Basic Highlight. MBA IV Semester Management of Financial Institutions. Post Raj Pokharel, M.Phil, Ph.D. Scholar,

Transcription

1 Basic Highlight MBA IV Semester Management of Financial Institutions POST RAJ POKHAREL M.Phil. (TU) 01/2010) 1 Syllabus Briefing References UNIT I: Introduction and Overview of Financial Institutions Overview of Financial Institutions. Economic Functions Performed by Financial Institutions. Role of Financial Institutions in the Financial System as a whole. Types and Growth of Financial Institutions in Nepal. Structure of the Nepalese Economy and Financial System. 2 UNIT I: Introduction and Overview of Financial Institutions LH 4 Overview of Financial Institutions. Economic Functions Performed by Financial Institutions. Role of Financial Institutions in the Financial System as a whole. Types and Growth of Financial Institutions in Nepal. Structure of the Nepalese Economy and Financial System. UNIT II: Regulatory body - Central Bank LH 3 Introduction Objectives Functions History of Central Banking system in Nepal UNIT III: Banking and the Management of Financial Institutions LH 8 The Bank Balance Sheet. Basics of Banking. General Principles of Bank Management: Liquidity Management, Asset Management, Liability Management and Capital Adequacy Management. Off-Balance Sheet Activities: Loan Sales, Generation of Fee Income, Trading Activities and Risk Management Techniques. Measuring Bank s Performance: Bank s Income Statement, Measures of Bank Performance. Recent Trends of Bank Performance Measures in Nepal. UNIT IV: Commercial Banking Industry and Other Depository Institutions LH 8 Definition of a Commercial Bank. Size, Structure and Composition of the Commercial Banking Industry. Technology in Commercial Banking. Financial Statements of Commercial Banks and Their Analyses. Regulation of Depository Institutions in Nepal: Balance Sheet and Off-Balance Sheet Regulations. Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their Roles, Size, Structure and Compositions. UNIT V: Management of Insurance Companies LH 6 Overview of Insurance Companies Fundamentals of Insurance Types of Insurance Life Insurance Companies: Meaning and Their Functions Types of Life Insurance Policies and Their Determination. Property and Liability Insurance Companies: Meaning and Their Functions Determining the Profitability to Property and Liability Insurance Companies. Regulation of Insurance Companies in Nepal. Existing Scenario of Insurance Industries in Nepal. Post Raj Pokharel, M.Phil, Ph.D. Scholar,

2 UNIT VI: Credit Risk Management in Financial Institutions LH 7 Need to Manage Risk by Financial Institutions. Types of Risks Incurred by Financial Institutions. Overview of Credit Risk Management. Credit Risk Analysis: Cash Flow Analysis, Ratio Analysis, Common Size Analysis Credit Scoring Models Calculating Return on a Loan UNIT VII: Liquidity Risk Management in Financial Institutions LH 6 Overview of Liquidity Risk Management. Causes of Liquidity Risk. Liquidity Risk and Depository Institutions: Asset Side Liquidity Risk, Liability side Liquidity Risk and Measuring bank s Liquidity Exposure Liquidity Risk and Insurance Companies. Liquidity Risk and Mutual Funds. UNIT VIII: Interest Rate Risk Management in Financial Institutions LH 6 Overview of Interest Rate Risk Management. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Insolvency Risk Management. References: Anthony Saunders and Marcia Millon Cornett. (2006). Financial Markets and Institutions. Tata McGraw Hill Publishing Company Limited, New Delhi. Anthony Saunders and Marcia Millon Cornett. (2003). Financial Institutions Management: A Risk Management Approach. McGraw Hill, Irwin, USA. Frederic S. Mishkin and Stanley G. Eakins. (2006). Financial Markets and Institutions. Pearson Education Inc. and Dorling Kindersley (India) Pvt. Ltd. L.M. Bhole. (2005). Financial Institutions and Markets: Structure, Growth and Innovations. Tata McGraw Hill Publishing Company Limited, New Delhi. Meir Kohn. (2005). Financial Institutions and Markets. Tata McGraw Hill Publishing Company Limited, New Delhi. Ram Sharan Kharel and Dilli Ram Pokhrel. (April 2012). Does Nepal's Financial Structure Matter for Economic Growth? NRB Working Paper. Nepal Rastra Bank Research Department. Nepal Rastra Bank. (2012). Banking and Financial Statistics. NRB: Bank and Financial Institution Regulation Department, Statistics Division. Banks and Financial Institutions Act, 2063 (2006). Nepal Rastra Bank. Quarterly Economic Bulletin (various issues). NRB: Central Office, Baluwatar, Kathmandu. Annual Report of NRB Dipak Bahadur Bhandari, Financial Institutions and Markets, Ashmita Books Publishers & Distributors, Insurance Act, Insurance Regulation, 1993 Insurance Board, Nepal. Annual Reports (Various Issues) Development of Financial Institutions in Nepal Overview of Financial Institutions Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions. a financial institution is an institution that provides financial services for its clients or members. Probably the greatest important financial service provided by financial institutions is acting as financial intermediaries. Categories of financial institutions Depository financial institutions Investment banks Contractual savings institutions Finance companies Unit trusts 7 Nepalese Financial Institutions Central Bank (Chapter II in Detail): Commercial Banks (Chapter IV in Detail) Development Banks : responsible to provide loans for the development of agriculture and industrial sectors, and also the larger scale developmental lending needed to support agriculture and industrial sector Finance Companies : The Act permits these companies to offer installment credit for the purchase of vehicles, equipment, or durable household goods, for purchase or construction of residential buildings, for leasing financing, and for operating industrial, commercial or other enterprises. Insurance Companies : (Chapter V) All the insurance business in Nepal is regulated by the Nepal Insurance Board. It invests in National Saving Certificate and Government Bonds, fixed deposits, shares and loans to insurance policyholders. Money Changers (Foreign Exchange Bureaus): These exchanges are providing their services to the non- Nepali citizens in particular. At the end of every fiscal year, it is mandatory to submit an annual transaction report to the NRB by all the money-changers. 8 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

3 Nepalese Financial Institutions Postal Savings Banks : (PSB) was established in 1975 with a view to nurture (raise) saving habits of the people residing in villages. In the initial few years of their establishment, these banks were successful to attract small savers, to some extent. Later on, the PSBs were not able to expand their service activities and failed to attract the small rural savers at the anticipated level. Employees Provident Fund: This is an autonomous body functioning under the Employees Provident Fund Act, It mobilizes the savings collected from employees. Total contributions and earnings under this scheme are completely tax-free. Upon the completion of the service the contributors or their nominees get all accumulated principal amounts plus the interests earned. Citizens Investment Trust (Mutual Fund): The Citizens Investment Trust was established under the Citizens Investment Trust Act, It encourages general public to save some percentage of their income. It collects funds by operating various schemes like Employees Savings and Growth Schemes, Citizen Unit Scheme, Gratuity Fund Scheme and Investor's Account scheme. Trust invests in corporate securities, government bonds, term loans, and borrowings. 9 Economic Functions performed by FIs 1. Funds Transformation: FIs facilitates the transfer of real economic resources from the Surplus units to deficit units. 2. Income generating productive assets: FIs open floor to avail portfolio of securities for investment through links between stock exchange and other agents. 3. Capital formation: FIs encourages investment in huge infrastructural sectors like: hydro-power, acquisition of plant, equipment through the funds raised from public. 10 Economic Functions performed by FIs 4. Value of Assets: FIs provide enough scope for the collection and transfer of funds to industries, with the confidence of investors, they able to get adequate return and enhance their assets (Return on assets) according to their expectations. 5. Import and export Financial Intermediary: FIs play significant role as an intermediary of means of payment that helps to maintain the creditability of national investors. The facility of LC, IBC, Bank documents availed credit facility to investors that has high siginificant in economy. 6. Transaction support: The facility of Debit card, Credit card, ATMs,. It has significant effect on monetization in the economy. 11 Role of Financial Institutions in the Financial System as a whole FIs helps to accumulate small and scattered resources which in turn discourages hoarding of unutilized and unproductive resources. Investment is necessary for the economic development of a nation. FIs provides capital needed for the productive activities. Productive investment sectors (like: agriculture, industry, trade, construction) growth has high effect due to rational presence and activities of FIs. 12 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

4 Role of Financial Institutions in the Financial System as a whole FIs helps encouraging savers and even investors. Saving and investment are the prime elements for the economic growth of a nation. FIs growth tends towards employment growth opportunities themselves and as well as creating opportunities through the effect of investment.. Motivates technological innovation. Overall economic activities flourish. 13 Nepalese Financial System Modern financial system of Nepal began in 1937 with the establishment of Nepal Bank Limited as the first commercial bank of the country (was established as semi- private commercial bank under Nepal Bank Act). NRB was established in 1956 under NRB Act 1955 as central bank of Nepal another major step in the development of Nepalese financial system. NIDC in 1959 under NIDC Act to provide industrial credit to industries and other entrepreneurs. Employment Provident Fund in to collect provident fund of government employees. Co-operative bank under Co-operative bank act 1964 to provide agricultural credit to farmers and primary cooperative societies (but could not provide well agricultural credit). As a result, the cooperative bank and the Land Reform Savings Corporation merged with ADB/N (Agricultural Devt. Bank.) 14 Nepalese Financial System Types & Growth of Nepalese FIs Rastriya Banijya Bank Second commercial Bank in 1966 under RBB act 1966 (fully government-owned) --- expansion of commercial banking services throughout the country. National Insurance Coorporation in 1967 and Nepal Insurance Corporation in 1968 to provide insurance services to Citizens. Securities Marketing Center in 1977, Converted to Securities Exchange Center in 1984, converted to NEPSE in to develop capital market in Nepal. 15 Ref: Banking and Financial Statistics No. 60, July Post Raj Pokharel, M.Phil, Ph.D. Scholar,

