Definition of Banking

Banking is defined as accepting, for the purpose of lending and investments, deposits of money from the public, repayable on
demand or otherwise, and withdrawable by cheque, draft, order or otherwise.

Over the years the nature and scope of services provided by banks have changed and expanded. At the same time, the primary
activities of the bank continue as stated above. b

Types of Banking

The banks can be categorized into different types based on the services offered to the customer. These banks specialize in different
lines of business. Some of the most common types of banks are:

 Retail banks
 Commercial or Corporate banks
 Investment banks
 Central banks

Retail bank is a bank that works with consumers, otherwise known as 'retail customers'. Retail banks provide basic banking
services to the general public, including:

 Checking and savings accounts

 Cash Deposits
 Safe deposit Lockers
 Deposits and Loans
 Auto loans
 Unsecured and revolving loans such as credit cards

Retail banks are the banks you most often see in cities on crowded intersections, the ones you probably use for your personal
checking account.

A commercial or corporate bank is a bank that works with businesses. Commercial banks handle banking needs for large and
small businesses, including:

 Basic accounts such as current and cash credit accounts

 Lending money for real and capital purchases
 Letters of credit & Guarantees
 Payment and transaction processing
 Foreign exchange

Commercial banks often function as retail banks as well, serving individuals along with businesses.

Investment banks help organizations use investment markets. For example, when a company wants to raise money by issuing
stocks or bonds, an investment bank helps them through the process. Investment banks also consult on mergers and acquisitions,
among other things.

Investment banks primarily work in the investment markets and do not take customer deposits. However, some large investment
banks also serve as commercial banks or retail banks.

Central Bank

In every country there is one bank which acts as the leader of the money market, supervising, controlling and regulating the
activities of commercial banks and other financial institutions. It acts as a bank of issue and is in close touch with the government,
as banker, agent and advisor to the latter. Such a bank is known as the central bank of the country. Bank of England is the Central
Bank of United Kingdom, Reserve Bank of India (RBI) is the central bank of India.
Features of Central Bank

 Aims at controlling the banking system in the country

 It has special powers to control and regulate the working of commercial banks of the country
 It is part of the government machinery and its actions are closely coordinated with those of the other departments of the
government, particularly with the Department of Finance or the Treasury
 It is managed by the Government Officials or those connected closely with the government.

Functions of the Central Bank

Bank of Issue

The central bank of a country is the sole authority that has powers to print and issue money. The issue of money was always the
prerogative of the government. The government delegates the right of printing currency notes to the central bank. In fact the right
and privilege of note issue was always associated with the origin and development of central banks which were originally called as
banks of issue.

Banker, Agent and Adviser to the Government

The central banks in each country perform the functions of banker, agent and adviser to the Government. As a banker to the
government, the central bank of the country keep the banking accounts of the government - both of the centre and the states,
performs the same functions as a commercial bank ordinarily does for its customers. As a banker and agent to the government, the
central bank makes and receives payments on behalf of the government. It helps the government with short-term loans and advances
to tide over temporary shortage of funds. It also manages public debt i.e. floats services and redeems government loans. It advises
the government on all monetary and banking matters.

Custodian of Cash Reserves of Commercial Banks

All commercial banks keep part of their cash balances as deposits with the central bank of the country, either because of convention
or because of legal compulsion. The cash deposits kept by all commercial banks with the central bank are known as cash reserves.
They withdraw funds from these cash reserves during the busy season and pay in surplus funds into them during the slack season.
Part of these cash balances are meant for cheque clearing purposes. As all commercial banks keep deposit accounts with the central
bank, payment by one bank to another is a simple book entry adjustment in the books of the central bank.

Custodian of Foreign Balances of the Country

The central banks in most countries maintain both gold and foreign currencies as reserves against notes issue and to meet any
adverse balance of payments with any other country. Besides, it is the responsibility of central banks to maintain reserves with
International Monetary Fund (IMF). These reserves are referred to as normal drawing rights and special drawing rights. It is the
responsibility of the central bank of the country to maintain the rate of exchange fixed by the Government, manage exchange
control and other restrictions imposed by the state.

Lender of the Last Resort

One of the fundamental principles of the central bank is that it (as the banker’s bank and as the supreme banking authority) never
refuses to accommodate any eligible commercial bank needing funds. At certain times of the year due to seasonal business activities
or in times of intense business activities, the commercial banks may need more funds to meet the requirements of their customers. In
the absence of central banks, the commercial banks will be required to carry substantial cash reserves with themselves to meet such
emergencies. Large cash reserves imply restricted lending and reduced income by way of interest. If a central bank exists, it is easy
for commercial banks to fall back on it in case of need. By lender of the last resort, it is implied that the central bank assumes the
responsibility of meeting directly or indirectly all reasonable demands for accommodation of commercial banks in times of
difficulties and crises.

Central Clearance, Settlement and Transfer

As the bankers’ bank, the central bank keeps the cash balances of all commercial banks. It is easier for member-banks to adjust their
claims against each other in the books of the central bank.
Apart from economy in the use of money, much of labour and inconvenience, associated with the individual system of clearance and
settlement is removed. This function is not restricted to a central bank alone; it may delegate the clearing activities region wise, to
any leading bank in the region.

Controller of Credit

Probably the most important of all the functions performed by the central bank is that of controlling the credit operations of
commercial banks. In modern times, bank credit has become the most important source of money in the country, relegating coins
and currency notes to a minor position. Moreover, it is possible for commercial banks to expand credit and thus intensify
inflationary pressure or contract credit and thus contribute to a deflationary situation. It is thus of great importance that there should
be some authority which will control the credit creation by commercial banks which is also know as Bank credit. As a controller of
credit, the central bank attempts to influence and control the volume of bank credit and stabilize business conditions in the country.

Roles Played by Banks

Roles played by Banks are

 Financial Intermediary
 Constituent of the payment System
 Financial Service Provider

Financial Intermediary

In the economic, every business either big or small requires investment of money for their business growth. They can not get money
from society because of

1. Credit Risks - Credit risk refers to the risk of default by the borrower for any reason. It is possible that the business does not
generate sufficient income to repay or the borrower is not honest. This is the most serious risks any lender faces.

2. Liquidity Risks – The borrower may have every intention to repay the loan and the business may be doing well too. However
there could be occasions when the borrower is not able to withdraw funds from the business when the lender demands repayment.

3. Interest Rate Risk – Another risk is due to change in the rate of interest in the market. At the time of the transactions the
borrower may have agreed to give the interest at the prevailing rate of, say, 8%. Subsequently, interest may be reduced or increased.

Intermediation provides a business opportunity as the depositors will be happy to earn interest without any risks and borrowers can
get loans easily.

Payment Systems

Apart from intermediary other two unique features differentiate banks from other intermediaries like financial companies. The
second part of the definition of banking points to this feature. Banks accept “……. deposits of money, repayable on demand …..
and withdrawable by cheque……”. Banks are the only institutions that can accept demand deposits or deposits repayable as and
when demanded by the depositor. All other financial institutions can only take fixed deposits. Second, banks are the only institutions
on which a depositor can issue a cheque to withdraw his deposits.

Financial Services

In ancient times banks have played the roles as safe keepers, financial intermediary and payment system constituent. As times
changed, banks have provided additional services to meet the changing needs of the people. Today banks offers more services like
selling of products of mutual funds and insurance companies, collection of utility bill payments, sale of gold coins and many more.
These activities also yield non-fund based income to bank.

Banking Services and Products

The services and products offered by banks can be summarized as

Role
Services Products
 1.Cheque
 2.Payorder / Bankers Cheque
 3.Demand draft
Payment System Payment and
 4.Electronic Funds Transfer
Consitituent Remittance

 5.Various Cards (Debit,

Credit..)
 1.Transfer
 2.Clearing
 3.Electronic clearing System
Payment System
Collection  4.Cheque Collection
Consitituent
 5.Cash Management System

 6.Bill Collection
Payment System  1.Purchase & Sale of Foreign
Forex
Consitituent Exchange
 1.Current Accounts
 2.Savings Accounts
Intermediary Deposits  3.Fixed Deposits

 4.Recurring Deposits
 1.Retail Loans
o Housing / Mortgage
Loan
o Vehicle Loan
o Personal Loan
o Loan against deposits
o Credit Cards
 2.Business Credits
o Term Loan
o Working capital Loan
Intermediary Loans (Overdraft, Cash
Credit)
 3.Trade Finances
o Cheque Purchase, Bill
Purchase, Bill
Discount, Letter of
Credit (LC), Bill
Negotiation,
Guarantees

 4.Packing-Credit Loans
 1.Mutual Funds
 2.Insurance Products
 3.Government Bonds
Financial Services Distribution
 4.Stamp Paper

 5.Gold Coins
 1.Taxes
Financial Services Collection
 2.Utility Bills
Financial Services DeMat  1.DeMat Share Account
Financial Services Safe Keeping  1.Safe Deposit Vault
  2.Safe Custody
Financial Services Advisory  1.Investment Advice

Payment System Constituent

Payment & Remittance Services

Cheques:
A Cheque is a written instruction issued by a customer (drawer) to his bank (drawee) to pay the specified amount to the person
named (payee) in the cheque. The payee can collect the amount of the cheque in cash across the counter of the drawee bank or
deposit the cheque with his banker for collection. If the cheque is crossed by drawing two parallel lines on the top left corner (“A/C
Payee”), it is necessarily collected through a bank.

Multi City Cheques – As name implies the cheques can be collected in any of the payees branch where the branches are
interconnected / net worked. They are also called at At Par Cheques’ i.e. full amount drawn in the Cheque will be paid without any
reduction irrespective of the location where presented”

Certified Cheque

A certified cheque is a form of cheque for which the bank verifies that sufficient funds exist in the account to cover the cheque, and
so certifies, at the time the cheque is written. Those funds are then set aside in the bank's internal account until the cheque is cashed
or returned by the payee. Thus, a certified cheque cannot "bounce", and, in this manner, its liquidity is similar to cash.

Payorder / Bankers Cheques

The lack of certainty regarding payment of a cheque makes it unacceptable to some entities like government departments and
institutions. A payorder or bankers cheques is a cheque issued by a bank on itself. Both the drawer and drawee is the same bank, in
fact same branch of the bank.

Demand Drafts:

A Payorder is generally used for making local payments as it payable at the place where it is issued. When payments have to be
made to far away places and the payee insists on certainty of payments, Demand Drafts are used.

Electronic Funds Transfer (EFT)

Sending or remitting money to a far away place through DDs involves delay, as the DD has to be reached to the payee through post
or courier. It is much faster for a bank to send an electronic instruction to their branch at the payee’s center to pay him the amount.
If the payee has an account with the paying bank the payment can be made instantly.

Instantaneous completion of the transaction cannot happen if the payer and payee maintain their account with two different banks.
In that case the transfer or remittance is completed through the Central Bank.

Collection Services:

Transfer

When a person gets a cheque from another and deposits it with his bank and bank has to “collect” the amount to the cheque and
credit it to the account of the depositor. If both the payer and payee are from same bank, collecting the cheque is simple as the bank
can debit the account of the issuer and credit the account of payee or depositor.

Clearing

If the cheque deposited by a customer is drawn on another bank in the same city it has to be sent to the payee bank and the amount
collected. Since all the banks in a city will be getting cheques drawn in other banks and it is cumbersome process and “Clearing
house” is used to meet and exchange cheques drawn on each other.

ECS or Electronic Clearing System:

To support and enable the large number of customer credits or debits Electronic Clearing system is used.
CMS – Cash Management Services : CMS is an upgraded packages of collection and payment services. Large companies have
large numbers of dealers across the country. The dealers have to make payments on a regular basis for the goods purchased from the
company. To speed up the collection process the companies ties up with the bank, which arranges to

 Pick up cheques from the dealers on a daily basis

 Get them collected the same day through the local clearing.
 Remit the total amount to the bank account of the company at its head quarters
 Provide information on the number and amounts of cheques collected and returned unpaid with full details of the dealers
involved.

Bill Collection:

Bill refers to “Bill of Exchange” which is a written instruction issued by the seller (drawer), to the buyer (drawee), to pay a certain
sum of money, to the person named in the document (payee). In short, a bill of exchange is an instrument to pay.

When a bill is payable as soon as it is presented it is called a “Demand bill" or "Sight bill". When the drawer is permitted some time,
say 90 days, to pay the bill it is called as a “Usance” bill.

Foreign Exchange:

Remittances like clearing; transfer with in the country is relatively easy as the currency involved in are the same. When remittances
takes place between places in two countries, settlement becomes a little complicated because of two different currencies are
involved.

Similar to banks maintaining accounts in central bank for interbank settlement (Clearing), bank maintains account with banks
abroad (Nostro Accounts) for facilitating foreign exchange transactions. All foreign remittances are routed through Nostro
Accounts.

Intermediary Services

Deposit Services

Banks accepts demand deposits and fixed or time deposits. Demand deposits are repayable on demand while fixed deposits are
repayable after the agreed upon period or maturity. Since demand deposits are more “liquid” (available for use) than fixed deposit,
the interest is paid on such deposits are low or no interest is paid at all. Lower the liquidity higher the rate of interest. Hence the
longer period deposits earn more interest.

Current Accounts / Checking Accounts

Current accounts are demand deposits that are primarily meant for facilitating settlements of transactions using cheques. Banks do
not pay interest on balances in these type of account. Generally current accounts are maintained by business entities.

Savings Accounts

Savings accounts are also demand deposits offered for the benefit of individual who would like to save their temporary surpluses
and at the same time have liquidity for payments. Savings account differ from current account in following three respects.

 Interest is paid on balances in savings accounts.

 The central Bank prohibits banks from opening savings accounts of business entities.
 Some banks impose restrictions on the number of transactions from savings accounts. Banks also monitor transactions in
savings accounts and if they found that it is used for business purpose, the account holder is instructed to route through
current account.

Fixed Deposit Accounts

As the name indicates, fixed deposits are accepted for fixed periods of term. They are repayable only after the period for which they
are deposited. Banks are entitled to levy penalty on premature closure and some banks does where others do not levy any penalty
from Individuals.

Recurring Deposit Accounts

Recurring deposits accounts are for the benefit of those who would like to save a fixed sum every month over a long period so that
at the end of the maturity they have reasonable large sum.

Loans

Retail Loans

Retail loans are given to individual for meeting one time requirements like buying properties such as house or car, or for meeting
large one time expenses. Generally the entire amount is given to the borrower upfront. In some cases like buying a flat under
construction, the loan may be disbursed in installments according to the payments to be made to the builder.

Repayments start after the entire loan is disbursed. Till then only interest is recovered from borrower. Loans are paid in periodical
installments such as monthly or quarterly. Interest is charged by banks, every month, on the balance outstanding in the loan account.

Personal Overdraft

Those with fixed income or salary income invariably run out of funds at certain times and they may not want to touch their savings
or breaking a fixed deposit as it would cause loss. To manage such occasions banks offer Overdraft (OD) loan whereby they can
withdraw from their account over and above their balance for certain limit (OD Limit). The interest is charged for the amount
utilized for those days. Such arrangements are usually given for one year and renewed every year.

OD limits may be secured or unsecured.

Credit cards

In Credit card, the card holder gets some time to pay for the purchases or cash withdrawals made. The amount up to which the card
holder can make purchase is called “credit limit” and it is fixed according to the credit worthiness of the card holder.

Business Credits

Term Loans

Funds required for acquiring fixed assets are given as longterm loans which are repaid in installments. The period of repayments
and periodicity of installments are fixed on the basis of estimated profits and cash generations of the company.

Working Capital Facilities

The amount required for financing current assets is called working capital and it will be ever changing. Hence the financial
assistance is provided in the following forms to meets the working capital requirements of the company.

Overdraft

Similar to personal overdraft, limits are given to business entities to meet the requirements.

Cash Credit

The most common and popular facility for financing working capital requirements is the cash credit. The withdrawing limit is
against the inventory, stocks and debtors or book debts.

Post Sale Finance or Trade Finance

Overdraft, Cash credit loan facilities are given to finance working capital requirements. For financing the post sale requirements
following facilities are provided.

Cheque Purchase & Bill purchase

Cheque issued by purchaser of goods, have to send for clearing or collection and this entails delay of one to several days. Banks
agree to lend the amount of the cheque as soon as the cheque is deposited and the advance is recovered when the cheque is realized.

Banks also give advance against documentary bills for collection and recover the amount when the drawee pays the amount.

Financial Services

Distribution

Mutual Fund Units

Investing in shares is rather tricky because of volatile and no one predict the movement of share prices. Individuals are best advised
to take the help of professionals for their investment.

Mutual Funds collets funds from investors and invest in shares and bonds. They have the expertise in judging the companies and in
taking right decisions. Since banks have the largest reach of customer base, MFs seeks the help of banks to sell and banks are happy
to help as they get commission income.

Insurance Products

Life insurance companies have tied up with the banks to offer their life insurance and saving products (endowment policies, ULIP’s,
Non-Life Insurance etc) to individual customers of banks. Banks also offering insurance products is called “bankassurance” and it
has been successful business model the world over.

Collection of Taxes and Bills

Banks are now authorized to collect taxes like Income tax, sales taxes, excise tax, customs duty and property taxes. The amounts
collected are remitted to respective accounts and banks.

A great convenience offered by banks is accepting payment of utility bills such as electricity, telephone etc. In the process, banks
earns commission and also get to maintain the accounts of the utility companies.

Safe Keeping

Safe Keeping Vaults (SKV)

Providing safe keeping facility of valuables is a traditional function of banks. Banks continue to offer the facility by providing to
customers small safes. The safes are kept in strong rooms. Safety and confidentiality are ensured by verifying the identity of the
customers before allowing access. Banks charge rents on annual basis.

Safe Custody is used to accept the sealed packets of valuables. The packets are kept in the banks safe. The customers were given a
“safe custody receipts” which had to be returned to the bank when the customer wants to take delivery of the packet.

Advisory Services

Investment Advice

The investment opportunities available today are many. For instance, the number of MFs and the number of funds they offer are
large. Investors need professional’s assistance to select the right investments options, track the performance of MFs and to switch
the investments at the opportune moments. Banks offers such assistance to their large customers, called private banking customers.

Banking Channels

Earlier banking services were provided by only one channel, namely branches. Today nearly 70% of the transactions take place in
other channels like ATM, POS as they are popular for following reasons.

 Customers have access to 24 hours of the day.

 The cost of providing services through such channels, are much lower than the cost of providing such services through
branches.

The non-banking channels available for customers are

  ATM
 POS (point of sale) terminal for debit and credit cards
 Phone Banking (Call center)
 Internet Banking
 Mobile Banking (SMS through Mobile Phones).

In ATM, customers can use additional facilities like cheque book request, cheque deposit in addition to cash withdrawal.

Risk Management

Banks face a number of risks in order to conduct their business, and how well these risks are managed and understood is a key
driver behind profitability. Some of the main risks faced by banks include:

 Credit risk: Risk of loss arising from a borrower who does not make payments as promised.
 Market risk: Risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to
the change in value of the market risk factors.
 Operational risk: risk arising from execution of a company's business functions.
Introduction to Customer Insight

The most important asset to the success of any business is its customers. Today’s banking customers are more demanding than ever.
They want products and services that are tailored to their specific needs, delivered through the channels that are most convenient to
them. In today’s evolving marketplace, customers face a “world of extremes” characterized by unprecedented complexity, intense
competition and market polarization. Customers are increasingly demanding relevant value propositions that meet their individual
needs and preferences and seek out those who are able to provide them. Retail banking profitability is connected to the customer
insight. Customer Insights will help and enable banks to provide superior customer service.

What is Customer Insight?

The terms “'customer intelligence', 'customer insight', 'citizen insight', 'customer focus', 'customer-centric'” are often used
interchangeably, which can be confusing. A common definition of 'customer insight' relates to "A deep ‘truth’ about the customer
based on their behavior, experiences, beliefs, needs or desires, that is relevant to the task or issue”

Customer Insight represents a deep understanding of customer needs and the drivers of customer behavior at a level well beyond
what customers are able to articulate themselves. Customer Insight leads to opportunities for creating solutions that are tightly
linked to the core drivers of human needs and behavior. Developing Customer Insight includes:

 Understanding the explicitly stated or “articulated” needs of customers and potential customers, but more significantly
identifying their “unarticulated” needs.
o “Articulated Customer Needs” – Needs that are recognized and communicated (stated) by customers
o “Unarticulated Customer Needs” – Needs unrecognized by customers that – when recognized and satisfied –
lead to products and services that delight them

For many banks, understanding and meeting the needs of their customers, particularly their most profitable customers, is critical to
driving sustainable growth Every bank would like to have a rich well of descriptive and predictive insight about customers. With
available resource, the bank could know, for instance,

 that savings account customer Mr.A just bought a new house and is thinking about a home equity line;
 that credit card holder Mr. B has a college-age daughter and seeks a student loan from a local institution; and
 that Ms.C has had two unsatisfactory phone conversations regarding his investment advisors and is thinking of switching to
an online investment site.

With Customer Insights, bank employees will be well informed on all aspects of the customer so that they can quickly respond to
inquiries, effectively sell more products, and quote accurate product pricing. Customer Insights will facilitate quick access to
detailed credit status, pricing, quotes, orders, sales information, history information and more. Banks will also gain a 360-degree
view of the customer’s circumstances and relations with the bank could better meet the customer’s needs and save or expand the
relationship. The more customer knowledge the banks have, the easier it is to provide exceptional service and create new revenue
opportunities in existing customer base. By developing unique, proprietary insights about their customers, banks can create a more
tailored and relevant banking experience which sets them apart from the competition. Customer insight is rapidly rising up the
agenda of any organization. In essence, customers are the lifeline of business and are to be handled with insight.

Customer Insight will also help the banks in strategic innovation with the engagement of customers in this innovation process.
Customer Insight is the foundation for “Customer-Inspired Innovation”.

 Innovation becomes “strategic” when it is an intentional process focused on creating breakthroughs in the value delivered
to customers.
 Engaging customers as partners in the innovation process is essential for creating breakthroughs in:
o New Product/Service and category development and
o Corporate strategy development

In practical terms, customer insight entails:

 the use of data about customers to better understand their needs and expectations
 the application of this understanding in the design and delivery of services.

Insight is not just about:

  Collecting or purchasing data. Data often exists already and only needs synthesizing into useful forms
 undertaking demographic segmentation – it takes a broader range of data, tools and techniques to generate a rich
understanding of the customer
 a one-off activity – it is an ongoing journey.

Understanding customers

Getting customer insight only via statistics may not be the way to go because these track the middle of the picture and not the before
and after part of the picture.

The ‘what happens after-the-sale / service part’ may be the biggest of challenges in learning about the insights to customers’
thinking. This is where customer insight becomes so very important but is not often tracked. The only way this can be tracked is for
those selling the product/service need to get the feedback from their customer(s)/client(s).

Effective use of insight can help to:

 Accelerate an enterprise-wide view of customers

 Understand and respond to customer-specific needs
 Speed up customer on-boarding and drive greater retention
 Enable dynamic sales, customer service, marketing, and compliance processes
 Deploy front office applications in a multi-channel environment.
 deliver efficient and effective tailored services
 target resources according to priorities
 develop responsive services that encourage and reflect customer engagement
 enhance customer service and improve satisfaction
 Inform strategic-level planning and decision making, community engagement and improvement.
 Develop appropriate products and service propositions by segmenting and analyzing customer value.
 Respond to customer needs by providing the best resources and responses to representatives.
 Develop scorecards with appropriate objectives and measurements.
 Leverage data collected in risk and compliance processes to achieve competitive advantage and Return on Investments
(ROI).
 Build virtual real-time and historic single customer and business views to empower enterprise integration.

However, big obstacles stand in the way of this idea. In most banks, customer information is scattered across unrelated and different
databases owned by different lines of business. Often banks as the result of mergers and acquisitions over the years—have multiple
IT systems and data repositories that duplicate cross-enterprise functions and store customer data in multiple places. This can result
in an inconsistent experience for a customer who deals with the bank using different channels. The inability of the bank to develop a
comprehensive view of their customers also limits their ability to cross-sell and up-sell based on customer needs. The insights
hidden in those databases should be revealed, shared and published across the institution, but at the same time, data must be kept
strictly private and protected. Resolving these challenges requires IT investment at a time when bank IT budgets remain flat overall.

Amid these realities,

 how to get customer data under control?

 How to transform it from information into insight?
 What do financial institutions gain from customer analytics, and
 how should it be implemented?

This can be achieved through the implementation of customer analytics in Banking.

Customer Analytics and Benefits

1. React quickly to changes in customer behavior.

“As customers bank online, through ATMs or through mobile payments, they are sending subtle signals about their preferences and
frustrations with their banking relationships. Unless the customer activities are closely monitored, banks often don’t know what
customers want or are unhappy with until it’s too late. So some banks use analytics software to watch to immediately spot changes
in customer behavior, generate alerts, detect service problems and use that knowledge to make a sale or save a relationship.

2. Reduce customer and counterparty risk.

Analytics can help banks monitor the creditworthiness of borrowers and the reliability of counterparties. Integrated customer
databases will set the foundation for customer analytics, to assess at a glance bank’s exposures to ailing counterparties and troubled
clients. It will also be able to create 360-degree views of clients, for instance, gaining consolidated views of a customer’s accounts
in multiple cities around the world, to decide whether or not to extend more credit to that customer.

3. Reduce operational risk.

“Basel II rules are making banks look more closely at their operational risk. An unified data warehouse with an overlay of analytics
will reduce the operational risk associated with inconsistent reporting. By eliminating redundant systems and by improving the data
quality, the traceability can be improved. The time spent each day on manual data management tasks will get reduced from several
hours to less than 30 minutes, enabling employees to focus on more important tasks.

4. Fine-tune marketing campaigns.

Analytics has long been used in retail environments to improve marketing campaigns. Banks were not the first to adopt analytics for
marketing, but within banks, marketing departments have been among the first to recognize the value. Banks brought in customer
analytics to test its assumptions and to create product propensity models. For instance, the bank’s marketers might have an
assumption that 45 percent of customers who open checking accounts also open savings accounts. The marketing team inputs the
numbers around each campaign, analyzes the results and adjusts its models accordingly. More recently, the bank has been using its
customer analytics platform for predictive analysis, for instance, to forecast revenue and make sure a campaign has acceptable
return on investment before it is launched.

5. Predict the right communications channel to use for each customer.

Ideally, banks would like to determine the best combination of price and response rate for different customers and segments, by
product. A predictive model helps determine which channels are important to each customer, according to customer preference,
while factoring in the cost of that contact channel to the bank. If a model predicts that a customer will bring in $100 worth of profit,
and there’s a 60 percent chance that person will respond to a phone call, then it might make sense to add that person to a
telemarketing campaign, even though a phone call costs two dollars versus two cents for an e-mail.

6. Efficiently provide branches with lists of solid sales prospects.

Banks analyze a combination of household data and product ownership data every month, and then supply each of its branches with
a list of customers most likely to show interest in additional bank products. For example, customers who have a direct deposit
account and credit card through the bank might be good candidates for a debit card promotion. Customers with a checking account
and mortgage are good prospects for a home equity line of credit.

7. Manage debt collection. Customer Insight / analytics help the debt management and collection. Customers who have fallen
behind in their payments and those who might be having financial difficulties can be flagged. Banks also use analytics to segment
the customer portfolio into customer types so it can assign the right type of collections effort to each case.

8. Detect credit card and online banking fraud.

Banks have long used customer insight and analytics to detect card fraud, looking for unusual behavior that might indicate online
banking fraud. For instance, if a customer suddenly logs in from a different address, that could indicate foul play. If they’ve never
used online bill pay before, and they suddenly use it, or if the frequency of their payments goes up dramatically, those could also be
red flags.

9. Provide better research and reports to salespeople.

Banks use customer insight / analytics systems to improve the sales. Banks apply analytics to reveal new insights about sales
opportunities with its financial institution and enterprise customers. Armed with this analytically derived information, sales people
can give more timely, targeted and relevant presentations to customers.

Developing customer insight

Customer insight is an ongoing process that evolves with changes to customer and customer needs. It should be built into everyday
mechanisms for performance management, decision making and engagement.

People and skills

In practice, customer insight is often developed by an internal team – recognized experts with knowledge of the tools and
techniques, access to data, and the ability to bring the two together.

Insight tools, data and techniques Customer insight is as much about organizational culture and working practices as it is about
specific data sets and new tools. However, there are a number of tools and techniques available to support customer analysis.

 Analytical techniques for understanding customers

o Customer Segmentation
o Customer journey mapping
o Market research methods for understanding customers
o Market research tools
o Internal sources and repositories of data and
o External sources and data repositories

The following techniques can help, pull together and present customer insight to show who the customers are, as well as their
experiences and preferences.

Customer segmentation

Segmentation divides a target audience into groups by common characteristics and needs. Once groups have been differentiated,
councils can target and tailor resources appropriately. Segmentation information is often combined with geographic information
system (GIS) mapping to show where different customer groups live.

Customer journey mapping

A customer journey map is a way to describe a customer's experiences through a life event, intervention or interaction with one or
several services, and the emotional responses these provoke. Customer journey mapping can then be used to design service
improvements that reflect the customer’s experience.

Market research methods for understanding customers

Using specific market research methods can help to generate information about customers, how they experience services currently,
and how they would prefer to receive them in the future.

Market research tools

Consultation

Consultation, or directly asking the prospective customers what they need, is a basic source of insight, and is often legally required.
Neighborhood charters and other local forums for agreeing priorities and delivery targets can serve as a way of understanding local
preferences that goes beyond formal consultation. As with most tools, consultation is limited as it only reaches a small sample of the
population. It needs to be combined with other sources of information to bring about true customer insight.

Connecting with communities: communications toolkit

Focus groups

Focus groups or panels are a more qualitative form of consultation that brings together a small number of service users to examine a
particular issue or understand detailed preferences. This can provide a rich source of information and examples to support data
analysis.

Surveys

Surveys are a form of consultation and are a useful way of understanding user’s views in a quantitative way. Survey data can be an
especially useful input into segmentation exercises – for example, to understand the relative satisfaction of different groups.

Social media

Councils are increasingly using tools such as blogs or discussion forums and social networking sites like Facebook to supplement
other forms of consultation and to engage with people who prefer to communicate online.

Usability testing and website analysis

Assessing systems and websites from the customer's perspective can help identify where the banks are letting the customer down,
even if they fulfill technical requirements. Website visitor statistics also provide a source of data about service use and channel
preference that can be fed into insight analysis.

Internal sources and repositories of data

The challenge in the large amounts of data which are already available is to use this data to inform decisions.

Local information systems (LIS)

An LIS brings together data from various sources to form a repository of local information for use in policy and decision-making.

Frontline and customer service staff

Staff are a key source of information on the preferences and concerns of customers. Holding interviews and workshops with staff
helps to capture their views and experiences.

Customer relationship management (CRM) systems

CRMs are an increasingly common source of information about customers and their contact with councils. The more services
covered by the CRM system, the more powerful the data source can be. The challenge, however, is to avoid duplication of customer
details.

Service area data

Individual service areas hold information and data about customers. This can include transaction records, which can be combined
with other sources of data to gain a deeper understanding of service users.

Banks team need not necessarily gain a lot of new skills, but they will need people to:

 Analyze and manipulate data

 Present and use data to inform strategy and policy
 Understand and use market research techniques and methods
 Communicate the results of customer insight analysis in a way that makes an impact on the organization.

Established processes are vital to collecting, analyzing and disseminating information. Business processes that should be informed
by customer insight include:

 service planning
 business cases
 Engagement and empowerment.
 Data and systems

Good data is the foundation of customer insight analysis. Information collected about customer / prospective customers must be
stored and shared within and between organizations. Data sets – particularly those purchased externally – need to be held in one
place and made available to the whole organization.

Understanding an individual customer's interactions – a 'single customer view' – is critical to setting up a single 'clean' data source
on a customer. This can then be used to develop reliable customer analysis.

Standard way to approach a customer insight project:

 Identify the objectives for using insight and the related question or issue.
 Work out how better understanding your customers will help you.
 Undertake an audit to establish what people, processes and data you already have, the data you need and where to get it.
This includes identifying the tools you will use.
 Develop a model for customer insight in your organization and a plan for achieving it.
 Undertake a pilot to help build skills and stimulate demand for customer insight throughout your council.

Customer insight and data protection

Because customer insight often involves sharing and manipulating large amounts of personal data, it is subject to data protection
laws. Data protection laws do apply, where data is being shared between organizations. Sharing of personal information should be
supported by a sound business case and preferably accompanied by a privacy impact assessment. This should identify the intended
benefits of collecting the data and show that the council has identified and addressed any risks to data protection.

For most customer insight purposes, as banks require information about trends within the customer / prospective customer
community – personal data can be anonymised keeping the aggregate level data. Data should therefore be shared in a way that
minimizes or avoids the use of personal identifiers.

All customer insight projects should start with a clear sense of how the knowledge will be used to make decisions.

Following is a list of some of the principal applications in customer insight projects:.

 Inform strategy and policy: Information on customers / prospective customer can be used to inform decisions and to input
into policy or scrutiny reviews.
 Manage performance: Understanding customers' needs and experiences can help to understand where services are
performing well or badly.
 Market services more effectively: Understanding different groups of customers makes it possible to market services more
effectively, including being able to encourage take-up of services or different channels to particular groups.
 Change behaviours: Social marketing techniques that employ a deep understanding of the customer to provide information,
products and services can be used to change people's behaviour.
 Improve service design: Knowing what customers want and need from a service can help identify areas of weakness and
feed into the design of that service.

Integrating customer information can fuel bank's growth. By creating a single customer view, bank can enhance analysis and
planning, and improve the development and deployment of multi-channel cross-sell and retention propositions. And measure the
effectiveness of marketing, sales and service strategies.

Customer insight solutions can be based on software, hardware and services combined with best-of-breed applications and tools
from alliance partners.

Any customer insight solutions should provide complementary analytics to empower multi-channel banking and successful staged
core systems transformation, integrating closely with risk and compliance to share corporate data.

Challenges in gaining customer insight:

The challenge with gaining customer insight is two-fold:

1. How can you know that what the customer says is true?

2. How can you know what the customer does with your product/service?

The first question can be partially resolved by using a variety of qualitative and quantitative techniques (focus groups, perceived
customer value surveys), and then seeing how the responses/results "converge". This is not a simple process, but it's critical -
especially when you're using that data to innovate, and not just to improve an existing process or product.

The second question is partially answered by transaction data, but additional work, such as ethnographic study, can be absolutely
critical in finding out how your service or product is actually used. And, given that your "service" is really your entire, lust-to-dust
relationship with a person, you really have to understand how you engage someone, how that engagement compares with other
sources of engagement, and then onward from there (exploration, selection, use, retirement of the product/service/relationship).

Ultimately all of this data should be in service of the question: What is the larger goal of the customer? It could be to solve a
problem, to get closer to an aspiration, to serve the ego. People don't buy a drill for the ability to drive a drill bit. They buy a drill to
make a hole. They want a hole, not a drill.

This is in part why this quest for insight is especially tricky when we try to innovate. Why does a customer want a hole? To put a
screw in. Why? For many customers: To hang something. So, if we want to innovate, what we really want to do is to come up with
something that helps people hang something. We might be able to circumvent having to continually improve your drill.

Pragmatically, the following can be tried:

1. Focus groups to determine the benefits sought by the customers.

2. Determine the aspects of this benefit

3. Do a survey.

4. Using factor analysis or similar technique, determine which aspects are most important, and which are truly independent of each
other.

5. Do a bigger survey, using a reduced and sufficiently independent set of value drivers.

6. Survey Non-Customer, or customers of competitors.

7. Use factor analysis again and determine how the customers "clump" in their needs.

If you want to take it further, you can also ask respondents to score how well you, and your key competitors, provide value along
these value drivers. That can give you a score relative to both the value drivers as well as to your competitors. Real insight can only
happen through dialogue, and surveys aren't enough. Imagine approaching your spouse/significant other and saying, "Dear, I'd like
to really understand you more than I do, and to get feedback about what I might do to improve our relationship. Would you mind
filling out this survey?". Deep customer insight is usually complex and requires a multi-faceted approach, integrating feedback (of
various types), transactional data and a dash of intuition.

Conclusion

Banks can no longer think of their customers in traditional, demographic-based segments and successfully deliver a differentiated
experience. Customers walk in to the Bank with a specific mission, driven by fundamental, personal values and attitudes. Customers
who share the same surface characteristics may well have meaningfully different needs and preferences.

Developing deeper insights through more sophisticated approaches to segmentation and innovative analytical models is a key step
toward creating a more customer-centric banking experience. Banks need to know how their customers make decisions, why they
bank there, and what their needs and preferences.

Armed with these insights, banks can develop services strategies that are better aligned to their target customers. Going forward, the
more tailored and personalized the experience that banks create for their customers, the greater the differentiation from their
competitors and ultimately, the greater the success.
Objective

The objective of this module is to give the reader an overview of the basic accounting concepts and terms applicable to bank
accounting, the various financial records maintained by a bank and the financial statements prepared by a bank.

Financial Accounting:

What is accounting?

Financial accounting involves:

 Understanding the standard accounting principles

 Applying the accounting principles while recording all transactions
 Classifying the recorded data under appropriate heads or accounts
 Summarizing accounts into various account statements

The following diagram displays the role accounting plays as an information system that aids business and economic decisions made
by user-decision makers.

What is the purpose of accounting?

Financial accounting information

 Helps the owners, managers and external users such as investors, stock exchanges, government authorities such as income
tax officials to understand the financial performance and position of any organization.
 Helps to understand the following aspects of any entity
o Whether the entity has made a profit or incurred loss during the accounting period
o Whether the profitability of the entity is adequate in terms of return on capital
o The values of entity’s assets, liabilities

Concepts of Accounting

 Cash Basis
 Accrual Basis

Cash Basis:
Entity records a transaction of income when realized or an expense when incurred. Ex. Rent paid – The transaction is recorded when
the rent is actually paid. If the rent for the month of March is paid in 10th of April, and a financial statement is prepared in 31st
March, the rent paid for the month of March will not be reflected in the statement prepared as on March.

Accrual Basis:

All the income and expenditure that has become due and is receivable or payable (in due course) is recorded. Accrual based
accounting is also known as mercantile system. For example, the rent for the month of March although paid in April, will be
recorded as ‘rent payable’ in the books of account in the month of March. Similarly, all the incomes that have become due and
receivable will be recorded in the books of account even if it is not recorded.

Book-Keeping Process

It is important to draw a distinction between book keeping and accounting. While book keeping is the simple recording of business
transactions, accounting is the use of the information recorded to produce reports for management, share holders and others.

Book-Keeping is a part of accounting and is concerned merely with the recording and keeping records of business transactions
accurately and systematically in accordance with certain well-accepted principles and rules.

All business transactions over a specified period of time are recorded and summarized as part of book-keeping. Such a specified
period of time is called the accounting period. This period may be month, a half-year, a full year or any length of time. To find the
profit or loss for an accounting period, only those transactions that fall within that period is taken into account.

Double Entry System for Accounting

As per this system, every transaction affects two or more accounts and is recorded in two or more accounts. One account receives
the benefit of the transaction while the other gives the benefit. The two aspects are called debit and credit. Debit and credit
transactions are posted to an account and the account balance is arrived at. Account balance refers to the amount of money
appearing against an account head.

Debit

An accounting entry, which results in either an increase in assets and expenses or a decrease in liabilities/networth. It is represented
by the abbreviation “Dr.”. For example, Bank charges debited to a customer’s account.

For posting the transaction, bank charges debited to a customer’s account, the customer’s account will be debited while charges
collected account will be credited.

Credit

An accounting entry which results in either an increase in liabilities and income or a decrease in assets or expenses. It is represented
by the abbreviation “Cr.” For example, interest credited to a customer’s account. Interest credited to customer’s account, the
customer’s account will be credited with the interest amount while interest account will be debited.
Types of Accounts

Accounts can also be classified as personal accounts, real accounts and nominal accounts.

Personal Accounts: are accounts of parties with whom business is carried on. These may be accounts of: Natural persons e.g. Mr.
X’s Account Artificial/Legal Entities e.g. ABC & Co

Accounting of Personal Accounts: Debit the Receiver Credit the Giver Real Accounts: are accounts of assets/properties in/with
which business is carried on. E.g. Building Account

Accounting of Real Accounts:

Debit what comes into the business Credit what goes out of the business

Nominal Accounts: are accounts of expenses/losses a business incurs and income/gains a business earns. E.g. Rent Paid Account

Accounting of Nominal Accounts:

Debit all expenses and losses Credit all incomes and gains

Assets & Liabilities Assets Assets refer to the properties owned by a bank and debts due to it from other parties that can be
converted into cash.
It can be further classified as:

 Current assets: refer to temporarily held assets meant for conversion into cash within a short period of time. Includes
Cash, Investments and Accounts Receivable.
 Fixed Assets: refer to assets which are of permanent nature and are held for use in the business and not for sale. Includes
land and buildings, furniture and fixtures and plant and machinery.
 Intangible Assets: refer to assets that lack physical existence. Includes goodwill, copyrights and patents.

