Management of Financial Institutions

Assignments - A

Question 1: Define money market. What are its broad objectives and functions?
How is money market different from capital markets?
Answer:
The money market is the market where short-term financial instruments are traded.
Money market instruments include Treasury bills, bankers acceptances, commercial
paper, Federal funds, municipal notes, and other securities. The common characteristic
of money market instruments is that they all have maturities of one year or less, and
often 30 days or less. The money market does not have one fixed physical location.
Rather, trading in money market instruments takes place in large financial centers, like
New York and London. Companies and investors often use money market securities as
temporary "parking places" for storing cash. While the returns on money market
instruments are relatively low, they are among the safest of investments. Indeed, most
money market securities are considered cash equivalents and are included with cash on
a company's Balance Sheet.
The broad objectives and main functions of money market are
-

To provide a reasonable access to users of short term funds to meet their

requirements at realistic / reasonable price.

To enable central bank intervention for influencing and regulating liquidity in the
economy.

To serve as an mechanism to even out short term surplus funds and deficits.

Money market is different from capital market which is a market for securities (debt or
equity), where business enterprises (companies) and governments can raise long-term
funds. It is defined as a market in which money is provided for periods longer than a
year, as the raising of short-term funds takes place on other markets (e.g., the money
market). The capital market includes the stock market (equity securities) and the bond
market (debt). The different types of financial instruments that are traded in the capital
markets are equity instruments, credit market instruments, insurance instruments,
foreign exchange instruments, hybrid instruments and derivative instruments.

Question 2: What is a derivative contract? Explain forward, future and options

contracts.
Answer:
A derivative contract is a contract which is derived from but independent of another
contract and involves a party not associated with the original underlying contract. A
derivative contract is an enforceable agreement whose value is derived from the value
of an underlying asset; the underlying asset can be a commodity, precious metal,
currency, bond, stock or indices of commodities, stocks etc. The most common example
of derivative contracts is forwards, futures and options.
A future contract is a standardized contract between two parties to sell a commodity at a
specified price on a later date. The commodity traded may be any commodity, bond,
currency or stock index. Futures are distinguished from generic forward contracts in that
they contain standardized terms, traded on a formal exchange, are regulated by
overseeing agencies, and are guaranteed by clearing houses. Also, in order to ensure
that payment will occur, futures have a margin requirement that must be settled daily.
The risk to the holder as well as the seller is limited in the case of a futures contract.
A forward is different from a future in the sense that they are privately negotiated (unlike
futures which occur through a clearing firm) and are not standardized. It essentially
means a cash market transaction in which delivery of the commodity is deferred until
after the contract has been made. Although the delivery is made in the future, the price
is determined on the initial trade date. For example, a farmer would use a forward
contract to "lock-in" a price for his grain for the upcoming fall harvest. Also, since these
are not exchange traded, there is no marking to market requirement, which allows the
buyer to avoid almost all capital outflow initially( although some counterparties might set
collateral requirements).
An option is a contract between a buyer and a seller that gives the buyer of the option
the right, but not the obligation, to buy or sell a specified asset on or before the options
expiration time, at an agreed price called the strike price. In return for granting the
option, the seller collects a payment (premium) from the buyer. An option may be a call
option or a put option. A call option gives the buyer of the option the right but not the
obligation to buy the underlying at the strike price. A put option gives the buyer of the
option the right but not the obligation to sell the underlying at the strike price. The buyer
may choose not to exercise the right and let it expire. An important class of options is an
employee stock option, real estate options and prepayment options included in
mortgage loans.

