�

SOURCES AND USES OF BANK FUNDS

​

UNIT II�

Sources of Bank Funds

• Deposits
• Borrowings
• Capital
• Interbank Market
• Reserve funds
• Retained earnings

Uses of Bank Funds

• Lending
• Investments
• Reserve Requirements
• Operating expenses 
• Acquistion & Expansion
• Risk Management
• Infrastructure & Technology
• Compliance & Regulatory Requirements 
• Marketing 
• Research & Development 
• Co-operative Social Responsibility (CSR)

​

Types of Deposits & Interest Rates 

• Saving Accounts 
• Current Accounts 
• Money Market Accounts 
• Foreign Currency Deposits 
• Individual Retirement Accounts
• Business/Merchant Accounts 
• Joint Accounts 
• Students Accounts 
• Trust Accounts 

​

​

• Fixed/Term Deposits Accounts 
• Recurring Deposits 
• Re-Investment Accounts 
• Non Resident Ordinary ACCOUNTS (NRO)
• Non-Resident  (External ) Rupee Account
• Foreign Currency Non Resident Account (FCNR)

​

Basically above deposits are broadly divided into two categories namely: 

1)Demand Deposit

2)Term Deposit 

​

Pricing of Deposits 

Refers to the interest rates that the bank offers on various types of deposits.

 The pricing influenced by various factors such as :

• Market interest rates 
• Funding cost 
• Liquidity Requirements
• Competitive Requirements 
• Customer Relation
• Customer Segmentation
• Regulatory Considerations 

Pricing deposit-related services

​

​

• Banks need to pay high enough to attract depositors.

​

• Banks should avoid costly interest rate to protect potential profit margin.

​

• Banks are price takers, not price maker.

​

• Banks must decide to pay market-determined price to attract and hold depositors or lose funds.
• 12-2

​

Pricing of Deposits 

​

​

• Cost-plus pricing

​

• Marginal cost of deposits

​

• Conditional pricing

​

• Relationship pricing
• 12-2

�

​

cost approach

​

​

• Cost-plus deposit pricing encourages banks to determine  what costs they are incurring in labor and management time, materials, etc., in offering each deposit service.

​

• Cost-plus pricing generally calls for a bank to charge deposit service fees adequate to cover all the costs of offering the service plus a small margin for profit.

​

• Determines the bank’s cost of funds by looking at the past. It looks at what funds the bank has raised to date and what those funds have cost.

​

​

​

​

Cost plus Pricing 

• Cost plus profit margin is a pricing strategy used by businesses to determine the selling price of a product or service.
• In this approach, the selling price is set by adding a markup or profit margin to the cost of producing or acquiring the product.
• Profit margin percentage can vary depending on various factors, including industry standards, market conditions, and the company's goals
• The cost plus profit margin formula is as follows:

             Selling Price = Cost + (Cost x Profit Margin)

​

Cost plus pricing example :

Let's say you have a product with a cost of ₹50 and you want to apply a profit margin of 20%. Using the formula, the selling price would be:

​

Selling Price = ₹50 + (₹50 x 0.20) = ₹50 + ₹10 = ₹60

​

So, in this example, the selling price would be set at $60 to cover the cost and include a 20% profit margin.

​

Cost plus profit deposit pricing

​

Unit Price Charged the  Customer for Each Service =

​

[ Operating Expense  Per Unit of Deposit  Service 

 +

   Estimating Overhead Expense Allocated to the Deposit        

   Function

+

   Planned Profit from Each Service Unit Sold  ]

• 12-3

​

​

Marginal Cost Rate

• Determines the bank's cost of funds looking at the future.

​

• What minimum rate of return is the bank going to have to earn on any future loans and securities to cover the cost of all new funds raised?

​

• Many financial analyst would argue that the added cost of bringing new funds into the bank should be used to price deposits.

Marginal cost refers to the cost of producing one additional unit of a product or service. It is the change in total cost that occurs when the quantity of output is increased by one unit.