5 Types & Growth of Nepalese FIs Structure of Nepalese Economy The number of commercial bank branches operating in the country increased to 1547 in Mid July 2014 from 1486 in mid July Among the total bank branches, 49.7 percent bank branches are concentrated in the central region followed by Eastern 18.6, Western 17.1 percent, Mid- Western 8.8 percent and Far Western 5.8 percent respectively The economy remains mainly agrarian as over a third of its GDP originates from agriculture. The share of agriculture in the GDP has declined over the years since The share of industry in the GDP peaked in the mid-1990s, but declined thereafter because of the insurgency. In fact, the activities in manufacturing, construction and mining decreased as indicated by their falling shares in the industrial GDP due to the nationwide insurgency in the country in the post to date. The rising share of services in the GDP has been at the cost of the other sectors, not because of their improvements. 18 Structure of Nepalese Economy Nepal in the Global Economy Nepal is least developed (among 50 countries) as well as a landlocked (among 40 countries). It is a low income (among 53 countries) country, too. Nepal ranks 50 th in population size (28 millions in 2006). It is 108th in GNI size in 2006 (among 112 economies of the world, inclusive of Macao, Nauru, Taiwan, and Tuvalu, and 110 th in GDP size. The country ranks 201 st in nominal per capita GNI, and 185 th in PPP GNI per capita in Among the 177 countries or economies in the world, the country stood at 138 th in the 2004 human development rank and slid down to the 142 nd in It ranked 112 th among 117 countries in per capita wealth in In brief, Nepal is at the bottom in development Post Raj Pokharel, M.Phil, Ph.D. Scholar,

6 The Financial System Financial system is a mechanism that works for investors and people who want finance. It is an interaction of various intermediaries, market instruments, policy makers, and various regulations to aid the flow of savings from savers to investors and managing the proper functioning of the system. Additional.. Knowledge. Remaining Slides.. The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. 22 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

7 Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Banking - NRB, Commercial banks, Co-operatives Non-banking Insurance Companies, Developmental Agricultural Development, Tourism development, infrastructural development, Regulatory Institutions - SEBON, NRB, insurance regulatory and development authority, Functions of Financial Intermediaries Risk Sharing 1.Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). 2.Also lower risk by helping people to diversify portfolios 26 Functions of Financial Intermediaries Adverse Selection 1. Before transaction occurs 2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Moral Hazard 1. After transaction occurs 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won t pay loan back Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits Functions of Financial System Attributes of financial assets Return or yield Total financial compensation received from an investment expressed as a percentage of the amount invested Risk Probability that actual return on an investment will vary from the expected return Post Raj Pokharel, M.Phil, Ph.D. Scholar,

8 Functions of Financial System Functions of Financial System Liquidity Ability to sell an asset within reasonable time at current market prices and for reasonable transaction costs Time-pattern of the cash flows When the expected cash flows from a financial asset are to be received by the investor or lender The financial system facilitates portfolio restructuring The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows An efficient financial system Encourages savings Savings flow to the most efficient users Implements the monetary policy of governments by influencing interest rates The combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows Global Financial System The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financing. The first modern wave of economic globalization began during the period of , marked by transportation expansion, record levels of migration, enhanced communications, trade expansion, and growth in capital transfers Late 19th century during the first modern wave of economic globalization, its evolution is marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations At the onset (start) of World War I, trade contracted as foreign exchange markets became paralyzed by money market illiquidity After World War II, improved exchange rate stability, fostering record growth in global finance observed Global Financial System The world economy became increasingly financially integrated in the 1980s and 1990s due to capital account liberalization and financial deregulation. A series of financial crises in Europe, Asia, and Latin America followed with contagious (infectious) effects due to greater exposure to volatile capital flows. The global financial crisis, which originated in the United States in 2007, quickly propagated (spread) among other nations and is recognized as the catalyst for the worldwide Great Recession Post Raj Pokharel, M.Phil, Ph.D. Scholar,

9 Methods of Moving Loanable fund from lender to borrower Methods of Moving Loanable fund from lender to borrower Direct flow markets Users of funds obtain finance directly from savers Advantages Avoids costs of intermediation Increases range of securities and markets Disadvantages Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk Methods of Moving Loanable fund from lender to borrower Direct flow markets Users of funds obtain finance directly from savers Advantages Avoids costs of intermediation Increases range of securities and markets Disadvantages Matching of preferences Liquidity and marketability of a security Search and transaction costs Assessment of risk, especially default risk 35 Methods of Moving Loanable fund from lender to borrower Intermediated flow markets A financing arrangement involving two separate contractual agreements whereby saver provides funds to intermediary, and the intermediary provides funding to the ultimate user of funds Advantages Asset transformation Credit risk diversification and transformation Liquidity transformation Economies of scale Sectorial flow of funds The flow of funds between business, financial institutions, government and household sectors and the rest of the world Influenced by fiscal and monetary policy 36 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

10 NRB Nepal Rastra Bank (NRB), the Central Bank of Nepal, was established in 1956 under the Nepal Rastra Bank Act, 1955, to discharge the central banking responsibilities including guiding the development of the embryonic domestic financial sector. Since inception, there has been a significant growth in both the number and the activities of the domestic financial institutions. To reflect this dynamic environment, the functions and objectives of the Bank have been recast by the new NRB Act of 2002, the preamble of which lays down the primary functions of the Bank as: to formulate necessary monetary and FOREIGN EXCHANGE policies to maintain the stability in price and consolidate the balance of payments for sustainable development of the economy of Nepal; to develop a secure, healthy and efficient system of payments; to make appropriate supervision of the banking and financial system in order to maintain its stability and foster its healthy development; and to further enhance the public confidence in Nepal's entire banking and financial system. The Bank is eminently aware that, for the achievement of the above objectives in the present dynamic environment, sustained progress and continued reform of the financial sector is of utmost importance. Continuously aware of this great responsibility, NRB is seriously pursuing various policies, strategies and actions, all of which are conveyed in the annual report on monetary policy. 38 Basic Highlight MBA IV Semester Management of Financial Institutions Unit II Central Bank Syllabus Briefing References UNIT II: Regulatory body - Central Bank LH 3 Introduction Objectives Functions History of Central Banking system in Nepal POST RAJ POKHAREL M.Phil. (TU) 01/2010) Post Raj Pokharel, M.Phil, Ph.D. Scholar,

11 Central Bank/ NRB See: Annual Report of NRB 41 NRB the Central Bank of Nepal, was established in 1956 under the Nepal Rastra Bank Act, 1955, to discharge the central banking responsibilities including guiding the development of the embryonic (developing) domestic financial sector. Since inception, there has been a significant growth in both the number and the activities of the domestic financial institutions. To reflect this dynamic environment, the functions and objectives of the Bank have been recast by the new NRB Act of 2002, the preamble of which lays down the primary functions of the Bank as: 1. to formulate necessary monetary and FOREIGN EXCHANGE policies to maintain the stability in price and consolidate the balance of payments for sustainable development of the economy of Nepal; 2. to develop a secure, healthy and efficient system of payments; 3. to make appropriate supervision of the banking and financial system in order to maintain its stability and foster its healthy development; and 4. to further enhance the public confidence in Nepal's entire banking and financial system. 5. The Bank is eminently aware that, for the achievement of the above objectives in the present dynamic environment, sustained progress and continued reform of the financial sector is of utmost importance. Continuously aware of this great responsibility, NRB is seriously pursuing various policies, strategies and actions, all of which are conveyed in the annual report on monetary policy. Ref.: 42 Central Bank/NRB Objectives of NRB Central is the bank whose essential duty is to maintain stability of the monetary standard. A central bank is the lender of the last resort. 43 To achieve price and balance of payments stability, manage liquidity and ensure financial stability, develop a sound payments system and promote financial services. To formulate necessary monetary and FOREIGN EXCHANGE policies to maintain the stability in price and consolidate the balance of payments for sustainable development of the economy of Nepal To develop a secure, healthy and efficient system of payments; To make appropriate supervision of the banking and financial system in order to maintain its stability and foster its healthy development; and To further enhance the public confidence in Nepal's entire banking and financial system. To promote entire banking and financial system of the kingdom of Nepal system. 44 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