Question 3: In every lending decision, credit officers refer to a principle of lending

known as the 5 Cs of credit.
(a) What is the relevance of this principle in a loan evaluation process?
(b) Explain with details, the 5 Cs of credit.
Answer 4a):
In every lending decision, regardless of where you seek funding - from a bank, a local
development corporation or a relative credit officer / a prospective lender will review
your creditworthiness based on the 5 Cs of credit. A complete and thoroughly
documented loan request (including a business plan) will help the lender understand
you and your business. The "5 C's" are the basic components of credit analysis. The
goal or purpose of doing credit analysis of a customer is to confirm that the borrowers
credit history meets or exceeds the credit guidelines for the product for which the loan is
to be underwritten. Due to the inherent credit risk involved in any transaction, it is
essential that diligence is exercised in evaluating any loan transaction so that an
abnormal or dangerous amount of risk is avoided. Hence, the 5 Cs viz; character,
capacity, capital, collateral and conditions (of both the buyer and economy) of the buyer
are evaluated to sanction or not, the loan proposal.
Answer 3b):
The 5 Cs of credit are
Character is the general impression you make on the prospective lender or investor.
The lender will form a subjective opinion as to whether or not you are sufficiently
trustworthy to repay the loan or generate a return on funds invested in your company.
Your educational background and experience in business and in your industry, will be
considered. The quality of you references and the background and experience levels of
your employees will also be reviewed.
Capacity to repay is the most critical of the five factors, it is the primary source of
repayment - cash. The prospective lender will want to know exactly how you intend to
repay the loan. The lender will consider the cash flow from the business, the timing of
the repayment, and the probability of successful repayment of the loan. Payment history
on existing credit relationships - personal or commercial- is considered an indicator of
future payment performance.
Capital is the money you personally have invested in the business and is an indication
of how much you have at risk should the business fail.
Collateral are additional forms of security you can provide the lender. Giving a lender
collateral means that you pledge an asset you own, such as your home, to the lender

with the agreement that it will be the repayment in case there is a default in payment of
loan.
Conditions describe the intended purpose of the loan. Will the money be used for
working capital, additional equipment or inventory? The lender will also consider local
economic conditions and the overall climate, both within your industry and in other
industries that could affect your business.
Question 4: Outline the main elements of the prudential norms relating to the
credit and investment portfolios of banks. Discuss briefly the capital adequacy
norms applicable to banks.
Answer:
The various elements of the prudential norms given by RBI serve as guidelines to the
banks for classification, valuation and operation of investment portfolio by banks. They
are
1. Investment policy - Banks should frame and implement a suitable investment
policy to ensure that operations in securities are conducted in accordance with
sound and acceptable business practices.
2. Classification - The entire investment portfolio of the banks (including SLR
securities and non-SLR securities) should be classified under three categories
viz. Held to Maturity, Available for Sale and Held for Trading. However, in the
balance sheet, the investments will continue to be disclosed as per the existing
six classifications viz. a) Government securities, b) Other approved securities, c)
Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f) Others
(CP, Mutual Fund Units, etc).
3. Valuation - Investments classified under Held to Maturity category need not be
marked to market and will be carried at acquisition cost unless it is more than the
face value, in which case the premium should be amortised over the period
remaining to maturity. The individual scrips in the Available for Sale category will
be marked to market at the quarterly or at more frequent intervals. The individual
scrips in the Held for trading category will be marked to market at monthly or at
more frequent intervals as in the case of those in the Available for Sale category.
The book value of the individual securities in this category would not undergo any
change after marking to market.
4. Uniform accounting for Repo/ Reverse Repo transactions - In order to ensure
uniform accounting treatment for accounting repo / reverse repo transactions and
to impart an element of transparency, uniform accounting principles, have been
laid down for repo / reverse repo transactions undertaken by all the regulated
4