​

To calculate marginal cost, you can use the following formula:

​

Marginal Cost = (Change in Total Cost) / (Change in Quantity)

​

Marginal Cost example:

• let's say a company produces 100 units of a product at a total cost of $10,000. If they decide to produce an additional 101st unit and the total cost increases to $10,500, the marginal cost would be:

​

• Marginal Cost = ($10,500 - $10,000) / (101 - 100) = $500 / 1 = $500

​

• In this case, the marginal cost of producing the 101st unit is $500.

​

​

Marginal Cost example:

• let's say a company produces 100 units of a product at a total cost of $10,000. If they decide to produce an additional 101st unit and the total cost increases to $10,500, the marginal cost would be:

​

• Marginal Cost = ($10,500 - $10,000) / (101 - 100) = $500 / 1 = $500

​

• In this case, the marginal cost of producing the 101st unit is $500.

​

​

Conditional Pricing

​

Conditional pricing based on one or more of the following factors:

​

• Schedule of fees were low if customer stayed above some minimum balance-fees conditional on how the account was used.

​

• The number of transactions passing through the account.

​

• The average balance held in the account during the period.

​

• The maturity of the deposit.

​

​

• Conditional pricing is used today as a tool by banks to attract the kinds of depositors they want to have as customers.

​

• With this pricing technique a bank will post a schedule of offered interest rates or fees assessed for deposits of varying sizes and based on account activity. 

​

• Generally larger volume deposits carry higher interest returns to the depositor or are assessed lower service charges, encouraging customers to hold a high average deposit balance which gives the bank more funds to invest in earning assets.

​

Relationship Pricing 

​

• The bank prices deposits according to number of services purchased or used .

​

• The customer may be granted lower fees or have some fees waived if two or more services are used.

​

• It involves basing fees charged to a customer on the number of services and the intensity of use of services the customer purchases from a bank.

​

​

​

TOTAL CUSTOMER RELATIONSHIP METHODS or MANAGEMET (TRMC)� 

​

​

• Refers to comprehensive strategies and approaches that business employ to effectively manage and enhance their relationship with customers.
• TRCM focuses on building long-term mutually beneficial relationships with customers by understanding their needs, delivering values and providing exceptional customer experiences.
• By implementing TCRM , businesses stive to create customer-centric cultures and foster long-term customer loyalty.
• TRCM not only contributes to customer satisfaction and relations but can also lead to increased sales referrals ,positive brand reputation. 

​

Methods/Practices of TRCM:

• Customer Segmentation
• Customer data management 
• Customer Engagement 
• Customer experience enhancement 
• Cross-Selling and Upselling
• Customer retention and loyalty 
• Continuous feedback and improvement 

Non Deposit Loyalties & other sources of borrowed funds:

• Also called Managed liabilities.
• These are funds borrowed for short period of time to adjust liquidity.
• Alternative ways of banks and financial institutions to raise capital and obtain financing ,aside from traditional customer deposits.
• These source of funds are often used to support lending activities ,invest in new projects or meet liquidity needs.
• Availability and terms of these sources may vary depending on factors such as the creditworthiness of the borrowers ,prevailing market conditions ,and regulatory requirements 

Non deposits liabilities  Examples

• Bonds 
• Commercial Paper 
• Bank Loans
• Lines of Credit
• Asset-backed securities (ABS)
• Debentures 
• Trade Credit 

FEE BASED INCOME SOURCES 

• Refers to revenue generated by businesses through provision of services that incur fees.
• Specific fees charged and their structures depends on factors such as the nature of services provided , market conditions , competitions and regulatory requirements .
• Fee-based income is often associated with service industries .
•  These fees are usually charged to customers/clients for specific services or benefits.

Common sources of fee-based income 

• Services fees 
• Subscription fees 
• Asset Mangement fees 
• Custodial and Trust Fees 
• Transaction Fees 
• Licensing and Royalty Fees 
• Advisory and Consulting fees 
• Performance based Fees 

Mangement of Capital

• Refers to the process of effectively and efficiently managing a company's financial resources to maximize its values and achieve its financial objectives.
• Involves planning ,allocation and control of capital resources to ensure optimal utilization and return on investment.
• Effective capital management is essential to achieve sustainable growth ,maintain financial stability and create value for shareholders.
• It requires comprehensive understanding of financial markets ,risk management techniques and company's strategic objectives.