12 Functions of NRB 1. Bank of Note Issue: The central bank has the sole monopoly of note issue in almost every country. The currency notes printed and issued by the central bank become unlimited legal tender throughout the country. The main advantages of giving the monopoly right of note issue to are : (i) Brings uniformity in the monetary system of note issue and note circulation. (ii) Increases public confidence in the monetary system. (iii) Enables the central bank to exercise control over the creation of credit by the commercial banks. 2. Banker, Agent and Adviser to the Government: The central bank functions as a banker, agent and financial adviser to the government, a) As banker to government, the central bank maintains the accounts of the central as well as state government, receives deposits from it, makes short-term advances and collects cheques and drafts deposited in the government account. b) As an Agent to the government, the central bank collects taxes and raises loans from the public and thus manages public debt. c) As a financial adviser to the lent, the central bank gives advise to the government on economic, monetary, financial and fiscal matters. Functions of a central bank 45 Functions of NRB 3. Bankers' Bank: The central bank acts as the bankers' bank in three capacities: (a) custodian of the cash preserves of the commercial banks; (b) as the lender of the last resort; and (c) as clearing agent. In this way, the central bank acts as a friend, philosopher and guide to the commercial banks 4. Lender of Last Resort: In case if the commercial banks are not able to meet their financial requirements from other sources, they can, as a last resort, approach the central bank for financial accommodation. It increases the elasticity and liquidity of the whole credit structure of the economy. It provides financial help to the commercial banks in times of emergency. It enables the central bank to exercise its control over banking system of the country. 46 Functions of NRB 5. Clearing Agent : The function of clearing house in the central bank has the following advantages: (i) It economies the use of cash by banks while settling their claims and counter-claims. (ii) It reduces the withdrawals of cash and these enable the commercial banks to create credit on a large scale. (iii) It keeps the central bank fully informed about the liquidity position of the commercial banks. 6. Credit control: - The significance of the function has increased so much that for property understanding. The central bank has acquired the rights and powers of controlling the entire banking. Central bank can adopt various quantitative and qualitative methods for credit control such bank rate, changes in reserve ratio selective controls, moral situation etc. 7. Collection of Data: Central banks collects statistical data regularly relating to economic aspects of money, credit, FOREIGN EXCHANGE, banking, economic growth etc. 47 History of Central Banking System in Nepal In Nepal Rastra Bank that is an autonomous (sovereign) and corporate body having perpetual succession. NRB act states that GoN, after consultation with the Governor can give directions to the bank as may be necessary in the national interest. Central Bank has a pivotal role in the country's economic system in which no other organization is likely to substitute it. NRB is the highest monetary authority of the country. The bank's activities on the whole are directed towards the financial and economic growth of the country. NRB works in close collaboration with GoN so that the monetary and financial policies formulated by the bank do not contradict with plans and programs of the Govt. 48 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

13 History of Central Banking System in Nepal New NRB Act states to formulate monetary and foreign exchange policies and continued reform in the financial sector to reflect the dynamic and vibrant economy. NRB started its operations with a total no. of 23 employees including Governor and Chief Accountant having department like: Bank Office, Account, Currency Issue and Research. With passage of time, various departments and offices at the central and regional level were set up. In the initial year of operation, bank had focused on abolishing dual currency system, regulating the circulation of Nepalese currency throughout the kingdom and maintaining stability of exchange rates of Nepalese currency 49 History of Central Banking System in Nepal The bank extended its activities opening number of offices and currency exchange counters in various areas like: Biratnagar, Birgunj, Siddharthnagar, Nepalgunj, Illam, Bhojpur, Dhankuta, Pokhara, Palpa, Baitadi, Doti 50 MBA IV Semester Management of Financial Institutions UNIT III Banking and the Management of Financial Institutions LH 8 POST RAJ POKHAREL M.Phil. (TU) 01/2010) 52 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

14 Basic Highlight UNIT III: Banking and the Management of Financial Institutions LH 8 The Bank Balance Sheet. Basics of Banking. General Principles of Bank Management: Liquidity Management, Asset Management, Liability Management and Capital Adequacy Management. Off-Balance Sheet Activities: Loan Sales, Generation of Fee Income, Trading Activities and Risk Management Techniques. Measuring Bank s Performance: Bank s Income Statement, Measures of Bank Performance. Recent Trends of Bank Performance Measures in Nepal. Reference: Chapter 17 Mishkin Book The Bank Balance Sheet The Balance Sheet is a list of a bank s assets and liabilities Total assets = total liabilities + capital A bank s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers The Bank Balance Sheet: Liabilities (a) Checkable Deposits: includes all accounts that allow the owner (depositor) to write checks to third parties; examples include non-interest earning checking accounts (known as DDAs demand deposit accounts), interest earning negotiable orders of withdrawal (NOW) accounts, and money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts. (in Nepal: Practically Current and Saving Account) Checkable deposits are a bank s lowest cost funds because depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes Post Raj Pokharel, M.Phil, Ph.D. Scholar,

15 The Bank Balance Sheet: Liabilities (b) The Bank Balance Sheet: Liabilities (c) Nontransaction Deposits: are the overall primary source of bank liabilities and are accounts from which the depositor cannot write checks; examples time deposits (Fixed Account in Nepal; also known as CDs or certificates of deposit) Nontransaction deposits are generally a bank s highest cost funds because banks want deposits which are more stable and predictable and will pay more to the depositors (funds suppliers) in order to achieve such attributes Borrowings: banks obtain funds by borrowing from the Federal Reserve System, other banks, and corporations; these borrowings are called: discount loans/advances (from the Fed), fed funds (from other banks), interbank offshore dollar deposits (from other banks), repurchase agreements ( repos from other banks and companies), commercial paper and notes (from companies and institutional investors) The Bank Balance Sheet: Liabilities (d) The Bank Balance Sheet Bank Capital: is the source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings (retained earnings being the portion of funds which are earned as profits but not paid out as ownership dividends) Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write-offs (capital is also called the balance sheet s shock absorber, thus capital levels are important) Post Raj Pokharel, M.Phil, Ph.D. Scholar,

16 Basics of Banking Basics of Banking Before we explore the main role of banks that is, asset transformation it is helpful to understand some of the simple accounting associated with the process of banking. T-account Analysis: Deposit of $100 cash into First National Bank First National Bank Assets Liabilities Vault cash +$100 Checkable deposits +$ Basics of Banking Basics of Banking Cash items in process of collection First National Bank Assets Liabilities First National Bank Assets Liabilities +$100 Checkable deposits Reserves +$100 Deposits +$100 Deposit of $100 cheque +$100 Second National Bank Assets Liabilities Reserves -$100 Deposits -$100 This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded. Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount Post Raj Pokharel, M.Phil, Ph.D. Scholar,

17 Basics of Banking Basics of Banking T-account Analysis: Deposit of $100 cash into First National Bank Required reserves Excess reserves First National Bank Assets Liabilities +$10 +$90 Checkable deposits +$100 As we can see, $10 of the deposit must remain with the bank to meeting federal regulations (NRB Regulation). Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers Basics of Banking General Principles of Bank Management T-account Analysis: Deposit of $100 cash into First National Bank Required reserves Loans First National Bank Assets Liabilities +$10 +$90 Checkable deposits +$ Liquidity management 2. Asset management Managing credit risk Managing interest-rate risk 3. Liability management 4. Managing capital adequacy Post Raj Pokharel, M.Phil, Ph.D. Scholar,

18 Principles of Bank Management Liquidity Management Reserves requirement = 10%, Excess reserves = $10 million Assets Liabilities Reserves $20 million Deposits $100 million Loans $80 million Bank Capital $10 million Securities $10 million Assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% (the bank is required to keep 10% of its time and checkable deposits as reserves) Principles of Bank Management If a deposit outflow of $10 million occurs, the bank s balance sheet becomes Deposit outflow of $10 million Assets Liabilities Reserves $10 million Deposits $90 million Loans $80 million Bank Capital $10 million Securities $10 million With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet Liquidity Management Liquidity Management Assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $10 million, so that it holds no excess reserves. Its initial balance sheet would then be No excess reserves Assets Liabilities Reserves $10 million Deposits $100 million Loans $90 million Bank Capital $10 million Securities $10 million When it suffers the $10 million deposit outflow, its balance sheet becomes Deposit outflow of $10 million Assets Liabilities Reserves $0 million Deposits $90 million Loans $90 million Bank Capital $10 million Securities $10 million With 10% reserve requirement, bank has $9 million reserve shortfall With 10% reserve requirement, bank has $9 million reserve shortfall Post Raj Pokharel, M.Phil, Ph.D. Scholar,