Liabilities
Liabilities refer to amounts owed by a bank to other parties either for deposit of money in the bank, the purchase of goods on credit
or for the purchase of assets on credit, loans borrowed, services received on credit and shareholder money. Liabilities can be further
classified as:

 Current liabilities: refer to liabilities required to be repaid within a short period of time, usually one year. Includes
Deposits taken from the public, other banks and institutions, borrowings in India and outside from other Banks.
 Long term Liabilities: refer to those liabilities that are repayable for a period beyond one year. It includes Share Capital,
Reserves & Surplus. In essence, all monies deposited in a bank are liabilities from the bank’s point of view, while all forms
of lending/investment by the bank are its assets.

Income & Expenditure

Income
Refers to income earned by a business by way of sale of its products and services.

Expense
Expense, as the name suggests, refers to expenditure incurred by a business.

Suspense Accounts:
Suspense Accounts are used to store short-term funds/securities until a permanent decision is made about their allocation. Or route
entries when accounting entries for certain transactions cannot be determined or when a mismatch of accounting entries in an
account occurs. The balance in the suspense account is subsequently scrutinized and suitable rectification entries are passed.

Contingent Accounts:
These are accounts that are maintained in order to monitor and keep a record of contingent or conditional future liabilities. These
transactions have no direct effect on a bank’s position. Such accounts are not taken into account at the time of preparation of the
Trial Balance, Profit and Loss Report and the Balance Sheet. For example, Letters of Credit opened, Guarantees issued, etc.

Trial Balance

In double entry accounting system, for every transaction, the amount involved is entered on the debit side of one account and the
same amount is entered on the credit side of another account. Every debit is matched by an equivalent credit. Therefore, when the
debit and credit balances in various accounts are listed and totaled, the totals will tally.

Trial balance is a list of closing balances in all accounts with the debit and credit balances written separately. The total of debit
balances must tally with the total of the credit balance. When the balances do not tally, it indicates there is something error or
mismatch in posting and or in calculating the balances in the account or in totaling the two sides of the Trial balance.
Main purpose of trial balance is to check the arithmetical accuracy. It can be prepared based on following principle.- Debit: All
expenses, losses and assets Credit: All Incomes, gains and liabilities

The Chart of Account

This is a list of all accounts based on their codes which ensures that the accounts are grouped as per their type, classification,
cost/profit centre-wise and currency-wise defined as in the accounting system.

The hierarchy of grouping of ledger accounts in the Chart of Accounts is highlighted by the following example wherein the
“Balance with Banks” is arrived at by grouping “Balance with Banks in India” and “Balance with Banks outside India”. Each of
these balances are arrived at by grouping “Balance held in Current Accounts” and “Balance held in Deposit Accounts”:
Inter Branch Accounting

All accounting entries pertaining to transactions which are affected between two branches of the same bank are routed through the
Inter Branch account. Such transactions could be in the nature of cheques sent for collection, telegraphic transfers, transfer of
expenses, transfer of customer accounts and so on. lnter-branch entries may be routed through the Head Office/the Regional
Office/directly between branches.

Inter Bank Accounting

All banks maintain accounts with the Central Bank, through which all inter bank transactions, are routed. Such transactions are
mainly of the following nature:

 Clearing Transactions
 Drawing and Collection Arrangements
 Call Money and other Treasury related activities
 Payment System Activities – RTGS / NEFT

Reporting

Types of Reports

Regulatory Reports: refer to those reports which a bank is required to prepare in order to fulfill the requirements of the Central
Bank which is the regulatory authority for all banks. Examples: Statement of key banking indicators. There are also other regulatory
bodies like Securities & Exchange Board of India (SEBI), Government Departments like Income Tax Department, Customs &
Central Excise Department, etc.. Any reports generated and submitted to them also comes under the Regulatory Reports category.

MIS Reports: refer to reports prepared by a bank for internal management purposes. The nature and type of these reports would
vary from bank to bank depending on the individual requirements of each bank’s management.

Examples: Deposits-Interest Accruals / Payment Report, Deposits Paid Report, Matured Deposits Due Report, Unclaimed Deposit
Report, Account Listing
Examples: Loans- Limits Sanctioned Report, Collaterals Report, Credit Rating Report, Overdrafts Report, Group-wise Exposure
Report

Control Reports: refer to reports prepared by a bank for internal control purposes. Such reports enable the management in its
decision making. Eg., Monthly Tally Report of different GL balances with the respective account balance totals.

Generation of Reports
Reports are mostly generated for the following areas:

General Ledger

This is a book of account and is a collection of the control accounts of all the subsidiary ledgers, accounts of all assets held by the
business, all liabilities of a business, all expenses incurred and all incomes earned by a business and other accounts like suspense
accounts, contra accounts and so on.

General Ledger System, as the name suggests, refers to the system by which a business (in this case a bank) records and
consolidates its day-to-day financial transactions relating to the acquisition of funds and their allocation.

It provides the business with a conceptual and analytical framework for financial decision making by: Recording details of
transactions pertaining to all assets, liabilities, income and expenditure items
Subsidiary Ledgers

Separate ledgers are maintained by a bank for different types of accounts. These ledgers contain account-wise details of day-to-day
transaction postings. They are so called because they are subsidiary to the main ledger that is the General Ledger, in which control
accounts (totals of each subsidiary ledger) of these ledgers are maintained. The totals of these ledgers are tallied with their
respective Control Accounts appearing in the General Ledger on a daily basis.

Profit and Loss Statement

The profit or loss is ascertained by listing the balances in all the nominal accounts, the expenses on the debit side and income on the
credit side, and finding out the net balance. The consolidated listing of all nominal accounts is called the Profit and Loss account.
Since profit earned or loss incurred over a period is ascertained, the title of P & L a/c is written as Profit and Loss Account for the
Period Ended ____(date)_____. If the credit side (income) total is more, the business would have made a profit and if the debit side
is more it will indicate a loss. The balance in the nominal account is transferred to the P & L account, which is also a nominal
account at the end of the year. i.e. on financial year closure.

Balance Sheet Report

When the P & L a/c is prepared, all the nominal account would have been closed and only the real and personal accounts will be
left. Balance in the real accounts represents Assets of the business such as cash, furniture, computer and building. Balance in the
personal accounts represent amounts owed to the business by debtors (assets) and amount owed by the business to its creditors
(liabilities). Therefore, the balance in the real and personal account represents the assets and liabilities of the business. The debit
balance represent the assets and the credit balance the liabilities. These balances feature in the balance sheet. The liabilities appear
on the left and assets on the right.

The parameters that need to be defined are:

 Level of Reporting: Branch Level/Nodal Level/Bank (as a whole) level

 Period of Reporting
 Multi-currency classification
Who is a Customer ?

Like Individual persons, government organizations like railways, private limited companies, partnership firms, companies, and trust
associations clubs can own assets and have legal rights and obligations. All such entities are recognized by law can also maintain
various types of accounts with banks and all are customers of the bank.

Legally recognized entities have almost same rights as individuals and can do many of the things that individuals can do including
running business for which they can borrow money too. Since legal entities are fictitious persons and do not have physical presence,
they have to exercise their rights and discharge their obligations through the individuals who run them.

Need for a Customer ?

The bank’s approach to a customer is changing drastically day by day and banks have started seeing customers with more focus on
relationship they establish and maintain with the customer than seeing a customer who has a deposit or a loan account with the
bank. With this change in scenario, banks have started giving high importance to the various types of information they gather and
maintain about a customer during the lifecycle of an account. Banks use the personal information they gather more to give a
personal touch to the relationship with the customer like by sending birthday wishes, etc.

Customer of a Bank and not a Branch

Also in earlier days customers were merely seen from the branch perspective, where the customer had an account and operated. But
the present scenario is to look at a customer from the Bank’s perspective. With this perspective in mind, banks have started
designing banking solutions for the customers like ATM’s, IVR’s, Anywhere Banking facilities etc. These facilities provide the
customer the convenience of banking not only from their home locations but from any other locations where the banks have
presence.

With this idea in mind the banks have started moving from a decentralised data environment to a centralised data environment. The
centralised data environment makes maintenance of customer related information easier, since the information is stored at the bank
level and not at the branch level; this also results in uniformity of data for a customer across the bank.

Types of Customers

There are 2 broad types of customers we come across in banking namely, Personal (Individual) & Corporate.

Personal Customers are

 Any individual who opens an account with a bank/institution

 Operates the accounts for personal use
 Information collected during account opening will contain personal data of the customer
 Personal customers may be eligible for only certain types of accounts/services of the bank
Corporate Customers are

 Any group of individuals like partnership firms, limited companies etc., who opens an account with a bank/institution
 Operates the account for business purpose
 Information collected during account opening will contain business data of the customer
 Corporate customers may be eligible for most of the non-personal types of accounts/services of the bank.

Individuals

Individuals can open bank accounts singly or jointly with one or more other individuals. In a single account only account holder can
operate the account like

 Enquiring about his/her accounts (balances, cheque status)

 Depositing cash / Cheques
 Withdrawing cash or issuing cheque for payment to others
 Transferring money from his account to another
 Cheque book request, ATM card or phone banking facility
 Asking for TDS (Tax Deducted at Source) certificate
 Account modification like including another name of person in the account and make it as Joint account

Mandate Holder / Power of Attorney

A customer may authorize another person to operate the account by issuing a letter of authority. Such as letter of authority is called
a “Mandate”. The mandate holder has all the powers that a customer has. Bank has to take signature and photograph of the mandate
holder along with the mandate.

The account holder may also issue a power of attorney that has the same effect as mandate. A power of attorney is a registered
document by which a person grants certain powers to another person. The account holder can invoke mandate and power of attorney
at any time by issuing a letter to the bank.

Nomination

According to law, a nominee is a trustee not the owner of the assets. In other words, he is only a caretaker of the assets. The
nominee will only hold money/asset as a trustee and will be legally bound to transfer it to the legal heirs. For most investments, a
legal heir is entitled to the deceased’s assets. For instance, Section 39 of the Insurance Act says the appointed nominee will be paid,
though he may not be the legal heir. The nominee, in turn, is supposed to hold the proceeds in trust and the legal heir can claim the
money.

Joint Accounts

Two or more individuals can maintain joint accounts with the banks. At the time of opening the account the bank has to obtain clear
instructions from them on how the account will be operated.

The common operational instructions are

Both Jointly – The account can be operated by both the account holders together only.

Jointly or Survivor – While the account can be operated by both the account holders together only, on the death of any one of
them, the balance becomes payable to the survivor.

Either or Survivor – Any one of the customer can operate the account. In case of death of a joint holder, the balance becomes
payable to the survivor.

Minor: - A minor is a person who has not competed 18 years of age. As per law, a minor can not be held responsible for not
keeping his words. In the circumstance, lending money to minor is a dangerous proposition. While banks do not lend to a minor,
they do open deposit accounts of minors to be operated by their guardians who are expected to protect the interest of the minors.
Proprietorship Concerns

A business owned by one individual is known as Proprietorship Concerns. Since only one individual is involved he is entirely
responsible for any debt of the business. This is similar to the individual account except the legal status of the account. In this case
the account is opened by the company name and proprietor operates the account on behalf of the business.

Partnership Firms

The partnership act defines partnership as “the relation between persons who have agreed to share the profit of a business carried on
by all or any of them on behalf of all”. The understanding between the partners are documented and recorded in a registered
document called “Partnership deed”.

Operations of a partnership account can be done by one or more partner as per the operating instruction given by them at the time of
opening the account.

Joint Stock Companies

Like a firm, a company owned by a group of persons, but unlike a firm, a company has a legal existence separate from that of the
owners. The properties of the company and not jointly by the owners, who are called as shareholders, as the capital of a company is
divided in to units of equal amount called shares.

Unlike partners, share holders are not personally liable for the debts of the company. The company is managed by Directors who are
elected by the share holders. The Directors, collectively constitute the Board of Directors, who appoint the Managing Director who
is responsible for the company in accordance with the policies approved by the board. The joint stock companies are the legal
entities registered with the Registrar of Companies. These companies are governed by The Companies Act.

Two major types of companies are

 Private Limited Company

 Public Limited Company

Following documents are required for bank to open the accounts

 Account opening forms signed by officials who will operate the account
 Latest list of Directors
 Certified copy of resolution of the Board authorizing for account opening and authorizing the officials to operate the
account
 Certified copy of Certificate of Incorporation
 Certified copy of Memorandum of Association
 Certified copy of Articles of Association
 Certified copy of the certificate of commencement of Business, in the case of public limited companies.

Trusts

Trusts are created by persons known as “authors” of the trust to carry on some activities for the benefit of a person or a group of
persons known as “beneficiaries”. “Trustees” are appointed by the author of the trust for carrying out the activities of the trust for
the benefit of the beneficiaries.

A Trust Deed is a document that specifies the objectives the trust, the names of the beneficiaries of the trust, the activities that can
be carried on by the trust

The bank has to allow operations strictly in accordance with the provision of the trust deed and should not allow the Trustees to
misappropriate the funds of the trust.

Society and Associations

Bank accounts can be opened only for the registered societies and associations. Cooperative societies have to be registered with the
registrar of Cooperative societies. The account is operated by any authorized signatory.
The bank has to collect the Bye Law of the society / association for opening the account and should allow the operations in the
account strictly as per the Bye Law. The Bye Law specifies the objectives and rules for operation of the Society / Association
Clubs

Clubs may be run a business or as a non-for-profit entity. It could be registered as company or society or trust. The procedure to be
followed for opening the account of a club and allowing operations will depend upon its constitution.

Government departments and Municipal Bodies Government departments / bodies / agencies can open savings accounts and
current accounts provided

 They do not receive any funds from government budget for their functioning.
 They submit declaration that they do not receive any budget allocation.

Bank – Customer Relationship

The legal relationship between a banker and a customer varies with the nature of the services rendered by the bank. The various
relationships can be summarized as

Service
Relationship-
Relationship-Bank
Customer
Loans Creditor Debtor
Deposits Debtor Creditor
Pledge of Security Pledgee Pledgor
Collection Agent Principal
Remittance Fiduciary Agent Principal
Agent of MFs, Bond
Distribution Customer of MFs, Bond issuer etc
issuer etc
Safe Deposit Locker Lessor Lessee
Advisory Advisor Recepient

What is a Deposit?
A Deposit can be defined as a Sum of money received from a customer by a bank for a specified period of time, on a specific rate of
interest, repayable on maturity or on demand by way of cash cheque, draft or any other legal means as desired by the customer

Types of Deposits

Deposits are classified into 2 categories namely Demand Deposits and Time Deposits.
Concepts in Deposits

Characteristics of a Deposit
A typical deposit will have the following characteristics

 Can be opened by a Personal or Corporate Customer

 Will be for a specified period of time say 15 days to 5 years
 Will earn interest at the agreed rate
 Will mature at the end of the agreed period
 Will be repaid to the depositor only or his authorized representatives or heirs or nominees
 A Deposit represents a liability for the bank.

Demand Deposits

Demand Deposits are repayable on demand by the customer(s). Generally demand deposits are withdrawn by the depositor by
issuing a cheque, which is an “instruction to the bank to pay the stated amount to the person named in the cheque”.

The following are a few types of demand deposits.

Current Account:

Current accounts are primarily meant for business people which may be Sole Proprietorship concerns, Partnership firms, Joint stock
companies, Trusts, Associations and individuals with large number of transactions. It facilitates the transactions using cheques.
Generally banks do not pay interest on balances in the current account but there are few countries where the banks do pay interest
for current accounts also. As no interest is paid in current accounts, there is no restriction for number of transactions in the current
account. Minimum balance required to be maintained in current accounts are higher than savings account due to higher transaction
cost.

Savings Account:

Savings accounts are demand deposit accounts offered for the benefit of individuals or group of individuals. Savings account differs
from current accounts in three aspects: 1. Interest is paid on balances in savings account 2. Business entities cannot open savings
account 3. Some banks impose restrictions on the number of transactions that can be put through savings accounts on a monthly
basis.

In the view of the absolute liquidity offered by demand deposits, banks pay low interest (in case of savings account) or no interest
(in current accounts) on such deposits. Cost of maintaining the demand deposit accounts is high in view of the large number of
transactions involved. The higher transaction cost is an important reason for payment of interest at lower rates or no interest on
demand deposits. This makes it a low-cost deposit for the banks and it is much sought after by banks.

Both current and savings put together, is popularly known as CASA deposits in Banks and in the present competitive banking
scenario, every bank eyes for capturing larger share of CASA Deposits to improve their profit margins.

Generally, interest is calculated on daily closing balance on such deposits and paid at specified frequency (generally half-yearly).

Banks also prescribe certain minimum balance to be maintained in savings accounts. While some banks insist on a minimum
balance at all times, others insist on an average minimum balance during a specified period (generally during a period of three
months). Minimum Balance is the amount of credit balance a customer/s is required to maintain in the Savings / Current Account at
any point of time.

If the minimum balance drops below the prescribed level, banks levy charges for non-maintenance of minimum balance. Some
banks prescribe a minimum average relationship value. i.e. combined average balance in the several savings accounts / fixed deposit
accounts maintained by the customer.

Almost all the banks generate and send statements of accounts on periodical basis to the customers to keep track of the transactions
in their account. Some banks used to issue passbooks to savings account.

The following facilities are offered in savings account:

 Cash deposit and withdrawal

 Clearing of local cheques
 Collection of upcountry cheques
 Electronic funds transfer
 Debit Cards
 Access to ATMs of even other partner banks
 Access to Internet banking
 Access to phone banking services
 Access to mobile banking services
 Anywhere banking services
 Standing instructions for making regular payments
 Electronic Clearing Services (ECS) facility for making regular payments like telephone bills, other utility payments, loan
repayments and also for receiving dividends, interest and pension.
 Automatic withdrawal of fixed deposits to meet shortage of funds in savings account by linking fixed deposits to the
savings account (reverse sweep from fixed deposit to savings account).

Types of Balances in Demand Deposits

 Book Balance - This balance is arrived at taking into account all transactions that have been posted to the account
including cleared items and non-cleared items.
 Cleared Balance - This balance is arrived at after taking only the cleared transactions.
 Available Balance - This balance is arrived at after taking into account all transactions including cleared items and non-
cleared items. But the withdrawals are not allowed on the un-cleared balance. Available balance will also include any
overdraft limits provided to the customer. But this excludes the portion of balance on which there is lien / freeze marked in
the account.

Overdraft Facility

Overdraft is a facility available to a customer provided by a bank. This is an arrangement with the bank whereby the customers can
draw from their current or savings account a certain amount over and above the balance in their accounts. Since the customers are
allowed to draw over the balance in their account, the facility is called an Overdraft (OD).

Overdrafts are of two types namely Temporary overdraft or permanent overdraft. Temporary overdrafts are provided to well known
customers in times of emergency for a shorter duration of time or for specific transactions only. Permanent overdraft is usually
given for one year and renewed every year subject to certain conditions. The amount up to which over drawings are permitted is
called the ‘OD Limit’.

The customer will be charged interest to the extent of amount overdrawn from the savings/Current account.

OD limits may be unsecured or secured by fixed deposits or any other securities. When the fixed deposit amount is matured and if
the customer is not willing to renew the same, the proceeds of the fixed deposit will be adjusted towards the overdrawn amount in
the savings/current account and the overdraft facility will cease to exist.

Issue of Cheques

The account holder of a Savings or a Current Account could opt for cheque book facility with the bank. Once a cheque book is
issued, the customer is expected to make all withdrawals from the Savings/Current Account through Cheques only. Generally, the
banks issue cheque books to the customer, free of any charges. But under special circumstances the banks may charge a nominal
amount towards issue of cheque books.

Stop Payment of Cheques

An account holder, who has issued a cheque from his account to a third party, may for various reasons request the bank not to honor
the cheque. This is called Stop Payment of Cheque.

The account holder will give the cheque particulars like cheque no, cheque date, cheque amount and the person to whom the cheque
is issued to the bank as reference. The bank on receiving this instruction will record the cheque details and track the cheque each
time a cheque comes for payment from the customer’s account. When the relevant cheque comes for payment, the payment will be
refused by the bank. The bank will also inform both the customer and the third party to whom the cheque was issued by the
customer.

 Banks may charge stipulated fees from the customer for this service.
 Stop Payment of cheques could be requested for Savings or a Current account.
 Only the drawer of the cheque could issue Stop Payment instructions or a person authorized to operate the account.
 The drawer of the cheque only could revoke a cheque under Stop payment.

Standing Instructions

A customer, who is required to make periodic payments to satisfy various obligations, need not make repeated withdrawals from the
savings Account. Instead the customer could issue a Standing Instruction to the bank to make the periodic payments towards his/her
obligations. The bank will act upon the instruction, debit the account of customer and make payments as required.

The features of this facility are as below:

 SI could be set up for specific payments/transfers like payment of Recurring Deposit installments on monthly basis,
payment of utility bills of the customer.
 Customer has to specify the account number and the amount to be debited, the beneficiary, the start date and end date of
Standing Instruction.
 The bank will carry out the Standing Instruction on the designated dates as specified by the customer automatically till the
end date or as required by the customer.
 The customer as desired could revoke the Standing Instruction in which case the bank will stop debiting the customer’s
account.
 The banks generally charge the customer for this service.
 When a SI is setup the customer is expected to hold sufficient balance in the account to meet the SI, If a SI is dishonored
for want of funds, the banks may treat the same as dishonor and charge the customer for the same.

Interest Accrual

The process of calculating interest amount from the last interest application day till the next date of Interest application is called
Interest Accrual. In this case the Interest amount to be credited to the account is calculated but not yet credited. Interest accrual may
be for debit interest or credit interest and applies to both Savings & Current accounts.

Interest Booking

Banks do Interest Booking (provisioning) activity during the month end / quarter end / half year / year end, from the last applied
date till the end of period as above for those account where next interest application date is still not yet due as at the above end of
period. This process will pass accounting entries usually not at the individual account level but at the General Ledger level to reflect
the correct interest expenditure / income for the period. Such provision entries are either reversed on the next working day or at the
time of next interest application.

Interest Application
The process of crediting the interest to the account of the customer and debiting the General Ledger account is called Interest
Application. Interest Application is done on pre-determined frequency as decided by the bank. This process of crediting the interest
to the account of the customer is normally called as Interest Posting.

Account Status

The status designated to Savings or a Current account, by the bank depending upon the operation of the account is called as an
Account Status. The different types of account statuses are listed below:

 Active - This status is assigned to an account, which is in continuous operation

 NEW - This status is assigned to newly opened accounts and such new accounts are closely monitored for the first six
months, to ensure happening of genuine operations and not any irregular / abnormal operations in the account.
 Inactive - This status is assigned to an account without customer activity for a specified period of time.
 Dormant - This is just like Inactive status, where the account is without any customer activity for a specified period of
time.
 Closing - This status is primarily assigned when a customer wishes to close an account but has outstanding checks. Credits
and deposits into the account are not allowed to accounts in closing.
 Closed - This status follows the closing status and after the balance in the account becomes zero and after the expiry of the
stipulated number of days for zero balance maintenance. This sentence may be added “While it is possible to move
accounts with all other status to ACTIVE status, CLOSED account will become permanently closed and it cannot be
brought back to any other status.
 Frozen – This status restricts certain external monetary transactions from posting to an account. This status is most
commonly used when legal action is taken against an account holder.

Time Deposits

These are the deposits types which repayable to the customer at the expiry of contracted period of time. The following are a few
types of Time deposits:

 Fixed Deposit accounts

 Recurring Deposits

Fixed Deposits

As the name indicates, fixed deposits are accepted for fixed period ranging from seven days to five years. The period may vary from
country to country. They are repayable only after the period for which they are deposited. Interest on fixed deposits is paid at regular
frequency (like monthly, quarterly) during the period of the deposit at fixed agreed rate of interest. The interest can also be re-
invested in the fixed deposit account. In this case, the deposit earns interest on interest and hence called cumulative fixed deposits.
Due to low liquidity, the rate at which interest is paid on fixed deposits are higher than on savings deposit.

The minimum amount of deposits varies from bank to bank with additional deposits in multiples of certain units (like 1000) and
depends on the nature and term of the deposit.

Banks may or may not permit the pre-mature withdrawal. In this case, interest will be paid only for the period for which the deposit
has remained with the bank. The bank may also levy penalty for early withdrawal / closure. Premature encashment without any
penalty is offered as an incentive to attract deposits.

In case of fixed deposits that are units based, customer can prematurely withdraw partial amount of deposits in multiples of required
units. Premature and penal interest are levied only on the withdrawn units and other un-drawn units continue to get contracted rate
of interest. Whenever interest rate revision happens upwards, entire fixed deposit can be prematurely closed without any penalty, for
the purpose of extension of deposits to get higher rate of interest benefit. However such a deposit should be extended for the full
amount and for the duration that stretches beyond the original maturity date.

To help customers tide over temporary requirement of funds, banks may offer loans against fixed deposit up to 85% (or as stipulated
by the individual banks) of the value of deposits. The rate of interest on the loan could be 1% or 2% over and above the rate paid on
deposit. On maturity, the deposit will be automatically adjusted against the deposit and only the balance, if any, will be repaid to the
customer.

Banks will also deduct tax from the interest paid on fixed deposits, either for the full interest earnings or if the amount of interest
paid to a customer exceeds certain amount in a financial year. The tax rule may vary from country to country depending on the rule
stipulated by the country. The tax will be deducted at source (TDS). The rate at which TDS is deducted also varies from country to
country and from customer to customer depending on the type of the customer. The TDS deducted have to be paid to the tax
authorities by the banks.

Bank issue a separate receipt of each fixed deposit. The fixed deposits can be encashed or renewed on maturity. Automatic renewal
of fixed deposit is also possible, incase the deposit holder places formal instruction for renewal. On the date of maturity, such
deposits will be renewed automatically for the similar period as the original deposit at the rate prevailing on the date of renewal. The
fixed deposit receipt (FDR) has to be surrendered to the bank at the time of renewal of encashment. Bank may also issue duplicate
FDR, incase the FDR is lost or misplaced. Fixed deposits cannot be paid by cash over and above certain amount as fixed by the
bank or by law enforcing authorities. Repayment on such deposits has to be by cheque in the name of the depositor or by credit to
the savings or current account of the depositor.

2 in 1 Account

2 in 1 accounts are FD linked savings account, which gives liquidity as savings account as well as higher interest rate as fixed
deposit account.

The money on the savings account in excess of the stipulated amount is swept into a fixed deposit (by auto sweep instructions) for a
particular period. This carries an interest rate higher than the savings account interest rate. If the money in the savings account is
insufficient to meet any debit transaction, the shortfall is withdrawn from the latest fixed deposit and credited to the SB account
automatically (reverse sweep) for honoring the cheque.

Features of 2 in 1 account

 Auto Sweep facility – Maximum returns

 Balance in excess of stipulated amount is automatically transferred to a fixed deposit (FD) for a period as instructed or as
per the product.
 The transfer (auto sweep) will be done daily / weekly depending on the bank policy
 FD formed through auto sweep will carry the rate of interest prevailing on the date of Auto sweep.

 Reverse Sweep facility – Maximum liquidity

 This facility will give easy access to funds in Fixed Deposit accounts
 Incase of shortfall in savings account to honor any cheque or debit instruction, Fixed Deposits will be automatically broken
to that extent of the shortfall. The remaining balance in Fixed Deposits will continue to earn higher interest at the original
rate applicable to the Fixed Deposits.
 Fixed Deposits will be broken in multiples of some fixed amount as stipulated by the bank.
 For the maximum benefit of interest, they will be broken on Last-In-First-Out (LIFO) basis. i.e. the fixed deposit last
opened / created is broken first.

 Automatic Renewal Facility

 When fixed deposits mature, they get automatically renewed with principal and accrued interest for a default period (as per
the product feature) or for a longer period, if specified by the depositor.
 All existing terms on payment of interest and premature closures as applied to existing fixed deposits shall apply to fixed
deposit linked to the savings account.

Recurring Deposits

Recurring deposits are for the benefit of those who would like to save a fixed sum every month over a longer period of one to five
years. It is equivalent to making fixed amount, as fixed deposit every month in such a way that all the fixed deposit will mature on
the same date. Since it is inconvenient to issue fixed deposit receipts on every month, the monthly deposits are accumulated in an
account. Interest paid on recurring deposits usually at the rate applicable to fixed deposit as the deposits cannot be withdrawn before
the due date. For default in making deposit in any month or for premature withdrawal, bank will levy penalty.

The maturity value of the recurring deposit account will be indicated to the depositor assuming that the monthly installment will be
paid regularly on the due date. If any installment is delayed, the interest payable in the account will be reduced and will not be
sufficient to reach the maturity value. Hence the difference in interest will be deducted from the maturity value as a penalty. The
rate of penalty is fixed upfront. Tax (TDS) is not applicable to interest paid in Recurring Deposit accounts.

Interest accrual (including catch-up accrual) and interest payment

Interest can be paid in any of the following modes:

 by cash
 by banker’s cheque
 by transfer to savings account
 by transfer to GL account
 by transfer to loan account

When interest becomes payable, the tax on interest, if any, must be deducted from interest and credited to tax withheld account and
the net interest should be credited to the interest payable account.

Interest capitalisation/compounding

Capitalizing / Compounding interest involves no payment of interest to the customer, but it is notionally credited to the Time
Deposit Accounte / Cumulative Type of Deposit. Thus the customer would be eligible for higher rates of returns on the Investments
made. At the time of maturity of the Term Deposit / Cumulative Type of Deposit, the Interest amount is paid out.

Maturity of time deposit

When a time deposit matures, the principal and/or interest can be paid out or renewed as per maturity instructions or force-renewed
if there is a lien on it. The principal and/or interest can be paid out by cash, by cheque or by transfer to savings account.

What is a Retail Loan ?

Banking is defined in terms of the intermediation role played by them as, accepting deposits and lending or investing the funds is
indeed the primary functions of banks. Lending has been the largest source of income for the banks in terms of interest income.
Greater competition amongst banks, led to the banks looking to broad base their lending activities by targeting retail customers or
individuals. Retail credit encourages economic growth by generating demand for products and services as purchasing power of
individual’s increases. Retail loans are loans given to individuals for meeting one time requirements like buying tangible goods like
a car (auto loans) or a house (Mortgage loans) or for meeting large one time expenses like on hospitalization, education, marriage
etc..(Consumer loans). From Bank’s perspective, retail credit is less risky and more profitable compared to business / corporate
lending.

Characteristics of Retail Credits

 Small loan sizes

 Large number of customers (well diversified portfolio)
 Target customers are normally an individual or small enterprise
 Standard product offering to simplify process and delivery
 Decentralized and quick credit decisions – to improve customer satisfaction
 Centralized operations – to reduce cost
 Risk Management at portfolio level rather than at individual account level – to reduce cost and manage risk more
effectively.

Components of a Loan

Principal

This is the amount borrowed. From the point of view of the bank, this is the amount of loan it gives to its customer. It represents an
asset for the bank and a liability for the borrower.
Interest

This is the cost the customer pays for borrowing money from a bank. It is computed as a percentage of the amount borrowed. While
the principal represents an asset for the bank, interest represents income earned by the bank. Interest is computed on the principal
outstanding in the account.

Methods of Interest Calculation

Reducing Balance Method

The interest rates quoted by banks are based on a reducing balance method. In this method interest is computed on the principal
outstanding on a specified frequency (such as daily, monthly or quarterly) on the principal outstanding in the account. Therefore
when the customer makes repayment of some portion of the loan, the principal outstanding would be reduced by the amount of
principal received and the interest will then be computed on the reduced amount – hence the term, reducing balance. In this method,
the more often the interest is computed the more beneficial it would be for the customer.

Flat Rate Method

This method of quoting interest rates is mostly used by financial services companies. In this method, the interest is computed at the
beginning for the entire term of the loan. This method does not take into account the reduced principal at the end of a repayment
period, with the result that the interest may be substantially higher than the amount the customer pays using the reducing balance
method for the same rate of interest.

Fees and Charges

Banks collect various fees and charges from customers for loans. When the loan is being disbursed to the customer, banks may
collect a processing fee associated with the loan-related paperwork, and later they may collect other charges. These include
insurance premium to be paid by the customer towards insurance of the collateral, inspection charges to be paid by the customer,
service charges for certain types of transactions, commitment fee etc. These fees and charges represent income for the bank.

Concepts in Loans

Generally the entire amount is given to the borrower upfront. In some cases like buying flat under construction, the loan may be
disbursed in installments according to the payments to be made to the builder. Generally the repayment start after the entire loan is
disbursed. Till then, only interest is recovered from the borrower. Loans are to be repaid in periodic installments such as monthly or
quarterly that is fixed according to the periodicity of income of the borrower and as per the loan product conditions. Interest is
charged by banks, every month, on the balance outstanding in the loan account. As the loan gets repaid, the interest burden of the
borrower comes down.

Retail loans are generally recovered in Equated Monthly Installments (EMI). The amount payable every month is determined by
calculating the total interest payable assuming that the installments are paid according to the schedule and dividing the total of loan
and interest amount by the number of months over which it has to be paid. Part of EMI is appropriated or adjusted towards interest
and the balance towards the principal.

Normally, the full cost of the assets is not financed. The borrower is required to put in a portion of the amount, which may vary
from 10% to 30%. The amount contributed by the borrower is called ‘margin’. Margin is insisted upon to take care of depreciation
in value of the asset soon after it is purchased and also to increase the commitment of the borrower to repay the loan and protect the
asset.

If a person who has taken a loan for buying a car defaults in repayment, the bank can take possession of the car and sell it to recover
the loan. When the bank has recourse to a specific property or asset for recovery, the loan is said to be ‘secured’ loan.

At the time of granting the loan, borrower gives the bank the right by signing a document to take possession and sell the asset. This
activity is called ‘charge’ creation over the asset in favour of the bank.

When a loan is given for consumption purpose (consumer loan) and no specific security (asset) is available to the bank, the loan is
said to be ‘Unsecured’ loan.

The features of retail credit are:

 Types of facilities
 Secured / unsecured facilities
  Guarantee
 Interest
 Tenure
 Loan to Value ratio
 Loan eligibility
 Credit scoring
 Negative caution list
 Equated Monthly Installments

Types of facilities:

Different types of credit facilities offered to retail customers are:

Loans:

 When the entire amount of credit is ‘disbursed’ or made available to the customer upfront and every deposit or ‘credit’ into
the account is treated as repayment, the facility is called a loan.
 A loan is a one time facility and once an amount is repaid it cannot be withdrawn by the customer as it will be adjusted
against the amount outstanding in the loan account.
 Repayment could be after a period, in one installments could be monthly, or quarterly or half yearly or any other
periodicity as mutually agreed between customer and the bank

Overdrafts

 Overdrawing means withdrawing more than the credit balance in the current / savings account.
 Every subsequent credit into the current account will be adjusted against the overdrawing towards payment. Such short
term over drawings are called ‘Temporary Over Draft’ or TOD.
 TODs are expected to be repaid in about a week.
 Banks will provide overdraft facility on permanent basis by setting up permanent OD limit enabling the customer to
overdraw the account up to a limit and when he requires and to repay it according to his convenience.
 While every credit is adjusted against the amount outstanding, the customer can again withdraw up to the sanctioned limit
(unlike a loan account).
 Hence, while loan is a one time facility, an overdraft is a running or continuing facility.
 Overdraft limits are generally granted for one year and are secured by shares, bonds, bank’s term deposits and such other
financial assets.
 Bank may roll over or extend the limit for another year at the end of one year at the discretion of the bank.

Secured / Unsecured facilities

Secured facilities

 Secured loans are always secured by an underlying asset against which funding is extended like in the case of an overdraft
against shares. This is also called asset based lending.
 A specific ‘charge’ is created on the asset against which funding is extended. A charge on an asset gives the lender the
right to take possession of the asset and sell it to recover the loan in case of default.
 In the case of immovable properties, i.e. land and building, the charge is called ‘mortgage’
 In case of moveable assets like vehicles and goods the charge usually created is called ‘hypothecation’.
 In both the charges, the asset continues to be in the possession of the borrower, but in case of default, the lender can
exercise his right to take possession and dispose of the asset subject to completing legal formalities, namely, filing a case
and obtaining an order from the court.
 On financial assets like fixed deposits and bonds, charge is created by marking “lien”. Lien gives the right to the lender to
appropriate the deposit or bond and adjust it against the loan.
 In case of shares, charge is created by marking ‘pledge’ in the demat account. In pledge, the possession of the shares passes
on to the lender. Hence the lender can straight away sell the shares on default and there are no legal formalities to be
completed.
The different kinds of secured loans are:

 Mortgage finance
 Vehicle loans
o Car loans
o Two wheeler loans
o Commercial vehicle loan
 Construction and material handling equipment loans
 Professional equipment loans for purchasing medical and office equipments
 Loan against securities (shares, bonds etc..)

Collateral

The “security” charged to the bank is also called “collateral”. The world collateral has two meanings; 1. Security given as guarantee
for repayment of loan 2. Additional but subordinate Banks use the word collateral in both senses.

In retail credit,” collateral” is used to refer to the security whether primary or additional. When granting a housing loan in addition
to the mortgage of the house, the bank may take some additional security such as pledge of fixed deposit or shares. Both the main
and additional security is referred to as collateral.

In corporate / business credit, the asset financed is called the primary security and any additional security is called as collateral.

Some banks use the world collateral to refer to additional security only.

Unsecured Loans

Unsecured loans do not have any underlying security and are extended purely on the basis of credit worthiness of the applicant.

The different kinds of unsecured loans are:

 Personal loans
 Credit Cards

Guarantee

 A guarantor is a person, other than the borrower, who promises to pay the loan to the lender in case of default by the
borrower.
 Some banks make the guarantor as co-borrower while some others take only a letter of guarantee.
 Guarantor’s adequacy of his income to repay the loan in case of need will be assessed by the banks before accepting a
person as a guarantor.

Interest

The two types of rate of interest are:

 Fixed rate of Interest: Interest will be charged throughout the tenure of the loan at the rate fixed at the time of granting the
loan.
 Floating rate of Interest: When the rate at which interest is charged on a loan varies from time to time, according to
movement of interest rate, it is called a floating rate loan. The floating rate will be changed according to change in the
benchmark rate.

Tenure

 The period over which the loan has to be repaid is called the tenure of the loan.
 Tenure would depend upon the amount of loan and the repayment capacity of the borrower.
  The maximum tenure permitted would depend upon the period over which the asset financed could depreciate or reduce in
value.
 Tenure would also depend upon the age of the customer.
 Tenure would also depend on type and purpose of lending product

Moratorium

Payment of EMI may commence after few months from the date of full disbursement of loan. Such repayment holiday is called
“Moratorium”. Interest during the moratorium may have to be paid separately as in the case of Pre-EMI or may be added to the
principal and the EMI is calculated accordingly.

Capitalization

Capitalization is defined as the process of satisfying unpaid interest or fees by adding them to, and increasing, the principal balance
of a loan. Any interest due from the customer is added to the principal outstanding – while this would not increase the amount due
from the customer, it would change the nature of outstanding from interest and principal to principal only. This process of adding
the interest due to the principal and reducing the interest due to Zero is called capitalization.

Loan to Value Ratio (LVR)

 The maximum percentage of the value of the asset that will be given as loan.
 LVR varies according to the nature of asset and the rate at which the asset is expected to depreciate.
 An LVR of 85% means that the maximum loan that can be considered for purchase of the asset is limited to 85% of the
value of the asset.

Loan Eligibility

 Loan eligibility is determining the maximum loan amount that can be offered to a customer. This is determined based on
the following criteria:
o Capacity to repay:
 The customer should have adequate income to repay the loan. For example, for salaried person, the persons’s disposable
income is considered to assess the repayment capacity.
 Normally, banks consider 50% of the disposable income as adequate to meet the repayment obligation of the loan applied
for.
 The percentage may vary from bank to bank and product to product.
 Income stream of the customer should be consistent and stable.
 The income is validated by income tax returns.
o Liquidity to repay:
 The customer should be having liquidity at the point of time when his repayment is due.
 Surplus / additional income (if any) is also taken into consideration for assessing liquidity.
 The liquidity to repay is validated by checking bank statements, nature of business / profession, repayment track record
etc..

Credit Scoring

 Credit scoring is a statistical method for predicting the credit worthiness of applicant for credit.
 Banks are able to offer loan approvals online based on the credit scoring methodology.
 Customer’s relative importance is assessed on the basis of analysis of the past loans and various other parameters.
 Weightages are assigned to each measure of the variable criteria. The weightage may be assigned based on the following
variables:
 Age of the customer
 Qualification of the customer
 Income per month
 Weightages are assigned to each variable and the total score is calculated. If the total score is above a cut off limit, the loan
is approved else it is rejected.
 Without the human engagement and analysis (done by credit appraisers), it is not possible to build a complete objective
score card for customers.
The advantages of credit scoring are:

 Facilitates quicker decision making

 Ranks applications according to risk involved
 Minimizes subjectivity in credit approval
 Can also be used as a basis for portfolio rating

Negative / Caution List

This is a list of certain profile of customer segments, which have in past exhibited higher tendency to default.

