. (To access the previous article, visit:
https://www.pagalguy.com/articles/banking-an-overview-32499451)
In this article, let us take a closer look
at Banks. Banks in India are governed by the Banking Regulation act, 1949 and
it is this act that defines the common terms associated with banking. Banks
also come under some provisions of the Companies Act. Here are three of the
most important terms associated with Banking:
Bank: A financial institution which is in the business of Banking.
Banking: Accepting deposits of money from the public for the purpose of
lending or investment. Such moneys may be repayable on demand or otherwise and may
be accessed by Cheque, demand draft, and money order or otherwise.
Banker: A Banker is one who performs the business of Banking. He is an
intermediary and deals with money belonging to the public.
To better understand the workings of a bank,
we need to take a look at the flow of money in a typical bank. The figure given
here captures the flow of money in a bank. In this figure, the arrows point
towards the direction of flow.
Different categories of inflow of money to a
Bank:
a.
Deposits
b.
Debt including money borrowed under
Repo rate, Bank rate mechanism, Marginal Standing Facility
c.
Owner’s Capital including
Recapitalization fund
d.
Interest on Reverse Repo,
Foreign Exchange
e.
Returns on Investment
f.
Interest earned on Loans,
Advances and overdraft
g.
Restructured Loans
h.
Dividends
Different categories of outflow of money
from a bank:
a.
Interest on deposits and bonds
issued
b.
Interest at Repo rate, Money kept
with the RBI under Reverse repo, CRR and SLR
c.
Foreign exchange
d.
Tax paid
e.
Investment
f.
Loans, Advances and overdrafts
g.
Money lost in Re-structuring of
Loans
h.
Dividends
Let us
understand each of these categories.
Deposits: This refers to all of the deposits (funds) obtained from the
general public in various types of accounts.
Debt: The money borrowed by the bank from various creditors is
categorised as its debt. The sources of debt include promoters money, Bonds
issued, money borrowed from the RBI through various mechanisms, such as Long
term borrowing at Bank rate, or at repo rate, MSF, etc.
Owner’s
capital: The capital brought by the owners of the
bank or the parent holding company. This also includes recapitalization
funding. Recapitalization fund means funds released in order to change the
capital structure of the Bank. This is usually done by the owners of the bank. The
reasons for recapitalization may be large amount of debt raised by the bank –
hence, a need to reduce debt-to-equity ratio – or meeting the capital requirement
for banks as per Basel norms.
Interest
under Reverse repo rate and from Foreign Exchange: A
Reverse repo operation is when RBI borrows money from banks by lending
securities to them. Reverse repo operations are used to absorb liquidity from
the system. The interest rate paid by RBI in such cases is called the reverse
repo rate.
Banks interact with the RBI for all of
their need for foreign currency. Banks sell Indian rupees and purchase desired
currencies at the prevailing rates. This is usually done either to fund their
offshore branches or to provide loans to companies abroad, etc.
Returns
on Investment: Banks usually invest moneys on
various projects, depending on their investment priorities. Returns or earnings
are received from these projects and investments.
Interest/fee
earned on Loans, Advances and overdrafts: Banks are
advised by the Reserve Bank of India to use a benchmark rate for lending. This
rate is called the Base rate. The RBI provides the base rate on the basis of
various factors. The base rate is the benchmark for lending operations of banks.
It is the minimum rate of interest for banks to lend. It is not viable for
banks to lend below this rate. The base rate is arrived at through a
methodology that includes the following factors:
1.
Cost of deposits, interest on
the deposits of banks
2.
Adjustment for not utilizing
SLR, CRR
3.
Unallocated overhead cost
4.
Average return on net worth
Banks also charge interest on utilization
of credit in the form of credit cards, overdrafts, etc. Apart from the
interest, banks also charge a fee for providing overdrafts, advances, etc.
Restructured
Loans: A loan for which the parties (lender and
borrower) have agreed to alter the terms, usually in order to make them more favourable
to the borrower, is known as a restructured loan. Restructuring of loans is
done in order to prevent a default or when a loan is already classified as a non-performing
asset. This is considered as a loss in the book of accounts and hence, if the
loan is restructured, it results in a gain to the bank.
Dividends
retained: Listed companies often do not provide
dividends to their shareholders. Such funds (as would have been spent if
dividends were given) may then be used by the company for further expansion,
investment, etc.
Interest
on Deposits and Bonds issued: Banks give interest
on deposits depending on the type of deposit and the nature of deposit
Money
for Reverse repo, Interest at Repo, MSF and SLR kept with the RBI, Foreign
exchange: Reverse repo operations are those wherein
the RBI borrows money from banks by lending securities. So money from banks is absorbed
by the RBI in reverse repo operations.
Long term borrowing from RBI by banks is
done at the Bank rate. In other words, the Bank rate is the rate at which the
RBI lends to banks for the long term. There is no collateral for borrowing at
the Bank rate.
Repo rate: Repo is a collateralized
lending wherein banks borrow money from the RBI to meet short term needs. Such
borrowing is done by selling securities to the RBI with an agreement to
repurchase the same at a predetermined rate and date. The rate charged by
Reserve Bank of India for this transaction is called the repo rate.
MSF:
The Marginal Standing facility refers to the penal rate of interest at
which banks can borrow money from the RBI over and above the limits available
to banks through LAF (read repo).
SLR: It is a measure described in the Banking
Regulation Act 1949 under which all scheduled commercial banks in India must
maintain at least an amount equal to a fixed percentage of their total DTL/ Net
Demand and time liabilities (NDTL) in one of the following forms:
a.
Cash
b.
Gold
c.
Securities investments, including
Treasury Bills, Dated securities under Market stabilization scheme, State
development loans issued by State governments, other instruments as notified by
the RBI.
Tax: Bank have to pay taxes to the government on the profits earned during
each financial year.
Investment: Banks finance (and invest in) many projects. Such financing is
generally termed as corporate loans. These loans are long term loans and may
have terms as long as 10-20 years.
Loans,
Advances and overdrafts: Banks provide many credit
facilities to their borrowers. A common form of these is an overdraft, which is
a facility granted to a customer whereby the customer can overdraw his current
account up to a pre agreed limit.
Advances: Banks often pay money upfront to
a payee on behalf of the borrower, usually in lieu of a letter of credit. This
form of advances is commonly used in exports and in the transportation
industry.
Loans: These are standard loans taken by
consumers to fulfil their personal needs.
Money
lost in Re-structuring of Loans: Whenever a
borrower defaults in the payment of his loan and its interest, banks try to
restructure the loan repayment scheme and make it more flexible. To allow this
flexibility, banks lose money which should have been earned by them as per the
original terms of the loan.
Dividends
Paid: A listed company pays dividends to its
shareholders in proportion to the profit earned by the company. This earning is measured by a metric known as
Earning-per-share.
These are some of the most basic and
commonly used terms in the Banking sector. Hopefully, this article would have
helped you understand these terms and would have given you a better
understanding of the functions performed by banks.
All the Best for your prep!