19 Liquidity Management Liquidity Management After $10 million has been withdrawn from deposits and hence reserves, the bank has a problem: It has a reserve requirement of 10% of $90 million, or $9 million, but it has no reserves! To eliminate this shortfall, the bank has four basic options. One is to acquire reserves to meet a deposit outflow by borrowing them from other banks. If the First National Bank acquires the $9 million shortfall in reserves by borrowing it from other banks its balance sheet becomes: 1. Borrow from other banks Assets Liabilities Reserves $9 million Deposits $90 million Loans $90 million Borrowings $9 million Securities $10 million Bank Capital $10 million A second alternative is for the bank to sell some of its securities to help cover the deposit outflow. For example, it might sell $9 million of its securities and deposit the proceeds with the Fed, resulting in the following balance sheet: 2. Sell securities Assets Liabilities Reserves $9 million Deposits $90 million Loans $90 million Bank Capital $10 million Securities $1 million Liquidity Management A third way that the bank can meet a deposit outflow is to acquire reserves by borrowing from the Fed (NRB). In our example, the First National Bank could leave its security and loan holdings the same and borrow $9 million in discount loans from the Fed. Its balance sheet would then be 3. Borrow from Fed Assets Liabilities Reserves $9 million Deposits $90 million Loans $90 million Discount Loans $9 million Securities $10 million Bank Capital $10 million Liquidity Management Finally, a bank can acquire the $9 million of reserves to meet the deposit outflow by reducing its loans by this amount and depositing the $9 million it then receives with the Fed, thereby increasing its reserves by $9 million. This transaction changes the balance sheet as follows: 4. Call in or sell off loans Assets Liabilities Reserves $9 million Deposits $90 million Loans $81 million Bank Capital $10 million Securities $10 million calling in loans that is, by not renewing some loans when they come due Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows Post Raj Pokharel, M.Phil, Ph.D. Scholar,

20 Asset / Liability Management Asset / Liability Management FI that issues liabilities of one-year maturity to finance the purchase of assets with a two-year maturity. Suppose that the FI s liability holders, such as depositors, demand cash at the end of year 1 for their financial claims Asset Management Asset Management To maximize its profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Banks try to accomplish these three goals in four basic ways First, banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. They seek out loan business by advertising their borrowing rates and by approaching corporations directly to solicit (request) loans. It is up to the bank s loan officer to decide if potential borrowers are good credit risks who will make interest and principal payments on time (i.e., engage in screening to reduce the adverse selection problem). Typically, banks are conservative in their loan policies; the default rate is usually less than 1%. It is important, however, that banks not be so conservative that they miss out on attractive lending opportunities that earn high interest rates Post Raj Pokharel, M.Phil, Ph.D. Scholar,

21 Asset Management Asset Management Second, banks try to purchase securities (i.e. investment in securities) with high returns and low risk. Third, in managing their assets, banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets (short- and longterm, Treasury Bills, and municipal bonds) and approving many types of loans to a number of customers. Finally, the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets. The bank must decide, for example, how much in excess reserves must be held to avoid costs from a deposit outflow. Summary Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. 1. Get borrowers with low default risk, paying high interest rates 2. Buy securities with high return, low risk 3. Diversify 4. Manage liquidity Liability Management Capital Adequacy Management Liability Management: managing the source of funds, from deposits, to CDs, other debt. 1. No longer primarily depend on deposits 2. When seen loan opportunities, borrow or issue CDs to acquire funds Banks have to make decisions about the amount of capital they need to hold for three reasons. First, bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business. Second, the amount of capital affects returns for the owners (equity holders) of the bank. Third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities Post Raj Pokharel, M.Phil, Ph.D. Scholar,

22 How Bank Capital Helps Prevent Bank Failure How Bank Capital Helps Prevent Bank Failure Let s consider two banks with identical balance sheets, except that the High Capital Bank has a ratio of capital to assets of 10% while the Low Capital Bank has a ratio of 4%. Suppose that both banks get caught up real estate market, only to find that $5 million of their real estate loans became worthless later. When these bad loans are written off (valued at zero), the total value of assets declines by $5 million. As a consequence, bank capital, which equals total assets minus liabilities, also declines by $5 million 86 Capital Adequacy Management Capital Adequacy Management 1. Bank capital is a cushion that prevents bank failure 2. Higher is bank capital, lower is return on equity ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital, EM, ROE Banks also hold capital to meet capital requirements 4. Strategies for Managing Capital Sell or retire stock Change dividends to change retained earnings Change asset growth Post Raj Pokharel, M.Phil, Ph.D. Scholar,

23 Off-Balance-Sheet Activities Off-Balance-Sheet Activities A loan sale, also called a secondary loan participation, involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank s balance sheet. Banks earn profits by selling loans for an amount slightly greater than the amount of the original loan. Because the high interest rate on these loans makes them attractive, institutions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original Generation of Fee Income: fees that banks receive for providing specialized services to their customers, such as making foreign exchange trades on a customer s behalf, guaranteeing debt securities such as banker s acceptances (by which the bank promises to make interest and principal payments if the party issuing the security cannot), and providing backup lines of credit. Even though a guaranteed security does not appear on a bank balance sheet, it still exposes the bank to default risk: If the issuer of the security defaults, the bank is left holding the bag and must pay off the security s owner. Backup credit lines also expose the bank to risk because the bank may be forced to provide loans when it does not have sufficient liquidity or when the borrower is a very poor credit risk. interest rate on the loan Off-Balance-Sheet Activities Measuring Bank Performance 1. Fee income from Foreign exchange trades for customers Guarantees of debt Backup lines of credit 2. Financial options 3. Foreign exchange trading 4. Interest rate swaps 5. Loan sales All these activities involve risk To understand how well a bank is doing, we need to start by looking at a bank s income statement, the description of the sources of income and expenses that affect the bank s profitability. Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts: Operating Income Operating Expenses Net Operating Income Post Raj Pokharel, M.Phil, Ph.D. Scholar,

24 Banks' Income Statement Recent Trends in Bank Performance Measures in Nepal FIs are closely watched by their customers, regulators and by the money and capital markets. The performance of a bank is evaluated not only relative to the institutions' own goals but also relative to the performance of the bank's competitors. Mainly four dimensions of bank performance tend to be the most closely followed in Nepal: a. The market value or stock price of a banking institution b. The rate of return or profitability ratios of a bank. c. The bank's risk exposure d. The operating efficiency of the institution Recent Trends in Bank Performance Measures in Nepal Recent Trends in Bank Performance Measures in Nepal a. Bank's stock price is usually the single best indicator of how well the bank is performing because its shareholders must be satisfied they are earning a competitive return on their capital. However banks around the world either do not have stockholders or have stock that is so infrequently trade that a realistic value cannot be determined. This is why many banks pay close attention to measures b. Profitability Ratios or Rate of Return Profit Margin = Net Income/ Operating Income 1. Net Interest Margin (NIM) = Where, Net Interest Income/ Interest earning assets (or TA) Net Interest Income = Total income from interest bearing assets Total interest cost on borrowed funds 2. Net Operating Margin = (interest income/ earning assets)- (int. exp / Interest paying Liabilities) 3. Earning Base = (Total assets- Non earning assets)/ Total Assets various ratios If the earnings base ratio is more then the bank will earn more profits and vice versa. Post Raj Pokharel, M.Phil, Ph.D. Scholar,

25 Question on GAP,NIM Q.No. 1. Given the following information First National Bank ($ Millions) Assets Liabilities and Equity Rate Sensitive $200 (12%) Rate Sensitive $300 (6%) NonRate Sensitive 400 (11%) NonRate Sensitive 300 (5%) Non Earning 100 Equity 100 Total Assets $700 Total Liabilities and Equity $700 a. What is the GAP? Net Interest Income? Net Interest Margin? How much will net interest income change if interest rates fall by 200 basis points? Earning Base ratio? The gap is $-100 ($200 - $300). The net interest income is ($200) (12%) + ($400) (11%) ($300) (6%) ($300) (5%) = $24 + $44 $18 $15 = $35. The net interest margin is $35/$600 = 5.8%. If interest rates change (fall) by $200 basis points, the net interest income would be ($200) (10%) + ($400) (11%) ($300) (4%)( ($300) (5%) = $20 + $44 - $12 $15 = $37. Earning Base ratio = ( )/700 = 85.7% C. The bank's risk exposure Solvency (Default) Risk: Solvency ratio measure the how much long-term capital the owners have placed in the institution relative to its risk exposed assets. If an institution's risk assets decline in value by more than the volume of its owner's capital (net worth), it will become insolvent. Risky assets are earnings assets either subject to credit risk or interest rate risk. Ratio of equity capital to risk assets = Total equity capital/total risky assets Credit Risk: Ratio of nonperforming assets to total loans = Nonperforming assets / Total loans D. Operating Efficiency Management response to improve efficiency Installing new labor saving machinery like computers, automated tellers to increase the productivity of employees in processing transactions. Status of productive employees in terms of revenue generation, assets management and accounts handling. Income Productivity Ratio = Net Income/ No. of Employees ramakandel2002@gmail.com Operating expense ratio = Total operating exp. / Total assets Post Raj Pokharel, M.Phil, Ph.D. Scholar,