List of classification are hereunder:

 Profile / occupation of the customer – based on the past experience and analysis of existing portfolios, persons in certain
profession who are known to have higher default rates may be identified in the negative list.
 The location of the customer from a particular area who tends to default is classified as caution or negative areas.
 Past repayment history of customer – The list contains information about the past borrowings and repayment history of the
customers collected from various sources (including credit bureaus)

Equated Monthly Installments

The statement given to the borrower giving details of repayment over the tenure of loan is called ‘Repayment Schedule’ The EMI is
calculated by first calculating the total interest payable during the tenure of the loan assuming that it is repaid over the period in
regular installments, adding the total interest to the principal and dividing the total amount by number of months in which the loan is
to be repaid.

Amortization

The process of splitting the EMI into principal and interest component to facilitate crediting the interest component to the profit and
loss account and the principal component to the loan account is called “amortization”.

Pre-EMI

As the EMI is calculated on the full amount, EMI cannot be calculated till the entire loan is disbursed. In case of housing loan, the
loan may be disbursed over a period of time in installments, which depends upon the progress of construction. Though the loan is
not fully disbursed and EMI is not calculated, the borrower has to pay interest for the amount, which is already disbursed. Such
interest payments are called “PRE-EMI” payments.

Advance EMI

Normally, EMI payments are to be made in ‘arrears’ or at the end of the month. It is possible to calculate EMI on the assumption
that the EMI is paid at the commencement of the month. In that case, the first EMI will become payable immediately after
disbursement of loan. The first EMI taken at the commencement of the loan is called “Advance EMI’.

What is a Mortgage ?

This chapter introduces the various concepts related to Mortgage. A mortgage is defined as a loan to finance the purchase of real
estate, usually with specified payment periods and interest rates. The borrower (mortgagor) gives the lender (mortgagee) a lien on
the property as collateral for the loan. According to the transfer of property act, mortgage is “Transfer of an interest in specific
immovable property for the purpose of securing the payment of money, to be advanced by way of loan.”

Concepts

Mortgage is very similar to hypothecation in that both ownership and possession remain with the borrower (mortgagor) and the
bank (mortgagee) gets the right to take possession and sell the mortgaged property after filing a suit and getting permission of the
court. During the subsistence of the mortgage, the borrower cannot sell the property without the consent of the bank (mortgagee).

Types of mortgages:

 Registered Mortgage
 Equitable Mortgage

Registered Mortgage

A registered mortgage is one which is registered with the registrar of properties with whom sale / purchase of landed property is
required to be registered. The mortgage will be known to anyone who checks the property record. Property will be released from the
mortgage by filing a cancellation deed with Registrar to enable him to record the release in the property record, once the loan is
repaid in full without any due. A registered mortgage is the most secured way of creating charge over an immovable property.

Equitable Mortgage

Property is not required to be registered. The Equitable Mortgage in real term is known as “Mortgage by deposit of Title Deeds”.
The essential characteristics of Equitable Mortgage are:

 Original Title deeds has to be handed over to the bank along with Tax receipts and the Non-Encumbrance certificate
obtained from registrar showing the property is free from all encumbrances.
 Intension to create mortgage: Banks will obtain a memorandum of deposit on plain paper wherein the borrower affirms the
fact of deposit of title deeds with the intention to create mortgage.
 At places notified by the Government: The property that is mortgage may be situation in any place, but the title deeds must
be deposited only in town / cities notified by the Government for creation of Equitable Mortgage.

Key Players in the Mortgage Business

 Property Developers - The people who build homes or develop plots of land
 Borrower –the prospective buyer of the home or plot
 Financial Institution – The entity which provides the necessary finance to the borrower to buy the home or plot

Types of Mortgage Loans - Conventional

The following are the types of Mortgage Loans most prevalent in the industry

 Fixed Rate Mortgage Loan

 Adjustable Rate Mortgage Loan (ARM)

Fixed Rate Mortgage Loan

Fixed Rate Mortgage loans are those loans where the monthly payments for interest and principal remain fixed and does not change
during the tenure of the loan.

Adjustable Rate Mortgage (ARM) Loan

ARM or Adjustable Rate Mortgage loans also known as Variable / Floating Rate Mortgage loans. In these types of mortgage loans,
the interest rate changes from time to time during the tenure of the loan according to some outside index. The interest rate changes
could happen based on various parameters like the change in the base rate (as fixed by the bank) on which the loans are offered.

Categories of Mortgage Loans

Mortgage loans are available for the following purposes

 Purchase of Residential sites

 Purchase of Ready built houses
 Purchase of Flats
 Construction of houses
  Extension / Upgradation of existing houses
 Repairs & Renovation of existing houses

Mortgage Process Flow

Various processes involved in a Mortgage loans from the application stage to the Mortgage Loan closure stage have been explained
below:

Application Submission

 Borrower submits the completed Application to the Mortgage Company along with the required documents and the
requisite Application Fee.

The documents that would be required include

 In case of Employed borrowers
o Pay-slips
o Other Income proofs
o Tax Returns
o Other Loan details
o Assets and Liabilities
o Bank Statements
o The above details will be required for the Co-borrowers also
 In case of Self-Employed borrowers
o Tax Returns
o Income & Expenditure Statement
o Balance Sheet
o Other Loan Details
o Bank Statements
o The above details will be required for the Co-borrowers also
 In case of Construction
o Proof of Land property in the name of the borrower
o Estimated Cost for construction
o Necessary approvals for Construction
  In case of Purchase of Property
o Agreement with the Property Developer
o Schedule of Completion of property

Application Scrutiny

 The Mortgage Company verifies and validates the following:

 Mortgage Loan Application
 Income Details of both the Borrowers and Co-borrowers
 Property Ownership Documents
 On satisfactory verification and validation of the above documents the borrower/s would be intimated of the acceptance of
their application

Credit Appraisal & Report

 The Mortgage company would carry out an appraisal of the loan documents from three angles namely
 Financial Appraisal - which includes
o Repayment capacity of the borrower and co-borrower
o Financial stability of the borrower and co-borrower
o Previous borrowing history of the borrower and co-borrower
o Verification of Salary details with the borrower’s employer
o Bank account transactions
o Quality of collateral security offered
 Technical Appraisal – which includes
o Validity of Approvals for Construction
o Compliance with local building laws
o Estimation for construction
o Condition of property to be financed in case of purchase
o Visit to Site to verify the property to be financed
o Valuation of Property
 Legal Appraisal – which includes
o Collection of property documents / Title deeds
o Obtaining legal opinion about the title from lawyers
o Creation of mortgage
o Applicability of laws like Transfer of property act, Stamp act, Registration Act
o Verifying succession of property, flow of title , encumbrances if any
o Preparation of Legal Scrutiny Report

Sanction of Loan

The mortgage Company, once satisfied that the Loan Application and related documents are acceptable from Financial / Technical
and Legal angles for providing a loan, issues a Letter of Sanction to the borrower with the following details:

 Loan amount offered

 Interest Rate applicable for the Loan
 Term of loan
 Amortization Schedule containing the Monthly Repayment Amount (EMI)
 Repayment conditions
 Validity of Sanction
 Obtaining loan acceptance letter from borrower
 Borrower would be required to pay Administrative / Processing Fees at this stage

Documentation

 After the Sanctioning of the loan, the Mortgage company will carry out the Loan Documentation Process. This is the stage
where the Mortgage for the property is created.
 The indicative documents that would be created are as follows:
o Deposit of Title deeds in original
 o Mortgage Loan Agreement between Mortgage Company & Borrower/s
o Collection of Post Dated Cheques or Direct Debit mandate
o Letter of guarantee
o Letter of Pledge (in case of additional securities)
o Tripartite agreement between Builder, borrower & Mortgage Company

Disbursement of Loan

 On completion of the Loan Documentation, the Mortgage Company would disburse the loan amount as per the request of
the borrower.
 In case of purchase of ready property, the disbursement would be in a single amount.
 In case of construction of the property, the disbursement would be in multiple pre-agreed installments
 In case of single disbursement, the Loan Repayment would start from the next subsequent month during which the
disbursement is made. In this case, the borrower would be required to pay Pre-EMI interest from the date of disbursement
till the last working day of the month.
 In case of multiple disbursements, the borrower would be required to pay Pre-EMI from the date of first disbursement, till
the last working day of the month in which the last disbursement was made

Loan Repayment

On completion of the disbursement of the Sanctioned Loan amount in full, the Repayment of Loan starts. The repayment will
normally start from the beginning of the next month subsequent to the month during which the full and final disbursement was
made. The repayment of loan falls under two categories as discussed below.

Normal Repayment

 Borrower repays the loan by payment of the fixed EMI (Equated Monthly Installments) as specified in the Amortization
schedule.
 Repayment would be by way of either Direct Debit mandate or Post Dated Cheques provided during the sanctioning of
loan.
 The repayment amount would be uniform throughout the mortgage term, unless there are special situations like Re-
scheduling or Re-phasing of loans

Pre-Payment of Loan

 Borrower sometimes may get additional funds and may decide to prepay either a part of the loan or the loan in full.
 In case the customer decides to prepay the loan in full, then the final loan outstanding calculation would be done and the
borrower will be required to pay the total outstanding amount and the loan account would be closed. This is called Pre-
closure of Loan.
 In case the customer decides to prepay only a part of the loan, then the loan would be re-scheduled and a new loan balance
and repayment schedule would be calculated and the borrower will start to pay the new EMI from the next month onwards.
 Generally at the discretion of the Mortgage company a nominal percentage of the outstanding loan amount is levied as Pre-
Closure charges.

Re-scheduling of Loans

 Re-scheduling of loans means re-adjustment or re-calculation of the amortization schedule taking into consideration any
pre-payments that have been done by the borrower towards the loan account from the start of the financial year till the date
of re-scheduling to arrive at a new balance for the remaining period of the loan.
 Rescheduling of loans would be done at the request of the borrower who wishes to reduce his monthly repayment
installments by making part prepayments in lump sum towards the loan outstanding.
 Rescheduling of loans would be done in such a way that after rescheduling the entire outstanding liability at revised
installment shall be paid within the unexpired term originally fixed

Re-phasing of Loans

 There may be situations where the borrower defaults in the repayment of the loan obligations due to genuine financial
temporary difficulties and the Mortgage Company may decide to re-adjust the loan.
  The mortgage company will add back the unpaid installments (dues), overdue interest and any other charges back to the
balance of the loan and arrive at a new balance. This process is called as Re-phasing of Loan.
 Under this facility all the arrears / overdue amounts will be added back to the loan and a fresh repayment schedule
(amortization schedule) will be determined, wherein the loan is repayable within the unexpired period of the term granted
originally

Closure of Loan

 When the borrower has completed all the installments of the mortgage loan repayments as per the schedule, the loan
account is said to be closed and this is called as “Normal Closure of Loan”.
 When the borrower decides to repay the loan in full before the completion of the Term of the loan, due to availability of
funds, the loan account in this situation is also said to be closed but called as “Pre-closure of Loan”.
 Generally the mortgage company does not penalize the borrower for Normal closure of a loan account. But in case of Pre-
closure of loan, the mortgage company does levy a certain percentage as “Pre-closure Charges”.
 On closure of the loan account, the Mortgage Company hand over all the original documents relating to the property to the
borrower and cancels all liens noted on the property and notifies the required authorities. The borrower becomes the
absolute owner of the property henceforth.

Risks in Mortgage

Various types of risks those are associated with Mortgages. The risks can be classified as below:

 Credit Risk
 Liquidity risk
 Interest Rate Risk
 Pre-payment Risk
 Regulatory Risk
 Environment Risk
 Uninsurable Loss

Credit Risks – Credit risk refers to the risk of default by the borrower for any reason. It is possible that the business does not
generate sufficient income to repay or the borrower is not honest. This is the most serious risk any lender faces.

Liquidity Risks – The borrower may have every intention to repay the loan and the business may be doing well too. However there
could be occasions when the borrower is not able to withdraw funds from the business when the lender demands repayment.

Interest Rate Risk – Another risk is due to change in the rate of interest in the market. At the time of the transactions the borrower
may have agreed to give the interest at the prevailing rate of, say, 8%. Subsequently, interest may be reduced or increased

Prepayment Risk - Prepayments can change the Account’s return because the mortgage company may not be able to reinvest the
proceeds at high interest rate as the original mortgage loan rate.

Regulatory Risks - Government regulation, including zoning laws, property taxes, fiscal, environmental or other government
policies, could operate or change in a way that hurts the Account and its properties. It is also possible that the property may be
acquired by the government for public purposes like widening of roads etc. in which case the compensation may not be in tune with
loan outstanding.

Environmental Risks - The Account may be liable for damage to the environment caused by hazardous substances used or found
on its properties. if the Account fails to comply with regulations requiring it to actively monitor the business activities on its
premises, the Account may have difficulty selling or renting a property or be liable for monetary penalties.

Uninsurable Losses - Certain catastrophic losses (e.g., from earthquakes, wars, terrorist acts, nuclear accidents, floods, or
environmental or industrial hazards or accidents) are uninsurable or so expensive to insure. If a disaster that we haven’t insured
against occurs, the Account could lose both its original investment and any future profits from the property affected.

Types of Mortgage Loans in US

When it comes to mortgages, there are almost as many choices as there are styles of homes. A few of them are discussed below.

FHA Loans

FHA loans are insured by the Federal Housing Administration and are often referred to as a government mortgage. These loans
require lower down payments and accept higher debt ratios than a conventional mortgage so they're good for some buyers who
might not otherwise qualify.

 While they require lower down payments, they do require a minimum cash investment of 3% of the sales price. If the down
payment is less, the balance goes toward closing costs.
 An upfront "mortgage insurance premium" (MIP) is required (on a 30-year loan, the MIP equals 1.50% of the loan amount
- 2% for a 15-year loan), plus an annual .5% renewal premium for the life of the loan.

VA Loans

VA loans are available to veterans and service personnel who have put in the required service time in the military. They're
guaranteed by the Department of Veterans Affairs and, in most cases, require no down payment.

 Loan maximum may be up to 100% of the VA-established reasonable value of the property.
 A 2% VA loan funding fee is required although a down payment will lower this fee - the fee is 2.75% for eligible
Reserve/National Guard personnel.
 No monthly mortgage insurance is required.

Rural Housing Loans

These low-interest-rate home loans are offered through the Rural Housing Service, a branch of the US Department of Agriculture.
They are specifically tailored to low and moderate income persons who live in rural areas or small towns and require no down
payment.

 100% financing available with fixed interest rates

 30-year term
 USDA Guaranty Fee required on all loans
 Property location must meet USDA standards
 Income and loan amount limits apply

Affordable Housing Program (AHP) Loans

An AHP mortgage can help low-to-moderate income families who cannot save for a down payment, but pay their bills and deserve
the opportunity to own a home. Applicants will complete a take-home pre-ownership education course in order to make the home
buying process easier to understand.

 Fixed annual percentage rates

 Mortgage credit insurance is not required
 Income and loan amount limits apply
 Home ownership counseling required

Few Mortgage Loan Products in US

Home Purchase Loan

  This is a normal Mortgage loan
 Interest Rates options could be Fixed Rate or Adjustable Rate
 Loan Period may vary from 10-30 years

Mortgage Refinance

 Mortgage Refinance is the process of re-mortgaging the same property for a lower rate of interest or higher period.
 There are three ways refinancing can lower the repayment amount.
 The first is simply to refinance at a lower interest rate.
 You can also change the term on your mortgage to lower your payment. Switching from a 15- to a 30-year term can
significantly lower your mortgage payment. But, if long-term savings is more appealing to you, refinancing from a 30-year
to a 15-year mortgage can save you thousands of dollars over the life of your loan.
 The third way to lower your payment is by switching from a traditional mortgage with principal and interest payments to a
mortgage program that allows interest only payments. Home Equity Loan
 A Home Equity loan is a new trend of loans in the US. Under this scheme the home/property owner borrows a sum of
money from another mortgage company by way of entering into a second mortgage on the same property/home for which
he already has mortgage.
 When you get a home equity loan, you are borrowing against your ownership stake in the house. The equity is the value of
the house minus your mortgage balance. A home equity loan uses your equity as collateral. If your house is worth
$200,000, and you owe $140,000 on the mortgage, you have $60,000 in equity. A home equity loan would allow you to
borrow some or all of that $60,000.
 You receive an equity loan as a lump sum, and repay it over a set time, usually at a fixed rate and for the same payment
each month. A home equity line of credit, or HELOC, is a type of equity loan that works like a credit card. It has a credit
limit and a revolving balance, meaning that you can borrow up to a certain amount, pay some or all of it back, and borrow
again up to the limit. Rates on most lines of credit vary as the prime rate moves up and down.
 Because they come in a lump sum, home equity loans generally are recommended for one-time expenses -- to consolidate
credit card debt, pay for a new roof, buy a business. Equity lines of credit often are recommended for recurring expenses
such as education expenses, or multistage projects such as home renovations, or to hold in reserve for emergencies such as
job layoffs.
 A line of credit starts with a draw period and ends with a repayment period. During the draw period, the homeowner can
borrow against the credit line by using a charge card or a checkbook. Minimum monthly payments cover only the interest
during the draw period. When the repayment period starts, the monthly payments cover interest and principal so that the
balance is repaid by the time the credit line expires. The length of the draw and repayment periods varies with the lender
and size of the credit line

What is Clearing ?

Clearing is the process of collecting the proceeds of a cheque, a demand draft or a pay order deposited into an account. i.e. When a
cheque / demand draft / pay order which is drawn on the other bank is deposited by the customer, it has to be sent to the payee bank
and the amount is collected and deposited to the beneficiaries (of the instrument) account.

Definition of Instrument:

The Negotiable Instrument Act, 1881, defines a Negotiable Instrument as a promissory note, Bill of Exchange or cheque.

A Bill of Exchange or a Promissory Note is an instrument in writing containing an unconditional order, signed by the maker,
directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the
instrument.

A Cheque is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand. A cheque is
a bill of exchange which is always drawn on a banker specified therein and payable on demand.

Types of Clearing:

Following are the different methods of clearing.

 Local Clearing
  National Clearing
 Cheque collection
 Electronic clearing System

Local Clearing: If the cheque deposited by a customer is drawn on another bank in the same city it has to be sent to the payee bank
and the amount collected. Since all the banks in a city will be getting cheques drawn in other banks and it is cumbersome to process,
“Clearing house” is used to meet and exchange cheques drawn on each other. Legally, a clearing house is an association of all banks
at a centre with its own by laws and management committee. Clearing house is a place or office, where the representative of all the
banks will meet and exchange cheques drawn on each other. Generally, the central bank of the country or a leading bank on behalf
of the central bank of the country manages the clearing house. All the banks at that centre will maintain accounts with the settlement
bank to facilitate settlement of the claims on each other. The payment is effected by the settlement bank by debiting and crediting
the net amount payable. This is known as net settlement.

The instruments settled through clearing house are as follows

 Cheques
 Drafts
 Pay orders
 Warrants
 ECS Debits / Credits
 Income Tax Refund orders
 Government Payment Orders

Service Center:

Typically, in a location, a bank could have more than one branch. In such a scenario, the bank will route the clearing operation
through a separate branch known as service branch or a processing center and this represents bank at the clearing house. The service
branch / processing centre; collects instruments from all the branches of the bank in that centre, sorts the instruments bank-wise and
presents them to the clearing house.

MICR Cheques:

The clearing process varies according to the types on the instrument used. To mechanize the process at the large centers, the central
Bank has mandated that only MICR (Magnetic Ink Character Recongnition) cheques to be used.

Hence Banks issue cheque, draft and other payment instruments in MICR format using the special quality paper and printing
specifications. On MICR instruments, there is code line at the bottom containing information printed in magnetic ink, which is
required for mechanical processing. The code line contains the following information

 First six numbers indicate the Cheque Number

 Next three numbers indicate city code
 Next three numbers indicate bank code
 Next three numbers indicate branch code
 After some space there is a number for transaction code (i.e. whether the transaction is for a saving or current account)
 The magnetic portion, when placed under MICR equipment, allows for instant readability and identification.

MICR Cheque Clearing Process Flow

 The cheque is deposited in the branch.

 All the branches send the cheque received by them to service branch
 The encoding of the cheques are done and sorted as bundles.
 The processed cheques are sent to clearing house (The cheques sent to clearing house are called “Outward Clearing
Cheques”)
 In clearing house, bundles are sorted bank wise.
  The cheques drawn on each bank will be sent to the respective service center (The cheques received from the other banks
are known as “Inward Clearing Cheques”)
 The service centers of each bank sort it branch wise and send it to the branches for debiting the accounts of the customer.
Banks which are fully computerized do not send the inward clearing cheques to the branches, as all accounts can be
accessed and processed in the service center itself.
 The return cheques (due to insufficient balance, stop payment instructions) are returned to the respective banks through
clearing house.

Reasons for Dishonour of Cheques

Cheques / instruments could be dishonoured or returned by the drawee banks for the following reasons

 Stop payment instructions has been issued for the cheque

 Account is closed
 Insufficient Funds
 Restrictions has been imposed either for posting any debits or any amount restrictions exist for the account.
 Any alteration in cheques
 Physical damage of the cheque

Non-MICR cheque clearing process

The primary difference with MICR and Non-MICR is that work of sorting the cheques bankwise. In case of Non-MICR the
presenting banks have to manually sort and consolidate bank-wise.

High Value Clearing

This is value added clearing service available in select cities for processing large value cheques on same day to facilitate the
customers to use the funds immediately.

Cheque Truncation

Cheque truncation refers to conducting clearing operations with digital images of the cheques rather than the physical cheques. The
presenting bank, instead of sending the physical cheques to the clearing house will scan the cheques with high speed scanners and
transmit the scanned images to the clearing house electronically. The clearing house will in turn sort the images and transmit to each
bank the images of cheques drawn on them. Since only scanned images will be sent, the physical cheques will remain with the
presenting bank itself. Cheque truncation has been made possible by the development of imaging and communication technology.
Cheque truncation can help to speed up clearing operations and make it more cost effective.

National Clearing: Clearing house handles cheques drawn on local branch only. Cheques drawn on upcountry branches are sent by
each bank to their branch at that centre for presentation through the local clearing at that centre. The National clearing is a facility
offered by clearing houses to collect upcountry cheques through the clearing house system rather than each bank collecting such
cheques through their branches. The central Bank has linked up the clearing houses in the large cities to facilitate such collection
with less time.

Cheque Collection:

As the clearing jurisdiction is local, a separate procedure has evolved for the collection of cheques drawn on banks outside the
clearing house area. In this case, the cheques are sent by post for collection to the representative branch or correspondent bank for
presentation in the clearing house in the outstation centre. Once the cheque is realized, the proceeds are remitted to the original
presenting bank for credit to the customer account. This leads to a significant delay in the payment of these cheques and there is
considerable uncertainty regarding the time of realization.

Due to delays in collection of outstation cheques, various alternative forms of payments instruments are widely used to settle
outstation payments. Some of the payment items such as demand drafts, “payable at par” warrants etc., are much widely in use in
current day scenario. In all these cases, whether cheques or drafts, the question of settlement between paying bank and the collecting
bank remains. In the case of demand drafts, the payment is usually internal to the bank and is settled by book transfers using an
internal pipe line account maintained in the bank. In the case of 'At par' items, a single account maintained in any branch is debited
and various paying branches are paid.

Cheques drawn on the bank’s upcountry branches

For a bank which is fully networked and has a centralized database, cheques drawn on any branch can be posted from any other
branch. Hence, cheques drawn on upcountry branches can be processed as a transfer transaction at the branch where the cheque is
deposited.

Cheques drawn on other banks at locations where the bank has branches.

The cheque has to be sent to the branch at the location for being presented in the local clearing.

Cheques drawn on other banks at locations where the bank does not have a branch

There are 3 ways of collecting such cheques: 1. Give the cheque to a correspondent bank which has a branch at the location. A
correspondent bank is one with whom the collecting bank maintains a current account. 2. Give the cheque to a non-correspondent
bank 3. Send it directly to the drawee bank.

Electronic Clearing System (ECS): Let us suppose that the company has thousands of employees who maintains their accounts in
various banks in the city. It will be difficult for the employees if the company pays the salary by cheque, where in they have to
deposit and collected through local clearing. This can be avoided through ECS where the payer will give to his bank the list of
payments to be made with bank details to authorize him to debit their accounts. The bank in turn will pass on the list to the clearing
house which will distribute to amongst the banks concerned.

There are two types of ECS

1. Credit ECS
2. Debit ECS

Credit ECS: As name implies, this is used to credit the customer. For example the companies that declare the dividend warrants
can use this to give credit to all its shareholders there by reducing the cost of paying dividends. This is popular for mass payments
such as dividends, interest, salary, commission to sales agents etc.

Scheme Coverage

The Scheme shall cover transactions of the following characteristics:

 Bulk payment transaction like periodic (monthly/ quarterly/ half-yearly/ yearly) payments of interest/ salary/ pension/
commission/ dividend/ refund by companies /corporations /government departments and such other organizations defined
as “User”
 The transactions to move from a single User source to a large number of Destination Account Holders.
 The credit transactions should pertain to the Destination various Bank Branches which fall under the jurisdiction of the
local Bankers’ Clearing House.
 The credit instructions from the User to the Destination Account Holders would be on magnetic tape/floppy ( a form of
electronic media that can be processed on computers) and would form the basis for the Sponsor Bank to debit the User’s
account and the Destination Banks to credit the Destination Account Holders’ Accounts.
 Such other payment transactions involving a single debit to a User’s account at one bank and multiple credits to a large
number of beneficiaries at many banks to be specified by NCC after ascertaining the level of infrastructure available at the
Service/Main branches of member banks.

Debit ECS: Utility services companies such as electricity boards, telecommunication companies or banks for loan installment
collection use debit ECS for collecting the amounts from consumers. This enables the companies to recover their dues in time and
more cost effectively. Customer has to give Debit ECS mandate in the specified form to the bank. ECS debit is also called as
“Direct Debit”

Scheme Coverage

The Scheme covers transactions of the following characteristics:

  Repetitive payment collections like periodic monthly/ bimonthly/ quarterly/ half-yearly/ yearly) payments of telephone
bills / electricity bills / loan installments / insurance premium etc. by companies / corporations / government departments
and such other organizations defined as "User".
 Transactions relating to collections by a single User from a large number of Destination Account Holders;
 Debit transactions should pertain to the Destination Bank Branches which fall under the jurisdiction of the local Bankers'
Clearing Houses ;
 Debit instructions from the User to the Destination Account Holders would be on magnetic tape/floppy ( a form of
electronic media that can be processed on computers ) and would form the basis for the Sponsor Bank to credit the User's
account and the Destination Banks to debit the Destination Account Holder's Accounts;
 Individual debit amount specified by the User;
 Such other payment transactions involving a single total-credit to a User's account with sponsor bank and multiple debits to
a large number of beneficiaries at many bank branches (Collecting/Destination-banks) to be specified by local NCC from
time to time.

An introduction to Collections

Introduction

This topic helps out in understanding the process of Debt collection and monitoring. Collections are also best known as
Delinquency management. It is associated with the recovery / delinquency management of the credits / loans disbursed to the
customers by the banks. The repayment record of borrowers needs to be monitored continuously with regard to the payment of
interest and repayment of principal. Whenever a borrower defaults or is likely to default, rigorous follow-up has to be made for
collection of the dues.

The business of a bank managing risks and its effectiveness lies in an efficient recovery and exit strategy. The collections effort is
very important in maintaining the quality of the credit portfolio. Timely follow up is the key to success in collections. The chances
of recovery diminish as time passes. Hence, intense follow up soon after default yields greater results.

Overview of Collections

The loan portfolio of a bank is to be monitored continuously to identify facilities which have exceeded and/or where payment of
interest /principal is late or long over due. The responsibility of collections department will start when an account becomes
delinquent until it is regularized by means of payment or closed after making full payment/charge-off.

The collection process for a credit facility offered by a bank will be initiated when the account holder fails to meet one or more
contractual payments (installments) on due date and thereby turn delinquent or when the customer exceed the granted limit fixed for
the overdraft facility by the bank. The objective of collections department in a bank is to minimize outstanding delinquent
receivables and thereby reduce credit loss to the bank.

The aim of the collections process is to obtain payments promptly while minimizing collections costs and write off cost. The
collections department protects the assets of the bank by continuous monitoring of accounts, identifying early warning signals of
delinquency to reduce financial losses.

Identification & Classification of Delinquent Accounts:

When a customer fails to pay the instalment amount or minimum payment due within the payment due date, the account is termed
delinquent or in arrears. Collections steps can be initiated on such an account in order to regularize the account and to protect the
banks interest.

Accounts that are in arrears or in delinquent stage are classified as overdue so that the accounts in different stages of delinquency
can be managed more efficiently and strategies for recovery of overdue formulated appropriately.

For intensive follow up overdue accounts are classified according to the period of default and each group is called a “Bucket”. As
the account moves from one month bucket to two months bucket, the account will be entrusted to another team. This would ensure
focus and appropriate strategy to recover the dues.

Example:
Consider a customer who has a Loan facility with a Bank. The customer is expected to make an instalment payment of $1000/-
every month before the 30th of Calendar month.

Instalment amount $1000/-

Current month August’2010
Payment Due Date (PDD) 31/08/2010

If the customer does not pay the amount, on or before 31st August 2010, the Loan account is considered to be in arrears /
delinquent. The account could get levied with late payment charges depending on the policies existing in the bank.

On 1st September 2010, this account is considered 1 DPD (one day past due) and collections procedures are initiated for this
account.

On 30th September 2010, if the customer has not made payment to the account, the account is 30 days past due and considered as
30 days delinquent and in the 30 DPD bucket.

If payment is not made to the account, the account will continue to age and there by move further up in the delinquency categories
(60 DPD, 90 DPD).

The collection strategies associated with each of these buckets will differ based on the procedures existing in the bank.

The different collection buckets and the days past due are listed below:

Days Past Due

Collection Bucket Comments
01 - 29 Days - Past Due
30 - 59 Days 30 DPD Doubtful
60 - 89 Days 60 DPD Bad Debts
>= 90 Days - Non Performing Asset

Bank has to make provisions from their profits for Non Performing assets and this reduces the overall profit earned by the banks.

Process Flow
Monitoring of Overlimit Accounts

In addition loans offered to the customers, banks also offer overdraft facility to the customer. (The overdraft facility has been
covered in detail in Retail loans and corporate modules). A credit limit (i.e. the maximum cap for the credit facility to be availed by
the customer) is assigned to the customer. The credit limit for a customer is arrived based on the credit worthiness of the customer,
security provided by the customer and the drawing power of the customer. The drawing power is arrived by calculating the current
value of the security (for example the stocks of the company) of the customer. The customer can avail of the credit facility up to the
limit available. When a customer exceeds the prescribed limit, then the customer is termed as “over limit”. Over limit customer
poses a financial risk to the bank. This type of over limit accounts also need to be monitored till the account gets regularized.

The monitoring, regularization of overlimit accounts are the responsibility of the collections department.
Collection Process and Strategies

The collection strategies prevalent in banks can be varied depending on the policies existing in the bank. The collection process
consists of the following main activities:

 Awareness Calling: A call will be initiated to the customer, when the first payment is due from the customer. This call is
to make the customer aware of the date of payment of his dues to the bank.
 Collection Calling: A call will be made to the customer, to make him aware that he has missed the due date and request
him to pay the arrears at the earliest.
 Demand Notice: In the event of customer not responding to the telephonic calls, a written communication is sent to the
customer informing the status of the loan account.
 Field Collection: The activity involves meeting the customer in person to persuade the customer to repay the loan. A
compromise deal may also be made with the customer, if it is found that the financial position of the customer has
deteriorated as a result of which recovery of the entire dues may not be possible.
 Re-possession and disposal of hypothecated assets: As per the law, the hypothecated assets or the collaterals provided by
the customers would be taken into the possession of the bank, when the customer fails to make payment of arrears and
settle the loan dues.
 Recovery through litigation: When the sale of asset(s) does not yield enough to cover the outstanding
balance in the loan account, bank will file a law suit for the recovery of balance dues. The following
table gives flavour of the different strategies used by banks in contacting delinquent customers and
collecting payments from them.

Days Past Due

Collection Strategy /
Actions
01 - 29 Days Letter, Statement message
Letter, Statement message, Phone
30 - 59 Days
calls, Suspension of facility
Reminder Letter, Statement message,
60 - 89 Days
Repeated phone calls
Letter, Statement message, Phone
90 - 119 Days
calls, Visit to residence/ Office
 Handled by collection agencies, Legal
120 - 149 Days
notice
Handled by collection agencies, Legal
150 - 179 Days
notice, Update negative list
Account charged off, Handled by
>= 180 days
recovery agencies, Legal Proceedings.

Collection Agent:

Once the account passes a certain level of delinquency, the account is allocated to a collection agency to work on. The customer and
the loan account details are given to the collection agency, who in turn works on these accounts on case to case basis.

The accounts are at times allocated to agencies for initiating legal proceedings. The task of the collection agencies is to trace the
defaulter and find out his exact financial position.

Once the bank and collection agencies are convinced of the genuineness of the non-repayment case, they enter into negotiations
with the customer. However, if the defaulter is hostile and does not agree to negotiations, banks hand over the case to their recovery
cell. At this stage, the loan account is closed and banks usually write off the debt and take recourse to legal action. In some cases, in
case the defaulter absconds, police help is taken. The collector is given power to negotiate with the customer and can offer waivers
in case on one time settlement made by the customer. The agencies are paid either on a flat rate or percentage of the amount
collected or combination of both.

Write Off Policy

When an account is deemed not collectable, the account is charged off in the books of account of the bank. The amount written-off
is shown as a loss to the bank. Banks are required to monitor cases which could get written-off and provide for a provision for write-
off. But the recovery procedures will continue from the banks end despite write-off. In case money is recovered from the customer
who has been written-off in the banks book, it is treated as income in the books of account of the bank.

Conclusion

The collection function is increasingly difficult to manage properly due to the growing size, complexity of the business and
collection’s labor-intensive nature. Banks use the technology (by implementing debt recovery / collection management software),
current and historical information at its disposal to formulate a plan or strategy for optimizing its collection efforts. In many banks,
collection strategies rely on behavioral scoring models which predict the likelihood of collection. Armed with such information,
bank managements effectively direct collection efforts with an emphasis on amount at risk.

An introduction to Remittances

Introduction

Banks constitute the payments systems. In the absence of banks, all transactions have to be settled in cash which is not possible at
all. In addition to cheques, there are many ways through which payments are effected. The traditional instruments, other than
cheques used for settling payments are pay orders and demand drafts. Gradually, electronic funds transfers are replacing these
instruments. Remittances of two types viz., Inward Remittance and Outward Remittance

Inward Remittance

When a customer receives a remittance (in the form of pay order / demand draft / Electronic remittance) from another customer, he
approaches the bank for encashment. This is called as Inward remittance.

Outward Remittance

When a client wishes to remit money to another and desires not to issue a cheque for this remittance, he approaches the bank for
providing a remittance facility. Such remittance may be in the form of a Demand Draft, Pay Order or electronic remittance. This is
called outward remittance. This function is referred to as issue of DD, issue of PO, etc. as the bank issues remittance instrument.

Foreign Remittances

The inward/outward remittances may be in the form of foreign currency also like Traveler’s Cheques (TC), Foreign DD, Foreign
TT, etc. Nostro, Vostro, and Loro accounts are used for these purposes. SWIFT assists in efficient and fast transmission of funds
between two countries. These are explained in “Forex operations/Export/Import Finance”.

Parties involved in remittances

 Applicant or remitter – who request for transfer of funds or who remits the funds.
 Bank – Through whom the funds are transferred or who issues the payment instruments
 Beneficiary - in whose favor the instrument is drawn, is called the beneficiary.

Pay Order (PO)

Payment through Cheques suffers from a deficiency wherein the cheques could be returned unpaid by the drawee bank for many
reasons including lack of funds. A pay order is a variant of cheque, where the payment is assured. This is also known as “banker’s
cheque”.

Features of Pay Order

 Pay order is a cheque issued by a bank on itself. The drawer and drawee of a pay order is the same branch of the bank. i.e.
the issuing branch and the drawee branch are the same.
 Pay order is issued by banks after collecting the amount from the applicant. The amount is kept in a separate account for
making payment of the pay order when it is presented.
 Payment of pay order cannot be stopped (except the court order) once it issued, as it is issued by the bank.
 It is a source of interest free funds and commission income for the issuing bank as the amount is kept in a separate account
till it is presented for payment.

Demand Draft

A demand draft is “an instrument in writing drawn by one branch upon another branch of the same bank. It contains an
unconditional order to pay on demand a specified sum to a specified person or to his order”.

 Demand drafts involve movement of funds from one place to another.

 Demand drafts are also cheques issued by the banks on themselves but with the difference that the issuing branch and
paying branch are different.
 Demand draft is a cheque issued by one branch of a bank and made payable at another branch of the same bank.
 It is used to settle transactions between persons of two different places.
Parties to a Demand Draft Following are the important parties to a DD:

 Drawer - One who draws the DD i.e. the Issuing Branch

 Drawee - One on whom the DD is drawn i.e. the branch on which it is drawn
 Payee - One in whose favour DD is drawn i.e. the beneficiary
 Purchaser - One on whose behalf DD is issued

Why & When a DD is required The probable reason for the customer to approach the bank for issue of DD could be one of the
following:

 One client of the bank wishes to remit money to another

 The client does not like to issue a Cheque to settle this dues
 The other party is in a different city
 The other party does not maintain any account with the bank in the other City or even if he maintains, the client wishes a
DD

Issue & Payment of a DD

Issue of Demand Draft

Following are the various aspects associated with issue of DD:

1. When the applicant requests for issue of DD, the bank verifies whether they have their own branch at the place requested. In
some cases, even if a branch does not exist in that place, in case Drawing Arrangement (i.e. tie-up with some other banks) is
available on any other bank in that place, DD is issued.

2. If more than one branch is located in the place requested, the DD is issued on the nominated branch. Instead of nominated
branches, some banks issue DDs on any branch as per customer’s preference.

3. The applicant need not be a customer of the bank for taking a DD.

4. DD can be issued either against cash or against debit to any operative account of the applicant. However in case of issue of DDs
against cash remittance, restrictions are imposed on the maximum amount for which DD can be issued. However there is no
restriction on maximum amount are for issue of DDs against debit to accounts.

5. Some banks issue DDs (single DD) only up to a specified amount. This is mainly to avoid frauds. When a customer requests for
issue of DD for more than such stipulated amount, the amount is broken into number of units and multiple DDs are issued for each
unit value. Cash payment can be made only after proper identification of the beneficiary.

6. DD issue attracts commission payable by the applicant. Such commission has a tier structure based on the amount of DD.

7. The DD is valid for a specific period (say 6 months) from the date of issue. The payee can encash the DD or the purchaser can get
the DD cancelled within this validity period. Else, revalidation of DD has to be done, which is discussed subsequently.

8. Every DD bears a number. This number may either be a check-digit method number or the printed serial number of the DD itself.

9. The DD is printed, signed by authorized officials of the bank and given to the applicant. The printing may be in a Magnetic Ink
Character Recognition (MICR) instrument or a Non-MICR instrument. But if the DD is drawn on a center where MICR
operations/clearing system is in force, printing in a MICR instrument is mandatory.

10. Particulars of name and address of the applicant, payee name, drawee branch, DD number, DD amount, commission collected,
etc. are maintained at issuing branch as record.

Payment of Demand Draft

 The purchaser sends the DD to the beneficiary. If the beneficiary has an account with a branch of the same bank, he
presents it to the branch. Else, he presents it to his bank. His bank becomes the collecting bank in this case and they present
the DD to drawee bank (branch) for payment. Such presentation happens through clearing house mechanism present in that
place.
 The drawee bank verifies whether the DD is in order and is presented for payment before expiry of the validity period. If
validity has expired, it is called “Stale DD” and can not be paid unless it is revalidated by the issuing branch.
  The drawee bank also verifies whether any reported lost message has been received from issuing branch for the DD. If so,
the DD is returned unpaid with suitable message.
 The applicant need not be a customer of the bank for taking payment of a DD. If the DD is in order, payment is made to the
client.
 DD can be paid and either cash is disbursed or credit is given to any operative account of the applicant. However in case of
payment of DDs through cash, restrictions are imposed on the maximum amount for which cash can be paid against DD.
However such restrictions on maximum amount are not applicable for payment of DDs and credit to operative accounts.

Duplicate Pay order / Demand Draft

 Duplicate PO / DD may be issued if the original is lost or mutilated.

 A stamped indemnity (an assurance from the customer that in case the bank is put to loss due to issuing the duplicate PO /
DD, he will pay the bank the amount of loss) will be obtained from the customer along with the request letter for issuing
Duplicate PO / DD.
 Bank may insist on guarantee from third party also incase the amount involved is too large.
 Bank will issue duplicate PO / DD, after ensuring that the original has not been paid.
 The original pay order will be marked as cancelled.

Cancellation of Pay order / Demand Draft

 PO / DD can be cancelled at the request of the purchase in writing.

 Amount after cancellation will be credited to the purchaser’s account, if it is large.
 Bank will also take indemnity and guarantee from the purchaser who is requesting cancellation.
 Bank will also ensure from the drawee that the pay order / demand draft is not received / paid.

Stop payment of Pay order / Demand Draft

 Payment of PO / DD cannot be stopped except by the court.