​

​

Key aspects of Capital Management

• Capital Budgeting 
• Capital Structure
• Working Capital Management
• Risk Management 
• Capital Allocation
• Cash flow Management
• Performance Measurement 

Need of Capital 

• Fundamental Requirement 
• Start up and Establishment 
• Expansion and Growth
• Working Capital 
• Investment in Assets 
• Research and Development (R&D)
• Financial Stability 
• Attracting Investors and Borrowing 

Sources of Capital

• Equity Capital 
• Debt Capital
• Retained Earnings 
• Government Funding 
• Venture Capital & Private Equity 
• Crowdfunding 

Risk Exposures 

• Market Risk 

​

• Credit Risk

​

• Operational Risk 

​

CAPITAL  ADEQUACY 

• Refers to company's financial strength and its ability to absorb potential losses and maintain financial stability in the face of various risk.
• Focuses on maintaining sufficient capital buffer to cover potential losses and protect interest of depositors ,policy holders , investors and other stakeholders .
• There are different metrics and regulatory framework used to access capital adequacy, including : Basel Accords ,Capital Adequacy Ratio, Tier 1 and Tier 2 Capital, Stress Testing 

CONCEPT OF ECONOMIC CAPITAL 

• Used by financial institutions to measure the amount of capital necessary to support and cover risks inherent in their business activities. 
• Represents capital needed to absorb unexpected losses .
• It ensures that financial institutions have adequate capital resources to withstand unexpected losses and remain solvent.
• Determines the appropriate level of capital to support their risk profile ,business activities ,and strategic objectives.

Economic Capital key aspects 

• Risk Measurement : Various risks as such credit risk ,market risk ,operational risk are quantified  through sophisticated risk measurement techniques like stress testing ,statistical models.
• Probability of Default (PD) : Represents likelihood of a borrower defaulting their obligations. Its determined based on factors such as credit rating, historical rates.
• Loss Given Default (LGD) :Refers to potential loss that financial institutions would incur in the events of borrower's default.
• Value at Risk (VaR):Risk measurement tool that estimates the maximum potential loss over a specified time horizon at a given confidence level.

​

Regulatory Capital 

• Refers to the capital requirements set by regulatory authorities ,such as central bank or financial supervisory agencies ,to ensure stability and soundness of financial institutions.
• It establishes minimum capital level that institutions must maintain to meet regulatory standards and comply with prudential regulations.
• It ensures stability and resilience of financial institutions ,protects depositors and policy holders and mitigate systematic risks.
• While economic capital focuses on the institution's internal risk assessment and risk appetite ,regulatory capital set the minimum capital standard established by external regulatory authorities.

Basel Norms 

• Bank of International Settlements (BIS) generated Basel Norm or Basek Accords.
• Basel Committee on Banking Supervision (BCBS) developed/formulated Basel Norms.
• There are of 3 types :Basel-I (1988), Basel-II (2004), Basel-III (2010).
• These norms serves as guidelines to Central banks to mitigate risks .

​

BASEL-1

• Also known as Basel Capital Accord .Introduced in 1988.
• First International banking regulations developed by Basel Committee on Banking Supervision (BCBS).
• Provides framework for assessing the capital adequacy and risk management practices of banks.
• Ensures banks maintained sufficient capital to cover credit risk.
• It primarily focus on credit risk ,neglecting other types of risks, such as market risks and operational risks.
• It categorizes assets  into 5 categories depending on risk 0%,10%,20%,50% and 100%

​

Basel-1 key features 

• Minimum Capital requirements: BIS recommended CAR as 8% of risk-weighted assets (RWA) for internationally active banks. Based on bank's credit risk exposure.
• Risk Weights: assets are categorized into broad risk categories ,with weighs ranging from 0% to 100%.Banks are required to allocate capital based on their RWA.
• Capital Components :Basel-1 defined two Tier Capitals namely  Tier 1 and Tier 2 
• Tier1 : Capital in liquid form by which banks can absorb losses without stopping functioning.
• Tier2 : Capital by which banks can absorb losses but it is not in liquid form and may require to stop operations to liquify it.