26 UNIT IV: Commercial Banking Industry and Other Depository Institutions LH 8 MBA IV Semester Management of Financial Institutions Unit IV Commercial Banking Industry and Other Depository Institutions POST RAJ POKHAREL M.Phil. (TU) 01/2010) Definition of a Commercial Bank. Size, Structure and Composition of the Commercial Banking Industry. Technology in Commercial Banking. Financial Statements of Commercial Banks and Their Analyses. Regulation of Depository Institutions in Nepal: Balance Sheet and Off-Balance Sheet Regulations. Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their Roles, Size, Structure and Compositions Commercial Bank As the name itself signifies, are designed to accept deposit and advance credit to commercial sector. These institutions are run to make a profit. Commercial banks are categorized under A class banks in Nepal Commercial Banks accepts deposits from different people and organizations. Banks allows for opening three types of accounts to accept deposit from customer i.e. current, saving and fixed deposit account. Commercial Banks provides different types of loans to peoples, organizations, business houses etc. the amount of loan given to these peoples, organizations, business houses depends upon the collateral provided. Commercial Banks provide letter of credit and guarantee facilities, which boost up international trade. 103 Commercial Bank Commercial Banks provide locker facilities to customers for safekeeping of valuable documents and precious articles. Commercial Banks provide various card services like debit cards, credit cards, ATM card that avoids risk in carrying money. Commercial Banks provide services like clearing of cheques and performs various agencies functions like transfer fund, pay house rent, telephone bills etc. Commercial banks provide easy payment and withdrawal facility to its customers in the form of cheques and drafts. It also brings bank money in circulation. This money is in the form of cheques, drafts, etc. 104 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

27 Size, Structure and Composition of the Commercial Banking Industry. By the end of mid July 2014, altogether 204 banks and non- bank financial institutions licensed by NRB are in operation. Out of them, 30 are A class commercial banks, The number of commercial bank branches operating in the country increased to 1547 in Mid July The total assets of commercial banking sector reached to Rs million As of Mid July 2014, Commercial Bank group occupied 77.9 percent of total assets/liabilities followed by Development Banks 13.6 percent, Finance Companies 5.8 percent and Micro-finance Development Bank 2.6 percent 105 Size, Structure and Composition of the Commercial Banking Industry. The composition of liabilities of commercial banks shows that, the deposit has occupied the dominant share of 81.5 percent followed by others 10.1 percent, capital fund 7.3 percent and Borrowings 1.0 percent in Mid - July 2014 The share of loans and advances to total assets remained at 60.3 percent in Mid - July Similarly, share of liquid funds and investment to total assets registered 15.3 percent Commercial Banks held dominant share on the major balance sheet components of financial system. Of the total deposits Rs. 1,488,834 million in Mid-July 2014, the commercial banks occupied 81.0 percent. Similarly, development banks held 13.4 percent, finance companies 4.9 percent and micro finance development banks 0.7 percent. on the loans and advances the share of commercial banks stood at 77.2 percent, development banks 14.0 percent, finance companies 5.7 percent and micro finance development banks 3.1 percent in Mid July Reference: Banking and Financial Statistics, Page 4 Mid-July, 2014 Technology in Commercial Banking Use of Software. Clearing House Central Depository System Use of sophisticated computers, system procedures, ERP ATM, Visa Card, Credit Card, Debit Card Mobile, , Online Payment, Online Payment Transfer Financial Statements of Commercial Banks and Their Analyses. Ref. Banking and Financial Statistics Mid- July, 2014, Page 21 to Post Raj Pokharel, M.Phil, Ph.D. Scholar,

28 Regulation of Depository Institutions in Nepal: Balance Sheet and Off-Balance Sheet Regulations. Regulation is essential to safeguard the people deposit made in the commercial banks Regulations also prevent the commercial banks from performing undesired activities in view of the national economy. It also helps to prevent the bank from being suffered by the several economic problems. Promote efficiency of commercial bank to operate in profit. Ensure adequate fund to meet all cash demands Maintain clear and fraud free financial transactions Record all financial transactions as per the banking rules Regulations under following headings: a. Credit control e. Priority sector b. Foreign exchange f. Capital adequacy c. Liquidity g. Assets quality d. Interest rate 109 Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their Roles, Size, Structure and Compositions. Development Banks: The total number of development banks decreased to 84 in Mid - July 2014 Among the component of liabilities, deposit constituted 77.2 percent followed by capital fund 10.7 percent borrowing by 0.9 percent and others by 11.2 percent On the assets side, loans and advances constituted 62.5 percent, liquid funds 26.6 percent and investment 1.9 percent 110 Role of Development Banks in Nepal Role of Development Banks in Nepal Industrial development bank:- The bank which is established for the development of industrial sector by providing financial, technical and administrative and other necessary assistance is known as development bank. NIDC provides medium term and long term loan to the industries, against securities for the development of bank. It helps industrial enterprises in collecting capital by selling their shares and debenture to different persons and organization in capital market. It also performs general banking transaction with other national and foreign banks, specially for the benefit of the industrial undertaking. It organizes industrial seminar, workshop, training etc. and assist the industrial also and govt. by providing necessary suggestion and advice for the betterment of industrial sector. Agriculture development bank (ADB) The bank which is established for the development of agricultural sectors by imitating the modern system and methodology through financial, technical and administrative assistance is known as ADB. Providing agricultural products. Providing loan for farm development. Providing loan for selling agricultural products. Providing loan to the tenants. Commercial function Post Raj Pokharel, M.Phil, Ph.D. Scholar,

29 Finance Companies: The history of the finance companies began with the establishment of the Nepal Housing Development Finance Company Limited in In addition to the private banks, there are numerous finance companies operating in Nepal. These institutions have all commenced operations over the past six years since the Finance Company Act was promulgated. The Act permits these companies to offer installment credit for the purchase of vehicles, equipment, or durable household goods, for purchase or construction of residential buildings, for leasing financing, and for operating industrial, commercial or other enterprises The total number of finance companies decreased to 53 in Mid - July 2014 The decrement in number of Finance Companies resulted the total assets/liabilities of the finance companies to shrink by 3.91 percent Among the total liabilities, deposits held the largest share of 66.6 percent followed by others 23.9 percent, capital fund 9.0 percent, and borrowings 0.51 percent. 113 Micro Finance: There is abundance of organizations involved in microfinance in Nepal -formal and informal mainly cooperatives and NGOs. Credit cooperatives first emerged in 1956 and were registered under the Cooperative Act in With a view to limiting political intervention and to institutionalizing cooperatives, a new Cooperative Act was enacted in This Act specified that a minimum of 25 persons were required to form a primary cooperative. Although around 5,000 credit and multipurpose cooperatives have been registered under the new Act, only 35 have obtained permission from the Nepal Rastra Bank to undertake limited banking functions. The nongovernmental organizations are also permitted to provide limited banking services in Nepal. To date, thirty NGOs have been licensed to conduct a limited banking business, of which two -Nirdhan and CSD - are Grameen replicator banks The total number of 'D' class rural & micro finance development banks increased to 37 in Mid July 2014 In Mid - July 2014, the total assets/liabilities of these banks reached to Rs. 50,189 million 114 UNIT V: Management of Insurance Companies LH 6 MBA IV Semester Management of Financial Institutions Unit V Management of Insurance Companies POST RAJ POKHAREL M.Phil. (TU) 01/2010) 115 Overview of Insurance Companies Fundamentals of Insurance Types of Insurance Life Insurance Companies: Meaning and Their Functions Types of Life Insurance Policies and Their Determination. Property and Liability Insurance Companies: Meaning and Their Functions Determining the Profitability to Property and Liability Insurance Companies. Regulation of Insurance Companies in Nepal. Existing Scenario of Insurance Industries in Nepal. 116 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

30 Overview of Insurance Companies Insurance companies are in the business of assuming risk on behalf of their customers in exchange for a fee, called a premium. Insurance companies make a profit by charging premiums that are sufficient to pay the expected claims to the company plus a profit. Why do people pay for insurance when they know that over the lifetime of their policy, they will probably pay more in premiums than the expected amount of any loss they will suffer? Because most people are risk-averse: They would rather pay a certainty equivalent (the insurance premium) than accept the gamble that they will lose their house or their car. Thus, it is because people are risk-averse that they prefer to buy insurance 117 Overview of Insurance Companies Consider how people s lives would change if insurance were not available. Instead of knowing that the insurance company would help if an emergency occurred, everyone would have to set aside reserves. These reserves could not be invested long-term but would have to be kept in an extremely liquid form. Furthermore, people would be constantly worried that their reserves would be inadequate to pay for catastrophic events such as the loss of their house to fire, the theft of their car, or the death of the family breadwinner. Insurance allows us the peace of mind that a single event can have only a limited financial impact on our lives. 118 Fundamentals of Insurance Fundamentals of Insurance Although there are many types of insurance and insurance companies, all insurance is subject to several basic principles. 1. There must be a relationship between the insured (the party covered by insurance) and the beneficiary (the party who receives the payment should a loss occur). In addition, the beneficiary must be someone who may suffer potential harm. For example, you could not take out a policy on your neighbor s teenage driver because you are unlikely to suffer harm if the teenager gets into an accident. The reason for this rule is that insurance companies do not want people to buy policies as a way of gambling The insured must provide full and accurate information to the insurance company. 3. The insured is not to profit as a result of insurance coverage. 4. If a third party compensates the insured for the loss, the insurance company s obligation is reduced by the amount of the compensation. 5. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. 6. The insurance company must be able to compute the probability of the loss occurring. The purpose of these principles is to maintain the integrity of the insurance process. Without them, people may be tempted to use insurance companies to gamble or speculate on future events. 120 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