 Bank may refuse payment, if PO / DD is tampered or altered.

Revalidation of a DD

 The DD is valid for a specific period from the date of issue. The payee can encash the DD or the purchaser can get the DD
cancelled within this validity period. Else, revalidation of DD has to be done.
 Revalidation is nothing but validating the DD for a further period, say 3 months. Many banks have maximum period for
such revalidation e.g. one year from the date of original expiry date, etc.
 Revalidation can be done either at the request of the purchaser or payee.
 The fact of revalidation is done on the DD itself.
 Such DDs can be paid before the extended validity period.
 Revalidation of DD attracts service charges.

Loss of a DD

 In case the DD is lost by the purchaser either during transit or otherwise, the purchaser has to report loss of DD to the
issuing bank.
 Only the purchaser can report loss of DD and that too at the issuing branch only.
 Issuing Bank will immediately inform the drawee branch and send an “Exercise caution while payment” for such DDs to
the drawee branch.
 The drawee branch records such losses. After noting down loss of DD, in case the original DD is received for payment,
drawee branch returns the DD with the remark that the DD has been reported lost.
 Some branches charge service charges for the action taken on receiving information regarding loss of DD.
 The purchaser has two choices in this case. He can either get the DD cancelled or get a duplicate DD.
 Generally no accounting entries are passed in DD account for report of loss of DD. Only collection of service charges will
result in the entry mentioned under “Revalidation of DD”.

Reconciliation

By issuing a DD, bank undertakes a liability to pay the amount and as such it becomes a current liability to the bank. There are
chances of the fraudulent alteration of the instrument especially the amount portion. Hence, banks have a reconciliation mechanism
for DDs mainly for the following purposes.

 To ascertain the details of outstanding DDs

 To ensure that the material portion of issue of DD and payment of DD matches.

Particulars are collected from issuing branch and also the paying branch on a periodical basis and matching of the DD entries are
done one by one. In case of mis-matches the issue is taken with the concerned branches. In case banks have centralized banking
applications and all the branches are connected to the data-center, automated reconciliation happens immediately during payment
itself.

Electronic Funds Transfer

 Electronic fund transfer enables the payees to get the funds instantaneously avoiding the transit time involved in sending
the instrument by post or courier and also the time involved in the local clearing process.
 As cost of mailing and cost of handling are saved, EFT is cheaper than any other mode of remittance.
 Electronic Funds Transfer are of the following types:
o Intra Branch
o Inter Branch
o Inter bank

Intra branch – Transfer of funds from one account to another in the same branch by debiting one account and crediting another
account. Both the remitter and beneficiary are with the same branch of the bank.

Inter branch – Transfer of funds from one account to another account in the different branch. Beneficiary and remitter maintain
account with different branches of the bank

Inter bank – When the beneficiary and remitter maintain account with different Banks, then an intermediary is required to pass the
funds and message electronically from one bank to another. Central Bank plays the role of the intermediary in facilitating EFTs.
Two facilities of inter-bank transfers are:

 NEFT
 RTGS

NEFT

The process of electronic funds transfer is as follows:

 Remitter
o Initial funds transfer through branch or internet banking
 Remitter’s Bank
o Central processing centre of the bank extract details of the payment made from the bank systems
o Payment file is processed in central bank’s electronic funds transfer package.
o The file will be encrypted and uploaded in central bank’s site
 Central Bank
o Downloads funds transfer files from the remitting bank
o Sorts the data beneficiary bank wise
o Uploads the file to the beneficiary banks
o This operation will be performed at regular intervals in a day (viz., 10.30 am ; 12.00 noon and 4.00 pm) to ensure
the credit happens to the beneficiary account on the same day.
o Central bank debit the remitting bank’s account and credit the beneficiary’s bank account maintained with them.
 Beneficiary Bank
o Downloads EFT file from central bank site
o Decrypts the file for processing the funds transfer to the beneficiary
o Credits the beneficiary’s account
RTGS

Real Time Gross Settlement (RTGS) Systems, has made the inter-bank funds transfer possible on a real time basis.

In NEFT, the funds are pooled at regular intervals and settlement is made, whereas in RTGS, the funds transfer happens on real time
basis. i.e. one transaction per transfer request.

To reduce the load / network traffic on such funds transfers, a limit is fixed by the central bank, which ensures that the system will
accept the funds transfer request only, if the amount is higher than the stipulated limit.
Cards - Credit / Debit / Smart
Introduction to Cards

Advancement in telecommunications and computing technologies has caused revolutionary changes in business models. Many
businesses have been freed from the constraints of physical space, limited working hours and political boundaries. Technology has
also impacted banking business in a big way. Banking has been freed from the constraint of physical branches. It is now possible for
customers to access the accounts and withdraw cash any time any where across the globe through ATMs, which are linked
internationally through VISA and MasterCard networks. However, branches continue to be most important channel for sales and
delivery of banking services and all other channels can at best support the branch channel.

Types of Cards

Cards are of different types as given below:

 ATM Cards
 Credit Cards
 Debit Cards
 Purchase Cards
 Private Label Cards
 Secured Credit Card
 Smart Cards

ATM Cards

ATMs or Automated Teller Machines, as the name indicates, are meant to provide the services that a teller at a branch provides on a
24 hour basis. ATMs started out as cash withdrawal machine to serve the customers any time, any where for the convenience of the
customers. The bank also benefited as the cost of installing the ATM was much lower than that of a branch. Gradually numbers of
services are increased in the ATM. The card is protected and the customers has to provide PIN (Personal Identification Number)
which is validated before the transactions.

Credit Cards

Credit cards are basically lines of credit that once established, depending on the specific terms, allow an individual to spend up to a
set amount of money, which is known as limits and pay back these amounts either in Part or in full. This can be also called as
“Plastic Money”. Credit card terms differ on annual fees, percentage rates, payback terms and creditworthiness restrictions. Cards
can be issued with Primary and Add on cards linked to the main card, where the limit fixed is an overall limit. They have a validity
period usually ranging from 1-2 years.

Corporate Credit Cards are also issued to Company designated employees where the charged amounts are debited to the company
account.

Credit cards are plastic cards with readable magnetic strips issued by a bank or a business, which allow the cardholder to purchase
goods or services on credit. Common credit cards include Visa, MasterCard, American Express and Diner’s Club.
Most of the Banks issue card that are affiliated to either VISA or MASTER because of its wide acceptability. Through Credit Cards,
besides purchase of goods and services, even cash withdrawal can be done upto a specified sub limit within the overall card limit.

Credit cards allow you to make purchases up to a specified limit and then enjoy a period of credit - usually up to the period varying
from one month to 50 days - before having to settle your bill. Every time you use a credit card, you are actually borrowing money
that is made available to you by a bank or other financial institution. You however have to repay a minimum amount each month, in
which case interest is charged on the balance amount, usually at a high rate. However, if you pay the bill in full you incur no
interest. This is like 50 days interest free loan. Why does any bank do that?

If you borrow Rs.20, 000 on personal loan at 11%.

Interest to be paid for 50 days = Rs. 20,000 * 11% * (50/365) = Rs. 301.40.

But, here the bank is giving you a loan without interest when you use their credit card. Do you astonish something is wrong
somewhere?. Well, the concept is explained below with a typical illustration:
1. When you use your card to pay for the camera which you bought from Sony World, You present your Bank credit card, say ABC
bank credit card (VISA card) for the payment.

2. Sony World swipes your card on a machine provided by Citibank. Here Citibank is the acquirer bank

3. Citibank communicates with the card issuer i.e. ABC Bank through VISA Network to check if the card is valid and has the
required credit limit.

4. ABC Bank reviews and approves / declines which is communicated back to Sony World.

5. You sign a receipt / slip called Sales Draft given by Citibank. This is the obligation on your part to pay the money to ABC Bank.
Data on this receipt can be captured electronically and transmitted.

6. At the end of day or at the end of some period Sony World submits the receipt signed by you to Citibank, which in return pays
Sony World the money. For the whole process Sony World pays Citibank a fee called Merchant Discount. Let us say this is 6% of
the sale value = 6% * 20,000 = Rs. 1200.

7. Citibank sends the receipt electronically to a Visa data center which in turn sends it to ABC Bank.

8. ABC Bank transfers the money to a settlement bank which in turn transfers the funds to Citibank.

9. Citibank pays ABC Bank an Interchange Fee of 4% of the sale value = 4% * 20,000 = Rs. 800.

10. 20 to 50 days later ABC Bank gets the money from you and you don’t need to pay the interest.

Sony World pays more than the interest that you should have paid for the loan that you take. As a cardholder, you have the
following benefits:

1. Convenience of not having to carry cash.

2. Credit availability that too free of interest

However what benefits does Sony World get for paying so much money? Isn’t it more profitable for them to take cash? They can
save as much as Rs.1200.

When you don’t count the money that you are spending, you tend to buy more! Cards encourage this activity which is called
impulse purchase. If you did not have access to credit, you would not have bought the camera this month or may be not any time
soon either. By accepting cards, the merchant is actually extending you credit at the risk of the card issuer. He pays money to the
banks to carry that risk.

Some banks provide cash back when you use Credit Card of that bank...why is it so..?

If the sales draft that you sign at the retailer is also be from ABC Bank (and not from Citibank), they save on the Interchange Fee. A
part of the Merchant Discount that they got may be passed on to you partially as Cash back.

Also if you have noticed, ABC Bank gives you cash back only in the next credit cycle which will get reflected only in the next card
statement. It means they keep the cash back money with themselves for 60 days before passing on a part to you. This accrues them
interest too. And that also explains why banks has tie up with petrol pumps for example. ABC Bank has tied up with an oil
marketing company where you could re-fuel your vehicle without paying the fuel surcharge of 2.5%. This is because the card issuer
and the acquiring bank is the same and that saves interchange fees.

Debit Cards

Debit cards are issued in conjunction with a business bank account, and are a substitute for cheques. This is similar to ATM card
and additionally these cards can be used at any Point of Sale (POS) terminal. These cards are normally powered by Visa or
Mastercard. It differs from Debit card in one way by rather than allowing you a period of credit, payments are deducted almost
immediately from your bank balance. As a result, spending is limited by your available funds and only signatories of a business
account can use these cards.

Purchasing Cards

Purchasing cards are generally restricted to big businesses or public-sector bodies. Issued by a range of banks and companies such
as Barclaycard and American Express, they’re designed to cut down on paperwork and the need for purchase orders.

Charge Cards

Charge cards also allow you a period of credit before you pay - but they must be paid off in full each month. Business banks tend to
make charge cards as part of their offer to small businesses. They can be issued to as many key employees as you choose - some
card issuers will allow you to set spending limits on employees’ cards.

Private Label Cards

Merchants can issue cards that can be used only in their retail chains/outlets .For example Sears may release a card in association
with any bank/network that can be used only in sear’s outlets. The advantage for the merchant in releasing such a card is that the
customer loyalty/reward with the merchant could be encouraged in the form of discounts and special offers. The cardholder can
accumulate points based on the purchases made and these points can be later redeemed for gifts, services or discounts. Banks issues
this type of products in association with large retail stores or airline companies.

Secured Credit Card

Secured credit cards are credit cards targeted to customers with poor or limited credit histories who do not qualify for a credit card.
Secured credit cards are collateralized by cash deposits, generally a passbook savings account or certificate of deposit. Depending
upon the bank’s policy, the credit limit is 50 percent to 100 percent of the deposit amount. The bank may pay interest on the deposit
account.

These programs benefit consumers by helping them either establish or reestablish a satisfactory credit history. If these customers
perform satisfactorily, many banks will “graduate” them to an unsecured credit card.

Smart Card

Cards that can electronically store a fixed value, which you have prepaid .As you make purchases, the value gets reduced by the
amount of the purchase, and can be replenished.

Smart Cards have a 8 bit micro processor embedded in the card which stores information about the cardholder, instead of the
magnetic stripe Though costlier, smart cards offer better security than the conventional cards with magnetic stripe.

Credit Card –Concepts

VISA, MasterCard & American Express are the three largest payment card systems in the world. Visa accounts for half of the global
purchases using cards followed by MasterCard and American express. These associations are managed by board of directors
composed of representatives on banks.

These associations are responsible for:

 Developing and implementing operating rules

  Processing transactions and interchange payments between members.
 Developing system-wide innovations such as interchange technologies.
 Promoting the association brand through advertising.
 Coordinating Fraud Control initiatives
 Signing up card issuers, Acquirers and merchants

Key Players in Card Business

 Issuer/ issuing bank: The Financial Institution that extends credit to customers through bankcards.
 Cardholder: The customer who possesses the card and conducts financial transaction using it as cash substitute.
 Merchant: Any business establishment is a “merchant” once an acquiring bank authorizes them.
 Acquirer/ Acquiring processor: The acquirer (the merchant/retailer’s bank) buys (acquire) the merchant’s sales slips (ticket) and
credit the ticket’s value to the merchant’s account.
 Interchange Networks (Visa & MasterCard): They provide services such as conducting authorizations, clearing and settlement
processing of transactions, supervising the bankcard processing within member banks and setting and enforcing bankcard rules and
regulation

Functions of Issuing / Acquiring Banks Function of an Issuing Bank

 Issue card to qualified customers

 Receive transaction information from franchise/ settlement house.
 Provide transaction and outstanding balance information to card members
 Take credit and fraud risk on card members.

Function of an Acquiring Bank

 Provide authorization.
 Accept transactions for credit to merchant accounts.
 Submit transaction information to franchise/ settlement house
 Provide statements and reconciliation to merchants.
 Take credit and fraud risk on merchants

Card Storage Information The details of what exactly the number in the credit card mean, and what type of information’s are
stored in the magnetic stripe are given below.

The first digit in your credit-card number signifies the system:

 3 - travel/entertainment cards (such as American Express and Diners Club)

 4 - Visa
  5 - MasterCard
 6 - Discover Card

The structure of the card number varies by system. For example, American Express card numbers start with 37; Carte Blanche and
Diners Club with 38.

 American Express - Digits three and four are type and currency, digits five through 11 are the account number and digits
12 through 14 are the card number within the account and digit 15 is a check digit.
 Visa - Digits two through six are the bank number, digits seven through 12 or seven through 15 are the account number
and digit 13 or 16 is a check digit.
 MasterCard - Digits two and three, two through four, two through five or two through six are the bank number (depending
on whether digit two is a 1, 2, 3 or other). The digits after the bank number up through digit 15 are the account number, and
digit 16 is a check digit.

The Stripe

The Stripe on the back of a credit card is a magnetic stripe, often called a magstripe. The magstripe is made up of tiny iron-based
magnetic particles in a plastic-like film. Each particle is really a tiny bar magnet about 20-millionths of an inch long.

The magstripe can be "written" because the tiny bar magnets can be magnetized in either a north or South Pole direction. A
magstripe reader can understand the information on the three-track stripe. If the ATM isn't accepting your card, your problem is
probably either:

 A dirty or scratched magstripe

 An erased magstripe (The most common causes for erased magstripes are exposure to magnets, like the small ones used to
hold notes and pictures on the refrigerator, and exposure to a store's electronic article surveillance (EAS) tag
demagnetizer.)

Information on the Stripe

The card details are stored / encoded in magnetic strip as Track 1,2 and 3. Each track is about one-tenth of an inch wide.

 Track 1 contains Card holder Name , expiry date, etc

 Track 2 contains Card number , expiry date, service code, CVV , PVV , etc
 Track three is a read/write track (which includes an encrypted PIN, country code, currency units and amount authorized),
but its usage is not standardized among banks.

Credit Card Life Cycle

The life cycle of card can be explained as below:

1. Cardholder uses the card to buy a product / service from the merchant

2. The transaction is captured and approved by the issuing bank

3. Bank issues statement to the customer informing the amount to be paid and the payment due date

4. There are three possible out comes

5. Cardholder pays in full in which case there is no interest charged, or the cardholder pays in part in which case the interest is
charged and levied to the customer during the next statement

6. Cardholder disputes the transaction in which case the charge back process/fraud investigation process kicks off

7. Cardholder does not pay in which case the collection process kicks off. If the amount is not recoverable, the amount is written off
and the account is closed.

POS Terminal Authorization

POS terminal transactions involve three steps:

 Authorization
 Clearing
 Settlement

Authorization

On presentation of the card, the merchant swipes the card through a card reader, which reads the data on the magnetic stripe and
adds information that identifies the merchant and the value of the purchase. The Electronic data capture (EDC) is the software at the
point-of-sale (POS) terminal that dials a stored telephone number and calls an acquirer.

The Acquirer reads the message and determines the type of Interchange Networks (Visa, Master Card). If the interchange network is
Visa, then it dials the Visa’s computer, which checks with the Issuer’s computer to verify the credit balance to cover the purchase.

If it founds enough credit, the issuer’s computer will send back a message to the interchange network (Visa, Master Card)
authorizing the transaction. The interchange network relays the message back to the terminal at the store as well as the acquirer.

Clearing
At the end of each business day, the merchant sends the sales transaction data with a request for payment to his acquirer, who in
turn sends it to the interchange network (Visa, Master Card). The interchange computer passes the request to issuer’s computer,
which posts the transaction to the cardholder’s account.

Settlement

The interchange network consolidates all the transaction for the day and sends the transaction details to the acquirer and issuer. The
issuer then sends the amount to the interchange network, which then posts it to the acquirer’s account.

Internet Credit Card Authorization

 Consumer goes web site, chooses goods and/or services, and fills out the merchant commerce application
 Consumer enters credit card information into a secured form that is sent over the Internet via Real Time Online Processing
software (i.e.Authorize.net), which then sends the encrypted transaction to the acquiring processor for credit card
authorization
 Acquiring processor sends transaction to card association, which in turn sends the request for credit card authorization to
the issuing bank
 Issuing bank accepts or declines the credit card transaction and sends message to the card association
 The card association contacts the credit card processor with the credit card authorization, and then the request to deliver
goods and services is given to the merchant by way of the online credit card processing software
 Merchant sends the credit card processing company "fulfillment notification to permit settlement" meaning that the goods
and services have been delivered or are ready to be shipped
 The capture takes place when the credit card authorization information is given to the issuing bank and the consumer's
credit card is charged for goods and services requested/received ** This entire process takes place in less than ten seconds.
 Finally, when the merchant decides to settle batch, the acquiring processor finalizes the credit card transaction with the
issuing bank and they transfer money into the merchant's bank.

Credit Card - Interest Calculation:

Billing Cycle and Statement date: Billing cycle is the one month period, the transactions done during the period are billed for the
customer on the last day of the billing cycle. The statement is generated and sends to the customer at the end of the cycle and the
print date is called statement date.

Total Amount Due (TAD) and Minimum Amount Due (MAD)

The total amount of billing during the billing cycle is the TAD (plus balance carried from previous bill if any). Card issuing banks
may insist only minimum amount say 10% of the TAD subject to minimum amount of say Rs 100 and this is called as MAD.

Payment Due Date & Interest Free Period

Normally the payment due date is some 20 or 22 days after the statement date. The customer has to pay either TAD or MAD on or
before the due date. If the customer pays TAD before the due date no interest is charged for the amount used on the purchases.

Interest Payment

When a card holder does not pay the TAD on or before the due date, he becomes liable to pay interest. For instance, if the TAD is
Rs 2000 and the card holder pays only Rs 800, on the balance Rs 1200, interest will be charged from the date of purchase. On the
remaining balance the customer loses the benefit of interest free credit period.

Further on all fresh purchases interest will be charged from the date of transaction itself. Non Payment of the TAD is called
“Rollover” as the balance is tolled over from one billing cycle to another billing cycle.

Example

Billing Cycle Oct 16 to Nov 15

Statement Date Nov 15
Payment Due Date Dec 7

Purchases during the billing cycle

Oct 23 Rs 1100
Nov 11 Rs 2300
TAD Rs 3400
MAD (5% of TAD) Rs 170
Interest Rate 3.65% per Month

Purchase after Billing Cycle

Nov 17 Rs 1650
Dec 03 Rs 980

Scenario 1:
On Dec 5 the customer pays Rs 3400, i.e. TAD

Consequences
Since customer has paid the TAD before the due date he will be eligible to get interest free credit period for the transactions after
Nov 15.

Scenario 2:
On Dec 6 the customer pays Rs 170, the MAD Consequences On the remaining balances interest will be charged at 3.65% per
month from the date of transactions.

 From oct 23 interest has to be paid on Rs 930 (1100 less 170) till it is paid in full.
 From Nov 11 interest has to be paid on Rs 2300 till it is paid in full.

On purchase after the billing cycle, interest has to be paid from the date of purchase

 From Nov 17, interest has to be paid on Rs 1650 till it is paid in full
 From Dec 3, interest has to paid on Rs 980 till it is paid in full

Default

Non payment of even the MAD is considered as default. It shows the lack of ability or inclination of the card holder to honour his
commitments. In the event of default, Bank initiate recovery proceedings.
Foreign Exchange
Introduction

This module introduces the meaning of Foreign Exchange and its importance in cross-border monetary transactions. It also covers
some basic concepts and terminologies used in Foreign Exchange transactions.

What is Foreign Exchange?

Foreign Exchange refers to changing money of one country for the money of another country. This is necessary since the money of
one country is of no value/use at the other country - it cannot be used freely – and there is no single universal currency in which all
settlements could be made.

Consider these scenarios:

1. An Indian resident is touring USA on business commitment - he needs US Dollars for his tour; he cannot use Rupees in USA.

2. A British tourist decides to purchase an antique in India - he has to pay Indian Rupees for the purchase; he cannot use (Sterling or
Great Britain) pounds.

3. A German firm procures (purchases/imports) ready made Garments which an Indian firm supplies (Sells/Exports) - the Indian
firm has to be paid in Indian Rupees and not EURO.

4. An Indian firm Imports Television Kit from a Japanese firm - the Japanese firm has to be paid in Japanese Yen and not Indian
Rupees.

Thus, the process of exchanging one currency to another is called Foreign Exchange.

Need for foreign exchange

As enumerated in the above example, whenever there is involvement of two different countries in any kind of exchange, the value
needs to be paid in the currency of the country eligible to receive funds. In a nutshell, foreign exchange is required for cross-border
transaction/trade settlement.

Foreign Exchange Market

The foreign exchange market can be defined as a market in which individuals, business firms and banks buy and sell foreign
currency. It is a large, growing and liquid financial market that operates 24 hours a day. It is not a market in the traditional sense
because there is no central trading location or “exchange". Most of the trading is conducted by telephone or through electronic
trading networks. Authorized Dealers

Not all persons or entities can deal in foreign exchange; it is governed by the regulations of the respective country and need
permission/license to transact. Those Banks and Institutions who have been permitted to deal in Foreign Exchange are called
Authorized Dealers (AD). Almost as a rule, all the banks are authorized to entertain foreign exchange transaction.

Money changers

Apart from AD, some firms or companies are also granted permissions to deal in foreign exchange. They cannot entertain the entire
gamut of transactions but can undertake transaction involving purchase or sale of Foreign Currency and Travelers’ check only.
These firms are known as Money Changers.

Foreign Currency

All currencies are denoted in 3 letter format standardized by ISO (International Standard Organization). The first two letters denote
the country and the last letter denotes the currency. Exception to this is EURO, where there is no country/currency combination
letters, but the letters denoting the common union – European Union.

The most commonly traded currencies are US Dollars (USD), Great Britain Pounds (GBP), European Union Common Currency
(EUR), Japanese Yen (JPY), Canadian Dollars (CAD) and Australian Dollars (AUD). Some other currencies are Singapore Dollars
(SGD), New Zealand Dollars (NZD), Indian Rupee (INR), Saudi Arabian Riyals (SAR), and UAE Dirhams (AED).

Currency pair

An AD buys foreign currency at lower rates and sells at higher rates (thereby earning profits). Meaning he always has two rates for
any currency pair - a buying rate and a selling rate.

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange
market. There are the two currencies that make up an exchange rate. When one is bought, the other is sold and vice versa.

Base Currency and Counter Currency

For any foreign exchange trading, currencies are quoted in terms of a currency pair. The first currency in the pair is the base
currency and the other currency is counter currency. For example, in a USD/JPY currency pair, the US dollar is the base currency
and JPY is the counter currency.

Exchange Rate

You are well aware that a kilogram of Rice does not cost the same as a kilogram of silver; there is considerable difference in the
cost or Rate. Likewise, each currency has a procurement rate different than the other. The Rate at which a currency is converted into
another currency is Exchange Rate. In other words, the rate at which one currency can be exchanged for another is an exchange rate.
For instance, each US Dollar costs Rs. 46.2750 means the rate for USD 1 is Rs. 46.2750, and each GBP costs USD 1.5925 means
the rate for GBP 1 is equal to USD 1.5925.

Exchange rates are generally quoted to 4 decimal points and in some cases up to 6 decimal points. For instance, USD/INR exchange
rate is 46.1424. Similarly, GBP/USD exchange rate is 1.59253.

Exchange rates are quoted

 In two methods – direct and indirect

 For selling and buying transactions
 For different periods – spot and forward

Direct and Indirect methods

1. Direct Rates

Under this system, the exchange rate for a foreign currency is expressed in terms of units of local currency equal to one unit of
foreign currency.

Example: USD 1.00 = Rs.48.50 would be a direct exchange rate for the USD in India

2. Indirect Rates

Under this system, foreign exchange rate is quoted as the foreign currency per unit of the domestic currency. In an indirect quote,
the foreign currency is a variable amount and the domestic currency is fixed at one unit. Example: INR 1 = USD 0.02062 would be
the corresponding indirect quotation in India for the USD.

An exception to the above rule is JPY (Japanese Yen), in which the rate is quoted per 100 Units instead of per unit.

The system prevalent in India until Aug 1993 was to quote exchange rates in the indirect method – all quotations used to be in terms
of foreign currency units equal to Rs.1.00. A switch was made to the direct rate system and consequently all quotations are now in
terms of rupees equal to a unit of foreign currency.

Purchase and Sale transactions

1. Purchase Transaction

It is a transaction in which the AD buys foreign currency (FC) and pays (sells) in equivalent local currency (LC); it converts FC into
LC

Example:
a. Inward remittance – USD 5000 remitted from USA converted to Indian Rupees (purchased) and credited to Savings Bank
Account in India.

b. Export bill paid – An Indian firm receives USD 10000 from USA which is converted to Indian Rupees (purchased) and credited
to the Current Account of the firm in India.

2. Sale Transaction

It is a transaction in which the AD sells foreign currency by taking (purchasing) a local currency.

Example:

a. Outward remittance - Rs.10000 from a Savings Bank Account in India converted to USD (sold) and remitted to an Account in
USA.

b. Import bill paid – An Indian firm imports machinery from USA and pays Rs.50000 which is converted to USD (sold) and
remitted to the exporter in USA.

One currency is bought (procured/accepted) and the other sold (paid/given). In other words, there are always two legs to one
transaction – buying of one currency and selling another currency.

The foreign exchange transactions result in increase/decrease of foreign currency holding and decrease/increase in local currency
holding of the entities involved.

Forex - Buying and Selling Rates

As mentioned earlier, there are always two legs for the same transaction – buying and selling. When one currency is bought, the
other is sold. For commercial transactions – transactions undertaken with customers for settling commercial deals like Imports,
exports etc. – rates are quoted based on the nature of transaction.

The following are the rates quoted for BUYING transactions:

1. Telegraphic Transfer (TT) Buying Rate

This is the rate at which a Foreign Inward remittance received by Telegraphic Transfer is converted into Rupees.

Example: If you are the beneficiary of a USD remittance from USA, Bank will apply this rate to convert the USD amount and credit
to your Savings Account in rupees.

2. Bill Buying Rate

This is the rate which is applicable to purchase an export bill. When a bill is purchased, the equivalent currency of the bill value is
paid to the exporter immediately. However, the proceeds will be realized by the Bank after the bill is presented on the due date.

Example: If you have exported machinery to USA and your counterparty has agreed to pay you after 60 days, you have an option to
approach your Bank in India requesting them to purchase the bill / pay you the amount of bill immediately and claim it later from
the counterparty’s Bank. The Bank will apply this rate to convert / purchase the USD bill amount and pay you in Rupees. There are
detailed rules governing `purchase of export bills which will be discussed later.

3. Travelers’ Cheque (TC) Buying Rate

This is the rate at which foreign currency Travelers’ cheques deposited by the customer is converted into Rupees.

Example: If you hold USD Travelers Cheque and approach a Bank to en-cash it. The Bank will apply this rate to convert the USD
TC amount, and pay you in rupees.

4. Currency (CN) Buying Rate

This is the rate at which foreign currency cash deposited by the customer is converted into Rupees.

Example: If you hold USD Currency Notes and approach a Bank to en-cash it, the Bank will apply this rate to convert USD Notes
and pay you in Rupees.
The following are the rates quoted for SELLING transactions:

1. Telegraphic Transfer (TT) Selling Rate

This is the rate applicable when a customer sends an outward remittance through Telegraphic Transfer for purposes other for
imports.

Example: If you approach a Bank in India to remit USD to one of your relatives/friends in USA, the Bank will apply this rate to
convert your Rupees to USD, and send it to USA.

2. Bill Selling Rate

This is the rate used for all transactions which involve handling of document by the Bank (payment against import).

Example: If you have imported machinery from USA and approach a Bank in India to pay your USA counterpart in USD, the Bank
will apply this rate to convert your Rupees to USD and send to USA.

3. Travelers’ Check (TC) Selling Rate

This is the rate applicable when a customer buys foreign currency Travelers’ checks from the Bank.

Example: If you approach a Bank in India for obtaining travelers’ checks to be used during your travel to USA, the bank will apply
this rate to convert your rupees to issue you USD TC.

4. Currency (CN) Selling Rate

This is the rate applicable when a customer buys foreign currency notes from the bank.

Example: If you approach a Bank in India for obtaining USD currency notes to be used during your travel to USA, the Bank will
apply this rate to convert your Rupees to issue you USD Currency Notes (CN).

Other rates which were quoted before liberalization of Indian economy (1991), but are no longer of much significance are DD/MT
buying, Cheque Buying and DD Selling.

Spot and Forward Deals

A Forex transaction concludes either immediately or after sometime. This depends on the accrual (actual receiving in this case) of
funds. For example, funds can be received immediately as in the case of receipt of remittance from abroad, or after sometime as in
the case of realization of export proceeds, which generally takes place after the goods reach the buyer and he pays the money for the
goods. In both the cases, exchange rates can be agreed on the date of transaction itself.

The deal (transaction) for which funds would be received immediately is called spot deal and for that to be received later is called
forward deal.

Why are Authorized Dealers interested to entertain foreign exchange transactions?

As you would appreciate, any trade is done to earn profits. For example, a wholesale grain merchant buys rice from the
farmers/middlemen at say, Rs. 300.00 per quintal, and sells it to other retail traders at say, Rs. 325.00. Retailer in turn will sell it to
end users at say, Rs.340.00. Meaning, wholesaler makes a profit of Rs. 25 and retailer earns a profit of Rs.15.00 in the transaction.

However, not always does the trader earn profit; he could incur a loss as well, for instance, when there is a bumper crop and hence
reduction of rate. Taking the above example, after having bought rice from farmers at Rs.300.00, the merchant also exposes himself
to the risk of a loss, selling it to the other retail traders at Rs.290.00 due to sudden spurt in supply of rice in the market.

The same is applicable for buying/selling of foreign currency also. The AD buys USD from the other AD/customers at say, Rs.
46.00 and sells it to other customer at Rs. 46.10, earning a profit of 0.10 paisa. Here again, the AD is exposed to a loss also that in
case, if the market fluctuates adversely and he is forced to sell USD to other AD/customers at Rs.45.90, he incurs a loss of 0.10
paisa.

In a nutshell, foreign exchange transactions, while earning profit for the AD also exposes them to the risk of loss from the rate
difference between buying and selling.
Foreign Exchange - Deals and Trading

Foreign Exchange transactions between entities are commonly called Deals and this process of dealing is called Trading.

Any Trading has two aspects – purchase and sale. A trader has to purchase goods from his suppliers which he sells to his customers.
Likewise, the Bank purchases as well as sells its commodity (foreign currency).

Two points need be constantly kept in mind while talking for a foreign exchange transaction.

1. The transaction is always talked off from the Bank’s (AD) point of view.
2. The item referred to is the foreign currency.

When we say a purchase, we imply that –

1. The bank has purchased.

2. It has purchased foreign currency.

When we say a sale, we imply that –

1. The bank has sold; and

2. It has sold foreign currency.

Foreign exchange transactions can be in Currency Notes, Travelers Cheques, realization of export proceeds (inward remittance),
payment of imports (outward remittance), Bank Deposits etc.

How FX Trading takes place

While AD enters into a transaction with his customer/client, he is well aware whether he is going to buy or sell foreign exchange to
his customer. However, the same is not true while trading with other AD – also called counter-party.

When the counter party asks for a rate – commonly termed quote - he is not aware if the counter-party wants to buy or sell. He
would, however, be aware of the amount of the transaction, since while asking for rate, the amount is specified. He has to
necessarily quote two rates simultaneously - also called two-way quote - the rate at which he is ready to buy and the rate at which he
is ready to sell. This is as per international norms/practice.

For instance, Deutsche Bank (DB) would typically ask “Quote USD/INR rate”. The rate quoted by say, SBI would be, for instance,
46.1735/40, meaning SBI is willing to buy at 46.1735 and sell at 46.1740. If the rate is agreeable, depending on whether DB wants
to buy or sell, he would say ‘Mine’ (meaning USD is mine – DB is taking/buying from SBI), ‘Yours’ (meaning USD is yours – DB
is giving/selling to SBI), or ‘Thanks’ (meaning “thanks for the quote; not suitable and hence not interested either to buy or sell”).

Key Players in Forex Market

The following are the key players in Forex Market:

1. Central Bank: The country’s central Banks play a crucial role in controlling money supply, maintaining stability of the local
currency by timely intervention in case of volatility in Forex Market (by supplying/sucking currency to/from the market), regulating
inflation, and also in handling Government related Foreign exchange transactions.

2. Commercial Banks (AD): These engage both in the commercial transaction based Forex transaction (like Imports, Exports and
remittances) and in ‘Trading’. (Forex Trading refers to the transactions entered between AD without any underlying Commercial
Transaction; it is done more a speculation like share markets, but well defined and transparent).

3. Hedge funds: These investment vehicles, which are having considerable funds, impact the market by investing in Forex Market
as their strategy.

These apart, others who are indirectly involved in Forex Deals (as commonly referred for the transactions) are Inter-Bank Brokers
(who enable conclusion of transactions by finding counter-party), Commercial companies (who have large exposure in foreign
exchange owing to global business undertaken), retail brokers (who offer dealing platforms, analysis and strategic advice) and
Investors and speculators (who speculate regarding market movement and invest suitably for earning profits)

Strong and Weak Currency

When the exchange rate of a currency pair moves upwards, the base currency is said to become strong and the counter currency
weaker.

If USD/INR goes from 46.1025 to 46.1050, USD is said to become strong and the INR weak. Conversely, if on the other hand it
moves to 46.1010, then INR is strong and USD is weak.

Determination of Currency Prices

The predominant factor governing the exchange prices is the demand and supply. When the demand for currency is high, the rates
for the currency which is sought goes up in relation to the counter currency, and the vice-versa occurs when the supply is more than
demand. This apart, political stability, interest rates and inflation are other factors which govern the exchange rate. Where the local
currency is hurt meaning the local currency becomes weak, the Central Bank intervenes by injecting Forex into the market, and vice
versa.

Major Currencies

The currencies which are in high demand globally and widely traded in the global market are the Major Currencies. Generally, the
currencies belonging to G7 Countries are considered the Major Currencies. They include USD (US$), CAD, GBP (£), EUR (€) and
JPY (¥).

“PIP”

As mentioned earlier, currency rates are generally quoted to 4 decimals. The last decimal of a quotation is a PIP. If currency rate
moves from 1.1677 to 1.1676, the movement is one PIP.

Spread and Commission

As mentioned earlier, the buying rate is always less than selling rate. The difference between buying and selling rate is the spread
(profit).

Apart from the exchange rate, banks load additional amount to the exchange rate offered to customer towards its cost; this
percentage is dependant on the nature of transaction, and is the commission of the AD.

Fixed Rate

It is the exchange rate decided, and the rate at which deals are done, by the Central Bank of the country transactions.

Floating Rate

This is the exchange rate determined by the market forces. This is based on the demand and supply of Forex in the market, and
varies with the change in demand and supply.

BID and ASK rate

As mentioned earlier, the AD quotes two-way rates – the rate at which it buys and sells. Buying rate is termed BID rate and Selling
rate is termed ASK or Offered rate.

Example:

The Mid Rate fixed by a Central Bank for USD/INR is 46.50

BID (Buying Rate) quoted by an AD for USD/INR is 46.40 which indicate that the AD is willing to buy Rupee against USD @
46.40, thereby earning a spread (profit) of 0.10.

ASK (Selling Rate) quoted by an AD for USD/INR is 46.65 which indicate that the AD is willing to sell Rupee against USD @
46.65, thereby earning a spread (profit) of 0.15.

In the example above, the difference between buying and selling is the profit, popularly called spread.

Value Date

Every foreign exchange transaction involves exchanges of two currencies by the counterparties to the transaction. Example – Mr. X
receives dollars in New York and pays out Rupees in Mumbai. The counterparty Mr. Y pays out dollars and receives Rupees in the
respective centers. The date on which the exchange of currencies is to take place is the Value Date of the transaction.
The currencies need to change hands at the same point of time but this is not possible because of the time differences in the two
centers. Hence, the use of value dates. Since money in any currency has a time value, namely interest, the value date of a foreign
exchange transaction will have to be a working day in both the centers where the money transfers are to take place.

FX Dealer

Person concluding Forex transaction is called a dealer. He takes position in one of the currencies, and enters into a counter deal
when the spread (profit rate) is favorable, thereby earning profit.

FX Broker

They enable conclusion of deals by finding a matching counter deal, earning commission for the services.

“Rollover” of Contracts

When the transactions are not concluded on the due date, and is instead postponed to a future date with mutual agreement of the
parties involved, the contract is said to be ‘Rolled Over’. The rollover happens for two business days, and involves payment of
interest for the two day period.

Extension

Contracts which cannot be utilized on the due date, the contract may be extended; the original contract is will be liquidated and a
new contract is entered. The profit/loss arising out of the transaction is for the customers’ account.

Nostro Account

Nostro Account is the foreign currency account of an AD in the country of the currency. An India based bank would have USD
Account in AMEX New York, GBP Account in Barclays Bank UK, EUR Account in DB Frankfurt, and JPY account in Bank of
Japan Tokyo. These accounts are called Nostro Accounts. These accounts are used for settlement of Forex transactions in the
respective currency.

Vostro Account

Account of a foreign Bank held in local currency is called Vostro Account. For example, Citi Bank New York holding a Rupee
Account with SBI in India is called Vostro Account.

The activities in these accounts are maintained in the Banks’ books; these are called mirror accounts. The entries in the mirror
accounts are matched with the counter entries in the Nostro Account to ensure correctness of accounting; this process is called
reconciliation.

Correspondent Bank

This is the Bank with whom business relationship exists; it is not necessary that a bank maintains Nostro account with the
correspondent Bank. For example, an Indian Bank holds Nostro Account with Chase Manhattan Bank, New York, but could route
the transaction through Bank of California, San Francisco.

Payments/Settlements

You will agree that funds pertaining to the Forex deals need be settled; the foreign currency amount need be transferred to the
beneficiary’s Nostro Account and the local currency amount through the locally prevalent arrangement.

While the local currency is settled by transferring funds from one account to other account maintained generally by the central bank
or a bank designated by the central bank – funds are transferred from payer’s account to beneficiary’s account – through clearing or
direct account to account transfer, foreign currency amounts are settled by transferring funds from one Nostro account to another.

In both the cases, authorization is issued by the payer to his correspondent bank – central bank is the “correspondent” in respect of
local currency settlement – to transfer funds from their account to the beneficiary’s account. Local currency settlement happens by
issuing Cheques, and foreign currency settlement happens by communicating instructions electronically.

A few years ago – prior to year 2001 – settlement instructions were transmitted through telex from India. Since then, messaging
system developed by SWIFT – Society of Worldwide Inter-bank Financial Telecommunication – and agreed by banks globally are
in vogue, since it affords secure, fast and cost effective means of transmitting settlement instructions.
Banks which maintain Nostro Account of various banks charge for maintenance of accounts, including for the activities happening
in the account. The charges are on per-transaction basis, and termed Nostro Activity charges.

To curtail payment of these charges, Foreign Exchange Clearing system is operational in India and in few other countries (may be in
different flavor), wherein netting of both payment and receipt of foreign currency is done, and one instruction is transmitted for the
net amount payable.

For transaction of very huge volumes, a payment system called RTGS – Real Time Gross Settlement – is prevalent. Funds
transferred through RTGS reach beneficiary within couple of hours. This eliminates the requirement of writing cheques and the
clearing process. This is especially helpful when payment is to be made beyond clearing hours.

Dealing Room

A Dealing Room is a place where foreign exchange deals are entered. It occupies an important place in the organization as a profit
centre. It is staffed by specially trained personnel – popularly known as “Dealers” - who are specialized in executing foreign
exchange deals.