entities. The accounting principles to be followed while accounting for repos /

reverse repos are with regards to coupons for interest on securities, Repo
interest income/ expenditure, marking to market, book-value on repurchase,
disclosures to be made, accounting methodology to be followed and other
aspects relating to Repo/ reverse Repo.
5. General There are norms regarding income recognition whereby banks should
follow accrual basis of income recognition except in case of income from mutual
funds whereby cash basis should be followed. Then, there are also norms
regarding broken period interest and dematerialized holding.
Question 5: Write short notes on any three of the following: Commercial Banks
NBFC
Universal Banking
Securitizations
NASDAQ
Answer:
Commercial Banks
A commercial bank is a type of financial intermediary and a type of bank. Commercial
banking is also known as business banking. It is a bank that provides checking
accounts, savings accounts, and money market accounts and that accepts time
deposits. Commercial banking may also be seen as distinct from retail banking, which
involves the provision of financial services direct to consumers. Many banks offer both
commercial and retail banking services.
NBFC
NBFC is the abbreviation of Non-Banking Financial Company, a company registered
under the Companies Act, 1956 of India, engaged in the business of loans and
advances, acquisition of shares, stock, bonds, debentures and securities issued by
government or local authority, or other securities of a marketable nature, leasing, hirepurchase, insurance business, or chit business: but does not include any institution
whose principal business is that includes agriculture or industrial activity; or the sale,
purchase or construction of immovable property.
Universal Banking
Universal Banking is a multi-purpose and multi-functional financial supermarket (a
company offering a wide range of financial services e.g. stock, insurance and realestate brokerage) providing both banking and financial services through a single
window.
As per the World Bank, "In Universal Banking, large banks operate extensive network of
branches, provide many different services, hold several claims on firms(including equity

and debt) and participate directly in the Corporate Governance of firms that rely on the
banks for funding or as insurance underwriters".
In a nutshell, a Universal Banking is a superstore for financial products under one roof.
Corporate can get loans and avail of other handy services, while can deposit and
borrow. It includes not only services related to savings and loans but also investments.
However in practice the term 'universal banking' refers to those banks that offer a wide
range of financial services, beyond the commercial banking functions like Mutual Funds,
Merchant Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans,
Investment banking, Insurance etc. This is most common in European countries.

Assignment- B
Question 1: Explain briefly the main elements of the Asset Liability Management
Framework prescribed by the RBI , for the banks in India.
Answer:
ALM is a comprehensive and dynamic framework for measuring, monitoring and
managing the market risk of a bank. It is the management of structure of balance sheet
(liabilities and assets) in such a way that the net earning from interest is maximized
within the overall risk-preference (present and future) of the institutions. The main
elements of the Asset Liability Management Framework prescribed by the RBI in Feb99
for the banks in India include among other things interest rate risk and liquidity risk
measurement / reporting framework and prudential limits. As a measure of liquidity
management, banks are required to monitor their cumulative mismatches across all
time buckets in their Statement of Structural Liquidity by establishing internal prudential
limits with the approval of the Board /Management Committee. As per the guidelines,
the mismatches (negative gap) during the time buckets of 1-14 days and 15-28 days in
the normal course are not to exceed 20 per cent of the cash outflows in the respective
time buckets.
These guidelines have been subsequently reviewed and it has been decided
that:
(a) The banks may adopt a more granular approach to measurement of liquidity
risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural
Liquidity into three time buckets viz. Next day 2-7 days and 8-14 days.
(b) The Statement of Structural Liquidity may be compiled on best available data
coverage, in due consideration of non-availability of a fully networked environment.
(c) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14
days and 15-28 days buckets should not exceed 5 %,10%, 15 % and 20 % of the
cumulative cash outflows in the respective time buckets in order to recognize the
cumulative impact on liquidity.
(d) Banks may undertake dynamic liquidity management and should prepare the
Statement of Structural Liquidity on daily basis.
The format of Statement of Structural Liquidity has been revised suitably. The
guidance for slotting the future cash flows of banks in the revised time buckets has also
been revised.