31 Benefits of Insurance to Society Indemnification of loss Reduction of worry and fear Source of investment fund Loss prevention Enhancement of Credit 3. Categories of Insurance Business : (1) Subject to the provisions made in the Insurance Act and Regulation, the Insurance Business to be operated by an Insurer shall be divided into the following categories : (a) Life Insurance Business, (b) Non-Life Insurance Business, (c) Re-Insurance Business Life Insurance Business : (1) The Insurer may operate the following Insurance Business under the Life Insurance Business:- (a) Whole Life Insurance, (b) Endowment Life Insurance, (c) Term Life Insurance. 123 Non-Life Insurance : (1) The Insurer may operate the following Insurance Business under the Non-Life Insurance Business : (a) Fire Insurance, (b) Motor Insurance, (c) Marine Insurance, (d) Engineering and Contractor's Risk Insurance, (e) Aviation Insurance, (f) Miscellaneous Insurance. 124 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

32 Types of Insurance The most common types are life insurance and property and casualty insurance. In its simplest form, life insurance provides income for the heirs of the deceased. Many insurance companies offer policies that provide retirement benefits as well as life insurance. 125 Life Insurance Term Life: The simplest form of life insurance is the term insurance policy, which pays out if the insured dies while the policy is in force. This policy is issued for a short period such as from 3 months to 7 years. Once the policy period expires, there are no residual benefits. In addition, the policyholder cannot borrow against the policy. As the insured ages, the probability of death increases, so the cost of the policy rises. Assuming that benefits are paid at the end of the year, and that the probability of dying next year for an individual of age is p a, then the fair premium, R, paid at the beginning of the year is: Fair Premium (R) = (L* P a )/ (1+r) 126 Life Insurance The insurance company has a cost of money of 10%, the fair premium on a one year Rs. 1,00,000 term life insurance policy for a 30- year old individual, whose probability of dying over the next year is 0.133%. Calculate the fair premimum. Here, Cost of money (r) = 10%, Policy Amount (L) = Rs. 100,000 Probability of dying over the next year (Pa) = 0.133% Now, Fair premium (R)= (100000*.00133)/(1+0.10) = Rs Life Insurance Suppose that the management of a life insurance company wants to set a competitive premium for a group of 10,000 potential policyholders, each 50 years of age and each requesting a Rs. 100,000 life insurance policy. Mortality tables indicate that the proportion of 50-year-old individuals expected to die in their 50 th year is seven of 1000 policyholders. If this death-rate estimate is accurate for this group of 10,000 policyholders of the company. The insurance company will invest any incoming premium payments by the policyholders at the prevailing market interest rate of 8.5%. Required: The number of deaths expected = 10,000*7/1000 = 70 deaths Volume of expected death benefit claims = 70 * Rs. 100,000 = Rs. 70,00,000 Present value of expected death benefit income = Rs 70,00,000/(1+.085) = Rs Estimated net premium to charge each policyholder = /10000= Rs Post Raj Pokharel, M.Phil, Ph.D. Scholar,

33 Life Insurance Whole Life: This policy is called cash-value or permanent or ordinary or investment life insurance. Here, purchaser pays fixed annual premiums, which entitle the policyholder's beneficiaries to the value of the policy in case of death. Endowment (gift) cum Whole Life : This plan is a combination of Endowment Assurance and While Life Plans. It provides financial protection against death throughout the lifetime of the life assured with the provision of payment of a lump sum at the maturity of the policy to the assured in case of his survival. Universal Life: have two parts, one for the term life insurance and one for savings. It is a very flexible policy that allows the insured to pay in excess of the pure premium each year. The excess funds can then be invested in money market instruments or other investments that the policyholder chooses. 129 Life Insurance Annuity: A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer) a life insurance company makes a series of future payments to a buyer (annuitant) in exchange for the immediate payment of a lump sum (single-payment annuity) or a series of regular payments (regularpayment annuity), prior to the onset of the annuity. The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate and the remainder of the fund accumulated is forfeited unless there are other annuitants or beneficiaries in the contract. 130 Life Insurance Health Insurance: Individual health insurance coverage is very vulnerable to adverse selection problems. People who know that they are likely to become ill are the most likely to seek health insurance coverage. This causes individual health insurance to be very expensive. Most policies are offered through company-sponsored programs in which the company pays all or part of the employee s policy premium. 131 Property and Casualty Insurance Property and casualty insurance protects property (houses, cars, boats, and so on) against losses due to accidents, fire, disasters, and other calamities. Marine insurance, for example, which insures against the loss of a ship and its cargo, is the oldest form of insurance, predating even life insurance. Property and casualty policies tend to be short-term contracts subject to frequent renewal. Property and casualty insurance was the earliest form of insurance. It began in the Middle Ages when merchants sent ships off to foreign ports to trade. A merchant, though willing to accept the risk that the trading might not turn a profit, was often unwilling to accept the risk that the ship might sink or be captured by pirates. To reduce such risks, merchants began to band together and insure each other s ships against loss. The process became more sophisticated as time went on, and insurance policies were written that were then traded in the major commercial centers of the time. 132 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

34 Property and Casualty Insurance Property insurance can be provided in either named-peril policies or open-peril policies. Named-peril policies insure against loss only from perils that are specifically named in the policy, whereas open-peril policies insure against all perils except those specifically excluded by the policy. For example, many homeowners in low-lying areas are required to buy flood insurance. This insurance covers only losses due to flooding, so it is a named-peril policy. A homeowner s insurance policy, which protects the house from fire, hurricane, and other damage, is an example of an open-peril policy. 133 Reinsurance is an arrangement by which the primary insurere that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. The primary insurer that initially writes the business is called ceding company. The insurer that accepts part or all of the insurance from the ceding company is called the reinsurer. The amount of insurance retained by the ceding company for its own account is called the retention limit or net retention. The amount of the insurance ceded to the reinsurer in turn may reinsure part or all of the risk with another insurer. This is known as retrocession. In this case, the second reinsurer is called a retrocessionaire. 134 Regulation of Insurance Companies in Nepal Principles areas for regulations: Formation and licensing of insurers: After being formed, insurers must be licensed to do business and also meet requirements as per the regulation. Solvency Regulation: Minimum capital and surplus requirements. An insurer must have sufficient assets to offset its liabilities. Rate regulation: rate must be adequate, not excessive, and not unfairly discriminatory. Policy forms: is to protect public from misleading and unfair provisions. Consumer Protection Existing Scenario of Insurance Industries in Nepal Rastriya Beema Sansthan (RBS) in 1968 under Company Act, 2024 and was converted into Corporation in the following year under Rastriya Beema Sansthan Act, 1969 Insurance Act, 1968 made a provision of Beema Samiti (Insurance Board), as a sole authority to regulate the insurance activities within Nepal (as the insurance supervisory Authority) In 1986, a new experiment was done in Nepalese insurance scenario by licensing a joint venture insurance company to operate both life and non life business In 1986, National Life and General Insurance Company Limited (Now operating life and non life business separately) was licensed as the first insurance company in the private sector with minority interest of foreign equity Three life insurance companies were licensed in 2001 and four in Post Raj Pokharel, M.Phil, Ph.D. Scholar,

35 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

36 UNIT VI: Credit Risk Management in Financial Institutions LH 7 MBA IV Semester Management of Financial Institutions UNIT VI Credit Risk Management in Financial Institutions LH 7 Need to Manage Risk by Financial Institutions. Types of Risks Incurred by Financial Institutions. Overview of Credit Risk Management. Credit Risk Analysis: Cash Flow Analysis, Ratio Analysis, Common Size Analysis Credit Scoring Models Calculating Return on a Loan POST RAJ POKHAREL M.Phil. (TU) 01/2010) Risks at Financial Institutions Source: Financial Institutions and Management: A Risk Management Approach, Saunder and Cornett, Page 322, One of the major objectives of a financial institution s (FI s) managers is to increase the FI s returns for its owners Increased returns often come at the cost of increased risk, which comes in many forms: credit risk foreign exchange risk liquidity risk country or sovereign risk interest rate risk technology risk market risk operational risk off-balance-sheet risk insolvency risk Post Raj Pokharel, M.Phil, Ph.D. Scholar,

37 Risks at Financial Institutions Risks at Financial Institutions Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full FIs that make loans or buy bonds with long maturities are relatively more exposed to credit risk a key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans FIs also charge interest rates commensurate with the riskiness of the borrower Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices day-to-day withdrawals by liability holders are generally predictable unusually large withdrawals by liability holders can create liquidity problems the cost of purchased and/or borrowed funds rises for FIs the supply of purchased or borrowed funds declines FIs may be forced to sell less liquid assets at fire-sale prices Risks at Financial Institutions Risks at Financial Institutions Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile asset transformation involves an FI issuing secondary securities or liabilities to fund the purchase of primary securities or assets if an FI s assets are longer-term than its liabilities, it faces refinancing risk the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments if an FI s assets are shorter-term than its liabilities, it faces reinvestment risk the risk that the returns on funds to be reinvested will fall below the cost of funds Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices closely related to interest rate and foreign exchange risk adds trading activity i.e., market risk is the incremental risk incurred by an FI (in addition to interest rate or foreign exchange risk) caused by an active trading strategy FIs trading portfolios are differentiated from their investment portfolios on the basis of time horizon and liquidity trading assets, liabilities, and derivatives are highly liquid investment portfolios are relatively illiquid and are usually held for longer periods of time declines in traditional banking activity and income at large commercial banks have been offset by increases in trading activities and income Post Raj Pokharel, M.Phil, Ph.D. Scholar,