As you know, exchange rates are guided basically by the demand and supply factors. Because of this one sees fluctuations in
exchange rates in foreign exchange markets. Dealers take advantage of such volatility in exchange rates and enter into trading
positions – purely buying and selling – to maximize profits.

Dealing Room Operations – An overview

Dealing room has three sections:

1. Front Office: Where actual dealing operations take place.

2. Middle Office: Where MIS, policies and Risk Management aspects are dealt with
3. Back Office: Which takes care of tracking settlements, Reconciliation, accounting and reporting.

When a deal is entered by the dealer, a deal slip is generated by him and passed on to the back office for obtaining confirmation of
deal, settlement and accounting including arriving at the profit/loss position of the dealing room operations. Middle office ensures
that all the policy guidelines are duly complied and proper MIS reports are generated.

Direct Deals

With the advancement of technology, platforms wherein a forex transaction can be concluded electronically – on the rate display
screen itself – are available. Various agencies like Reuters and Bloomberg, which updates the global events and exchange rates on a
continuous basis, offer the possibility of entering and concluding forex transaction on the screen itself. It also enables printing of
deal slips immediately on conclusion of deal.

Wherever deals are done over phone, facility to record the conversation is available, to ensure that disputes if any are immediately
settled by replaying the recorded message.
Limits & Collaterals
Introduction

A typical Business scenario:

1. You propose to be in the business of trading in commodities.

2. You want to engage in manufacturing and selling of spare parts/components required for manufacturing TV.
3. You want to purchase or construct a house.
4. You desire to own a brand new car.
5. You have invested in NSC for tax saving purposes and in shares to earn better returns sometime back. However, you now require
funds for some family commitment.
6. A construction company is given a contract to construct a bridge.
In all the above circumstances, the main ingredient required to achieve the desired goal is finance.

You will agree that availability of entire quantum of finance required for the targeted goal is extremely rare. To achieve the target,
therefore, you would scout for source of funds.

This is where the banks pitch in; they offer to finance you for an agreeable return – or interest and fees.

Limits

In simple words, the amount up to which the bank agrees to lend is called the Limit. In other words, it is the maximum amount of
credit that a financial institution will extend to a borrower.

Before proceeding further, let us get acquaint ourselves with a few terms used in lending.

Retail loans

Lending of money to individuals is Retail Lending. Loans like car loans, housing loans etc. are called retail loans

Corporate Loans

Loans granted to business units or corporates for business purposes are called corporate loans. Lines of Credit, Term Loans etc. are
corporate loans.

Interest and Margin

Any lending attracts interest and Margin.

The interest rate and margin percentage depends on the client including his past performance, conduct and value of the account and
his standing in the business circle amongst others. Margin is stipulated to ensure that the value of security is not eroded, and is
sufficient to cover the outstanding liability.

Period

This is the maximum timeframe within which the loan amount is expected to be liquidated.

Types of Limits

Limits can be classified on the basis of funds outflow as fund-based limit or non-fund based limit.

Fund based limits

Fund based limits involve outflow of funds, meaning the money is lent/physically parted by the banker. They can be generally of
following types:

1. Cash Credits / Overdrafts

This is the primary method in which Banks lend money against the security of commodities and debt. It runs like a current account
except that the money that can be withdrawn over and above the amount deposited in the account, up to the extent agreed by the
bank.

It is arrangement by which a banker allows his customer to borrow money upto a certain amount – called limit. This is the most
popular mode of borrowing by large commercial and industrial establishments, on account of the advantage that a customer need not
borrow entire money (projected as required) at once but can draw such amounts as and when required.

Let us see how a Bank arrives at the limit / amount of credit assistance for a Cash credit beneficiary with an example:

A commodity trader is engaged in business on a continuous basis. Meaning, he needs finance on an ongoing basis. Under such
circumstances, how do the banks go about granting financial assistance?

The trader projects -

Annual sale Rs.600000 (Projected)

Purchase value Rs.480000 (assuming 20% profit margin)
Traders’ stake Rs.120000 (20%)
Shortfall Rs.360000
Fortnight sale Rs. 25000

Assume that the past performance evidences his per fortnight sale. In such an event, you can accept his projected sale as achievable.

However, it should be noted that the entire sale does not happen in one lot; it happens in stages – once in a fortnight he sells goods
worth Rs.25000. If he normally receives payment in about 15 days from the date of sale, the total period his funds would be blocked
would be one month, in which period, he would make total sale of Rs. 50,000.

Sales Rs. 50,000

Purchase Rs. 40,000 (assuming 20% profit margin)
Customers’ stake Rs. 10,000
Financial Assistance Rs. 30,000

In other words, he would require Rs.30000/- as bank finance at any given point of time for ensuring continuity of business.

Overdrafts

Loans granted against LIC policy, National Savings Certificates, and Shares (where there is no availability of stocks) is called
Overdraft. Depending on the security, margin is stipulated in this case.

Example:

Face value of National Savings Certificate Rs.10000

Margin stipulated 20%
Finance granted Rs. 8000

Similarly, margin of up to 50% could be stipulated against shares. This can also be a one-time loan or running account.

2. Term Loans

Banks lend money in this mode, when the repayment is sought to be made in fixed, pre-determined installments. This type of loan is
normally given to the borrowers for acquiring long term assets (assets which will benefit the borrower over a long period –
exceeding at least one year).

Purchase of plant and machinery, constructing building for factory, setting up new projects fall in this category. Vehicles loans,
loans for purchase of consumer durables, home loans also form a part of term loans.

Based on the period of repayment, Term Loans are further classified into –

a. Short term loans (repayable within 2 to 3 years)

b. Medium term loans (repayable within 5 to 7 years)
c. Long term loans (for tenor above 7 years)
Let us see how a Bank arrives at the limit / amount of credit assistance for a term loan (home loan) beneficiary with an example:

If you decide to purchase a flat, you require finance to the extent of cost of flat. Yet again, you need to invest a portion of money
from your own sources, and the bank will finance the rest.

Total cost of the ready to occupy flat Rs.2500000

Margin (your stake) Rs. 500000 (20%)
Bank finance Rs.2000000

If on the other hand, if the dwelling unit is under construction, the loan is ‘disbursed’ (released) in stages as per the work progress.

The above principle is also applied in various other types of loans – like Car loans, loans to purchase consumer durables etc.

3. Bill Discounting

In Bill discounting, Bank takes the bill drawn by borrower on his (borrower’s) customer and pays him or her immediately deducting
some amount as discount / commission. The Bank then presents the Bill to the borrower’s customer on the due date of the Bill and
collects the total amount. If the bill payment is delayed, the borrower or his customer pays pre- determined interest to the Bank
depending upon the terms of transaction.

Let us see how a Bank arrives at the amount of bill discounting with an example:

An exporter has exported goods for USD 50,000, the payment of which is due after 60 days. The exporter maintains a fund based
limit of USD 100,000 (which is arrived after thoroughly assessing his portfolio, value of security offered, collateral value and his
creditworthiness) with his bank. He is in need of funds / wants to discount the bill and approaches his/her bank.

Total Bill amount USD 50,000

Interest charged by the Bank USD 2,000 (4%)
Commission / Charges USD 500

Discounted Bill amount USD 47,500

The Bank assesses the bill against the purchase order and if all the terms and conditions of the export contract are complied with, the
Bank decides to discount the bill.

The Bank has discounts the bill / credits the party with USD 47,500 with interest / commission for 60 days working out to be USD
2,000 plus commission / charges USD 500. The Bank claims the bill value of USD 50,000 from the borrower’s customer after 60
days.

Non-fund based limits

In this type of credit facility, the banks funds are not lent to the customer but there is a commitment to part with funds in case of
necessity. The Banker undertakes a risk to pay the amounts on happening of a contingency.

They can be of the following types among other -

1. Letter of Credit Facility

The Banker undertakes to pay on presentation of documents of title to goods. (Explained in detail under “Trade Finance”)

2. Bank Guarantee

The Banker undertakes to discharge the liability of borrower to third parties. (Explained in detail under “Trade Finance”)

Other factors influencing limits

Limits are influenced by a variety of factors including your credit history and credit rating.

While credit history shows payment and borrowing pattern of the borrower, credit rating shows a subjective assessment of the
creditworthiness based on the credit history and assets / liabilities of the borrower. These factors are a part of the evaluation process
used by Banks in setting limits.

Monitoring of limits
Limits are carefully monitored to ensure that the designated amounts are not exceeded. Borrowers with excellent credit rating and
credit history are often rewarded with increase in limits. Having a high credit limit but exceeding that limit is often viewed
favorably among Banks. A borrower who has the ability to utilize a large amount but opts not to do it is often seen as a responsible
borrower.

Security

When a bank sanctions a loan, it has to secure its funds. In other words, it has to protect the funds against default.

1. In case of limits against stocks, the stocks – also called inventory - are held as security.
2. When the stock is converted into finished goods and sold, the receivables become security.
3. When the loan is sanctioned against car or flat, the car or flat, against which loan is sanctioned is taken as security.
4. When limit/loan is granted against permitted security, the instrument (like NSC, LIC policy, shares etc.) are taken as security.
5. In case of construction contract, there is no physical security available. Nevertheless, finance is needed for payment to men and
machinery amongst other things. The only security available is the receivables – either bills raised or to be raised – against which
limits are sanctioned.
The securities enumerated above are termed prime security. They are basically the securities available, against which the loan is
sanctioned. It is the main security.

The terms used for obtaining security are

 Pledge (of stocks)

 Hypothecation (of vehicle)
 Mortgage (of land and building)
 Guarantee (of the business owner)

Collateral Security

In case of a default, the loan amount can be recovered by disposing of the underlying security. But the amount realized may not
meet the outstanding loan amount or liability. In other words loan may not be cleared by disposal of proceeds. To obligate such an
event, further securities are taken. These securities are termed collateral securities.

Collaterals are properties or assets that are offered to secure a loan or other credit. Collateral becomes subject to seizure on default.

Example:

When a housing loan is sanctioned, apart from residential property, further securities in the form of NSC or LIC policies may be
taken by the bank.

Likewise, in case of business loans, apart from inventory, further security like factory premises may be taken as collateral security.

The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and
interest under the terms of a loan obligation. If a borrower does default on a loan (due to insolvency or other event), that borrower
forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral.

Security or Collateral Management

Security or Collateral Management is the process of agreeing, confirming and advising collateral transactions.

As enumerated earlier, when the banks lend money to the customers, sufficient security is taken to safeguard the finance. The bank
regularly assesses value of assets to ensure that the value of assets covers their exposure. You will agree the value of plant and
machinery, and other equipments, is reduced with usage. As against this, the value of the value land and building generally increases
with passage of time.

Stock Statement

The value of securities taken is subject to fluctuation. In the example of lending to trader, while the customer would have stocks
worth Rs. 25,000 on a particular day (when he procures the same), on a subsequent date it could be Zero, since he would have sold
the stock.
Under the circumstances, the bank has to ensure that there is no liability outstanding in the account. Meaning the customer has to
deposit the sale proceeds in the account. However, it is possible that the customer would not have received the payment since he
would have afforded some time (credit period) to the buyer before making payment. And the customer would have raised an invoice
for this amount. In which case bank would finance against the bill – receivable – and clear the inventory finance.

This procedure, however, cannot happen always, considering that the business is a continuous process. A more feasible method is
adopted by the banks – they advice the trader to submit their stock holding position – called stock statement – at regular intervals.

The bank officials inspect the stock at periodic intervals to ensure that the statement submitted is correct. The paid value of stocks is
the physical holding less the stock received on credit (for which the customer has not paid). As a prudent practice old, and hence
possibly non-disposable stock value is also reduced (it is unrealizable stock).

Money Market
Introduction

The money market is a component of the financial markets involved in short-term borrowing and lending with original maturities of
one year or shorter time frames. These transactions are concluded to either plug the gap in fund requirement or deployment of
surplus funds. It is better known as a place for large institutions and government to manage their short-term cash needs. However,
individual investors have access to the market through a variety of different securities.

While we have given a global Overview on money markets in this module, for clarity in understanding the concepts, we have
focused on the Indian scenario wherever required. Nevertheless, the money market transactions are the same with locally applicable
regulations.

Consider the following situations:

1. When a customer deposits funds in Bank, a portion of the amount has to be deposited by the Bank with RBI as cash to meet CRR
and SLR requirement.
To either tide over the shortfall, or to deploy surplus funds, banks trade in the money market instruments.

2. Corporate entities are sometimes surplus of funds, which is probably not required immediately. As you will agree, these funds are
idle and hence does not yield any return. To earn some returns by way of interest, these idle funds are deployed in money market
instruments.

3. Government requires funds for their various initiatives. An example is development of infrastructure.
To fund the initiative, they raise short term funds from the market by trading in money market instruments. As can be seen from the
above instances, short term monetary transactions are entered through money market instruments.

Features of Money Market

Money Market instruments are issued and traded by Government, Financial Institutions and large corporations. These instruments
are considered highly liquid (easily disposable), extraordinarily safe, and very conservative, and hence yield low returns.

Money market investments are otherwise known as cash investments because of their short maturities and easy liquidity.

Trading in Money markets are for huge volumes and only large corporations, Government and Financial Institutions, who have
substantial amount of surplus funds, trade in money market instruments.

It would be interesting to note that the investments in money market is on their own account, and hence the investor themselves
carry the risk. (This is as against share market wherein a broker acts on behalf of his client and earns a commission for enabling the
transaction).

The money market interest rates are deregulated; they are determined by demand and supply. However, these rates generally would
be linked to some benchmark rates
Money market trading obligations take place in over-the-counter markets; traders across different banks generally close their money
market positions over phone or through brokers.

Need for Money Market

Money Market is a market place which enables the various players – Government, Financial Institutions and Large Corporations –
to borrow or lend short term funds to earn a return. If the above facility not were to be available, these institutions would have not
been able to deploy the funds and earn return for their idle funds. Likewise, short term requirements could also not have been met.
Thus, money market enables management of short term funds.

Money market operations are handled by treasury department of the organizations, which may either be integrated with Forex
operations, or working in unison.

Objectives of Money Market

1. It provides an equilibrating mechanism for productively investing short-term surpluses and plugging short term deficits.
2. It provides a focal point for central bank intervention for influencing liquidity in the economy (as SLR, CRR & Repo Rates are
controlled by RBI in India)
3. It provides reasonable access to users of short-term money to meet their requirements at a realistic price. Money market
instruments

Money market securities are essentially Promissory Notes issued by governments, financial institutions and large corporations.
There are several different instruments in the money market, offering different returns and different risks. Here are the major ones -

1. Call Money / Notice Money

Call Money or Call deposit is the money loaned where the borrower has to repay the funds when called on to do so by the lender.

Notice money refers to money loaned where the lender has to give a certain number of days notice to the buyer to repay the funds;
the notice period is agreed at the time of contract. Participants are permitted to lend / borrow for tenors ranging from overnight to a
maximum of 14 days.

2. Term Money

Term Money refers to those borrowing / lending transactions between the inter-bank participants which have tenor greater than 14
days.

3. Certificate of Deposits (CD)

A Certificate of Deposit is a time or fixed deposit with a Bank. They bear a specific maturity date, a specified interest rate and can
be issued in any denomination. They offer slightly higher return than Treasury Bills (issued by the Government – see item 9 below)
because of the slightly higher default risk for a bank.

The amount of interest that you earn depends on the current interest rate scenario, amount invested, period invested and the Bank.
The main advantage of CD is their relative safety and the ability to know your return ahead of time. On the other hand, the money is
locked up for the specified period and there could be penalty for premature withdrawal.

CDs are issued at discounted price (i.e. interest rate is applied on discounted basis for the duration of the CD and discounted value is
accepted as deposit and the agreed maturity value specified on the instrument will be paid on maturity to the holder. CDs are
negotiable & can be transferred by endorsement and delivery and hence are tradable in money markets like Over The Counter
Exchange of India (OTCEI).

4. Commercial Paper

Commercial Paper (CP) is an unsecured short-term loan / instrument issued to finance short-term credit needs of large institutional
buyers. It is issued at a discount – lesser than mentioned on the instrument - reflecting current market interest rates. Maturities on
CP are usually no longer than nine months, with maturities between one and two months, average.

CP is a very safe investment because the financial situation of a company can easily be predicted over a few months. Only
companies with high credit ratings and credit worthiness issue CP and subscribed by the investors.
Even CPs are negotiable & can be transferred by endorsement and delivery and hence are tradable in money markets like Over The
Counter Exchange of India (OTCEI).

5. Bankers’ Acceptance

Bankers’ Acceptance (BA) is a short term credit investment created by a non-financial firm and guaranteed by a bank to make
payment. They are traded at discounts from face value in the secondary market. It is simply a bill of exchange drawn by a person
and accepted by a Bank. It is a buyer’s promise to pay to the seller a certain specified amount at certain date. The same is
guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person drawing the bill must have a
good credit rating otherwise the Banker’s Acceptance will not be tradable.

For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods and is highly useful
when the credit worthiness of the foreign trade party is unknown. One advantage of a BA is that it does not need to be held until
maturity and can be sold in the secondary markets where investors and institutions constantly trade BA.

Example:

Let us assume the face value of a BA to be USD 10000. Commission for one year is 3% p.a. Then, the amount received by the
Exporter in one year is USD 9700.

6. Euro Dollars

Eurodollars are US dollar-denominated deposits at banks outside the US. This market evolved in Europe and hence the name. Euro
dollars can be held anywhere outside the US.

This Euro dollar market is relatively free of regulation because of which Banks operate on narrow margin than their counterparts in
the US. Euro dollars have maturity of less than six months. There is Euro dollar Time Deposit so also Euro dollar Certificate of
Deposit. Euro dollar CDs are less liquid and offer higher yields.

7. Inter Bank Participation Certificates

Inter Bank Participation Certificates (IBPC) are short term money market instruments to even out liquidity within the banking
system. This is purely an inter bank instrument whereby the banks can raise money and also deploy short-term surplus.

The objective is to provide some degree of flexibility in the credit portfolio of banks and for smooth consortium arrangements. In
the case of IBPC, the borrowing bank passes / sells on the loans and credit that it has in its book, for a temporary period, to the
lending bank.

8. Collateralized Borrowing and Lending Obligations (CBLO)

CBLO is a money market instrument developed for the benefit of entities who have either been phased out from inter-bank call
money market or have been given restricted participation in terms of ceiling on call borrowing and lending transactions and who do
not have access to the call money market.

It is basically a discounted instrument available in electronic book entry form for the maturity period ranging from one day to ninety
days.

9. Treasury Bills (T-Bills)

Treasury Bills are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially T-Bills
are a way for the government to raise money from the public. T-Bills are issued by the US Government, Indian government and
governments of many other countries. They are short term securities that mature in one year or less from their issue date.

T-Bills are considered to be the safest investments in the world because the governments back them. They are exempt from state and
local taxes in many countries.

They are issued with different maturities and purchased for a price that is less than the face value (at a discount). The holder gets the
full par value on maturity. The return to the investor is the difference between the purchase price of the security and what he gets at
maturity.

Example:

If Mr. X buys a 180-days T-bill at USD 9600 and holds it till maturity, he will earn USD 400 on his investment considering the
maturity value of the T-bill to be USD 10000.

10. Municipal bond

A Municipal Bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds
include cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned
airports and seaports, and any other governmental entity (or group of governments) below the state level.

11. Federal Funds

In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks
keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. These loans are
usually made for one day only, that is, "overnight". The interest rate at which these deals are done is called the federal funds rate.
These are much like SLR and CRR requirements of RBI in India.

12. Repurchase Agreements (Repo)

Those who deal in government securities use Repo as a form of overnight borrowing. It is a form of short-term borrowing for
dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys
them back the following day. They are short term loans – normally for less than two weeks and frequently for one day – arranged by
selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

This short-term maturity and government backing means Repo provides lenders with extremely low risk. Repo is popular because
they can virtually eliminate credit problems.

a. Reverse Repo – It is the complete opposite of a Repo. In this case, a dealer buys G-Securities from an investor and then sells
them back at a later date for a higher price.

b. Term Repo – It is almost the same as a Repo except the term of the loan is greater than 30 days.

Participants in Money Market

Predominant participants in Money Market are:

1. Government (Central/State)

The Central and State Governments issue short term instruments to finance their budget requirements, deficits and public sector
development programs.

Example:

The Indian Government is an issuer of Government Securities (popularly known as G-Sec.) and Treasury Bills (popularly known as
T-Bills). The State Government issue securities termed as State Development Loans (SDL) to fund their budget deficit.

2. Public Sector Undertakings

PSU issue taxable and tax-free bonds to finance their working capital requirements and long term projects.

3. Banks

Banks issues Certificate of Deposits for period ranging from 7 days to 1 year. Banks also invest their surplus funds in PSU bond
market and trade to take advantage of rate volatility.

Example:

Banks in India participate in overnight (call) markets to manage their Cash Reserve Ratio (CRR) commitments so also in G-
Securities to maintain their Statutory Liquidity Ratio (SLR).

Cash Reserve Ratio (CRR)

Banks in India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks do not hold
these as cash with themselves, but deposit such cash with Reserve Bank of India (RBI) 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.

Example:

When a bank’s deposits increase by Rs.100, and if the cash reserve ratio is 6%, the banks will have to hold additional Rs. 6 with
RBI. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be able to use for lending and investment. This
power of RBI to reduce the lend-able 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.

Statutory Liquidity Ratio (SLR)

SLR stands for Statutory Liquidity Ratio. This term is used by bankers in India and indicates the minimum percentage of deposits
that the bank has to maintain in form of quickly realizable approved securities. Thus, we can say that it is ratio of approved
securities held vis-à-vis deposits accepted/held by the bank from the public. Currently, the SLR is pegged at 25%. Meaning for
every INR 100.00 accepted as deposit, INR 25.00 should be held in the form of quickly realizable approved securities. This also
enables regulating the credit growth in India.

In a nut shell, out of INR 100.00 the bank accepts as deposits, INR 6.00 has to be held as CRR and INR 25.00 should be held as
SLR. In effect, the banks would be able to lend INR 69.00 to the borrowers.

4. Private Sector Companies

They issue Commercial Papers (CP) and corporate debentures. Companies with cash surplus are active investors in instruments like
Fixed Deposits, Certificates of Deposit and T-Bills.

5. Provident Funds & Mutual Funds

PF invest their short term and long term surplus funds in instruments according to their internal guidelines as to how much they can
invest in each instrument category. Mutual Funds invest their funds in money market and debt instruments according to their
approved investment pattern declared in each scheme.

6. General & Life Insurance Companies

GIC have to maintain certain funds which have to be invested in approved investments like G-Sec and Bonds. They also participate
as lenders in this market. LIC invest their funds in G-Sec, Bonds or short term money markets.

7. Non Banking Finance Companies

NBFC, as a mandate, invest their funds in debt instruments to fulfill certain regulatory requirements and also to park their surplus
funds.

Clearing and Settlement

Clearing and settlement is the mechanism through which money market instruments are transferred and relative payments made.

Whenever a money market instrument is traded, some means must exist for transferring the instrument and for making payment. In
other words, there is a necessity for clearing and settling the trade, tasks that are usually referred to as operational or back-office
functions.

Clearing refers to processing a trade and establishing what the parties to the trade owe each other. Settlement refers to the transfer of
value/ instruments (securities and currency) between the parties so the trade is completed.

Steps involved in Clearing and Settlement

The first step is to convey details of the trade from traders to the back office. Second, the details must be compared and matched
between the buyer and seller to ensure that there is an agreement between the buyer and seller regarding what is to be traded and the
terms thereof. Failure to do so might lead to delivery problems. The participants in the money market are linked by clearing and
settlement systems.

Where banks fit in

At the center of the clearing and settlement mechanism for the money market are banks and the inter-bank payment system. Banks
connect the participants in the money market by acting in three capacities.
1. Banks act as agents for issuers of money market instruments; they therefore perform the physical tasks of issuing and redeeming
instruments in the market and of maintaining registration records.

2. Banks act as custodians of instruments: they render their services as safe-keepers of instruments to investors. The bank's balance
sheet does not show like valuables kept in a safe-deposit box, or instruments entrusted to a custodian bank, as either assets or
liabilities because they remain the property of their owners.

3. Finally, and most importantly, some banks specialize in clearing. The responsibility of clearing bank is transferring of securities
from one party to another and for transferring payment for securities.

Payments
Introduction to Payments

In this module, we look into various technology-dependant payment mechanisms which have been introduced, and are becoming
popular by the day globally, in the banking system.

Payments

Payments are generally understood as transfer of funds from the payer to the payee.

‘Payer’ is the party making the payment

‘Payee’ is the party receiving the payment

A payment that is initiated, processed and received electronically can be termed as an e-payment (technology dependant payment).
Conventional payments are enabled through cash or check whereas electronic payments are carried out by means of software,
payment cards and electronic cash.

The major components of e-payment system are money transfer applications, network infrastructures, and rules & procedures
governing the use of the system. Customers and merchants are the major actors of e-payment systems.

Technology dependant payments greatly increase efficiency by reducing transaction costs duly enabling trade in goods and services
cheaper. They may also increase the convenience of making payments by enabling them to be made swiftly and remotely from
various devices connected to global networks.

Check21

The Check Clearing for the 21st Century Act, commonly referred to as Check 21, is a federal law (of US) that enables banks to
handle more checks electronically, which makes check processing faster and more efficient. It is designed to replace the old process
whereby banks must physically move original paper checks from the bank where the checks are deposited to the bank that pays
them, transportation that can be inefficient and costly.

Check 21 makes a “substitute check” (created using an image of the check) the legal equivalent of the original paper check. Under
Check 21, banks can electronically transmit check images rather than physically moving the original paper checks between the
receiving and paying banks.

Check 21 applies to all types of checks: consumer, business, travelers and U.S. Treasury.

Reason for introduction of this system

One of the many hard lessons learned from the tragic events of September 11, 2001, was the importance of developing and
implementing improvements to ensure the safety and security of the U.S. payments system.

With the country’s domestic air transportation system grounded for several days, a serious weakness in the paper-based check
processing system was exposed, creating a potentially crippling set of circumstances. Since physical checks could not move, the
system came to an abrupt halt, signifying the need for a rapid conversion to electronic processing. Further, processing costs of
physical check are increasing, amounting to nearly twice that of electronic payments. A paper check is physically handled an
average of 26 times during processing, adding days to the total processing time. This also contributed to necessity for electronic
processing.

Check 21 was designed to improve the overall efficiency of check payment processing. Financial institutions and their corporate
customers are already realizing significant cost savings from float improvements, fraud detection and more efficient processing.
Imaging technology is decreasing dependency on postal and transportation systems. Check 21 is also shortening turnaround time,
improving customer service and increasing collection rates on returned checks.

Benefits of Check21

Operationally, financial institutions can reduce transportation costs, infrastructure costs, hardware maintenance, supplies and labor
resources, check storage expenses, and sorting time.

Through remote deposit, commercial businesses can also reduce check processing time and expenses, make deposits without leaving
the office, and access funds quicker than ever before.

The Industry Benefits

 Eliminates the risks associated with physically moving billions of checks.

 Improves efficiency and ensures stability of the U.S. check payment system.
 Facilitates, without mandating, check truncation.
 Reduces the overall cost of check processing.
 Streamlines the check collection and return processing.
 Capitalizes on existing technology.
 Promotes, encourages and enables image exchange.

The Financial Institution Benefits

 Accelerates settlements.
 Reduces the volume of physical checks.
 Reduces the number of times the physical check is handled.
 Facilitates rapid discovery of fraud.
 Allows for earlier or multiple transmission.
 Eliminates resubmits.
 Lowers clearing fees.
 Reduces check float.
 Improves collections.
 Promotes electronic processing of share draft returns.
 Accelerates receipt and processing of check collections returns.
 Enables potential increase in return check service fee income.
 Reduces research and adjustments.

The Commercial Customer Benefits

 Reduces the time it takes to process checks.

 Deposits can be made without leaving the office.
 Eliminates travel expenses and courier fees.
 Deposits can be made daily.
 Many banks have extended deposit cutoff times.
 Provides for faster access to funds.

Overview of Check21 process

As with all checks, the Check 21 clearing process starts with a person writing an original check. The payee then deposits the check
with the Bank of First Deposit or BOFD, which we will call Bank A. Bank A then stamps its endorsement onto the back of the
original check.

Let's assume that Bank A decides to “truncate” the original check and send electronic information about the check to Bank B;
therefore, Bank A is the “truncating bank.”

Of course, in order for this scenario to occur, Bank B must have previously agreed to accept checks electronically from Bank A.

In order to truncate the original check, Bank A:

 captures an image of the front and back of the original check;

 captures the magnetic ink character recognition (MICR) line data from the original check; and
 sends the image and MICR line data in lieu of the original check to Bank B, its correspondent bank.

Bank B applies its endorsement electronically and transfers the check image and MICR line data to Bank C. Again, in order for this
scenario to occur, Bank C must have previously agreed to accept checks electronically from Bank B.

Bank C wants to present the check for payment to Bank D, the paying bank. However, Bank D has not agreed to accept checks
electronically. Accordingly, Bank C uses the information received from Bank B to create a substitute check, and therefore becomes
the reconverting bank.

Finally, Bank C presents the substitute check to Bank D for payment. Bank D, the Paying Bank, uses the MICR line data on the
substitute check to process it just like an original check.

Bank D may provide the substitute check to its customer, who wrote the original check, in the customer’s monthly periodic
statement.

Legal aspects

The bank issuing substitute checks to the customers in lieu of the original instruments must provide a disclosure to that effect
immediately.

When a wrong debit is posted in the account, if the same is disputed by the customer with sufficient evidence, the dispute should be
immediately redressed. Pending redressal, depending on the circumstances, the bank may need to re-credit the check amount
disputed, subject to a maximum amount ceiling, Further, if the claim is found to be false, the bank, immediately after recovering the
amount (within 24 hours), should inform the customer about recovery.

The main disadvantage of this system is the cost of hardware required for check scanning/truncation, but it is more than offset over
a period of time by the cost saved in physical clearing process.

Electronic Funds Transfer

Overview

The term EFT refers to the application of computer and telecommunication technology in making or processing payments. This is
the term used for the payment system itself, rather than any specific product.

EFT can be broadly classified into wholesale and consumer payments. While wholesale payments are sizeable in volume, and hence
use wholesale EFT networks, consumer payments are small in value, but large in number.

Direct Payment

This is another form of electronic banking which is generally concluded through the Automated Clearing Houses (ACH) located at
the Central Bank or their branches. In this system, credit/debit to/from the account is done directly with a one-time written
authorization. This eliminates use of ATM cards repeatedly.

Direct credit is used predominantly for regular payments like salary and pension payment, and direct debit for preauthorized bill
payments. In India, this system is popularly known as ECS (Electronic Clearing System).

EFT (Electronic Funds Transfer)

This system is used to electronically move funds from one account to another in a different bank. The account at the other bank
could be of the same person or may be third party. This system is used predominantly for values lower than the minimum amount
specified for other types of payment systems.

In India, the EFT works as under:

The remitter fills in the EFT Application form giving the particulars of the beneficiary (city, bank, branch, beneficiary’s name,
account type and account number) and authorizes the branch to remit a specified amount to the beneficiary by raising a debit to the
remitter’s account; the instructions can be given online also if the bank provides online banking facility.

The remitting branch prepares a schedule and sends the duplicate of the EFT application form to its Service branch for EFT data
preparation. If the branch is equipped with a computer system, data preparation can be done at the branch level in the specified
format.

The Service branch prepares the EFT data file by using a software package supplied by RBI and transmits the same to the local RBI
(National Clearing Cell) to be included for the settlement.

The RBI at the remitting centre consolidates the files received from all banks, sorts the transactions city-wise and prepares vouchers
for debiting the remitting banks. City-wise files are transmitted to the RBI offices at the respective destination centers.

RBI at the destination centre receives the files from the originating centers, consolidates them and sorts them bank-wise. Thereafter,
bank-wise remittance data files are transmitted to banks. Bank-wise vouchers are prepared for crediting the receiving banks’
accounts the same day or next day.

The receiving banks at the destination centers process the remittance files transmitted by RBI and forward credit reports to the
destination branches for crediting the beneficiaries’ accounts.

It is pertinent to note that the transactions have a cut-off time; transactions originating after cutoff time are processed the next
working day.

Home Banking (Online Banking)

This facility, made available by many banks, and enabled through internet, offers a host of facilities to the account holders. They
include viewing account balances, transferring funds, request for demand draft, make utility payments, etc.

Electronic Check Conversion

This facility enables converting physical checks to electronic form. The necessity and usage is explained in detail under Check21.

Advantages

This EFT facility reduces processing cost and time, eliminates delay in payment and hence resultant penalty payment, and does
away with the cumbersome process and time of writing/delivering the check.

Real Time Gross Settlement (RTGS)

An RTGS payment system enables processing and settlement of payment instructions between banks individually and continuously
throughout the day. This is in contrast to net settlement systems (such as paper-based clearing houses and their more modern
electronic equivalents), where payment instructions are processed ("cleared") throughout the day but Inter-bank settlement (i.e. the
movement of the funds between the banks) takes place only afterwards, typically at the end of the day.

In other words, RTGS are funds transfer systems where transfer of money takes place from one bank to another on a "real time" and
on "gross" basis.

Settlement in "real time" means payment transaction is not subjected to any waiting period. The transactions are settled as soon as
they are processed.

"Gross settlement" means the transaction is settled on one to one basis without bunching or netting with any other transaction. Once
processed, payments are final and irrevocable.

Benefits of RTGS

The attraction of the RTGS systems is that payee banks and their customers receive funds with certainty, during the day, enabling
them to use the funds immediately without exposing themselves to risk.

The implementation of RTGS systems by Central Banks throughout the world is driven by the goal to minimize risk in high-value
electronic payment settlement systems.
RTGS in USA Federal Reserve Wire Network (Fedwire) is the Real Time Gross Settlement Funds Transfer system operated by the
Federal Reserve Banks in USA. In conjunction with the privately held Clearing House Interbank Payments System (CHIPS),
Fedwire is the primary United States network for large-value or time-critical domestic and international payments, and it is designed
to be highly robust and resilient.

RTGS in Europe

TARGET2 is the Real Time Gross Settlement system for the Euro currency, and is offered by the Eurosystem. The participants
comprise of the European Central Bank and the National Central Banks of those countries that have adopted the Euro currency.

It is used for the settlement of central bank operations, large-value EURO interbank transfers as well as other EURO payments, and
provides real-time financial transfers and debt settlement at central banks which is immediate and irreversible.

This "electronic" payment system is normally maintained or controlled by the Central Bank of a country. There is no physical
exchange of money; the Central Bank makes adjustments in the electronic accounts of Bank A and Bank B. For example, if an
RTGS transfer is initiated from a customer of Bank A favoring customer of Bank B for USD 100,000/-, the Central Bank makes
adjustments in the electronic accounts of Bank A and Bank B, reducing USD 100,000/- in Bank A's account and increasing in Bank
B's account by USD 100,000/-.

The RTGS system is suited for low-volume, high-value transactions. It lowers settlement risk, besides giving an accurate picture of
an institution's account at any point of time.

Such systems are an alternative to systems of settling transactions at the end of the day - also known as the net settlement system.

In the net settlement system, all the inter-institution transactions during the day are accumulated. At the end of the day, the accounts
of the institutions are adjusted. Extending the illustration above, say another person deposits a check drawn on Bank B in Bank A
for $50,000/-. At the end of the day, Bank A will have to "electronically" pay Bank B only $50,000/- ($100,000 - $50,000).

RTGS in India

The Reserve Bank of India (India's Central Bank) maintains RTGS payment network in India. RTGS is very similar to EFT process,
except that the system is used for large value transaction – INR 1,000,000 or more in India – and the funds are settled in pre-defined
time frame. Typically, the payment has to reach the beneficiary within a maximum of two hours.

Both the remitting and receiving must have Core banking in place to enter into RTGS transactions. Core Banking enabled banks and
branches have assigned RTGS 11-character alphanumeric codes, which are required for transactions along with recipient's account
number.

Trade Finance
Introduction to Trade Finance

Trade denotes buying and selling, and Finance in one word is “money”. Trade Finance is the method which buyers (importers) and
sellers (exporters) of commodities and goods use to finance their businesses.

In other words, the money or funds necessary/involved for performing buying and selling of various commodities is called Trade
Finance.

Trade can happen within the confines of the country or across the border. The former is termed inland Trade and the latter Foreign
Trade or International Trade. International Trade happens also due to cost consideration; if the cost of goods available locally is
more than that available in the international market, trade transactions are entered to save costs.

Any trade transaction can be broadly broken down into:

Movement of Goods
Movement of Documents
Movement of Funds

Banks role in trade transactions

Banks play a role in the “Movement of Documents” and “Movement of Funds” after “Movement of Goods” has been done through
a whole range of logistics players.

You would agree that trade can happen not only between known parties, but also with strangers; the ultimate goal of any trade is to
earn profit. For instance, a wholesale dealer in commodities sells it to a retailer – whosoever it is – so long as he gets the money; he
would not attach importance to who the buyer is. So also, the retailer sells it to the consumer so long as he gets the money for goods.

While the above is true for across the counter transactions, when the trade happens between parties unknown to each other, both the
parties involved would desire to know the credentials of the other before entering into any transaction. While the seller is interested
in ascertaining that the money for goods sold is realized, the buyer would be interested in ensuring that agreed quality and quantity
of goods, for which payment is/would be made, is received.

Banks involve in the trade transaction and enable receipt of goods by the buyer and money by the seller.

INCOTERMS

In international trade, the buyer and seller enter into a contract for supply of goods by the seller at an agreed price, which includes
all costs involved right from dispatch of goods from seller’s place to buyer’s place - freight, insurance, duty etc. The International
Commercial Terms (INCOTERMS) give a clear picture of the responsibilities of the seller-buyer in commonly used terms.

INCOTERMS are recognized by most countries and were first published by International Chamber of Commerce (ICC) in 1936
with subsequent amendments. ICC, for which most of the banks are members, was formed to frame rules for international trade,
applicable throughout the world. All the international trade transactions are governed by these rules framed by ICC.

There are 13 different INCOTERMS grouped into 4 different categories. We have restricted our study at this level to only 04 of the
active terms.

1.EXW (Ex-works)

The obligation of the seller under this contract is to make the goods available at his premises / factory. The BUYER has to bear the
full cost and risk involved in bringing the goods from the seller’s premises to the desired destination. All costs, taxes etc. both at the
seller’s country and the buyer’s country have to be borne by the BUYER.

2. FOB (Free on Board)

The seller’s obligation is to arrange to prepare the goods, pack them, place them on the vessel as per the terms of contract and obtain
a bill of lading evidencing shipment.

3. C&F (Cost & Freight)

The seller has to prepare, pack, transport upto the port and arrange to place the goods on board a vessel and obtain bill of lading
with freight paid. The buyer has to arrange to receive the goods at the destination. He has to arrange for insurance of the goods
during transportation.

4. CIF (Cost, Insurance & Freight)

Under this contract, the price quoted by the seller includes cost of goods, freight charges upto named destination and insurance
covering the voyage. The risk in the goods passes on to the buyer the moment they are placed on board a vessel in the seller’s
country.

Certain variants of the above major INCO terms are less in vogue.

Documents involved in trade finance transactions

1.Bill of Exchange or Draft

A bill of exchange is an instruction by the exporter (drawer) to the Importer (drawee) or the importer’s bank to make payment of the
amount mentioned in it. It is a very important document for any financial transaction; it is negotiable and can be produced in the
court of law as evidence of, and for recovering, dues.

A bill of exchange can be ‘Clean’ meaning not accompanied by any documents or ‘Documentary’ meaning accompanying with
commercial documents.

The tenor of the bill shows when it is due to be paid. It is either –

At sight – It is payable when the exporter (drawee) sees it (on demand).

Term or Usance – It is payable at the end of a fixed period. This period is usually a specified number of days (30, 60, 90 etc.) after
either sight or the date of the draft or the shipment date.

2.Commercial Invoice

A commercial invoice is a statement containing full details of the goods shipped.

It contains – names and addresses of the seller and buyer, details of goods shipped (quality, quantity, description and value),
packing details and packing marks, price and amount payable by the buyer, terms of trade (FOB, CFR or CIF), details of freight
charges, insurance premium and other charges etc.

3.Shipping Documents

This document evidences transportation of goods. It contains – name of the seller and buyer, transported from and to place, number
of boxes / cartons / bags.

Predominant modes of transport used –

LR (Lorry Receipt) – This is a receipt of goods for carriage by Road (Lorry).

RR (Railway Receipt) – This is a receipt of goods for carriage by Rail.

BL (Bill of Lading) – It is a receipt given by the shipping company to the shipper for goods accepted for carriage by sea. The most
important thing to note here is that – it also conveys title to the goods.

AWB (Airway Bill) – This is a receipt of goods from an airline company. As AWB is only a receipt, it is not a document of title.

Multimodal (Combined) Transport Document – This document lists the place of receipt, place of delivery and the different modes of
transport involved.

4.Insurance Documents (Policy / Certificate)

This provides actionable evidence of a contract of insurance and shows full details of risks covered. A marine insurance policy, for
instance, provides cover against perils of the sea and other connected risks which the goods are exposed to.