Question 2: Explain briefly the major types of risks to which banks are exposed.
Answer:
The major types of risks to which banks are exposed are
Credit risk It occurs when a borrower cannot repay the loan. Eventually, usually
after a period of 90 days of nonpayment, the loan is written off. Banks are required by
law to maintain an account for loan loss reserves to cover these losses.
Interest rate risk - A bank's main source of profit is converting the liabilities of
deposits and borrowings into assets of loans and securities. It profits by paying a lower
interest on its liabilities than it earns on its assetsthe difference in these rates is the
net interest margin.
This creates interest rate risk, which, in the case of banks, is the risk that interest
rates will rise, causing the bank to pay more for its liabilities, and, thus, reducing its
profits.
Liquidity risk - Liquidity is the ability to pay, whether it is to pay a bill, to give a
depositor their money, or to lend money as part of a credit line. A basic expectation of
any bank is to provide funds on demand, such as when a depositor withdraws money
from a savings account, or a business presents a check for payment, or borrowers may
want to draw on their credit lines. The main problem in liquidity management for a bank
is that, while bills are mostly predictable, both in timing and amount, customer demands
for funds are highly unpredictable. Another major liquidity risk is off balance-sheet risks,
such as loan commitments, letters of credit, and derivatives.
Trading risk Generally, greater profits can be earned by taking greater risks like
trading securities, buying debt securities and derivatives.
Foreign exchange risk - International banks trade large amounts of currencies,
which introduces foreign exchange risk, when the value of a currency falls with respect
to another. A bank may hold assets denominated in a foreign currency while holding
liabilities in their own currency. If the exchange rate of the foreign currency falls, then
both the interest payments and the principal repayment will be worth less than when the
loan was given, which reduces a bank's profits.
Operational risk Operational risk arises from faulty business practices or when
buildings, equipment, and other property required to run the business are damaged or
destroyed.

Question 3: Describe the role of developmental financial institutions in industrial

financing. Give examples of some of the developmental financial institutions in
India.
Answer:
Developmental financial institutions are institutions set up mainly by the government for
providing medium and long-term financial assistance to industry. As these institutions
provide developmental finance, that is, finance for investment in fixed assets, they are
known as development financial institutions. These institutions receive funds for their
financing operations primarily from the government or other public institutions. These
institutions also raise funds from the capital market.
These institutions play a very significant role in industrial financing. Over a period of
time, there has been a steady growth in the number of industrial units assisted, and in
the amount of loan sanctioned and distributed by these institutions.
These institutions have played an important role in the development of (a) Small scale
industry, and (b) Projects in backward areas.
They have helped new and small entrepreneurs in setting up industry.
Through their operations involving underwriting of and direct subscription to the issue of
shares and debentures, they have been important players in the capital market. These
operations have a favourable impact on the ability of industrial concerns to raise funds
from capital market.
They guarantee credit purchase of capital goods, imported as well as purchased within
the country.
They provide assistance, under the soft loans scheme, to selected industries such as
cement, cotton textiles, jute, engineering goods, etc.
They provide equipment (imported or indigeneous) to the existing industrial concerns on
lease under various schemes.
Some of the examples of developmental financial institutions are IDBI (Industrial
Development Bank of India), IFCI ( Industrial Finance Corporation of India), ICICI
(Industrial credit and Investment corporation of India), (NABARD) National Bank for
Agriculture and Rural Development, (SIDBI) Small Industries Development Bank of
India, state level institutions like SFC (State Financial Corporations), SIDC (State
Industrial Development Corporations), investment institutions like UTI (Unit trust of
India), LIC (Life Insurance Corporation of India), GIC (General Insurance Company).

Case Study
Question a: List the qualitative risks of Asia Paper Bag relation to bank lending.
Answer):
The qualitative risks of Asia Paper Bag relation to bank lending are
Raw materials supply risk There is a risk that the raw material PE resin, necessary for
production may become depleted or unavailable during the life of the project.
Production quality risk There is a risk that the final product, being the customized
plastic carrier bags may deviate from the quality standards of Marks n Spencer and
Boots pharmacy of United Kingdom.
Competition risk - Competition with other prospective borrowers vis--vis terms of
lending and also competition amongst banks may encourage banks to pursue riskier
lending policies which may in the prove to be adverse for Asia Paper Bag.
Cost escalation risk Cost escalation of various raw materials, labor, overheads
actually used in production can cause the project cost to be over run.
Environmental risk There may be environmental risk in relation to the raw material
used by Asia Paper Bag, production activities of the concern, wastes of production etc.
Question b: List and explain the appropriate financial ratios to analyze the
financial performance (profitability) of Asia Paper Bag SDN Bhd.
Answer:
The appropriate financial ratios to analyze the financial performance (profitability) of
Asia Paper Bag Sdn Bhd are
Return on sales (ROS) Return on sales or net profit margin shows how much of each
sales dollar shows up as net income after all expenses are paid. For example, if the net
profit margin is 5%, that means that 5 cents of every dollar is profit. It measures
profitability after consideration of all expenses including taxes, interest, and
depreciation. The formula is