38 Risks at Financial Institutions Risks at Financial Institutions Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilities OBS activity can increase FIs interest rate risk, credit risk, and foreign exchange risk OBS activity can also be used to hedge (i.e., reduce) FIs interest rate risk, credit risk, and foreign exchange risk large commercial banks (CBs) in particular engage in OBS activity OBS activities can affect the future shape of FIs balance sheets OBS items become on-balance-sheet items only if some future event occurs a letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring, most notably default of the agent that purchases the LOC other examples include: loan commitments by banks mortgage servicing contracts by savings institutions positions in forwards, futures, swaps, and other derivatives held by almost all large FIs Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI s assets and liabilities denominated in foreign currencies FIs can reduce risk through domestic-foreign activity/investment diversification FIs expand globally through acquiring foreign firms or opening new branches in foreign countries investing in foreign financial assets Risks at Financial Institutions Risks at Financial Institutions Country or sovereign risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments measuring sovereign risk includes analyzing: the trade policy of the foreign government the fiscal stance of the foreign government potential government intervention in the economy the foreign government s monetary policy capital flows and foreign investment the foreign country s current and expected inflation rates the structure of the foreign country s financial system foreign corporations may be unable to pay principal and interest even if they would desire to do so foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events Technology risk and operational risk are closely related technology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savings the major objectives of technological expansion are to allow the FI to exploit potential economies of scale and scope by: lowering operating costs increasing profits capturing new markets operational risk is the risk that existing technology or support systems may malfunction or break down the BIS defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events Post Raj Pokharel, M.Phil, Ph.D. Scholar,

39 Risks at Financial Institutions Credit Risk Management Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities insolvency risk is a consequence or an outcome of one or more of the risks previously described: interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity risk generally, the more equity capital to borrowed funds an FI has the less insolvency risk it is exposed to both regulators and managers focus on capital adequacy as a measure of a FI s ability to remain solvent 19- Credit risk : is the major risk that banks are exposed to during the normal course of lending and credit underwriting. Within Basel II, there are two approaches for credit risk measurement: the standardized approach and the internal ratings based (IRB) approach Due to various inherent constraints of the Nepalese banking system, the standardized approach in its simplified form, Simplified Standardized Approach (SSA), has been prescribed in the initial phase. (SSA): Under this approach commercial banks are required to assign a risk weight to their balance sheet and off-balance sheet exposures. 154 Credit Risk Management Credit Risk Management To earn high profits, FIs must make successful loans that are paid back in full (and so have low credit risk). The concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institution managers must follow to minimize credit risk and make successful loans. Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; in other words, those who are most likely to produce an adverse outcome are the most likely to be selected. Borrowers with very risky investment projects have much to gain if their projects are successful, so they are the most eager to obtain loans. Clearly, however, they are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans. 155 Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lender s point of view. In such situations, it is more likely that the lender will be subjected to the hazard of default. Once borrowers have obtained a loan, they are more likely to invest in high-risk investment projects projects that pay high returns to the borrowers if successful. The high risk, however, makes it less likely that they will be able to pay the loan back. 156 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

40 Credit Risk Analysis: Cash Flow Analysis, Ratio Analysis, Common Size Analysis Cash Flow Analysis: Source of Fund/ Use of funds, Increase in CA, increase in CL, Purchase of Assets, Raise of Funds through equity Ratio Analysis: Profitability Analysis, WC Ratios, DuPoint Analysis Common Size Analysis 157 Credit Scoring Models Credit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The models use data on observed economic and financial borrower characteristics to assist an FI manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to protect against future loan losses. 158 Credit Scoring Models Probability Model: Suppose the estimated linear probability model is Z = 1.1X 1 +.6X 2 +.5X 3 + error, where X 1 = 0.75 is the borrower's debt/equity ratio; X 2 = 0.25 is the volatility of borrower earnings; and X 3 = 0.15 is the borrower s profit ratio. a. What is the projected probability of repayment for the borrower? Z = 1.1(.75) +.6(.25) +.5(.15) = 1.05%. The expected probability of repayment is = 98.95%. 159 Credit Scoring Models b. What is the projected probability of repayment if the debt/equity ratio is 3.5? Z = 1.1(3.5) +.6(.25) +.5(.15) = 4.075%. The expected probability of repayment is = %. c. What is a major weakness of the linear probability model? A major weakness of this model is that the estimated probabilities can be below 0 or above 1.0, an occurrence that does not make economic or statistical sense. 160 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

41 Credit Scoring Models Linear Discriminant Models: Assets Liabilities and Equity Cash $ 20 Accounts Payable $ 30 Accounts Receivables $ 90 Notes Payable $ 90 Inventory $ 90 Accruals $ 30 Long Term Debt $150 Plant and equipment $500 Equity $400 Total Assets $700 Total Liabilities & Equity $700 Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40, net income = $44, the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value. 161 Credit Scoring Models Linear Discriminant Models: a. What is the Altman discriminant function value for MNO, Inc.? Recall that: Net working capital = current assets minus current liabilities. Current assets = Cash + accounts receivable + inventories. Current liabilities = Accounts payable + accruals + notes payable. EBIT = Revenues - Cost of goods sold - depreciation. Taxes = (EBIT - Interest)(tax rate). Net income = EBIT - Interest - Taxes. Retained earnings = Net income (1 - dividend payout ratio) Altman s discriminant function is given by: Z = 1.2X X X X X5 Assume prior retained earnings are zero. X1 = ( )/ 700 =.0714 X1 = Working capital/total assets (TA) X2 = 22 / 700 =.0314 X2 = Retained earnings/ta X3 = 140 / 700 =.20 X3 = EBIT/TA X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term debt X5 = 500 / 700 =.7143 X5 = Sales/TA Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = = = Credit Scoring Models Linear Discriminant Models: b. Should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan? Since the Z-score of is greater than 1.81, ABC Inc. s application for a capital expansion loan should be approved. Calculating Return on a Loan The interest rate on the loan. Any fees relating to the loan. The credit risk premium on the loan 163 gross return on the loan k, b (compensating balances), direct fees ( of ), loan interest rate ( BR + m ), 164 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

42 Calculating Return on a Loan 1. Calculate the promised return ( k ) on a loan if the base rate is 13 percent, the risk premium is 2 percent, the compensating balance requirement is 5 percent, fees are ½ percent, and reserve requirements are 10 percent. (16.23%) = ( )/(1-0.05*(1-0.1)) 2. What is the expected return on this loan if the probability of default is 5 percent? (10.42%) E(r) = p(1+ k) -1 = 0.95*( )-1 Where, p = probability of repayment ( p ) = = UNIT VII: Liquidity Risk Management in Financial Institutions LH 6 MBA IV Semester Management of Financial Institutions UNIT VII Liquidity Management in Financial Institutions LH 6 Overview of Liquidity Risk Management. Causes of Liquidity Risk. Liquidity Risk and Depository Institutions: Asset Side Liquidity Risk, Liability side Liquidity Risk and Measuring bank s Liquidity Exposure Liquidity Risk and Insurance Companies. Liquidity Risk and Mutual Funds. POST RAJ POKHAREL M.Phil. (TU) 01/2010) Post Raj Pokharel, M.Phil, Ph.D. Scholar,

43 Overview of Liquidity Risk Management Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs) At the extreme, liquidity risk can lead to insolvency Some FIs are more exposed to liquidity risk than others depository institutions (DIs) are highly exposed mutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk Overview of Liquidity Risk Management One type of liquidity risk arises when an FI s liability holders seek to withdraw their financial claims FIs must meet the withdrawals with stored or borrowed funds alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices A second type of liquidity risk arises when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holder unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down Liquidity Risk and Depository Institutions DIs balance sheets typically have large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors large amounts of relatively illiquid long-term assets such as commercial loans and mortgages DIs know that normally only a small portion of demand deposits will be withdrawn on any given day most demand deposits act as core deposits i.e., they are a stable and long-term funding source Deposit withdrawals are normally offset by the inflow of new deposits 171 Liquidity Risk and Depository Institutions DI managers monitor net deposit drains i.e., the amount by which cash withdrawals exceed additions; a net cash outflow DIs manage deposit drains with: stored liquidity relied on most heavily by community banks purchased liquidity relied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds 172 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

44 Liquidity Risk and Depository Institutions Purchased liquidity allows FIs to maintain the overall size of their balance when faced with liquidity demands purchased liquidity is expensive relative to stored liquidity purchased liquidity includes: interbank markets for short-term loans fed funds repurchase agreements fixed-maturity certificates of deposits notes and bonds Liquidity Risk and Depository Institutions Stored liquidity may involve the use of existing cash stores or the sale of existing assets banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements when managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes Most DIs utilize a combination of stored and purchased liquidity management Liquidity Risk and Depository Institutions A DI with the following balance sheet (in millions) expects a net deposit drain of $15 million. Loan commitments and other credit lines can cause liquidity problems as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity If stored liquidity is used, the composition of the asset side of the balance sheet changes, Show the DI's balance sheet if the following conditions occur. but not the size of the balance sheet a. The DI purchases liabilities to offset this expected drain. b. The stored liquidity management method is used to meet the If purchased liquidity is used, the liquidity shortfall. composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet Post Raj Pokharel, M.Phil, Ph.D. Scholar,