Basel-2 

• Introduced in 2004 as an updated framework of BASEL-1.
• To keep banks stable Supervisory review and Market discipline was incorporated to mitigate market and operational risk.
• Aimed to enhance the risk sensitivity, soundness and resilience of the international banking system.
• More comprehensive and risk-sensitive framework compared to BASEL-1. 
• It's important to note that since the introduction of BASEL-2, the Basel Committee has further updated and revised the regulations.

​

​

Key features of BASEL-2 

​

• Risk-Based Framework: maintained capital framework of Basel-I but introduced a more sophisticated approach for calculating RWA.
• Market Risk: expanded the coverage of market risk by introducing specific capital requirements for banks trading activities.
• Operational Risk: recognized operational risk as a significant risk category and required banks to hold capital to cover potential losses arising from operational failures, such as fraud, legal risks, and systems breakdowns. 
• Supervisory Review: emphasized the role of supervisors in assessing banks capital adequacy, risk management practices, and internal controls. The supervisory review process aimed to ensure that banks capital levels and risk management systems were appropriate.

Raising Capital 

Companies often use a combination of internal and external sources of capital to meet their financing needs. Choice of raising method depends on factors such as the company's growth stage ,financial conditions ,risk appetite and availability and cost of capital.

• INTERNAL SOURCES OF CAPITAL: involves company's own retained earnings or profits to fund its activities. It provides more control over financing.
• EXTERNAL SOURCES OF CAPITAL: Involves raising funds from external parties ,such as investors ,lenders, or public. Access larger pool of funds ,expertise and potential strategic partnerships.

Internal Sources of Capital

• Depreciation 
• Amortization
• Working Capital Management 
• Cost Reduction 
• Efficiency Measures 

External Sources of Capital 

• Equity Financing 
• Debt Financing 
• Venture Capital
• Private Equity 
• Crowdfunding 

​

Uses of Funds 

• Business Expansion
• Research and Development 
• Capital Expenditures 
• Working Capital
• Debt Repayment 
• Marketing and Advertising 
• Hiring and Human Resource 

Steps in Lending Process 

• Loan Application
• Pre-Screening and Initial Assessment 
• Credit Analysis
• Loan Underwriting 
• Loan Documentation 
• Loan Disbursement
• Loan Monitoring and Servicing 
• Loan Repayment 

Types of Business Loans

• Term Loans
• Line of Credit
• Small Business Administration (SBA) Loans 
• Equipment Financing
• Commercial Real Estate Loans 
• Invoice Financing /Account Receivable /Factoring 
• Merchant Cash Advances 
• Business Credit Cards 
• Startup Loans 
• Franchise Financing 

Analyzing Business Loan Application

• Business Credit Score 
• Financial Statements 
• Business Plans 
• Purpose of Loan
• Collateral & Guarantees 
• Cash Flow Analysis 
• Debt Service Coverage Ratios (DSCR)
• Industrial Analysis
• Management and Experiences 
• Legal & Regulatory Compliance 

Credit Risk Management in Banks

• Credit Risk Policies and Procedures 
• Credit Evaluation & Approval
• Risk Grading and Classification
• Collateral and Security 
• Credit Monitoring and Early Warning Systems 
• Credit Risk Mitigation Techniques 
• Credit Risk Assessment and Model and Metrics
• Credit Risk Reporting and Portfolio Management 
• Loan Recovery and Collection
• Regulatory Compliance 

Pricing of Business Loans 

Involves determining the interest rate and fees charged to the borrowers.

• COST PLUS PRICING
• PRICE LEADERSHIP
• BELOW PRIME MARKET PRICING 
• CUSTROMER PROFITABILTY ANALYSIS