10

Net Profit
Net Sales

% margin

Both terms of the equation come from the income statement.

Return on equity (ROE) - The Return on Equity ratio is perhaps the most important of all
the financial ratios to investors in the company. It measures the return on the money the
investors have put into the company. This is the ratio potential investors look at when
deciding whether or not to invest in the company. The formula is:
Net Income
Stockholders equity

=_______%

Net income comes from the income statement and stockholder's equity comes from the
balance sheet. In general, the higher the percentage, the better, with some exceptions,
as it shows that the company is doing a good job using the investors' money.

Return on Assets (ROA) - The Return on Assets ratio measures the efficiency with
which the company is managing its investment in assets and using them to generate
profit. It measures the amount of profit earned relative to the firm's level of investment in
total assets. The calculation for the return on assets ratio is:

Net Income = _____%.

Total Assets
Net Income is taken from the income statement and total assets is taken from the
balance sheet. The higher the percentage, the better, because that means the company
is doing a good job using its assets to generate sales.

11

Assets Turnover Ratio (ATO) - This ratio is useful to determine the amount of sales that
are generated from each dollar of assets. As noted above, companies with low profit
margins tend to have high asset turnover, those with high profit margins have low asset
turnover. The formula is :

Revenue
Total Assets

Indicates the relationship between assets and revenue

Question c: State the motives for using ratio analysis as a credit evaluation tool.
Answer :
The motives for using ratio analysis as a credit evaluation tool are
i) It helps to qualify and quantify the borrowers performance , both financial and
non-financial.
ii) It helps to make comparison with industry averages.
iii) It helps to exploit the relationships between ratios and real life situations for
predictive analysis.

12

Assignments - C

1 a) Involves the movement of huge quantities of money.

2 a) T-bill.
3 c) Forward Contract.
4 a) Debenture.
5 d) (B) and (C) of the above.
6 a) A tie up between insurance and bank whereby the insurance company can
use the sales channel of the bank.
7 c) Non-banking Financial Corporation.
8 b) Citibank.
9 a) EXIM Bank.
10 d) It is the total capital of the bank.
11 c) Swap
12 a) Future.
13 a) A subset of the capital market, where the company issues new equity.
14 c) A subset of the capital market, where the equities are traded .
15 a) Positive
16 c) It is a kind of risk management technique adopted by banks.
17 b) Risk if non payment of dues to the bank by its borrowers.
18 d) Employee Turnover.
19 a) The exchange rate.
20 a) Norms related to Management of bank funds in a systematic manner.
21 b) IRDA.
22 c) Both are true.
13

23 c) Both are true.

24 d) Insurance taken on something which is already insured.
25 a) Banks.
26 e) None of the above.
27 d) less;higher
28 b) Have been providing services only to small depositors since deregulation
29 a) Provide a channel for linking those who want to save with those who want to
invest.
30 d) Do all of the above.
31 a) (I) is true, (II) false.
32 c) Reserve bank of India.
33 c) Interest rate.
34 c) They are the markets where interest rates are determined.
35 b) It is the most widely followed financial market in the United States .
36 c) Extremely volatile.
37 d) Both (A) and (B) of the above.
38 d) Both (A) and (C) of the above.
39 d) All of the above.
40 d) All of the above.

14