5. Inspection Certificate

Certain buyers stipulate that the goods being shipped are inspected before shipment; they could also specify agencies that should
inspect the goods. These inspecting authorities issue certificate after inspecting the goods, duly recording their observations.

Various internationally reputed Inspection agencies provide the Inspection services for a nominal charge, thus building in an
element of comfort in the international transactions by assuring the importer / buyer that goods being shipped are as per the
standards agreed upon between the importer and the exporter.

6. Packing list

This document indicates the way goods are packed, meaning whether in cartons, gunny bags etc. They also indicate the quantity,
measurement and weights of goods contained in each pack.

7. Certificate of Origin

This document evidences the country in which the goods exported were manufactured or produced.

Depending on the nature of goods involved in the trade, other documents, which could also be variants of the above, may be
stipulated for submission.

Modes of International Trade

There are 03 major recognized ways of effecting payment in international trade:

Clean Payments (a) Advance Payment (b) Open Account

Bills for collection (a) Docs against Payment (b) Docs against Acceptance

Documentary Credit (Letter of Credit)

Let us assume that Company X from India wants to import machinery from Company Y incorporated in USA. We shall see each of
the ways that Company X can pay Company Y in this trade.

1. Clean Payments

Clean Payments are basically driven by trust. Either the exporter sends the goods and trusts the importer to pay once the goods have
been received or the Importer trusts the exporter to send the goods after payment is effected.

In Clean Payment, all documents are handled directly by the trading parties (importer and exporter). The role of banks is limited to
only effecting payments.

(a) Advance payment

The exporter may require that the importer should make full payment in advance for the goods to be exported. This is possible
where the goods enjoy sellers’ market (seller can dictate terms). This mode of transaction is demanded by the exporter (seller) when
the selling party is a well-known and reputed company in its field. The exporter would dispatch the goods after he receives the full
payment from the importer.

Advance payments are usually adopted when the trading parties do not yet have a long term relationship. Here the importer has to
fully rely on the integrity of the exporter and his capacity to execute the order in time. The entire risk of the transaction is
shouldered by the Importer.

Example:

Company X (importer) remits money to Company Y (exporter) and after receiving the full payment, Company Y dispatches the
goods to Company X.

(b) Open Account

This situation is reverse of that for advance remittance. Under this method, goods are dispatched to the buyer who takes delivery of
them without making payment. It is agreed that he will make the payment to the seller at a predetermined future date (30, 60, 90
days after shipment etc.). Open Account as a method of settlement is possible where the commodity commands buyer’s market.

Here the exporter bears the entire risk, loses control over the goods and relies on the integrity of the importer to receive payment.
This type of a transaction symbolizes a long-term regular relationship between the two parties. As long as the exporter can trust the
importer to make his payments on time, an Open Account transaction is the simplest mode of doing long-term business.

Example:

Company Y (exporter) dispatches the goods to Company X (importer) and after receiving the goods, Company X remits the money
to Company Y.

2. Bills for collection (Documentary Collection)

In Bills sent for collection, the exporter does not part with the goods or the control over the goods till he receives payment and the
Importer does not pay until he gets the possession or control over the goods. The exporter draws a Bill of Exchange (Draft) on the
importer for the good exported.

Goods are dispatched to the importer’s country but the relative documents are sent through a bank for collection. The bank hands
over the documents to the importer only on receiving from the latter the value of the goods as advised by the Exporter.

Two important points to be noted in Documentary Collections –

Banks involved do not give any guarantee of payment. Collections are subject to Uniform Rules of Collections (URC) framed by
ICC.

There are two types of Documentary Collection transactions: (a) Documents against Payment (D/P)

Also called Cash against Documents / Cash on Delivery, D/P means payable at sight (on demand). The Bank at the importer’s end
hands over the documents only when the importer has paid the bill. The attached instructions to the documents would read –
“Release Documents against payment”

The exporter, in this case, keeps control over the goods (through the banks) until the importer pays.

Example:

Company Y (exporter) ships the goods to Company X (importer) and submits the shipping and financial documents to its bank
(PQR Bank). PQR Bank sends the document with a covering letter (instructions) to Company X’s Bank (JKL Bank) detailing the
release of documents to Company X on payment.

As per the instructions of PQR Bank, JKL Bank releases the documents to Company X on paying the value of the bill. Company X
takes delivery of the goods and JKL Bank sends the payment to PQR Bank to be credited to Company Y.

(b) Documents against Acceptance (D/A)

In D/A, the Bank at the importer’s end hands over the documents against acceptance of a draft (to pay on a future date as per
instructions) by the importer. The future date is pre-defined (30, 60 or 90 days etc.)

Here, the exporter allows credit to the importer; the period of credit is called as “Usance”. The importer is required to make a signed
promise to pay the bill at a set date in the future. The attached instructions to the documents would read – “Release Documents
against Acceptance”. The exporter, in this case, loses control over the goods.

Example:

Company Y (exporter) ships the goods to Company X (importer) and submits the shipping and financial documents to its bank
(PQR Bank). PQR Bank sends the document with a covering letter (instructions) to Company X’s Bank (JKL Bank) detailing the
release of documents to Company X on acceptance to pay after 60 days.

As per the instructions of PQR Bank, JKL Bank releases the documents to Company X on accepting the Draft to pay the value of
the bill after 60 days. Company X takes delivery of the goods and makes payment after 60 days. JKL Bank sends the payment to
PQR Bank to be credited to Company Y.

Here, Company X may or may not pay after 60 days and JKL Bank does not give any guarantee of payment.

3. Documentary Credit (Letter of Credit)

Documentary Credit is an instrument of settling trade payments.

If the seller (exporter) is not comfortable in sending the documents for collection, and instead desires to have some kind of
assurance of payment – this scenario arises when buyer (importer) is new – he requests the seller (exporter) to arrange for an
undertaking from the bank to make payment when the documents are received. By this, he eliminates dependence on the buyer
(importer) for realization of funds. The buyer (importer) in turn approaches his banker to give an undertaking to pay the bill amount.
This undertaking issued by the bank on behalf of his customer to make payment on receipt of bills, or on a future date, is called
Letter of Credit (LC).

A letter of Credit is an irrevocable undertaking issued by the banker on behalf of applicant (buyer/importer) favoring the beneficiary
(seller/exporter) to pay a certain sum of money against presentation of documents stipulated, and in compliance with the terms and
conditions stipulated therein. The decision to pay under a LC is based entirely on whether the documents presented to the Bank
appear on their face to be in accordance with the terms and conditions of the LC. It may be noted that banks deal only in documents
and not in goods. However, by building suitable terms in the LC, they ensure that the underlying shipment indeed takes place.

High degree of involvement by banks in the LC process builds in trust into the transactions.

Two important points to be noted in Documentary Credit –

It is binding on the LC issuing Bank to pay the LC value to the exporter provided documents presented are in accordance with the
terms and conditions specified in the LC. Documentary Credits are subject to Uniform Customs and Practices for Documentary
Credits (UCPDC) framed by ICC.

Example:

Company X (importer) from India enters into a contract with Company Y (exporter) incorporated in USA to buy machinery.
Company X approaches his bank (PQR Bank) to issue an LC favouring Company Y.

PQR Bank issues an Import LC and sends an MT 700 Swift message to JKL Bank (USA) at exporter’s end. JKL Bank advises the
LC to Company Y.

As per the terms and conditions mentioned in the LC, Company Y packs and ships the goods to India. Company Y submits
documents to JKL Bank which in turn sends the documents to PQR Bank.

Based on the documents presented being in accordance with the terms and conditions of the LC, PQR Bank releases the document
to Company X and makes payment to JKL Bank to be credited to Company Y.

Here, it is binding on PQR Bank to make payment provided documents presented are in accordance with the terms and conditions
specified in the LC.

Inter Bank communication - SWIFT

The interbank communication between banks/organizations is routed through SWIFT (Society for Worldwide Inter-Bank Financial
Telecommunication) network, which is a co-operative society owned by its member financial institutions and head quartered in
Belgium. It is a secure network for transmitting messages between financial institutions. The message formats are pre-defined and
referred to by category numbers called MT numbers.

MT 700 series deals with Documentary Credits and Guarantees (Imports), and MT 400 series deals with Documentary Collections
(Exports). (Other series are defined for other purposes). The message formats which are also associated with Trade Finance are
MT103 (Customer Transfer) and MT202 (General Bank Transfer); they enable trade finance related payments.

As mentioned above, individual message formats are available for specific requirement under each series. One cannot write SWIFT
instructions that do not work with the preset messages and expect the sending bank to accept them, or the receiving bank to respond.

Partial shipment

Goods under LC can be shipped in full (one lot) or in installments or in parts (multiple lots). Shipment in multiple lots is termed
Part-shipment.

Transshipment

When goods are shipped between end destinations with intermittent stops involving unloading and reloading of goods, cargo is sent
with Transshipment.

Bank Guarantees

Assume that Company X decides to purchase manufacturing equipment of considerable value, duly undertaking to make payment
for equipment in 10 half-yearly installments spread over a five year period. You will agree that the supplier of the equipment would
not generally agree for that, unless somebody undertakes to make payment of installments in case Company X fails to pay.

Assume that you have requested a contractor to construct your house. Assume further that the contractor demands advance payment
of 25% of the cost of construction. Considering the value involved, you would not desire to part with such huge amount, unless
somebody undertakes to make good the advance paid, if the contractor defaults from his obligation to construct your house.

In both the above instances, if somebody undertakes to make good the loss arising out of default, the supply/payment is made. And
this somebody is generally a banker.

Guarantee is an undertaking issued by the bank on behalf of its constituent, favoring the beneficiary, to pay the underlying amount if
the terms of the contract or agreement are not honored

In the first instance, if the installment is not paid on due date, and in the second, if the contractor fails to construct the building to the
extent of advance received, the bank would compensate for the financial loss.
When the payment under the contract is defaulted, the beneficiary of the guarantee demands payment under the guarantee. This
demand is referred to as invoking of Guarantee. Soon after the guarantee is invoked, the bank is expected to make payment of
invoked amount.

Here again, for extending facility to establish a Guarantee, prior arrangement is set up between the banker and the applicant.

Export Finance

Pre-shipment and Post-shipment Finance

Assume that an order is received to supply (sell) 1000 TV Sets every month. Procurement of such large number of TV sets involves
substantial cost, which the seller may not be able to invest fully from his sources. To enable seller procure and sell TV sets, the
banks lend certain percentage of total money required by the seller. This is called pre-shipment finance or inventory finance –
financial assistance extended before transportation or shipment for building up inventory.

Again, some time would lapse before the cost of goods is received (recovered) from the buyer. Till such time, the seller would be
out of funds. This disables him from procure next set of TV sets for want of funds. To ease the situation, the banks lend against the
sale proceeds to be received. This is called post-shipment finance or receivable finance – financial assistance extended after
transportation or shipment against the money to be received.

As in any other kind of loan or advance, the above finance is also eligible for interest recovery.

Types of Pre-shipment Finance

Based on the disbursement currency, Pre-shipment finance can be classified into two:

1. Packing Credit (Local Currency) - PCL

This is the financial assistance extended for meeting the cost incurred before shipment. This financial help is in local currency and
the interest chargeable is at rates applicable to local currency advance.

2. Pre-shipment Credit (Foreign Currency) - PCFC

This is the financial assistance for meeting the cost incurred but extended in Foreign Currency. The interest charged are governed by
the interest rate applicable for the foreign currency (LIBOR) which is generally less than the local currency rates.

Types of Post-shipment Finance

Based on the disbursement currency, Pre-shipment finance can also be classified into two:

 Local currency advance

 Post-shipment Credit in Foreign Currency

Post-shipment finance depends on the type of bill and nature of Transaction.

Purchasing a Bill (For Sight Bill)

Discounting a Bill (For Usance Bill)
Negotiating a Bill (For Bills under LC)

For extending either pre-shipment finance or post-shipment finance, prior arrangement is set up between the banker and the seller.
The arrangement amongst other things, specify the amount up to which the banker is willing to lend, the percentage he is willing to
share (business owner needs to have stake in the business, either already existing or stipulated; bank would chip-in with the balance
amount), the period till which this arrangement would exist, and the interest and other charges payable for the services.

London Inter Bank Offered Rate (LIBOR)

LIBOR is the interest rate at which banks in London lend to each other. LIBOR is considered to be the most active interest rate in
the world and even though it is a London-based interest rate, LIBOR is used in various markets around the world including in the
US.
In this case, it acts as a base rate to calculate interest rate to be charged on a Foreign Currency loan.

Example:

Company X (exporter) from India enters into a contract with Company Y (importer) incorporated in USA to sell pharma goods
costing USD 50000 in 90 days. Company X approaches its bank (PQR Bank) to avail Pre-shipment Credit in Foreign Currency for
90 days.

Let us assume USD 3 Months LIBOR Rate to be 4.00 %.

PQR Bank calculates the interest rate to be charged on USD 50000 PCFC for 90 days with USD 3 Months LIBOR as the Base Rate.

The rate of interest charged by the Bank will be 4.00 + 0.75% = 4.75%

0.75% is the spread (margin or profit) that the Bank earns on this PCFC loan.

Whether the bank acts as a collecting agent or extends financial assistance, they are entitled for a fee – Commission – and interest
where financial assistance is extended.
Delivery Channels - Introduction

Evolution of Delivery Channels

Traditional banking requires the physical presence of the customer at the branch or a retail outlet of a bank for most transactions.
The retail outlet/branch is a brick and mortar structure requiring maintenance of infrastructure, branch networks and developing
trained personnel thus leading to high costs of operations. While Banks tried to reach out the un-banked areas by opening more
retail outlets, these outlets had a higher cost per transaction because of the overhead costs involved.

Further traditional banking branches also had other limitations with respect to the growing demands of customers. For example,
specific timings to transact business which made it difficult for customers on the move who did not have the time to visit a retail
outlet for a transaction. These limitations and inconveniences of traditional banking forced a group of people to think for an
alternate banking delivery channel option. The outcome was the invention of an Automatic Teller Machine (ATM), the first
alternate delivery channel being operational in 1969.

The main advantages of alternate banking delivery channels are:

 Reduction in costs and increased convenience through remote payments

 Balance between personalized services and emerging transactional services
 Improved outreach especially in areas where the traditional bricks and mortar approach is unfeasible thereby increasing
financial inclusion and
 Increased product diversification by making savings and remittance products convenient, efficient and profitable.

Traditional banking gave way to Branchless banking, a distribution channel strategy used for delivering financial services without
relying on bank branches. While the strategy may complement an existing bank branch network for giving customers a broader
range of channels through which they can access financial services, branchless banking can also be used as a separate channel
strategy that entirely forgoes bank branches.

Evolution of Delivery Channels

The first modern day Automatic Teller Machine (ATM) was introduced to consumers in 1969 by Chemical Bank, US. This
primitive ATM supported only limited functionality but heralded an era of changes in Banking.

Since then the ATM has become a strategic necessity and the main item on the business agenda for the survival of a bank, instead of
just being a money dispensing/telling facility. The drastic changes in the information technology sector in the recent past further
forced banks to move along with the latest technologies, lest they lose their customer base. Banks are in a race to embrace the latest
technologies and provide the best of its services to its customers as customers are also becoming tech savy. It is commendable to
note that even smaller banks are also in the race with big Banks to establish their credentials in this area as they do not want to see
the flight of customers to other banks for choice of best services.

As mentioned earlier, changes in technology have made the banking services enter a new era in banking i.e., reaching out to the
customer and not the customer reaching out to the bank. Evolution of other delivery channels like Net Banking, Mobile banking,
Interactive Voice Response System (IVRS) / Phone Banking, Call Center, etc has totally changed the Banking scenario with more
and more services being provided by the banks. Banks are increasingly trying to shift customers to transact through automated
channels for the simple reason of convenient and hassle free banking, cost cutting efforts as well as cross selling of bank’s other
products.
Associated Channels -Familiarising with some of the delivery channels

Automatic Teller Machine

It is an electronic terminal enabling transactions on Debit, Credit and pre-paid cards. These cards can be either magnetic stripe cards
or smart / chip based cards. All transactions done in an ATM needs a Personal Identification Number (PIN).

Point of Sale (POS) Machines

Point of Sale (also called as Electronic Data Capturing –EDC machines) is also an electronic machine installed at merchant outlets
to enable transactions using debit or credit cards (magnetic or smart cards). A few transactions need customer PIN for authentication
of transaction. For example, Maestro debit cards from MasterCard International.

Another term commonly used to describe POS in Australia and New Zealand is EFTPOS i.e., Electronic Funds Transfer at Point of
Sale. This is the general term used for debit, credit and charge card payments and transacting at POS

Phone Banking (IVRS)

Phone Banking or Interactive Voice Response System is an automated banking system that guides you through a series of options to
perform the required banking transactions. It needs customer’s card details and PIN for performing the transaction. But no physical
card presence is required.
Mobile Banking

As the technology advanced, Mobile banking service has became the most wanted channel for Banks & Financial Institutions to
service their clients in a cost effective way by leveraging the advancements in mobile communication technology. It is also known
as M-Banking, mbanking and SMS Banking.

Net Banking

It is true that, the convenience of banking comes when we talk about Net banking or banking at your finger tip. Online banking is
not for to change your money habits. Instead, it uses today's computer technology to give you the option of bypassing the time-
consuming, paper-based aspects of traditional banking in order to manage your finances more quickly and efficiently.

Kiosks (Touch points)

Kiosks or touch points are also electronic device/terminal like an ATM where customer can interact and do most of the banking
financial and non-financial transaction except cash transactions.
Except ATM, POS and Kiosk no other channels need physical interaction of customer card with devices. Or otherwise transactions
in ATM, POS and Kiosks are called as Card Presented transactions where IVRS/Phone Banking / Mobile Banking / Call Center are
non-card presented transactions.

Other Banking Channels

Banking Agents

A Banking Agent is retail or a postal outlet that processes clients’ transactions under contract with a Bank/Financial institution or a
mobile network operator through POS devices. The retail or postal outlet can conduct transactions like cash deposit, withdrawal,
funds transfer, payment of bills, account balance enquiry etc. Banking agents can be post offices, pharmacies, supermarkets,
convenience stores, lottery outlets, etc.

TV Banking

TV Banking is a new concept introduced recently in India which aims at revolutionizing Banking by bringing it into the customer’s
living room. Customers can access details and information regarding all banking services even if they do not have internet access
through a Satellite DTH or Digital Cable connection.

Architecture Overview

A typical integrated delivery channel architecture is shown below where all the channels are integrated to a centralized transaction
switching system and interfaced to the host systems like Core banking solutions, card management system, etc.

However, the architecture depends on the individual bank’s needs and will have a different approach when each bank implements its
delivery channel. Banks can go with single delivery channel like ATM also where this channel only need to be interfaced with Host
system/s. If multiple channels are part of bank’s Delivery channel strategy, the below diagram may find its place in Banks solution
approach.
ATM-Switch system

An ATM-Switch application is a centralized system which controls the operations of the delivery channels connected to it and does
a transaction validation and switching to the destination systems. The transaction from delivery channel hit the Switching system
and based on the business rules configured, it decides what to do with the transaction received. It stores the customer card and
transaction data. Switch system can be interfaced to an external Card Management System or it can be a part of the Switch system
itself. Switch system never stores the PIN of a customer in its database instead it stores the computed Pin Verification Value (PVV).
Switch system architecture has an interface layer which accepts the transaction details from the channels, forward to its core layer
for processing the transaction.

For example, an ATM cash withdrawal transaction has the following flow in switching application. (Refer the above architecture)

1. Channel Interface layer (inbound) receives the transaction message from ATM in TCPIP message format, transform the message
to Switch internal message format and intimate the Core layer.
2. Core layer or the business rule engine handles the transaction received as below:
a.Identify the Issuer
b.Validate the Card
c.Validate the PIN
d.Validate the limit

If found correct, intimate the Host interface layer (outbound) to communicate to Host system-say for example Core Banking
Solution.
3. Host Interface layer (outbound) forward the message to Host system and Switch system waits (Timer starts here) for reply from
Host and intimate core layer after receipt of message.
4. Core layer does necessary system updates, and intimate channel interface layer to communicate the ATM.
5. Channel Interface layer (Inbound) transform the message and intimate the ATM to dispense cash.
6. ATM completes the transaction and intimate Switch application by way of return completion message.

The above is an example of online transaction where Host system is available for communicating and responding.

There could be some scenarios when Host systems will be down due to network issues, or other process like End-of-Day operations,
etc. In such cases, Switch system will perform a Stand In Processing. For this, the latest balance of customer data or called as
‘Positive Balance File (PBF)’ is loaded to Switch system at a scheduled time intervals. Based on this limit, Switch system will send
a respond message to ATM. This is called as an ‘offline transaction’. These transactions are stored in a file called ‘Store And
Forward (SAF)’ file in Switch system and when the Host system become online, these transactions are routed to it for debiting the
customer accounts.

Known ATM-Switch application is:

1. Base24/Base24eps from ACI Worldwide, US
2. Postillion from Celtron International, UK
3. Oasis-IST from Fidelity, US
4. Sparrow from CR2 systems, Ireland.

Delivery Channels - ATM

Independent Channels

This section covers the independent delivery channels available and deployed by various banking organizations. Let us start with the
oldest delivery channel that is ATM.

Automated Teller Machine (ATM)

The Automatic Teller Machine was the first alternate banking channel to be introduced and is used widely across the globe for both
normal convenient banking operations and also for cross selling of other products of the Bank.

A brief history

History of an automatic teller machine goes like this.

Don Wetzel (US) was the co-patentee and chief conceptualist of the automatic teller machine, an idea he thought of while waiting in
line at a Dallas bank. At the time (1968) Wetzel was the Vice President of Product Planning at Docutel, the company that developed
automatic baggage-handling equipment. The other two inventors listed on the patent were Tom Barnes, the chief mechanical
engineer and George Chastain, the electrical engineer. It took million dollars to develop the ATM. The concept of the ATM first
began in 1968, a working prototype came about in 1969 and Docutel was issued a patent in 1973. The first working ATM was
installed in a New York based Chemical Bank. The first voucher based cash dispensing machine was installed in 1967 by Barclay's
Bank in London. Experts, however, do not consider this an ATM. The first modern day ATM was introduced to consumers in 1969
by Chemical Bank, US. The first IBM-compatible Diebold machine is installed at a bank in Indianapolis in 1978.
Technical information:

An ATM is an electronic device / terminal having mechanical devices to do the required actions on receiving instructions from
source system. Note that it is a dump terminal only having a PC core with different configurations like 80 GB HDD,
Windows2k/Xp, 1 GB SDRAM, network card, graphic cards, etc and some other mechanical devices/part (explained later sections)
to perform the functions. It is being controlled/driven by its own operating system software (for example NDC+) provided by the
maker of the ATMs (for example, Aptra software for NCR ATMs) which run on Windows. It waits for the instructions, act up on it
and complete the instructions. If couldn’t completed, intimate the source system, that is Switch its failure. How obedient it is! Yes, it
works as a 'slave' to the Switch system. All ATMs are networked, either leased lines, VSAT (Very Small Aperture Terminal) a
satellite connections, or dial-up connections through routers to the centralised Switch application and uses mostly TCP/IP protocol
for communication (can be X.25 also). In past years, there were stand-alone ATMs where it was attached to that particular branch
operations and controlled by local Switch application.

Types of ATMs:

1. Front loading: Fit to shopping mall, lobbies, etc where cash is loaded by opening the currency chest from front side
2. Rear loading: Used at Banks branches normally, where cash is loaded from the back side of the ATMs.
3. Multi-functional ATMs with cash / cheque deposit modules
4. Mono-functional ATMs with out cash/cheque deposit module (cash dispenser only) or called as sleek ATMs since small in size.
5. Kiosks - Information Kiosks where no cash deposit/ no cash withdrawals functions are allowed.

Manufacturers of ATMs

1. NCR
2. DieBold
3. WinCor
4. Fujitsu
5. Triton, etc

How an ATM work:

An ATM is simply a data terminal with two input and four output devices. Like any other data terminal, the ATM has to connect to,
and communicate through, a host processor. The host processor is analogous to an Internet service provider (ISP) in that it is the
gateway through which all the various ATM networks become available to the cardholder (the person wanting the cash).

Most host processors can support either leased-line or dial-up machines. Leased-line machines connect directly to the host processor
through a four-wire, point-to-point, and dedicated telephone line. Dial-up ATMs connect to the host processor through a normal
phone line using a modem and a dedicated telephone line.

Leased-line ATMs are preferred for very high-volume locations because of their thru-put capability and dial-up ATMs are preferred
for retail merchant locations where cost is a greater factor than thru-put. The initial cost for a dial-up machine is less than half that
for a leased-line machine. The monthly operating costs for dial-up are only a fraction of the costs for leased-line.

The host processor may be owned by a bank or financial institution, or it may be owned by an independent service provider. Bank-
owned processors normally support only bank-owned machines, whereas the independent processors support merchant-owned
machines.

Parts / Components of an ATM

Like any other electronic device an ATM is also driven by its electronic / mechanical devices when it is requested to do so. Let us
have a look at some of such components of an ATM, its terminologies and a little technical information also.
1. Monitor: (Screen / Touch screen)

 ATM screens have different types like crt/vga/svga/tft-touch screens size varies between 10" to 15" screens. Recently TFT
Touch screens are widely used in most of the ATMs.
 Its function is for display functional menu, messages, advertisement screens, motion pictures, etc.

2. Option Keys:

 These are the keys provided on the left/right side of the screens for selecting the choice of functions by the customer. These
keys are called as 'Option Keys’ or termed as “Optkeys”.
 Used for selecting the required functionality / menu in an ATM by the customer.
 Technically each 'OptKey' is represented by an alphabet (eg. A, B, C, D) in arriving at the option selected and the coding
logic to be followed for executing the function opted.

3. Key Pad (Encrypted Key/ PIN Pads)

 Key Pad contains alpha numeral keys for user inputs. After implementing the 3DES (Data Encryption Standard) security
requirements, all the key pads are now encrypted with security network keys.
 Its function is for customer inputs. Entering PIN, Amount, canceling operations, etc

4. Card Reader:

 Card Reader reads the customer data from the Card Track data for allowing the operation, flickers a glowing light when
idle. There are 3 types of card readers, Motorised card reader, Dip card reader and Smart card reader.

1. Motorised card reader: It holds the card till the operation is completed. Once the operation is completed card
will be ejected.
2. Dip Card Reader: Card need to be swiped once to read and store the information till the operation is over.
Normally in a dip card operation only one transaction is permitted due to transaction security reasons.
3. Smart Card Reader: Reads the smart/ chip card for accessing the data stored in the chip. Note: Hybrid card
readers are being used for motorised and Dip card readers to read cards including smart cards.
 Its function is for reading the card holder's information from the card's magnetic data area and pass information to Switch
for action.
 Technically, the card contain card holder's information like Name, card number, expiry, cvv, etc stored in Track 1 and
Track2. The information stored starts with a ";" (semi-colon, called as 'start sentinel') in Track 1, thus making the card
readable in card reader.
 1. If the card data doesn't start with ";" card won't be read by system. For eg. Track 1 of card data may have like
this, ";^4569123400000…….". If the card has lost the data, card reader won’t read the card.

5. Cash picker & dispenser

 Cash from the cash cassette is picked based on the dispensing logic.
 Its function is for picking the cash from cash cassettes and stacks the same before presenting it as a bunch, move the cash
through a small conveyor belt to the presenter.
 Technically, cash is picked either using 'Friction method' or by 'Vaccum method'. Under friction method currency is picked
from top edge where as vaccum method currency is sucked out. Hence if the currency is spoiled or not stiff, dispensing
error or chances of getting additional currency may happen.

6. Cash Presenter

 Device to present the stacked (bunch) cash to the customer.

 Its function is for presenting the cash to the customer with in the time specified (normally 15-30 seconds). If cash is not
taken out or presented with in the time, cash will be retracted and the same for diverting to Divert Bin.

7. Divert Bin

 Divert bin contains the currencies diverted during presentation timed out, or due to some other technical errors.
 Its function is nothing except to hold the diverted currencies for cash tallying purpose. Some times this divert bin may
become full, if some technical issues are there while cash dispensing. In such cases, ATM won’t function and go out of
service.

8. Deposit Module:

 Mostly seen in multi-functional ATMs where cash / cheque deposit can be done. Envelopes are to be used to drop the
cheque or cash while depositing along with challans with Account Number.
 Its function is for accepting deposit (cash/cheque) from the customer when opted for 'Deposit'.
 Technically, when customer opted for 'Deposit', ATMs instructs the Deposit module slit to open, customer need to put the
cover containing cash/cheque. ATM - deposit module will print the transaction details on top of the cover to identify the
Transaction details, while inserting. (That is card number, date, etc).

9. Journal/Journal printer:

 Journal contains all the successful/failed transaction details stored. It is an electronic journal where all transactions
happened in ATM is stored. It simultaneously prints the transaction details on a paper roll also. Journal printer is inside the
ATM can be either dot matrix or thermal printer. Thermal printout need special type paper rolls also.
 Its function is to print the events / transactions happening while customer operates the ATM in a specific message format.
It contains the transaction data and is as equal as the cash scroll/journal of a Branch since the cash paid details are stored in
ATM Journal. This details are stored in the PC Core of the ATMs and can be retrieved (called as journal pulling) for
reconciliation of transaction data with other systems. Normally such data are stored for a maximum period of one month in
ATMs. Thereafter the records will be overwritten. However, all these transactions will be available in the ATM-Switch
application also.

10. Receipt Printers

 Small size dot matrix /thermal printer, printing size configurable. Receipts prints normal size of 36 chars
 Its function is to prints receipts / statements, etc.

11. Currency Chest:

 Currency Chest contains the currency cassettes stored in slots inside the ATM.
 Its function is to safe custody of cash, through secured locking.

12. Currency Cassettes:

  Currency cassettes can be a minimum of 2 or 5 depends on the bank's requirement loaded with cash with different
denominations currencies. Each cassette is marked for the Currency to be placed in the cassette. E.g. Rs.1000/= or Rs.500/-
, Rs.100/-
 Its function is to contain currencies sorted and stacked/arranged in order for disbursement/tallying. Currencies are placed
so tightly stacked that when disbursement happens, remaining currencies moved automatically so that cash picker picks the
next currency.
 Technically, each cassette is configured (using hexa decimal value method) to keep only one type of currency only. If some
other currency is kept in the cassette meant for one currency, there will be a mismatch of disbursement and either excess or
short dispense may happen. Each ATM vendors need to be UL 291 certified for the Currency Chest (that is tamper /fire
proof, etc) with out which ATM cannot be deployed.

13. Deposit box:

 It is a drop box inside ATM where cover containing cash/cheque is directly dropped in to.
 Its function is to store the Cash / Cheques deposited in ATM till operation team picks it up for accounting.

14. PC-Core (Computer system):

 PC Core is the core computer system inside the ATM, available with the latest configurations.
 Its function is to drive the ATM using the ATM controlling software loaded, for example Aptra–NCR, and networked to
external systems for action. The screen jpegs, motion pictures, executable images, etc are stored in PC-Core respective
directory path. When ATM boots up, these images are loaded to PC Core memory for operations.
 Technically, it drives the ATMs using the controlling software.

15. Hidden Camera

 Some of the ATMs are fitted with hidden camera (for example Wincor ATM) next to the Key Pad.
 Its function, there is no need to explain. Capture all your actions while you are at the ATM location.

16. Security Lock:

 Security locks for the Currency Chest. This can be electronic or manual or can be both.
 Its function is to lock the currency chest, either 1) Normal manual lever method and lock Or 2) Electronic key using
Password, Digital numbers.

Functionalities supported

ATM supports the following functionalities

 Cash Withdrawal
o Fast Cash: Where pre-defined amount can be selected and withdrawn with out much key selections involved.
o Normal Cash: Where customer needs to enter the required amount.
o Cash withdrawal can be done from savings / checking or current / credit card accounts
 PIN change: PIN change with in issuing bank. PIN change of another bank card also can be done in another bank ATM, if
there is a network tie-up arrangement exists.
 Balance Inquiry from savings / checking or current account.
 Deposits
o Cash deposit
o Cheque deposit
 Mini Statements where last five or ten transactions are printed
 Fund Transfer
o From Own accounts – Savings to Checking , vice versa
o To third party / designated accounts where transfer is permitted through network tie-up arrangements.
 Check Truncation where cheque image is captured electronically in an ATM and the image details are sent for clearing.
 Value Added Services
o Mobile Top up
o Utility Bill payments like – Electricity, Telephone, etc
  Statement Printing (if supported)

Transaction Flow

A typical Balance enquiry transaction flow from savings account (Dip card ATM) is described below:

1. Customer inserts card

2. ATM reads the card and requests PIN
3. Customer enters PIN
4. Switch system verifies PIN
5. ATM displays menu options
6. Customer selects Balance Inquiry option from Savings
7. Switch system send the transaction details to Host System (example Core Banking Solution)
8. Host system responds with reply
9. Switch system intimates ATM
10. ATM displays the result.

However, PIN verification flow can be changed based on individual bank’s requirement.

Delivery Channels - POS

Introduction

A Point of Sale is an electronic device that allows a bank’s customers to make payment for their purchase of goods / commodities /
merchandise.

They are called POS, as these are placed at merchant’s locations i.e. at the point of sale and enables buyers to make payment
electronically. The debit cards or credit cards can be used for such payments. The cards are swiped in the POS system and
customers are asked to sign on the charge slip or vouchers to confirm the payment.

Examples for usage of POS are -

  Grocery stores
 Gas stations
 Discount superstores
 Book stores
 Ticket counters
 Pharmacies
 Hotels / Restaurants

A Brief History:

History shows that Point of Sale systems can be traced back to year 1870 when the idea of developing Cash Register was mooted by
John Ritty in Dayton since he faced issues in his business for improper accounting of cash. Ritty finally succeeded in inventing a
Cash Register, patented and named as “Ritty’s Incorruptible Cashier”.

In August 1973 IBM announced the IBM 3650 and 3660 Store Systems that were, in essence, a mainframe computer packaged as a
store controller that could control 128 IBM 3653/3663 point of sale registers. This system was the first commercial use of client-
server technology, peer to peer communications, Local Area Network (LAN) simultaneous and remote initialization. By mid-1974,
it was installed in Pathmark Stores in New Jersey and Dillard's Department Stores.

Today’s modern-day computer driven multi-faceted point of sale system is an enhanced version of the earlier cash register. This has
got more functionality and is integrated with other host of applications.

Technical / Operations

Point of Sale systems is an electronic device having serial ports connected through a leased or dials up line to the Host system for
transmitting the transactions for authorizations. It is controlled by the software provided by the POS machine vendor and stores the
transaction data in the terminal. Each POS machine must follow the data encryption standards (DES) as per VISA / MasterCard
norms and data is encrypted with DUKPT (Derived Unique Key Per Transaction). Transactions done through POS machines are
encrypted with these security keys and are transmitted to the Host applications.

During End-of-Day operations, merchant transmit the consolidated transaction data as a batch to the Host application. The
consolidated transaction amount less the charges applicable by the Host service provider will be credited to the Merchant’s account
after processing the transaction.

Few examples of POS vendors are:

1. Verifone
2. Hypercom
3. Nurit, etc

Parts/Components of a POS machine

1. POS -Electronic Data Capture (EDC) Terminal:

This is a normal POS machine unit which contains data card slots, thermal printers, LAN port, Wireless modem, internal pin/key
pad, internal smart card reader, LED display unit and rechargeable battery.
2. A all in one POS machines have the following parts:

1. POS computer having CPU with POS software loaded by the vendor.
2. TFT Monitor with key display
3. Bar-Code scanner
4. Cash drawers
5. Graphical customer displays
6. Key Boards
7. Magnetic Stripe Readers (MSR)
8. PIN Pads
9. Receipt printers

Functionalities Supported:

POS systems support the following functionalities:

1. Sale and purchase Transactions

2. Preauthorization transaction or blocking the funds.
3. Balance inquiry (only debit cards)
4. Void transaction where transactions are cancelled by making it voids.
5. Adjustments
6. Tip-adjust (restaurants only)
7. Refund
8. Settlement of transactions ( End of Day operations)

Transaction flow
1. Merchant / Customer swipes the card in POS machine
2. Merchant enters the transaction amount.
3. Customer enters PIN (if PIN required)
4. POS system encrypts the security key and transmits the data to Switch application.
5. Switch system process the transaction:

a. Identify issuer
b. Validate the card
c. Validate the PIN
d. Route the transaction to destination system

6. Switch system wait for the response, receives it and send back to POS.
7. POS receives the transaction completion message. If successful, prints the charge slip/voucher for the amount.
8. Customer signs the voucher.
Delivery Channels - KIOSKS
A Brief History:

Tracing back the history of a Kiosk system shows that the first self-service, interactive kiosk was developed in 1977 at the
University of Illinois at Urbana-Champaign by a pre-med student, Murray Lappe. The content was created on the PLATO computer
system and accessible by plasma touch screen interface and he named it as ‘The Plato Hotline’. He created this for allowing students
and visitors to find movies, maps, directories, bus schedules, extracurricular activities, courses and email student organizations

The first successful network of interactive kiosk used for commercial purposes was a project developed by the shoe retailer
Florsheim Shoe Co. In 1991 the first commercial kiosk with internet connection was displayed at Comdex. The application was for
locating missing children.

The first touch screen is shown by Elotouch at the 1982 World's Fair in Knoxville, TN, USA. 1982 is also the first year that the
word "Internet" is used.
Technical / Operations

Technically, kiosks are similar in appearance like an ATM, but don’t have all the features of an ATM. Kiosks are also controlled by
the centralized switching system like an ATM terminal. Like an ATM it is also a dumb terminal where it follows the instructions
from the controlling switch.

Parts / Components of a Kiosk contain the following:

 TFT LCD Monitor

 Kiosk Computer –CPU

 Magnetic Card Reader

 MICR Check reader

 Signature Capture Card

 Bill acceptor

 Receipt Printer

 Additional options - Web Cam, Speakers, Microphone, etc

Functionalities Supported:

Kiosks systems support the following functionalities:

 Balance Enquiry
  Fund / Wire Transfer

 Bill Payments

 Statement printing (if supported)

 Information -Product Information, etc

 Application capturing

 Check processing

Transaction flow

The flow for balance inquiry in a Kiosk is as follows:

1. Customer swipes / inserts the card

2. Customer enters PIN and select Balance Inquiry option

3. Kiosk system encrypts the security key and transmits the data to Switch application.

4. Switch system process the transaction:

a. Identify issuer

b. Validate the card

c. Validate the PIN

d. Route the transaction to destination system

5. Switch system wait for the response, receives it and send back to Kiosks

6. Kiosk receives the transaction completion message and displays it.

Delivery Channels - Net Banking
A brief history

In 1990 the Wells Fargo Bank, based in California USA, introduced the world's first online banking service. It was not until 1997
that a similar service was launched in the UK by the Nationwide Building Society. Since the introduction of the first services many
banks have started their electronic banking services with access available via personal computer, mobile phone, or an interactive
Television.

Many banks now offer Internet based services alongside their traditional banking facilities, whilst other organisations have
established new breeds of 'Internet' or 'Telenet' banks. Telenet banks are those that allow their customers to communicate by
telephone as well as the Internet. Most of the UK's new 'Internet or 'Telenet' offerings have the backing of large and well known
financial institutions.

Technical Architecture / Operations

Internet banking is usually conducted through a personal computer (PC) that connects to a banking Web site via the Internet. For
example, a consumer at home accesses a financial institution's Web site via a modem and phone line or other telecommunications
connection, and an Internet service provider of that individual country, such as AT&T WorldNet in USA, Aortal/ BSNL / Reliance
in India, etc.

Internet banking also can be conducted via wireless technology through Personal Digital Assistants (PDA) or cellular / mobile
phones.

Components of Net Banking:

 Application Server: An application server is a server program in a computer in a distributed network that provides the
business logic for an application program. The application server is frequently viewed as part of a three-tier application,
consisting of a graphical user interface (GUI) server, an application (business logic) server, and a database and transaction
server.
 Internet Connectivity: Net connections either LAN / WAN or Wireless.
 Browsers: A browser is software that provides a way to view web pages. The two most popular web browsers are
Microsoft® Internet Explorer and Netscape® Navigator.
 Firewall: A firewall is a small program that helps protect your computer and its contents from outsiders on the Internet or
network. When properly installed, it prevents unauthorised traffic to and from your PC.
 Web Server: Web servers are computers on the internet that host websites, serving pages to viewers upon request. This
service is referred to as web hosting. Every web server has a unique address so that other computers connected to the
internet know where to find it on the vast network. The IP (Internet Protocol) address looks something like this:
69.93.141.146. This address maps to a more human friendly address, such as www.abcbank.com
 Host Applications where financial transactions are transmitted for authorization. For example, Core Banking solution.

The other concepts connected with Net banking are:

 Digital Certificates: A digital certificate is an electronic ID card that helps establish your identity when doing business via
the Internet. Such certificates can be browser based (“Soft Certificates”) or embedded into a smart card (“Hard Token”)
and used with special card readers.
 Encryption: Internet Banking uses 128-bit encryption, one of the most advanced technologies available for safeguarding
your online banking. Encryption is a process that transforms sensitive information into a string of unrecognisable
 characters before they are sent over the Internet. Encryption helps provide a secure channel for data transmission to keep
information private between the bank's computer system and your Internet browser.
 Secure Sessions: When you log in to Internet Banking you are said to be in a “secure session”. SSL technology is used
within your Internet Banking session to encrypt information before it leaves your computer, in order to ensure that no one
else can read it. SSL or Secure Sockets Layer is a security protocol created by Netscape that has become an international
standard on the Internet for exchanging sensitive information between a website and the computer communicating with it,
referred to as the client.
 Cookies: Cookies are small files stored on a computer's hard drive. Cookies are generally harmless and are used to
recognise a user so that they can receive a more consistent experience at a particular website. Cookies can contain
information about your preferences that allows customisation of a site for your use.

Functionalities supported

Net Banking system supports the following functionalities:

 Account Inquiries-Balance, transaction history, statement, loan limit, etc.

 Account Opening – Deposits, Standing Instructions / mandate, etc.

 Check stop payments / check book requests

 Fund Transfer
o To own account

o Third party account

o Designated account – Payee maintenance account where a template is created for regular payees. User can select
the desired payee from the list available.

 Bill Payments to utility providers (UP) who have a tie up with the bank for this purpose. It is applicable only after the bank
has assigned an account (SAVINGS/CURRENT/GL or any other type) to the UP.

 Password / Address Change, etc

 Other services
o Standing Instructions / Mandate

o Order Demand Draft

o Request issue of Letter of Credits / Guarantee

 Message and bulletins

 Product Information
Transaction Flow

The flow for Account Inquiry in is as follows:

 Customer enters PIN and Account Numbers on Net (client browser)

 SSL encrypts the PIN and data and transmits to the Web Server through Firewall.

 Web Server accepts the transaction message, authenticate the SSL encryption. If correct, web server sends the request to
Net banking application.

 Net banking application authenticates the PIN and requests the customer data from Host Application. For example, Core
Banking Solution.

 Host system provides the customer information to Net banking system.

 Web Server collects customer data and displays in customer personal computer.

Internet Banking Risks

Internet banking creates new risk control challenges for banks. From a supervisory perspective, risk is the potential that events,
expected or unexpected, may have an adverse impact on the bank’s earnings or capital. The defined nine categories of risk for bank
supervision purposes are credit, interest rate, liquidity, price, foreign exchange, transaction, compliance, strategic, and reputation.
These categories are not mutually exclusive and all of these risks are associated with Internet banking.

However, the most vulnerable risk is security risk on transactions.

Security issues in online banking

Internet security is always an issue and is regularly commented upon in the media. The Internet is constantly changing and
undergoing development and hence it is wise to make sure that you are using the latest version of a well known Internet browser.

Most data transferred over the Internet is normally unencrypted. This means that anyone intercepting that data can read it. This is
normally not a problem as most internet data is not sensitive or private. To protect the secrecy of any data you transfer over the
Internet sensitive information can be encrypted using SSL.

SSL technology means that the any data you send or receive over the Internet is encoded in a way that makes it almost impossible to
read by anyone that is not supposed to receive it. All they will see is a meaningless stream of data if they try to listen in on your
transactions. The effectiveness of SSL is measured in bits (binary digits). The latest web browsers support 128-bit encryption that
provides a high level of security that should foil all but the most determined federal authorities in decoding its contents.

As with all computer based security there are a number of steps you should take yourself to protect your security details:

 Never write down your ID, password or PIN number

 Never give them to anyone else
 Never send them via email (email is NOT secure or private)
 If given the option to set a password for your Internet banking service, never use an obvious password or a password that
someone who knows you might guess
 When you have finished with your Internet banking session, always close your browser so that someone else can't access
your account details after you leave your PC.
Overall if you bear these guidelines in mind, then the likelihood of you being a victim of any Internet fraud is extremely low indeed.

Delivery Channels - Mobile Banking

Introduction

Since the inception of alternate delivery channels like the ATM and net banking there has been a sea of change witnessed in the
servicing of customers by offering newer products and services by Banks and financial institutions. Banks were always waiting for
some innovative ways to encash the opportunities for business growth. Then came the mobile banking revolution.

The ‘Mobile’ phone gives the the user the mobility to carry it anywhere he wants. Mobile phones have penetrated deep in to the
mass of population. As mobile technology advances the features and functionality improve.

The tremendous progress and achievements noticed in telecommunication sector has shown far reaching results to the Banking
Industry also. Today, with the support of latest technologies and secured networks, customer can conduct financial and non-
financial transactions effortlessly and securely.

A brief history

Since inception of ATM channels in 1969 in Banking, the customers widely accepted the ‘banking at their convenience’ concept
though it didn’t provided full fledged banking functionalities.

Banking revolutions continued since then. Net Banking came in mid 1990s with a broader outlook on ‘convenient banking’ concept
where Internet banking enabled the customers to operate their accounts at their convenience sitting at home or office. However,
penetration of net banking in to the mass population is still in developing stages in some of the countries due to the non-availability
of personal computers and internet connectivity every where.

The same period saw explosive growth in mobile communication penetration in developing markets like India, China & Korea, etc.
These factors resulted in the rollout of Mobile Banking services channel by Banks & financial institutions by leveraging the
advancements in mobile communication technology.
Technical Architecture / Operations

A sample of Mobile banking architecture is provided below.

The Mobile Banking Services offered by a bank can be classified based on the originator of service as Push or Pull.

 A Push Service is when the bank proactively sends out information about promotional activities offered by the bank or
alerts based on certain rules setup in the system. Best example is a Structured Message Services (SMS) alert when your
account is overdrawn.
 A Pull service is when the customer requests for a service or information from the bank and the bank sends the information
to the customer in the form of a SMS message. These are two-way exchanges as banks need to take some action for the
user request.
 Mobile banking services can also be categorized based on the nature of service as 1. Transaction Based and 2. Enquiry
Based
 A request for mini statement is termed as an enquiry based service while a request for fund transfer is termed as a
transaction based service.

Components of Mobile banking system:

 Mobile phones with net facilities

 Phone Banking client application – Down loaded from application service provider.

 Mobile Operators – Application Service Providers

 WAP gateway

 Web Server

 Message Processing Server

  Host Application (for example, Core Banking solution)

Functionalities supported

 Transactions based services

o Pull Based
 Fund Transfer
 Bill Payment
 Stop Cheque
o Push Based
 No services
 Inquiry based services
o Pull Based
 Inquiries – Balance, Statement, check status, check book request, recent transaction history, rewards
point, etc.
o Push Based
 Alerts – Credit, Debit, Minimum balance, bill payment, payment due, large transaction, check bounce,
account overdrawn, etc.

Transaction Flow

When a customer applies for the mobile banking service, the customer is registered for the service, the account number, mobile
number and the rules based on which the customer wishes to get the messages are captured.

PUSH Messages:

The way PUSH messages works is:

 The rules define the kind of PUSH messages the customer require and also the threshold amounts which would trigger the
messages.
 When the system encounters an event which satisfies the rule setup for a customer, then the message is triggered.
 The System could use standard templates to create message and send the message to the customer.

PULL Messages:

The way PULL messages works is;

 The customer requests for information by sending an SMS containing a service command to a pre-specified number.
 Based on the keyword/ service command, the system will trigger action retrieve information form the core banking
application.
 Using a standard message template send the information in the form of a SMS to the mobile number registered by the
customer.
Delivery Channels - IVR
What is an IVR

 An Interactive Voice Response (IVR) processes inbound phone calls, plays recorded messages including information
extracted from databases and the internet, and potentially routes calls to either in-house service agents or transfers the
caller to an outside extension.
 It is a software application that accepts a combination of voice telephone input and touch-tone keypad selection and
provides appropriate responses in the form of voice, fax, callback, e-mail and perhaps other media.
 Using computer telephony integration (CTI), IVR applications can hand off a call to a human being who can view data
related to the caller at a display.

Interactive Voice Response (IVR) systems, with more advanced voice automation technologies, are used by many financial
institutions to:

 Handle routine and more complex transactions using the speech-driven technologies to give customers faster, more
convenient access to a wide range of information, from account inquiries and mortgage balances to stock prices, current
interest rates, special services, and even the location of ATMs in a far-away city based on their calling location.
 Reduce service costs.
 Provide faster and convenient banking.
 Boost overall customer satisfaction

Customer transaction and financial data are protected by incorporating advanced encryption and security features.

Public and private sector businesses of all sizes are using IVR technology for sales, marketing, customer service, collections,
inquiry and support calls to and from their organization.

A brief history

Tracing back the history of IVR shows that it began in 1941 when Bell Systems developed a new tone dialing methodology, when
they unveiled the first telephone that could dial area codes using Dual Tone Multi Frequency signaling technology.

It was between the periods 1970-80 when more companies started using the IVR systems to automate tasks in call centers, the IVR
technology started changing when new competitors entered the market.

However, the IVR systems shot into prominence, when call centers began to migrate to multimedia contact centers in late 90’s.
Companies invested in Web-enablement and Computer Telephony Integration (CTI) with IVR systems. IVR became vital for call
centers deploying universal queuing and routing solutions and acted as an agent which collected customer data to enable intelligent
routing decisions. The introduction of the VXML standard also simplified the integration process between IVR systems and any
back end hosts.

Historically, IVR solutions have used pre-recorded voice prompts and menus to present information and options to callers, and
touch-tone telephone keypad entry to gather responses. Modern IVR solutions also enable input and responses to be gathered via
spoken words with voice recognition. Technical Architecture / Operations involved
  Calls are “received” by the IVR and the caller is directed for the next step.
 The caller will utilize a brief series of key presses on a touch-tone phone or with voice recognition; the caller may
optionally speak the selections when prompted.
 The application with IVR may be connected to the organization’s data processing systems to provide virtually any
information or operation that you wish to make available.
 IVR applications can draw information from databases or input data or responses gathered from each person they contact.
 They can also gather input and make decisions based on spoken words with voice recognition technology. Components of
IVR / Phone Banking:
 PSTN Line: PSTN (public switched telephone network) is the world's collection of interconnected voice-oriented public
telephone networks, both commercial and government-owned.
 Private Branch Exchange (PBX): The IVR Application is connected to a PBX. A PBX is a telephone system within an
enterprise that switches calls between enterprise users on local lines while allowing all users to share a certain number of
external phone lines. The main purpose of a PBX is to save the cost of requiring a line for each user to the telephone
company's central office.
 Web Servers; Web servers are computers on the internet that host websites, serving pages to viewers upon request. This
service is referred to as web hosting.
 VoiceXML: This is an application of the Extensible Markup Language XML which, when combined with voice
recognition technology, enables interactive access to the Web through the telephone or a voice-driven browser. An
individual session works through a combination of voice recognition and keypad entry. This was created through a
collaboration of AT&T, IBM, Lucent Technologies, and Motorola, who were each working on their own approach but
joined forces to create an open standard.

Functionalities supported

 Inquiry
o Account Balance – Loan/deposit, etc
o Cheque status
o Information
o Rates
 Requests
o Statement Requests
o Cheque book requests
o Stop payment
o Last statement
o Last five transaction
o PIN change
o Lost / replacement card.
  Bill Payments
 Fund Transfer
 Standing Instructions

Transaction Flow

A sample IVR call flow is shown below.

 Customer dial in to IVR system

 Upon receiving an incoming phone call, the IVR phone system triggers the services to check for an IVR script.
 The IVR client process (IVR Application) invokes a server process on the IVR phone system and starts a two-way
communication.
 An IVR program controls the flow of the IVR script by prompting the caller and requesting key input or directing the caller to
another service, extension, or Voice Mail.
Delivery Channels - Call Center
Introduction

Call Centers or Contact Centers is one of the most spoken terms when we talk about Business Process Outsourcing (BPO) as a cost
cutting measure. Both terminologies go hand-in-hand and it has caught the world’s attention in the recent past due to the various
industry outsourcing deals for establishing contact or call centers out of their countries. Outsourcing to other countries can reduce
operational expenditure. However, differences in culture and language may have some problems for customers, whose
dissatisfaction can lead to customer complaints also.

We have noticed the mushrooming of call centers but at the same time they have been a lot of help to the customers of various
segments, including households, industries like banking, insurance, customer care, transportation, etc as an easy way of
service/solution provider. The availability of call centers round the clock, helped the service reach out to other geographies. In
countries with English speaking proficiencies, like India, the visibility of call centers has reached far across globe, making it a
global hub for call centers.

A brief history

History shows that, Call centres originated as a cost-cutting measure by US companies several decades ago, but they only really
started to take off in the UK in the 1970s. The initial centres were in-house operations in larger organisations and they tended to
share and be formed by the same basic assumptions and drivers.

The idea of a contact center was to:

 Cluster the majority of telephone based contacts with the customer in a single department, so that people could focus just
on call-related services.
 Benefit out by carefully managing with a clear focus on to provide efficient service and reduce the service cost.

Perhaps one of the most useful evolutions of interactive voice response has been the ability to provide accurate and satisfying 24hr
support. Whatever the business, IVR permits companies to help their potential customers at just about any time of the day. This not
only decrease expenses, but will also makes it easier for administrative professionals to take care of calls coming in at strange
periods or perhaps when the telephone system is overloaded.

Technical Architecture

Most of the Call Centers follows the IVR system for routing the customer calls, the same architecture and operations are applicable
to call center also. The call center process starts when the call is diverted to an active agent or helpdesk person to service the client.

Functionalities supported

Multiple vendor products are available in the market for Call centers and most of them provide the comprehensive functionalities.
Some of the generic functionalities supported are:

1. IVR
2. Skills based routing
3. Predictive Dialer
4. Blended inbound/outbound,
5. 100% call recording
6. Email facility
7. Chat whisper coaching,
8. Barge-in,
9. Skills base routing
10. Remote agent,
11. Reports / logs, etc

Transaction Flow

Transaction flow is also similar to IVR / Phone Banking except IVR responding back with pre-recorded message.
 When the call is diverted to an active agent, the agent will provide the information customer requested for. However, an
active agent does not have the privilege to execute a financial transaction on behalf of the customer.
 Call center personnel can have only limited access to view the customer data like transaction, charges, interest, etc and
sensitive data is masked from visibility.
 Call center personal can raise a request on behalf of the customer to the customer service executives for resolving it and
responding to the client.
Delivery Channels - Other Banking Channels

Banking Agents

A Banking Agent is retail or a postal outlet that processes clients’ transactions under contract with a Bank/Financial institution or a
mobile network operator.

 These agents are usually equipped with a combination of point-of-sale (POS) card reader, mobile phone, barcode scanner
to scan bills for bill payment transactions, Personal Identification Number identification number (PIN) pads, and
sometimes personal computers (PCs) that connect with the bank’s server using a personal dial-up or other data connection.
 Clients that transact at the agent use a magnetic stripe bank card or their mobile phone to access their bank account or e-
wallet respectively.
 Identification of customers is normally done through a PIN, but could also involve biometrics.
 With regard to the transaction verification, authorization, and settlement platform, banking agents are similar to any other
remote bank channel.

Local regulation will determine if financial institutions are allowed to work through retail outlets. Regulators generally determine
what kind of, if any, financial institutions are permitted to contract banking agents, what products can be offered at the retail outlets,
how financial institutions have to handle cash transport, Know Your Customer requirements, consumer protection, and other
operational areas.

Globally, these retailers and post offices are increasingly utilized as important distribution channels for financial institutions. The
points of service range from post offices in the Outback of Australia where clients from all banks can conduct their transactions, to
rural France where the bank Credit Agricole uses corner stores to provide financial services, to small lottery outlets in Brazil at
which clients can receive their social payments and access their bank accounts.

TV Banking

TV Banking is a new concept introduced recently in India which aims at revolutionizing Banking by bringing it into the customer’s
living room. Customers can access details and information regarding all banking services even if they do not have internet access
through a Satellite DTH or Digital Cable connection.

The following services are available through TV Banking:

 Features/ information on the Bank’s products

 Eligibility criteria for products
 Mandatory documents
 Loan EMI Calculators/Charts
 Current offers
 Investment updates
 Interest-rate charts
 Branch/ATM locator
 Safe Banking Tips
 How to pay bills online
 How to give standing instructions on one’s credit card
 Toll-free number for the client to reach the Bank or to apply for a product

Advantages:

 Customer convenience - banking from one’s living room

 Internet connection not required
 Wider reach
 24x7 availability
 Zero charges
Risk Management
Risk Management - Introduction
Introduction

Commercial banks are private corporations that provide payments services, financial intermediation, and other financial services in
anticipation of earning profits from those activities. The payments system and intermediation are required for economic growth.
Like any other for-profit corporation, their principal goal is to maximize shareholder wealth. Thus, decisions on lending, investing,
borrowing, pricing, adding new services, dropping old services, and other activities depend on the impact on shareholder wealth.

Shareholder wealth is measured by the market value of a bank’s stock and the amount of cash dividends paid. Market value depends
on three factors: (1) the amount of cash flows that accrue to bank shareholders, (2) the timing of cash flows, and (3) the risk
involved in those cash flows. Management decisions involve evaluating the impact of various strategies on the return and the risk of
those cash flows.

Types of Risks

Introduction to Risk in Banks

 Banks make money in one of the two ways

 By providing services to customers
 By taking risks
 The former way provides very less or no margin to Banks
 To be in business Banks must take risk
 Banks take more risk it can expect to make more profits
 Greater risk also increases the danger that the bank could lose badly and be forced out of business due to bankruptcy

Risk- Return relationship in Banks

 While a positive risk-return relationship is presented for profitable Banks, the risk-return relationship is negative for
profitless banks.
 Theoretically, a Bank taking a relatively high risk is supposed to earn high profits.
 However, Bankruptcy costs are relatively high for a Bank maintaining higher risk exposure.
 If Bank is internationally active, such high risk exposure could also lead to cascading effect to other Banks and thereby
might lead to country’s insolvency.

What should Bank’s objective be to respond to such sensitive ambience and still make profits?

 Banks must run their operations with two goals in mind

o Generate Profit
o Stay in Business
 To achieve above, two goals of risk management for every Bank should be:
o Decide Bank’s Economic Capital
 Ensure that the risk being taken is matched to the bank’s capital
 Bank’s capital is considered much enough to absorb the losses of bad situations
o Allocate Bank’s Economic Capital
 Help the CEO direct the limited resource of capital to the opportunities that are expected to create
maximum return with the minimum return.
o Risk Measurement and Management in Banks attempts to answer the following four questions:
 How much could we lose?
 Calculate the risk measure
 Can we absorb a significant loss without going bankrupt?
 Decide the economic capital
 Is the return high enough for us to take that risk?
 Calculate the return after considering risk
 How can we reduce the risk?
 Use risk mitigation techniques
  Hedge Risk
 Transfer Risk
 Diversify Risk

Types of Risks in Banks Broad Classification:

The risk in Banks arises mainly through the exposure taken on various assets. Typically, the key types of risk within the assets of a
firm are classified as follows:

 Credit risk – losses associated with the default (or credit downgrade) of an obligor (a counterparty, borrower or debt issuer).
Also called default risk;
 Market risk – losses associated with changes in market values;
 Operational risk – losses associated with operating failures.

Other Financial Risk Types / Terminologies:

There are other financial risk variants too which more or less (directly / indirectly) could be considered part of the Credit, the
Market and or the Operational risk. These risk variants/ terminologies are necessary to understand the topics discussed in
subsequent sections.

Interest Rate Risk:

The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two
rates, in the shape of the yield curve or in any other interest rate relationship.

Interest rate risk is the risk to earnings and capital that market rates of interest may change unfavorably. This risk arises from
differences in timing of rate changes and the timing of credit flows (repricing risk), from changes in the shape of the yield curve,
and from option values embedded in bank products. In essence, the market value of a bank’s assets (i.e., loans and securities) will
fall with increases in interest rates. In addition, earnings from assets, fees and the cost of borrowed funds are affected by changes in
interest rates. Banks can reduce their interest rate risk by hedging with derivative securities and by using the asset/ liability
management techniques.

Banks fund these assets by liabilities on which they pay floating rates of interest. As deposit interest rates increase, interest income
drops. The risk is managed by matching maturities and interest basis of assets and liabilities.

Liquidity Risk: There are three types of Liquidity Risks – Funding Liquidity Risk, Asset Liquidity Risk and Market Liquidity Risk.

Funding Liquidity Risk is the inability of a bank to raise funds at normal cost. Cost of funds is a critical profitability driver of a
bank, but is set in part by the market’s perception of the bank’s risk and funding policy.

Asset Liquidity risk is the risk to earnings or capital related to a bank’s ability to meet its obligations to depositors and the needs of
borrowers by turning assets into cash quickly with minimal loss, being able to borrow funds when needed, and having funds
available to execute profitable securities trading activities. Given the large amount of bank deposits that must be paid on demand or
within a very short period, liquidity risk is of crucial importance in banking.

This risk has a direct bearing on the nature of bank’s assets. Holding a pool of assets acts as a cushion against market liquidity as it
allows a bank to meet obligations without recourse to external financing. In some regulatory environments, there is a requirement to
hold a specific percentage of assets in cash and bank balances to protect against short-run obligations.

Market Liquidity Risk relates to problems of transaction volume in markets. In volatile circumstances when counter-parties are
unwilling to trade, prices can become very volatile and spreads widen. In these conditions it may be very difficult to liquidate assets
at a fair price.

Reinvestment Risk

The risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided.

Call Risk
Call Risk is the risk that a bond will be called by its issuer. Callable bonds have call provisions post issuance generally on one of the
interest payment date. This provision allows the bond issuer to purchase the bond back from the bondholders and retire the issue
before maturity date. This is usually done with an expectation that interest rates will fall and issuer is in a position to borrow at
lower interest rates. Call provisions allow the issuer to retire the old, high-rate bonds and issue new bonds / borrow at a lower rate.

Default Risk

The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all.

Currency Risk or Foreign Exchange Risk

It is the risk to earnings or capital due to changes in foreign exchange rates. It can arise in three ways viz., Transaction Risk and
Translation Risk and Economic Risk.

Transaction Risk is a form of market risk and relates to the movement in the value of the financial transaction due to exchange rate
movements. Transaction risk causes cash losses.

Translation Risk is a risk of an adverse impact on the balance sheet when foreign assets are translated into the home currency for
reporting purposes.

Economic Risk is a risk that a bank could lose business to competitors in other countries. This is due to the exchange rate between
currencies is more favorable to the foreign banks.

Sovereign / Country Risk:

A collection of risks associated with investing in a foreign country. These risks include political risk, exchange rate risk, economic
risk, sovereign risk and transfer risk, which is the risk of capital being locked up or frozen by government action. Country risk
varies from one country to the next. Some countries have high enough risk to discourage much foreign investment.

Traded Credit Risk

This risk applies to derivatives that buy and sell credit contracts. For example, if a bank sells a futures option, on a credit agreement
expecting interest rates to fall. If the interest rates rise, they would lose a potential profit.

Inflation Risk

The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect
on fixed bonds, which have a set interest rate from inception.

Managing Risk in Bank at Macro Level

 three keys for risk-management:

 deciding the target debt rating
 determining the amount of available capital
 allocating risk limits to each business unit within the bank

Determining the Target Debt Rating

 The debt rating is a measure of the bank's creditworthiness and corresponds to the bank's probability of default
 A high debt rating corresponds to a low probability of default
o For example, AAA-rated Bank vs. A-rated Bank
 The bank's creditworthiness is determined by
o The amount of risks a bank takes
o The amount of capital a bank hold
 Capital is the difference in value between the bank's assets and liabilities. It can be viewed as the current net worth of the
bank
 If the bank has a small amount of capital and takes a large amount of risk, there is a high probability that the losses will be
greater than the capital, and the bank will go bankrupt
  If the bank wants a high rating, it must hold a large amount of capital in relation to its risks.
o But a bank have to pay cost for holding extra capital in hand
o For example, by given fixed total profit of a bank, the average profit for per capital will decreases when the
amount of capital increases
 A low target debt rating has the advantage that the bank can take on many risks and expect to earn a high rate of return for
the shareholders.
o However, a low debt rating means that debt holders will charge higher interest rates to lend their money to the
more risky bank
 To conclude, a bank has to decide a suitable debt rating for itself and then decide the capital it has to maintain.

Determining the Amount of Available Capital

 The available capital is the current value of the assets minus the current value of the liabilities
 Capital = Nominal Asset Value-Liabilities
 If the board wishes to increase the capital quickly, it can do so by issuing more bank shares
 This gives the bank more cash without increasing the liabilities to avoid default.
 Alternatively, the capital can be increased over several years by retaining earnings and not paying dividends to
shareholders

Allocating Risk Limits

 Once the target debt rating is set and the amount of available capital has been calculated, the bank's total risk capacity is
fixed
 The next question is how to allocate the total risk capacity to the different business units
o Retail banking, Corporate Banking;
o Activities: Retail Lending, Corporate Lending, Investments -trading, credit cards, etc.
 In doing this it must consider
o the expected return and risk from each unit
o the diversification of the risk between units
o In general, we will allocate most (not all) of the risk capacity to the units that are expected to make the highest
returns

Understanding Credit, Market and Operational Risk in Banks

Sources of different types of risk to Bank are the assets they hold. Hence to understand the various types of risk, it is worth to know
the generic assets Banks hold.

“The assets are composed of all the items which are in possession of or due to the bank (from customers, other banks, Govt.,
etc), and it relies upon these assets to meet the liabilities which it owes to others.”
Understanding Credit Risk

 Credit risk is the risk of loss arising from the non-payment of principal & interest (obligation) by the borrower (obligor) on
time.

 Any amount of fund lent to a borrower is exposed to certain level of credit risk (unless lent to someone who is considered
default risk free).

 The price of loan or debt instrument which has higher credit risk is high relative to one with less credit risk. Banks add a
premium on risk to the price of the asset based on the level of credit risk they are exposed to. For instance a loan given to
business person might be highly priced when compared to a loan given to a salaried person.

 It is usually associated with loans and investments, but it can also arise in connection with derivatives, foreign exchange,
and other extensions of bank credit.

 Credit risk is the primary cause of bank failures and Bank’s success depends on how well this risk is managed.

 Credit Risk arises due to the failure of the borrower, endorser, guarantor or counter-party to repay a loan or to honor
another financial obligation.

 Concentration Risk: Besides the risk at the account or borrower level, what impacts banks more is the high concentration of
credit in select industries, similar profiled customers and / or geographies. A higher concentration of credit, e.g., to one
specific industry, surely leads to a bank failure if the industry is into recession/economic downturn.
  To avoid Concentration Risk, Banks should diversify the credit portfolio across various industries, Geographies and / or
different customer profile.

 Based on diversification of credit portfolio, risk limits (maximum exposure) for each Banking Product/Asset, Industries,
Geographies and / or customer profile should be set. Also manager should monitor that at any given point in time these
limits are not violated.

 An overall limit towards assets which expose to Credit risk is decided based on the capital bank is prepared to devote to
Bank lending/investment activities. This sets the maximum exposure that a Bank can take into assets with credit risk.

Understanding Market Risk

 Market risk refers to changes in the value of financial instruments or contracts held by a Bank due to unpredictable
fluctuations in prices of traded assets and commodities as well as fluctuations in interest and exchange rates and other
market indices.
 Loss of money due to change in the value of an instrument.
 Source of Market risk is Sales and Trading Group activities of the Bank.
 This group deals in investment activities of Bank and takes exposure in tradable debt and equity securities, and derivatives
and thereby exposes Bank to Market risk.
 Market Risk Factors:
o Stock price: For example, in a recession period, the S&P500 index fall down, then the price of the security a bank
holds will fall down as well.
o Exchange rate: For example, if a Bank holds a foreign bond and the foreign currency depreciates.
o Interest rate: For example if a Bank holds a bond and the interest rate increases.
 Market Risk involves the changes in equity and commodity prices and the following areas:
o Interest rate Risk
o Currency Risk
o Traded Credit Risk
o Liquidity Risk and
o Product Risk

Understanding Operational Risk

 Definition: “The risk of direct or indirect losses resulting from inadequate or failed internal processes, people and systems
or from external events”.
 Operating risk includes fraud and the possibility of a mistake being made.
 It includes Legal risks.
 Operational risk does not include strategic risk “the risk of a loss arising from a poor strategic business decision.
 Operational risk does not include reputation risk “damage to an organization through loss of its reputation or standing”.
Since this could be result of operational failures as well as other events.
 Operational risk encompasses the efficiency and effectiveness of all back-office operations including MIS, personnel,
compliance, external and internal frauds, lawsuits, and so on.
 The Enron bankruptcy case was mainly due to Operation Risk, specifically the lack of transparency in financial statements,
biased Audit practices, etc.
 Operational Risk Event Type Categories:
o Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, bribery, etc.
o External Fraud- theft of information, hacking damage, third-party theft and forgery
o Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and
safety, etc.
o Clients, Products, & Business Practice- market manipulation, antitrust, improper trade, product defects, fiduciary
breaches, account churning, etc.
o Damage to Physical Assets - natural disasters, terrorism, vandalism, etc.
o Business Disruption & Systems Failures - utility disruptions, software failures, hardware failures, etc.
 o Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting,
negligent loss of client assets, etc.

Risk from Different Bank Assets:

The assets discussed below include the usually held (and not all) assets by Banks.

Cash
Risk Associated:
No risk

Due from Government Treasury:

Risk Associated:
Country / Sovereign Risk

Loans and Advances:

Associated risk:
Credit / Default Risk: Non-payment of interest and / or Principal Amount

Credit Card Receivables:

Associated risk:
Credit / Default Risk: Non-payment of interest and / or Principal Amount

Investments in Securities – Short Term and Long Term:

Investments held by Bank include many variants of Debt and Equity Securities, ranging from different maturities (held to maturity
category) and tradable securities. Below is a list of securities with the associated risk.

Bonds

Bond is a Debt Security, in which issuer of the Bond owes the holders a debt. Based on Bond terms issuer is obliged to pay interest
(on given terms quarterly/semi-annually/yearly) and repay the principal at a later date termed as maturity.

Types of Bonds and Risks Associated:

Fixed Rate Bonds:

Bonds with fixed interest rate paid on agreed dates throughout the life of bond. On maturity the issuer should repay principal to the
bond holder.

Associated Risk:

Credit / Default Risk: Non-payment of interest and / or Principal Amount

Interest Rate: The risk that Bond value will change with change in the interest rates. Also reinvestment risk and inflation risk

Zero-Coupon Bonds:

Bonds issued at discount, pay no interest but principal repaid on maturity date. The bondholder receives full principal amount on the
redemption date. For instance, Zero-coupon bond valued $100 but issued at discounted price $95. On maturity date the Bondholder
receives principal amount of $100 (not the discounted value $95).

Associated Risk:

Credit / Default Risk: Non-payment of interest and / or Principal Amount

Interest Rate: The risk that Bond value will change with change in the interest rates. Also reinvestment risk and inflation risk.

Callable Bonds: Bonds that gives issuer the right (may or may not exercise) to repay the bonds on the call dates which is before the
maturity date.

Associated Risk:

Credit / Default Risk: Non-payment of interest and / or Principal Amount

Interest Rate: The risk that Bond value will change with change in the interest rates. Also Call Risk, reinvestment risk and inflation
risk

Floating Rate Notes:

(FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor. For example the coupon may
be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Associated Risk:

Credit / Default Risk: Non-payment of interest and / or Principal Amount

Interest Rate: The risk that Bond value will change with change in the interest rates. Also reinvestment risk and inflation risk.

Equity Securities:

All the equity securities that are traded on organized markets like Stock Exchanges.
Associated Risk: Market Risk and Liquidity Risk

Derivatives: Derivative instruments are financial instruments which derive their value from the value and characteristics of one or
more underlying assets. They can be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a
specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual
delivery of the item specified in the contract, or by a net cash settlement.

Associated Risk: None

Interest Rate Swaps: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a fixed and
floating interest rates. Cash flows from a fixed interest rate are swapped with floating interest.

Associated Risk:
Interest rate risk that originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party who pays the
floating rate benefits when rates fall and vice versa.

Currency swap:

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest
payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency

Associated Risk: None

Futures: Contracts similar to forwards but with the following differences: futures are generic exchange-traded, whereas forwards
are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled
by delivery of the underlying item or cash settlement.

Associated risk: Market Risk

Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified
quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a
specified period of time. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer)
of the option a fee (premium) to compensate the seller for the risk of payments under the option.

Associated risk: Market Risk

How Banks can lose money?

 Generally Blends of Different Risks

 Often Banks lose money from an incident that involves several forms of risk
 For instance, the Case of Barings Bank
  Nick Leeson was a trader in the Singapore branch of Barings Bank. He had seemingly generated 20% of Barings profit in
1994.
 In fact, he had been making losses and hiding them n a fictitious account. (Operating Risk)
 To recover the losses he tried a large, risky gamble with derivatives on the Nikkie225 index. (Market Risk)
 In 1995, he lost $1 billion and consumed out Baring’s capital. He was able to hide the original losses because he was in
charge of both trading and accounting in the Singapore office. (Operation Risk)
 He was able to take the final gamble on Nikkie because Senior Management had no effective oversight and / or
measurement or the risks being taken. (lack of risk management / measurement/ reporting tool)

Role of Capital in Banks

“Capital represents an ideal metric for aggregating risks across both different asset classes and across different risk types. Why so”?

This section explains the significance of Capital in Banks vis-à-vis any other firm.

Banks generate revenue by taking on more exposure to their customers and by earning appropriate return to compensate for the risk
of this exposure. In general, if a bank takes on more risk, it can expect to earn a greater return. The trade-off, however, is that the
same bank will, in general, increase the possibility of facing losses to the extent that it defaults on its debt obligations and is forced
out of business.

Banks that are managed well will attempt to maximize their returns only through risk taking that is prudent and well informed.

The primary role of risk management function in a bank is to ensure that the total risk taken across the enterprise is no greater than
the bank’s ability to absorb worst-case losses within some specified confidence interval.

Capital represents the difference between the market value of bank’s assets and the market value of its liabilities.

Capital can be viewed as a buffer against insolvency.

Capital adequacy is a measure of bank’s ability to remain a going concern under adverse conditions.

The primary role of capital in a bank is to act as a buffer to:

 Absorb large unexpected losses

 Protect depositors and other claim holders
 Provide enough confidence to external investors and rating agencies on the financial health and viability of the firm.

A Bank’s credit rating can be seen as a measure of its capital adequacy and is generally linked to a specific probability that the firm
will enter into default over some period of time. Bank’s which hold more capital are able to take on more riskier assets than firms of
similar credit rating which hold less capital.

Why Banks are regulated

Before knowing what are the regulations it is necessary to know why Banks are regulated.

Why are Banks regulated?

The most common objectives of Bank regulation are:

 Protect the public’s savings deposited in banks If Banks have no regulation on how they could use the funds collected
from Public as Deposits. The Bank employee’s definitely cannot use it for their personal purpose nor could they use it to
gamble or buy weapons;
 Control the money supply Banks are expected to maintain cash and liquid asset reserve ratio as mandated by the Federal /
Central Bank. They cannot simply lend all the money they have collected from various sources like deposits, equity capital,
borrowings, etc. If they are allowed money supply would increase, interest rates will fall down thereby impacting the
economy of the country.
 Ensure adequate supply of loans and to ensure fairness Pricing of Bank assets is regulated. For instance, in India, the
minimum price for a loan given by bank should be at least the prime lending rate (PLR). They cannot lend at a price which
 is below PLR. Likewise, interest rates offered on Deposits are also controlled. Some of the Banks also provide subsidized
rates for certain loans e.g., Farm Loans, special considerations for Educational Loans. Banks to promote economic growth
are mandated by Federal/Central Bank to perform certain activities.
 Maintain confidence in the Financial System The regulations by Federal Reserve Bank ensure confidence in system.
 Avoid monopoly powers Imagine if there were no such regulations on who can act as Bank and the Do’s and Don’ts on
banking business. People with money would have had their own terms in lending money. These issues were seen in
traditional Banking system and which lead to many regulations imposed on Banks.
 Provide support for Government activities
 Support special sectors of the economy The sectors like agriculture, Import / Export business, Education, Health Care,
Scientific Research, etc., are promoted by Government and have been given certain special considerations for the welfare
of the country per se.
 Impact of Bank failure is high and could fail the Financial System of country. Generally failure in one Bank could
cascade to the failure of several Banks and their by collapse the economy.

Bank Regulatory Environment:

Bank regulations are government regulations which subject banks to certain requirements, restrictions and guidelines.

Objectives of bank regulation The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common
objectives are:

 Prudential -- to reduce the level of risk bank creditors are exposed to (i.e. to protect depositors)
 Systemic risk reduction -- to reduce the risk of disruption resulting from adverse trading conditions for banks causing
multiple or major bank failures
 Avoid misuse of banks -- to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of
crime
 To protect banking confidentiality
 Credit allocation -- to direct credit to favored sectors Instruments and requirements of Banks regulation

1. Capital Requirement

 The capital requirement sets a framework on how Banks must handle their capital in relation to their assets.
 The Bank for International Settlements’ Basel Committee on Banking Supervision influences each country’s Capital
requirement.
 In 1988, Committee introduced a capital measurement system through Basel Capital Accord (Basel I)
 The latest capital adequacy framework is commonly known as Basel II

2. Reserve Requirement

 The minimum reserve each Bank must hold to demand deposits and bank notes.
 Banks, where applicable, must hold liquid assets as per the reserve requirement stipulated by the country’s Federal Bank.
 The purpose of minimum reserve is liquidity.
 Due to global emphasis on Capital Adequacy, the minimum reserve requirement has lost its significance.
 Only few countries still have such minimum reserve requirement for their Banks.

3. Corporate Governance Corporate governance requirements are intended to encourage the bank to be well managed, and is an
indirect way of achieving other objectives.

 To be a body corporate (i.e. not an individual, a partnership, trust or other unincorporated entity)
 To be incorporated locally, and/or to be incorporated under as a particular type of body corporate, rather than being
incorporated in a foreign jurisdiction.
  To have a minimum number of directors
 To have an organisational structure that includes various offices and officers, e.g. corporate secretary, treasurer/CFO,
auditor, Asset Liability Management Committee, Privacy Officer etc. Also the officers for those offices may need to be
approved persons, or from an approved class of persons.
 To have a constitution or articles of association that is approved, or contains or does not contain particular clauses, e.g.
clauses that enable directors to act other than in the best interests of the company (e.g. in the interests of a parent company)
may not be allowed.

4. Financial Reporting and Disclosure Requirements- Banks may be required to:

 Prepare annual financial statements according to a financial reporting standard, have them audited, and to register or
publish them

 Prepare more frequent financial disclosures, e.g. Quarterly Disclosure Statements

 Have directors of the bank attest to the accuracy of such financial disclosures

 Prepare and have registered prospectuses detailing the terms of securities it issues (e.g. deposits), and the relevant facts that
will enable investors to better assess the level and type of financial risks in investing in those securities.

5. Credit rating requirement:

Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to
investors and prospective investors. Also, banks may be required to maintain a minimum credit rating.

6. Large exposures restrictions:

Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected
counterparties. This may be expressed as a proportion of the bank's assets or equity, and different limits may apply depending on the
security held and/or the credit rating of the counterparty.

7. Related party exposure restrictions:

Banks may be restricted from incurring exposures to related parties such as the bank's parent company or directors. Typically the
restrictions may include:

 Exposures to related parties must be in the normal course of business and on normal terms and conditions
 Exposures to related parties must be in the best interests of the bank
 Exposures to related parties must be not more than limited amounts or proportions of the bank's assets or equity.

Banking Regulations:

Following Banking regulations are in place to ensure the instruments to Banking Regulations: Minimum Capital Requirement,
Corporate Governance and Financial Reporting and Disclosures are practiced. The below listed are most commonly followed
regulations by internationally active Banks.

 Basel II (originally introduced as Basel Capital Accord)

 Anti-Money Laundering (AML)
 Sarbanes-Oxley Act 2002 (SOX)
 Asset Liability Management (ALM)
 IFRS (originally IASB)
Risk Management - Anti Money Laundering

What is Money Laundering ?

Money laundering, the metaphorical "cleaning of money" with regard to appearances in law, is the practice of engaging in specific
financial transactions in order to conceal the identity, source, and/or destination of money, and is a main operation of underground
economy.

In the past, the term "money laundering" was applied only to financial transactions related to organized crime. Today its definition
is often expanded by government regulators (such as the United States Office of the Comptroller of the Currency) to encompass any
financial transaction which generates an asset or a value as the result of an illegal act, which may involve actions such as tax evasion
or false accounting.

As a result, the illegal activity of money laundering is now recognized as potentially practiced by:

 Individuals,
 Small and large businesses,
 Corrupt officials,
 Members of organized crime (such as drug dealers or the Mafia) or of cults, and
 Corrupt states, through a complex network of shell companies and trusts based in offshore tax havens.

As per US Laws, money laundering has been defined as “the movement of illicit cash or cash equivalent proceeds into, out of, or
through the United States (or) United States Financial Institutions (FIs).”

Anti Money Laundering:

Anti-money laundering is a term mainly used in the finance and legal industries to describe the legal controls that require financial
institutions and other regulated entities to prevent or report money laundering activities. Anti money-laundering guidelines came
into prominence globally after the September 11, 2001 attacks and the subsequent enactment of the USA Patriot Act.

Today, all financial institutions globally are required to monitor, investigate and report transactions of a suspicious nature to the
financial intelligence unit of the central bank in the respective country. For example, a bank must perform due diligence by having
proof of a customer's identity and that the use, source and destination of funds do not involve money laundering. United States
federal law related to money laundering is implemented under the Bank Secrecy Act of 1970 as amended by anti-money laundering
acts up to the present.

Process of Money Laundering:

Money laundering is often described as occurring in three stages:

 Placement
 Layering
 Integration
 Placement:
 Refers to the initial point of entry for funds derived from criminal activities.
 Initiated with placement of illegally derived funds into financial system/ (generally an institution).
 Depositing cash into a Bank account.
 Large amounts are broken into smaller less conspicuous amounts
 Deposit of these small amounts in different times of a single or in multiple financial institutions.
 The exchange of one currency into another;
 Conversion of larger denominations into smaller denominations;
 Illegal funds converted into financial instruments like money orders, securities, etc.,
 Purchase of an insurance contract
 Co-mingled with legitimated money to divert suspicion

 Layering:
 Refers to the creation of complex networks of transactions which attempt to obscure the link between the initial entry point,
and the end of the laundering cycle.
 Starts after the illegal money is entered into financial system/institution;
 Funds, securities, insurance contracts, etc., are converted or moved to other institutions to further separate them from their
criminal source;
 Funds are again used to purchase other securities, insurance contracts or other easily transferable investment instruments;
 These are sold through yet another institution;
 Funds could also be transferred by a form of negotiable instrument such as check, money order or bearer bond;
 Funds may be transferred electronically to other accounts in various jurisdictions;
 Pay for goods or services;
 Transfer the funds to a shell corporation;

 Integration:
 Refers to the return of funds to the legitimate economy for later extraction.
 Involves the integration of funds into legitimate economy;
 Accomplished through purchase of assets, such as real estate, securities or other financial assets, or luxury goods;

 The same three stages are also seen in terrorist financing schemes, except that stage three integration involves distribution of
funds to terrorists and their supporting organizations;
The AML Network recommends usage of terms Hide, Move and Invest instead of Placement, Layering and Integration respectively.

Occurrence of Money Laundering and Terrorist Financing

 Money laundering and terrorist financing can occur in any country in the world;
 Generally targeted to countries with complex financial systems;
 Countries with lax, ineffective, or corrupt AML and Combating the Financing of Terrorism (CFT) infrastructures are likely
targets for such activities;
 No country is exempt.

AML Regulations:

Many jurisdictions adopt a list of specific predicate crimes for money laundering prosecutions as a "self launderer" (the UK has an
"all-crimes" regime). In addition, AML/CFT laws typically have other offences such as "tipping off," "willful blindness," not
reporting suspicious activity, and conscious facilitation of a money launderer/terrorist financier to move his/her monies.

The USA Legislation:

The Money Laundering Control Act of 1986 made money laundering a federal crime.

In the United States, Federal law provides (in part): "Whoever . . . knowing[ly] . . . conducts or attempts to conduct . . . a financial
transaction which in fact involves the proceeds of specified unlawful activity . . . with the intent to promote the carrying on of
specified unlawful activity . . . shall be sentenced to a fine of not more than $500,000 or twice the value of the property involved in
the transaction, whichever is greater, or imprisonment for not more than twenty years, or both."

AML laws also apply to terrorist financing, including any legally obtained funds if intended for use in planning, committing, or
concealing a terrorist act.

 Three key laws lay out the basic anti-money laundering obligations of US Financial Institutions:
o The Bank Secrecy Act (BSA) of 1970
o The Money Laundering Control Act of 1986, and
o The US Patriot Act of 2002 (Amended to above two laws)
 There are similar laws for other countries too.
 The anti-money laundering laws are designed to prevent terrorists and other criminals from utilizing Financial Institutions
to commit their crimes.

USA PATRIOT ACT:

 The USA PATRIOT Act, commonly known as the "Patriot Act"

 An Act of the U.S. Congress and signed into law by President George W. Bush on October 26, 2001.
 Title of the Act is a contrived acronym, which stands for Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act of 2001.
 Act dramatically reduced restrictions on law enforcement agencies' ability to search telephone, e-mail communications,
medical, financial, and other records;
 Eased restrictions on foreign intelligence gathering within the United States;
 Expanded the Secretary of the Treasury’s authority to regulate financial transactions, particularly those involving foreign
individuals and entities; and
 Broadened the discretion of law enforcement and immigration authorities in detaining and deporting immigrants suspected
of terrorism-related acts.
 Expanded the definition of terrorism to include domestic terrorism, thus enlarging the number of activities to which the
USA PATRIOT Act’s expanded law enforcement powers could be applied.

Know Your Customer (KYC):

  KYC is the due diligence that financial institutions and other regulated companies must perform to identify their clients.
 Banks ascertain relevant information pertinent to doing financial business with them.
 KYC is a policy implemented to conform to a customer identification program mandated under the Bank Secrecy Act and
USA PATRIOT Act.
 KYC policies are becoming increasingly important globally to:
o prevent identity theft fraud,
o money laundering and
o Terrorist financing.
 In a simple form these rules may equate to answering twelve questions, but this is the tip of the iceberg and regulators now
expect much more.
 KYC should not be thought of as a format to be filled - it is a process to be undergone from the start of a customer
relationship to the end.
 KYC verifies that the customer is not on any list of known fraudsters, terrorists or money launderers, such as the Office of
Foreign Assets Control's Specially Designated Nationals list (OFAC List).
 This list contains thousands of entries and is updated at least monthly.
 KYC verifies customers on the sanctions lists too.
 There are lists of third party vendors that track links between persons regarded as high-risk owing to negative reports in the
media about them or in public records.
 KYC controls’ monitors transactions of a customer against their recorded profile, history on the customers account(s) and
with peers.
 Banks doing KYC monitoring for AML and CTF purposes increasingly use specialized transaction monitoring software,
particularly names analysis software and trend monitoring software.
 The generated alerts identify unusual activity which is then subject to due diligence or enhanced due diligence (EDD)
processes that use internal and external sources of information on the subject, including the internet.
 This helps to determine whether a transaction or activity is suspicious and requires reporting to the authorities.
 In the US SAR is filed with Financial Crimes Enforcement Network (FinCEN). Likewise in the UK reporting to Serious
Organized Crime Agency (SOCA).

KYC has different connotations and the definition above is from an AML/CFT perspective.

Know Your Customer processes are also employed by regular companies of all sizes, for the purpose of ensuring their proposed
agents, consultants or distributors anti-bribery compliance. Banks, insurers and export credit agencies are increasingly demanding
that customers provide detailed anti-corruption due diligence information, to verify their probity and integrity.

AML / CFT – Financial Action Task Force (FATF):

The Financial Action Task Force (FATF), also known by its French name Groupe d'action financière (GAFI), is an
intergovernmental organization founded in 1989 by the G7. The purpose of the FATF is to develop policies to combat money
laundering and terrorist financing. The FATF Secretariat is housed at the headquarters of the OECD in Paris.

The FATF Forty Recommendations and Special Recommendations on Terrorist Financing:

The primary policies issued by the FATF are the Forty Recommendations on money laundering and the 9 Special Recommendations
(SR) on Terrorist Financing (TF).

Together, the Forty Recommendation and Special Recommendations on Terrorist Financing set the international standard for anti-
money laundering measures and combating the financing of terrorism and terrorist acts. They set out the principles for action and
allow countries a measure of flexibility in implementing these principles according to their particular circumstances and
constitutional frameworks. Both sets of FATF Recommendations are intended to be implemented at the national level through
legislation and other legally binding measures.

The FATF issued the Forty Recommendations in 1990 and completely revised them in 1996 and 2003. The current (2003) Forty
Recommendations require states, among other things, to:
 Implement relevant international conventions
 Criminalize money laundering and enable authorities to confiscate the proceeds of money laundering
 Implement customer due diligence (e.g. identity verification), record keeping and suspicious transaction reporting
requirements for financial institutions and designated non-financial businesses and professions
 Establish a financial intelligence unit to receive and disseminate suspicious transaction reports, and cooperate
internationally in investigating and prosecuting money laundering.
The FATF issued 8 Special Recommendations on Terrorist Financing in October 2001, following the September 11 terrorist attacks
in the United States. The FATF issued a ninth Special Recommendation on Terrorist Financing in October 2004.

The Special Recommendations on Terrorist Financing broadly extend the application of the Forty Recommendations to terrorist
financing and introduce new requirements relating to services such as alternative remittance, wire transfers and cash couriers as well
as non-profit organisations.

Financial Intelligence Unit (FIU)

 Definition: A central, national agency responsible for receiving (and, as permitted, requesting), analyzing, and
disseminating to the competent authorities, disclosures of financial information (i) concerning suspected proceeds of crime,
or (ii) required by national legislation or regulation, in order to counter money laundering.
 FATF requires countries to establish an FIU, which has three essential functions:
o The collector or repository of reported information,
o Analysis function and,
o Financial information sharing for detecting and countering money laundering and terrorist financing.

Features of AML System:

 Satisfy Regulatory Requirements
 Suspicious Activity Monitoring
 OFAC and Other Sanction List Processing
 Know Your Customer
 Customer Database Scanning
 Payment Monitoring
 Be easy to use and change
 Provide long-term cost effectiveness

Key Components of AML Compliance System:

Challenges in AML:
 Sophisticated techniques used to launder money and finance terrorism add to the complexity of these issues.
 Launderers are very creative: when overseers detect one method to filter such activities, the criminals soon find another.
Hence scenarios built in the system to filter suspicious activities are not good enough;

AML Opportunities:
 Software industry is developed around providing software:
  To analyze transactions to identify transactions or
 To identify patterns of transactions that may constitute illegal financial activity.
 Financial institutions face penalties for failing to properly file reports:
 Cash Transaction Report (CTR)
 Suspicious Activity Report (SAR)
 A serious violation could lead to heavy fines and regulatory restrictions even to the extent of charter revocation.
 These software applications effectively monitor bank customer transactions on a daily basis and using customer historical
information and account profile, provide a "whole picture" to the bank’s AML compliance management.
 Transaction monitoring includes cash deposits and withdrawals, wire transfers, credit card activity, cheques (checks), share
(securities) dealing and Automated Clearing House (ACH) activity.
 In the banking terminology, these applications are known as "AML software".

Risk Management - Asset Liability Management

Introduction

ALM process involves managing Bank’s assets and liabilities with the scope of following functions.

 Liquidity Risk Management

 Interest-rate risk management
 Funding and capital planning
 Profit planning and growth projection

ALM Organization

 The Bank directors have overall responsibility of managing ALM risks and should have risk management policy of the
bank.
 A committee “Asset Liability Committee (ALCO) consisting of senior management including CEO should be set up.
 An ALM desk consisting of operating staff should be responsible of analyzing, monitoring and reporting the risk profiles to
the ALCO.
 The ALCO is a decision making unit.

ALM is a strategic management tool to manage two types of risks:

 Interest-Rate Risk: The interest-rate risk arises from the possibility that profits will change if interest rates change.
 Funding-Liquidity Risk: The liquidity risk arises from the possibility of losses due to the bank having insufficient cash on
hand to pay the obligations (/ or to the customers).
 Both risks are due to the difference / mismatch between Bank’s assets and liabilities.

Understanding Interest-rate risk for ALM:

 The best illustration of Interest-rate risk for ALM : U.S. savings and loan (S&L) crisis
o Savings and loan banks: retail banks, receive retail deposits and make retail loans
o For many years, interest rates were stable. Deposits for around 4% (floating rate), and they lent 30-year mortgages
paying about 8% at fixed rates.
o Then in the 1980s, the Federal Reserve allowed interest rates to float. Short-term interest rates rose to 16%.
o Many deposit customers withdrew their funds or demanded the higher rates.
o The rate of mortgages is fixed with 8%, however the rate of deposits is floating and the banks have to pay 16% for
the deposits of customers.
o This caused the banks a lot of loss and most banks were bankrupt.
o The cascading effect impacted entire Banking system not just in US but also in other countries.

Some pointers from the above illustration of ALM:

o The rate of deposit is floating and the rate of mortgage is fixed.
 o The deposit (loan) is more (less) sensitive to interest rate.
o OR, the Deposits (the bank’s liabilities) are rate-sensitive and the Mortgages (Bank’s assets) are rate-insensitive.
o The interest rate risk rises when risk sensitive liabilities (RSL) are not equal to risk sensitive assets (RSA).

Understanding Funding-Liquidity Risk for ALM

 The funding-liquidity risk arises from mismatches between the assets and liabilities.
 This risk arises because banks generally fund themselves with liabilities that have very short contractual maturity (e.g.,
demand deposits such as checking accounts).
 Banks take the money they receive from these liabilities, set aside a small amount in cash, and invest the rest in assets that
have long maturity, e.g., commercial loans.
 In general, customers leave most of their money in the demand deposits for a long time, and the small amount of cash that
the bank sets aside is sufficient to meet customers' requests for withdrawals.
 However, if withdrawals are unusually high, there is a risk that the bank would not have enough cash to meet the demand.
 In such a situation, the bank's choices can be simplified into three:
o Borrow money from other banks, if they are willing and able to supply more cash;
o Sell some of the loans, possibly at deeply discounted prices;
o Default to the customers, and go out of business.
 This risk of defaulting or being forced to sell at a loss is called funding-liquidity risk or cash-crisis risk.
 Funding-liquidity risk is different from the liquidity risk pertaining to trading risk.
 The liquidity risk in trading arises from the possibility of the bank’s losing money by being locked into a position that is
losing value.
 But in ALM, we are concerned that the bank will be unable to raise enough cash to pay its customers, or that it will be
forced to sell ("cash in") assets at an awkward moment, incurring a significant liquidation cost.

Risk Management - Basel II

An Introduction to Basel-II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was
initially published in June 2004, is to create an international standard that banking regulators can use when
creating regulations about how much capital banks need to put aside to guard against the types of financial
and operational risks banks face. Advocates of Basel II believe that such an international standard can help
protect the international financial system from the types of problems that might arise should a major bank or a
series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and
capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk
the bank exposes itself to through its lending and investment practices. This section provides more insight into
the concepts of Basel-II.

Background of the Basel Capital Accord

The Basel Accords refer to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel
II issued (and Basel III under development) by the Basel Committee on Banking Supervision (BCBS). They are called the Basel
Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee
normally meets there.

In 1988, the Basel Committee on Banking Supervision (BCBS), a group of banking regulators from leading industrialized nations,
established regulations regarding the amount of capital banks hold against credit risk. The major impetus for this Accord was the
concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after
persistent erosion through competition.

Introduction to Basel Accord

Basel-I was original Basel Accords, which are recommendations on banking laws and regulations issued by BCBS in July 1988.

Basel I was motivated by two interacting concerns:

 The risk posed to the stability of the global financial system by low capital levels of internationally active banks, and
 The competitive advantages accruing to banks subject to lower capital requirements. Fundamental Objectives of Basel I
Accord:
o Strengthening the soundness and stability of the international banking system.
o Diminishing an existing source of competitive inequality among international banks

Elements of the Basel I Accord

The Basel Committee released its final version of the Basel I Accord in July 1988. The elements of the accord were:

 Provided Capital Adequacy Standards

 Common framework for capital measurement
 Addressed only Credit risk in the Original Accord
 Market risk was addressed later in 1996 as amendments to original Accord
 The basic approach was:
o Assign each asset or off-balance sheet item held by a bank to one of five risk categories
o Calculate the capital required for each asset or item based on risk weighting, and
o Add all these amounts to produce the total minimum capital to be held by the bank.

Basel I Capital Ratio / Cooke Ratio

 (Total Capital) / (Weighted Credit Risk + Weighted Market Risk) >= 8%, wherein risk weight is flat per cent rate per asset
category.

The Accord provided two minimum capital ratios:

 Bank’s Core Capital or Tier 1 Capital: At least 4% of risk weighted assets

 Bank’s Total Capital or Tier 2 Capital: At least 8% of risk weighted assets

Definition of Capital in Basel I (Capital Elements):

 Tier 1 included:
o Paid Up Share Capital / Common Stock
o Disclosed Reserves
 Tier 2 included:
o Undisclosed reserves
o Asset revaluation reserves
o General Provision or Loan-loss reserves
o Hybrid (Debt / Equity) Capital instruments
o Subordinated debt
 Limitations and Restrictions
o Total of Tier 2 elements limited to a maximum of 100% of total of tier 1 elements.
o Subordinated term debt limited to a maximum of 50% of Tier 1 elements.
o Loan-loss reserves limited to a maximum of 1.25 percentage points.
o Asset revaluation reserves that take the form of latent gains on unrealized securities subject to a discount of 55%.

Drawbacks / Shortfalls in Basel I Capital Accord

 Limited guidelines for credit risk and collateral evaluation

  Sovereign / Country Risk was totally ignored while there were specific cases of country economy facing collapse.
 No reward for good credit risk practices
 No distinction between high-risk and low-risk loan portfolios
 No guidelines for adjusting collateral value
 No adjustments for sovereign/country risk
 General tendency was that more than required capital was set aside by Banks impacting their Profitability.
 No attention to operational risk
 Operational Risk: No standards for assessing levels of operational risk

Introduction to Basel-II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by BCBS. These
accords were originally published in June 2004.

Purpose of Basel II

 Addressing the limitations of Basel I Accord

 Provide more risk sensitive Minimum Capital calculation Framework
 Goals of Basel II:
 To discourage the manipulation and mishandling of regulatory capital.
 To reward banks that reduced their business risk levels by improving their risk management systems.
 Areas of Special Attention
 Credit Risk
 Operational Risk

Scope of Application of Basel-II

 Framework is applied on a consolidated basis to internationally active banks.

 The Holding company / parent entity should ensure that it captures the risk of the whole banking group.
 The framework will also apply, on a fully consolidated basis, to all internationally active Banks at every tier within a
Banking group.
 Individual Banks under a Group/ parent Bank are adequately capitalized on a stand-alone basis.

Structure of Basel II - The Three Pillars

The Basel II regulations are structured as three pillars as given in the picture.
Pillar I - Minimum Capital Requirements

 Calculation of Minimum Capital Requirements

o Calculation of the total minimum capital requirements for Credit, Market and Operational Risk
o Calculated using definition of regulatory capital and risk-weighted assets
o Total Capital Ratio must be no lower than 8%.
o Tier 2 Capital is limited to 100% of Tier 1 Capital.
 Maintenance of Capital for three major components of risk: Credit risk, Market Risk and Operational Risk
 Regulatory Capital
o Tier 1 Capital as per Basel I
 Equity Capital + Disclosed Reserves from Post Tax Retained Earnings
 Following deductions must be made from Tier 1
 Goodwill
 Increase in equity capital resulting from a securitization exposure
 Investments in subsidiaries engaged in banking and financial activities which are not
consolidated in national systems
o Tier 2 Capital
 Other elements, other than those included in Tier 1 capital will be admitted into Tier 2 limited to 100% of
Tier 1. The Tier 2 includes:
 Undisclosed reserves
 Revaluation reserves
 General provisions / general loan loss reserves
 Hybrid Debt Capital Instruments
o Tier 3 Capital
 Short-term subordinated debt covering market risk
 Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support market risks.
 Risk Weighted Assets
o Total risk weighted assets are determined by multiplying the capital requirements for market risk and operational
risk (i.e., reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of weighted
assets for credit risks.
 Calculation of Credit Risk

BCBS permits Banks to calculate capital requirements for credit risk by two approaches:
o Standardized manner supported by external credit assessments
 Standardized Approach
o Internal rating based approach, which is subject to explicit approval of the bank’s supervisor and allows use of
internal rating’s system. The approach has two versions of credit risk calculation.
 Foundation – Internal Ratings Based Approach (F-IRB)
 Advanced – Internal Ratings Based Approach (A-IRB)
 Calculation of Credit Risk – Standardized Approach
o Risk weights are based on the credit rating/assessment of the assets
 This is a revision of Basel I intended to make more risk sensitive
 Credit rating provided by external credit assessment institutions (ECAI) is used.
 For each category of rating, a Risk weight is defined.
 The risk weights range from 20% 50 150% for all the assets except for past due loans and securitized
assets.
 For past due over 90 day, net of specific provisions: the weights range from 50% to 150% based on the
specific provisions made for these loans.
 Risk weights on Claims from Banks cannot be lesser than the risk weight given to its Sovereign of
incorporation.
 There are thirteen categories of risk weights defined by Basel II in this approach.
 Risk Weighted Assets / Risk Adjusted Assets = Asset Exposure (e.g., Claims from sovereigns) X risk
weight. This is calculated for each of the assets.
 The total of all risk weighted assets is considered as Exposure at Default and is substituted in the capital
charge calculation formula.
 Capital Charge: Capital charge is a function of the following components.
 Probability of Default (PD)
 Loss Given Default (LGD)
 Exposure at Default (EAD) and
 Maturity

 Calculation of Credit Risk – Foundation Internal Rating Based Approach

o Under IRB approach, subject to certain minimum conditions and disclosure requirements and supervisory
approval for use of this approach, banks may rely on their own estimate of risk components in determining capital
requirements for a given exposure.
o Banks must classify their banking book exposures in six broad classes of assets: Corporate, Sovereign, Bank
Retail, Equity and purchased receivables. Also should identify 5 sub classes within Corporate and 3 sub lasses
within retail asset classes;
o Bank should internally create a Probability of default estimates for each of this assets categorized. Apply the Bank
calculated estimates of Probability of default and rely on supervisory estimates for other risk components: LGD,
EAD and Maturity.
o Calculate the capital charge based on above.

Calculation of Credit Risk – Advance Internal Rating Based Approach

o The only difference in this approach from the Foundation one is Banks create models to compute their own
estimates for risk components: PD, LGD and EAD and their own calculation of Maturity (M) subject to meeting
minimum standards.
o Apply the computed risk components to calculate the capital charge.

 Calculation of Market Risk

For Market Risk the preferred approach is Value at Risk (VaR) which provides the output Expected Loss from asset
exposure towards Market risk.

 Calculation of Operational Risk

o Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk. They are:
 Standardized Approach (TSA)
 Basic Indicator Approach (BIA)
 Advanced Measurement Approach (AMA)
  Basic Indicator Approach - based on a fixed percentage (or alpha) of the Bank’s annual gross income.
 Standardized Approach – Basel II identifies 8 business lines and for each of these provides Beta Factor in percentage
(risk adjustment factor) for adjusting the gross income to derive the capital charge. The capital charge is obtained by
multiplying gross income of each of the business lines of a bank by a fixed percentage (beta factor) and summing across
business lines.
 Advanced Measurement Approaches – Under this method the regulatory capital requirement will depend on the risk
measure generated by the bank’s internal operational risk management system. However, in order to use this approach, the
bank must demonstrate that its operational risk measure meets a soundness standard comparable to that of IRB approach
for credit risk. Banks will arrive at the Expected Loss as an output of their measurement system.

 Pillar II
 Supervisory Review Process
o Ensure Sound Processes
o Ensure adequate capital at all times
o Ensure motivation for improving risk management practices

 Pillar III
 Market Discipline
o Qualitative and quantitative disclosure of undertaken risks and risk methodologies

Issues and Challenges:

Depending on its current risk management processes, size, customers, portfolio, and market, a particular bank is likely to experience
varying effects of Basel II on at least four levels, as described below.

Internal Impact:

Basel II’s focus on enhanced risk sensitivity will prompt an enhanced focus on economic capital management, versus regulatory
capital management, because the New Accord drives banks to measure their performance against risk factors other than market
share or expected return.

Under Basel I, most banks were volume driven; Basel II drives them to become risk-return driven. Once banks can attribute risk to a
potential transaction, product, or process, they can ascribe a portion of economic capital to it (based on the risk it poses), define an
expected return on it, consider how best to price it, consider risk mitigating techniques, and thereby decide, for example, whether to
enter a transaction, engage in a business, or pursue an activity or process.

Customer Impact:

Improved risk management and data flows should enable banks to identify target clients, evaluate their customers in a more
thorough way than they might have done in the past, and determine whether to retain certain customers.

Banks will need to request new and timely information from borrowers to perform the internal rating assessments and the collateral
evaluation that are essential to Basel II’s risk calculation process.

The standardized credit risk approaches require external rating of most borrowers to be taken into account. Thus, external ratings
agencies acquire new importance under the New Accord.

Certain markets will remain accessible to un-rated borrowers, but they are likely to face premium pricing, as lenders would have to
set aside additional capital to cover the risks they pose. Moreover, even un-rated borrowers will find that banks are required to rate
them internally.

Business Impact:

Although banks reduce their credit risk in their transactions, their operational risk may rise. For example, a bank may choose to sell
a securities portfolio to a special purpose vehicle (SPV) or transfer credit risk via a derivatives transaction.

When it does so, the bank needs to designate separate people, processes, and IT systems to that SPV and ensure proper management
of related legal issues to mitigate risks. Moreover, increased overall operational risk may require higher regulatory capital, which
partly may offset savings on the credit side.
Banks may also discover that their best and/or largest customers no longer need their services. Such companies can access the
capital markets directly – by issuing bonds, equity, or asset-backed securities – and are as likely to do so as a bank. Retaining such
customers could become a challenge.

Global Impact:

The banking industry’s improved risk management, enhanced information flows, and related disclosures could drive parallel
improvements in the stability of the financial markets.

New disclosures will provide regulators with “early warnings” that banks or rating agencies could pass on to the public and
investors, potentially enhancing trust in the financial markets.

For the individual institution, the challenge will be to determine how to translate internal risk management into external disclosures.

Scenario analysis of both credit and operational risk – and to what extent to disclose such analysis – becomes increasingly important
for banks in an environment in which regulatory capital is aligned with economic risks.

Basel II's disclosure requirements are intended to allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.”

Such information has increased importance and potential value under Basel II, in which banks have new license to rely on internal
models and ratings to determine their capital requirements.

Overview of Basel II implementation:

 Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelines
and use of the varying methodologies being restricted.
 The various U.S. regulators have agreed on a final approach.
 They have required the IRB approach for the largest banks and the standardized approach will not be available to anyone.
 In India, RBI has implemented the Basel II standardized norms on 31st March 2009 and is moving to internal ratings in
credit and AMA norms for operational risks in banks.
 In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were
to implement Basel II, in some form or another, by 2015.
 The EU has already implemented the Accord via the EU Capital Requirements Directives and many European banks
already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008.
 Australia, through its Australian Prudential Regulation Authority, implemented the Basel II Framework on 1 January 2008.

Risk Management - International Financial Reporting

Standards (IFRS)
An Introduction to IFRS

International Financial Reporting Standards (IFRS) are principles-based Standards,

Interpretations and the Framework (1989) adopted by the International Accounting Standards Board (IASB).
Many of the standards forming part of IFRS are known by the older name of International Accounting
Standards (IAS). IAS were issued between 1973 and 2001 by the Board of the International Accounting
Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC the responsibility for
setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and
SICs. The IASB has continued to develop standards calling the new standards IFRS. This section provides
more insight into the concepts of IFRS.

Introduction to IFRS

 IFRS are principles-based Standards, Interpretations and the Framework adopted by the International Accounting
Standards Board (IASB).
 Framework for the Preparation and Presentation of Financial Statements.
 Originally known as International Accounting Standards (IAS) and were issued between 1973 and 2001 by International
Accounting Standards Committee (IASC).
 On 1 April 2001, the new IASB took over the responsibility for setting International Accounting Standards.
 The new Board started with adopting existing IAS and Standing Interpretations Committee (SIC).
 Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS).

Structure of IFRS:

 Considered a “principles based” set of standards.

 They establish broad rules and dictate specific treatments.

IFRS comprises:

o IFRS – standards issued after 2001

o IAS – standards issued before 2001
o Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC) – issued
after 2001
o SIC – issued before 2001
o Framework for the Preparation and Presentation of Financial Statements

Framework

o Framework states basic principles of IFRS.

o IASB and FASB Frameworks are being updated and converged.
o This joint conceptual framework project, undertaken by the IASB and the US FASB,aims to update and refine the
existing concepts to reflect the changes in markets, business practices and the economic environment that have
occurred in the two or more decades since the concepts were first developed.
o Its objective is to create a sound foundation for future accounting standards that are principles-based, internally
consistent and internationally converged.

List of IFRS specific to Banks

o IFRS 1 First-time Adoption of International Financial Reporting Standards

o IFRS 7 Financial Instruments: Disclosures
o IFRS 9 Financial Instruments

Brief on IFRS 7
 o Effective from 1 January 2007.
o Adds certain new disclosures about financial instruments to those currently required by IAS 32;
o Replaces the disclosures previously required by IAS 30, and
o Supersedes all the disclosures in IAS32 to put together a new standard on Financial Instruments: Disclosures.
o The remaining parts of IAS32 deal only with Financial Instruments Presentation matters.
o The two main disclosures required by IFRS 7 are:
 Information about the significance of financial instruments
 Information about the nature and extent of risks arising from financial instruments
o IFRS 7.36 to 42 requires disclosure of nature and extent of Credit Risk, Liquidity Risk and Market Risk exposure
of Financial Instruments held.

Brief on IFRS 9

o Applicable from 1 January 2013, however early adoption is permitted.

o Introduces new requirements for classifying and measuring financial assets.
o Will eventually replace IAS39 – Financial Instruments: Recognition and Measurement;
o Replaces the disclosures previously required by IAS 30, and
o IASB expanding IFRS9 during 2010 to include new requirements for:
 classifying and measuring financial liabilities;
 credit risk in measurement of liabilities;
 de-recognition of financial instruments;
 impairment of financial assets measured at amortized cost; and
 Hedge accounting.
o IASB plans to complete the replacement for IAS39 by adding above requirements.

List of IAS specific to Banks

The list is available for reference here, however a thorough reading of each IAS is part of only next level of this Course.
o IAS 25 Accounting for Investments – Superseded by IAS 39 and IAS 40 effective 2001
o IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions – Superseded by IFRS
7 effective 1 January 2007
o IAS 32 Financial Instruments: Presentation – Disclosure provisions superseded by IFRS 7 effective 1 January
2007
o IAS 39 Financial Instruments: Recognition and Measurement replaced by IFRS 9 effective 1 January 2013.

List of Bank related interpretations by IFRIC and SIC The list is available for reference here, however a thorough
reading of each Interpretations is part of only next level of this Course.

IAS32 / IFRS 7:
o IAS 32 (2003) superseded SIC 5 Classification of Financial Instruments - Contingent Settlement Provisions
o IAS 32 (2003) superseded SIC 16 Share Capital - Reacquired Own Equity Instruments (Treasury Shares)
o IAS 32 (2003) superseded SIC 17 Equity - Costs of an Equity Transaction
o IFRIC 2 Members' Shares in Co-operative Entities and Similar Instruments

IAS 39 / IFRS 9:
o IFRIC 16 Hedge of a Net Investment in a Foreign Operation
o IFRIC 12 Service Concession Arrangements
o IFRIC 9 Reassessment of Embedded Derivatives
 o IAS 39 (2003) superseded SIC 33 Consolidation and Equity Method - Potential Voting Rights and Allocation of
Ownership Interest

Adoption of IFRS by region

United States

 Allowed for foreign issuers in the US since 2007;

 Target date for substantial convergence with IFRSs is 2011; and
 Decision about possible adoption for US Companies expected 2011.

European Union

 All listed EU companies have been required to use IFRS since 2005.
 Approved for use only when a IFRS standard is endorsed by Accounting Regulatory Committee (ARC).
 Due to endorsement IFRS as applied in EU may differ from that used elsewhere.
India

 The Institute of Chartered Accountants of India (ICAI) made IFRS mandatory for financial statements for periods beginning 1
April 2011 based on company networth/ into specific business/ listed global.
 Existing accounting standards will be modified to make compatible with IFRS.
 RBI has stated that financial statements for Banks must be IFRS compliant effective 1 April 2011.
Other Countries

 http://www.ifrs.org/Use+around+the+world/Use+around+the+world.htm

IFRS Taxonomy
 It’s the XBLR representation of IFRS, including IAS and Interpretations issued by the IASB.
 The IFRS Taxonomy contains tags for all IFRS disclosures.
 Purpose: The IFRS Foundation seeks to address the demand for an electronic standard to transmit IFRS financial
information.
 Format: Taxonomies are the computer-readable ‘dictionaries’ of XBRL.
 Structure: Taxonomies provide XBRL tags, information about each tag, and organizes tags into a meaningful structure.
 Release/Version: On 30th April 2010, the IFRS Foundation released the IFRS Taxonomy for 2010.

Risk Management - Sarbanes-Oxley Compliance

An Introduction to Sarbanes-Oxley Compliance

The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response
to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public
from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities and
Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements.
Sarbanes-Oxley is not a set of business practices and does not specify how a business should store records;
rather, it defines which records are to be stored and for how long. The legislation not only affects the financial
side of corporations, it also affects the IT departments whose job it is to store a corporation's electronic
records. The Sarbanes-Oxley Act states that all business records, including electronic records and electronic
messages, must be saved for "not less than five years." The consequences for non-compliance are fines,
imprisonment, or both. IT departments are increasingly faced with the challenge of creating and maintaining a
corporate records archive in a cost-effective fashion that satisfies the requirements put forth by the legislation.
This section provides more insight into the concepts of SOX.

Introduction to SOX

 Sarbanes & Oxley Act is a United States federal law enacted on July 30, 2002.
 Also known as the 'Public Company Accounting Reform and Investor Protection Act' (in the Senate) and 'Corporate and
Auditing Accountability and Responsibility Act' (in the House) and commonly called Sarbanes–Oxley.
 Set new or enhanced standards for all U.S. public company boards, management and public accounting firms.
 It is named after sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH).
 The bill was enacted as a reaction to a number of major corporate and accounting scandals including those affecting Enron,
Tyco International, Adelphia, Peregrine Systems and WorldCom. These scandals, which cost investors billions of dollars when the
share prices of affected companies collapsed, shook public confidence in the nation's securities markets.
 The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires
the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law.
 It does not apply to privately held companies.
 Harvey Pitt, the 26th chairman of the Securities and Exchange Commission (SEC), led the SEC in the adoption of dozens of
rules to implement the Sarbanes–Oxley Act.
 It created a new, quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, charged with overseeing,
regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies.
 The act also covers issues such as auditor independence, corporate governance, internal control assessment, and enhanced
financial disclosure.

Events contributing to the adoption of SOX Act – A Case of Enron Corporation:

 The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation and the
dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world.
 Considered as the biggest audit failure in the world history.
 Billions of debt from failed deals and projects were hidden through the use of accounting loopholes, special purpose
entities, and poor financial reporting.
 CFO and other executives were able to mislead Enron’s Board of Directors and Audit committee of high risk accounting
issues as well as pressure Andersen to ignore the issues.
 The non transparent financial statements did not clearly detail its operations and finances with shareholders and analysts.
 Its complex business model stretched the limits of accounting.
 The company used accounting limitations to manage earnings and modify the Balance Sheet to portray a favorable
depiction of its performance.
 From late 1997 until its collapse, the primary motivations of Enron’s accounting and financial transactions seem to have
been to keep reported income and cash flow up, asset values inflated, and liabilities off the books.
 The combination of these issues later led to the bankruptcy of the company.
 The Enron scandal deeply influenced the development of new regulations to improve the reliability of financial reporting,
and increased public awareness about the importance of having accounting standards that show the financial reality of
companies and the objectivity and independence of auditing firms.
 One consequence of these events was the passage of Sarbanes–Oxley Act in 2002, as a result of the first admissions of
fraudulent behavior made by Enron.
 The act significantly raises criminal penalties for securities fraud, for destroying, altering or fabricating records in federal
investigations or any scheme or attempt to defraud shareholders.

Situation prior to adoption of SOX Act:

 Auditor conflicts of interest: Prior to SOX, auditing firms, the primary financial "watchdogs" for investors, were self-
regulated. They also performed significant non-audit or consulting work for the companies they audited. Many of these
consulting agreements were far more lucrative than the auditing engagement. This presented at least the appearance of a
conflict of interest. For example, challenging the company's accounting approach might damage a client relationship,
conceivably placing a significant consulting arrangement at risk, damaging the auditing firm's bottom line.
 Boardroom failures: Boards of Directors, specifically Audit Committees, are charged with establishing oversight
mechanisms for financial reporting in U.S. corporations on the behalf of investors. These scandals identified Board
 members who either did not exercise their responsibilities or did not have the expertise to understand the complexities of
the businesses. In many cases, Audit Committee members were not truly independent of management.
 Securities analysts' conflicts of interest: The roles of securities analysts, who make buy and sell recommendations on
company stocks and bonds, and investment bankers, who help provide companies loans or handle mergers and
acquisitions, provide opportunities for conflicts. Similar to the auditor conflict, issuing a buy or sell recommendation on a
stock while providing lucrative investment banking services creates at least the appearance of a conflict of interest.
 Inadequate funding of the SEC: The SEC budget has steadily increased to nearly double the pre-SOX level. In one of his
interviews, Sarbanes indicated that enforcement and rule-making are more effective post-SOX.
 Banking practices: Lending to a firm sends signals to investors regarding the firm's risk. In the case of Enron, several
major banks provided large loans to the company without understanding, or while ignoring, the risks of the company.
Investors of these banks and their clients were hurt by such bad loans, resulting in large settlement payments by the banks.
Others interpreted the willingness of banks to lend money to the company as an indication of its health and integrity, and
were led to invest in Enron as a result. These investors were hurt as well.
 Internet bubble: Investors had been stung in 2000 by the sharp declines in technology stocks and to a lesser extent, by
declines in the overall market. Certain mutual fund managers were alleged to have advocated the purchasing of particular
technology stocks, while quietly selling them. The losses sustained also helped create a general anger among investors.
 Executive compensation: Stock option and bonus practices, combined with volatility in stock prices for even small
earnings "misses," resulted in pressures to manage earnings. Stock options were not treated as compensation expense by
companies, encouraging this form of compensation. With a large stock-based bonus at risk, managers were pressured to
meet their targets.

SOX Mandates and Requirements for Financial Reporting

Sarbanes–Oxley contains 11 titles that describe specific mandates and requirements for financial reporting. Each title consists of
several sections (SOX Act), summarized below.
1.Public Company Accounting Oversight Board (PCAOB)
2.Auditor Independence
3.Corporate Responsibility
4.Enhanced Financial Disclosures
5.Analyst Conflicts of Interest
6.Commission Resources and Authority
7.Studies and Reports
8.Corporate and Criminal Fraud Accountability
9.White Collar Crime Penalty Enhancement
10.Corporate Tax Returns
11.Corporate Fraud Accountability
Key Provisions of SOX Act:
 Sarbanes–Oxley Section 302: Disclosure controls
 Sarbanes-Oxley Section 401: Disclosures in periodic reports (Off-balance sheet items)
 Sarbanes–Oxley Section 404: Assessment of internal control
 Sarbanes–Oxley Section 802: Criminal penalties for violation of SOX
 Sarbanes–Oxley Section 1107: Criminal penalties for retaliation against whistleblowers

Sarbanes–Oxley Section 404: Assessment of internal control

 The most contentious aspect of SOX is Section 404, which requires management and the external auditor to report on the
adequacy of the company's internal control over financial reporting (ICFR).
 This is the most costly aspect of the legislation for companies to implement, as documenting and testing important
financial manual and automated controls requires enormous effort.
 Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual
Exchange Act report. See 15 U.S.C. § 7262.
 The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control
structure and procedures for financial reporting.” 15 U.S.C. § 7262(a).
 The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the
effectiveness of the internal control structure and procedures of the issuer for financial reporting.” To do this, managers are
generally adopting an internal control framework such as that described in COSO.
 To help alleviate the high costs of compliance, guidance and practice have continued to evolve.
 The Public Company Accounting Oversight Board (PCAOB) approved Auditing Standard No. 5 for public accounting
firms on July 25, 2007.
 This standard superseded Auditing Standard No. 2, the initial guidance provided in 2004. The SEC also released its
interpretive guidance on June 27, 2007.
 It is generally consistent with the PCAOB's guidance, but intended to provide guidance for management.
 Both management and the external auditor are responsible for performing their assessment in the context of a top-down
risk assessment, which requires management to base both the scope of its assessment and evidence gathered on risk.
 This gives management wider discretion in its assessment approach. These two standards together require management to:
o Assess both the design and operating effectiveness of selected internal controls related to significant accounts and
relevant assertions, in the context of material misstatement risks;
o Understand the flow of transactions, including IT aspects, sufficient enough to identify points at which a
misstatement could arise;
o Evaluate company-level (entity-level) controls, which correspond to the components of the COSO framework;
o Perform a fraud risk assessment;
o Evaluate controls designed to prevent or detect fraud, including management override of controls;
o Evaluate controls over the period-end financial reporting process;
o Scale the assessment based on the size and complexity of the company;
o Rely on management's work based on factors such as competency, objectivity, and risk;
o Conclude on the adequacy of internal control over financial reporting.