45 Measuring Liquidity Risk Exposure The liquidity position of banks is measured by managers on a daily basis A net liquidity statement lists sources and uses of liquidity Ratio comparisons are used to compare a bank s liquidity position against its competitors loans to deposit ratio borrowed funds to total assets ratio commitments to lend to assets ratio Ratios are often compared to those of banks of a similar size and in the same geographic location 177 Measuring Liquidity Risk Exposure The liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions I = N i= 1 [( w )( P / P * )] i i where w i = the percent of each asset i in the FI s portfolio Pi = the price it gets if an FI liquidates asset i today i.e.fire sale price P i* = the price it gets if an FI liquidates asset i under normal market conditions i 178 A DI has the following assets in its portfolio: $20 million in cash reserves with the Fed, $20 million in T-Bills, $50 million in mortgage loans, and $10 million in fixed assets. If the assets need to be liquidated at short notice, the DI will receive only 99 percent of the fair market value of the T-Bills and 90 percent of the fair market value of the mortgage loans. Estimate the liquidity index using the above information. Thus, and assuming that fixed assets will not be disposed on short notice: I = (20/100)(1.00/1.00) + (20/100)(0.99/1.00) + (50/100)(0.90/1.00) + (10/100)(1/1.00) = <Fixed assets can't be used as liquid index> Measuring Liquidity Risk Exposure The financing gap is the difference between a bank s average loans and average (core) assets if the financing gap is positive, the bank must find liquidity to fund the gap The financing requirement is the financing gap plus a bank s liquid assets a widening financing gap can be an indicator of future liquidity problems 180 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

46 Plainbank has $10 million in cash and equivalents, $30 million in loans, and $15 in core deposits. Cash $ 10 Core Deposit $15 Loan $30 a. Calculate the financing gap. Financing gap = average loans average deposits = $30 million - $15 million = $15 million b. What is the financing requirement? Financing requirement = financing gap + liquid assets = $15 million + $10 million = $25 m c. How can the financing gap be used in the day-to-day liquidity management of the bank? Measuring Liquidity Risk Exposure The BIS Approach: Maturity Ladder/Scenario Analysis liquidity management involves assessing all cash inflows against cash outflows the maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder the BIS also suggests that DIs prepare for abnormal conditions using various what if scenarios 182 Liquidity Planning Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise lowers the costs of funds by determining an optimal funding mix minimizes the amount of excess reserves that a bank needs to hold liquidity plan components description of managerial responsibilities list of fund providers most likely to withdraw funds and a pattern of fund withdrawals identification of the size of potential deposit and fund withdrawals over various time horizons internal limits on separate subsidiaries and branches borrowings as well as acceptable risk premiums to pay in each market 183 Liquidity Risk Major liquidity problems arise if deposit drains are abnormally large and unexpected Abnormal deposit drains can occur because concerns about a bank s solvency failure of another bank (i.e., the contagion (inflection) effect) sudden changes in investors preferences regarding holding nonbank financial assets relative to bank deposits A bank run is a sudden and unexpected increase in deposit withdrawals from a bank 184 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

47 Liquidity Risk Demand deposits are first-come, first-served contracts The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole Regulatory mechanisms are in place to ease banks liquidity problems and to deter bank runs and panics deposit insurance 185 Liquidity Risk and Insurance Companies Life insurance companies hold cash reserves and other liquid assets to meet policy payments to meet cancellation (surrender) payments the surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early to fund working capital needs which can be unpredictable Property-casualty (P&C) insurance companies the claims against P&C insurers are hard to predict thus, P&C insurance companies have a greater need for liquidity than life insurance companies 186 Liquidity Risk and Mutual Funds Question Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds assets However, the way MFs are valued reduces the incentive of fund shareholders to engage in bank-like runs on any given day assets are distributed on a pro rata basis losses are incurred to shareholders on a proportional basis The following is the balance sheet of an DI in millions: Assets Liabilities and Equity Cash $ 2 Demand deposits $50 Loans $50 Plant and equipment $ 3 Equity $ 5 Total $55 Total $55 The asset-liability management committee has estimated that the loans, whose average interest rate is 6 percent and whose average life is 3 years, will have to be discounted at 10 percent if they are to be sold in less than two days. If they can be sold in 4 days, they will have to be discounted at 8 percent. If they can be sold later than a week, the DI will receive the full market value. Loans are not amortized; that is, principal is paid at maturity. a. What will be the price received by the DI for the loans if they have to be sold in two days. In four days? Price of loan = PVAn=3,k=10(3) + PVn=3, k=10(50) = $45.03 if sold in two days. = Int * PVIFA k,n + M * PVIF k, n = 3*(1-1/1.1^3)/ /1.1^3 Price of loan = PVAn=3,k=8(3) + PVn=3, k=8(50) = $47.42 if sold in four days Post Raj Pokharel, M.Phil, Ph.D. Scholar,

48 Question Question Consider the assets (in millions) of two banks, A and B. Each bank is funded by $120 million in deposits and $20 million in equity. Which bank has the stronger liquidity position? Which bank probably has a higher profit? Bank A Asset Bank B Assets Cash $10 Cash $20 Treasury securities $40 Consumer loans $30 Commercial loans $90 Commercial loans $90 Total Assets $140 Total Assets $140 A NOW account requires a minimum balance of $750 for interest to be earned at an annual rate of 4 percent. An account holder has maintained an average balance of $500 for the first six months and $1,000 for the remaining six months. She writes an average of 60 checks per month and pays $0.02 per check, although it costs the bank $0.05 to clear a check Question a. What average return does the account holder earn on the account? Gross interest return = Explicit interest return + Implicit interest return Interest earned by account holder $1,000 x (0.04/2) = $20.00 Implicit fee earned on checks $0.03 x 60 x 12 = $21.60 Average deposit maintained during the year ½(500) + ½(1,000) = $ Average interest earned = $41.60/750 = 5.55 percent b. What is the average return if the bank lowers the minimum balance to $400? If the minimum balance requirement is lowered to $400, the account holder earns an extra $500 x (0.04/2) = $10 in interest. The average interest earned = $51.60/750 = 6.88 percent. c. What is the average return if the bank pays interest only on the amount in excess of $400? Assume that the minimum required balance is $400. If the bank only pays interest on balances in excess of $400, the explicit interest earned = $100 x $600 x 0.02 = $2 + $12 = $14. The implicit fee earned on checks = $21.60, and the average interest earned = $35.60/$750 = 4.75% 191 Question Colonial Bank is considering a new consumer loan product. The loans will carry an interest rate of 15%, but the rate earned by Colonial Bank, after deducting operating expenses and allowed for bad debts will be 11%. Colonial bank can raise additional deposit funds at an interest rate of 9.5% but operating costs associated with these deposits will bring the effective interest rate to 10.5%. Colonial is required to maintain equity equal to 5% of total assets (I.e. Colonial raise deposit of only $95 for each $100 of loans), pays a tax rate of 34%, and must earn 15% return on equity to satisfy investors. Is the Loan product profitable? 192 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

49 Community Federal plans to raise additional funds through the sale of one year certificate of deposit. The certificates will carry 9% interest, with annual compounding, and the estimated cost of attracting one $1000 certificate is $20. The reserve requirement is 10%, and the reserves will earn 4%. Compute the cost of funds. Cost of funds = I e + E I S Question d R Where, I e = dollar annual interest paid on interest-bearing deposits E = annual cost of attracting and serving accounts Ir = Annual interest received on reserves, if any Sd = Average value of interest bearing deposits. R = Amount of required reserves for these deposits. r Question Neighborhood Bank has total assets of$110 million, with $100 million coming from deposits and $10 million coming from equity. The interest paid on deposit funds is 6%, and the cost of attracting and administering these accounts equals 1% of the average balance of deposits. The before tax cost of equity is 20%. The bank is required to maintain noninterest bearing liquid assets equal to 10% of deposits. Compute the cost of deposits. Compute the overall required return on funds available for investment. 1. The following details of its deposits accounts Account types Rs Avg Int rate(%) non-int rate(%) Checking(demand) a/c Now account Saving deposit Certificate of Deposit Money market deposit Non deposit borrowings The funds available for investment is about 80% of total deposits. Required: What is bank's historical average interest cost? What is the bank's average historical cost of funds raising? What is the minimum return on the earning assets to cover the firm's funds-raising costs? If the firm's equity is Rs. 10,00,000 and the required rate on equity is 15%. At what ratedoesthefirminvestinearningassets? shiva.sharma@mbl.com.np ramakandel2002@gmail.com acharya.aruna94@gmail.com kalwarsabi@gmail.com MBA IV Semester Management of Financial Institutions UNIT VIII Interest Rate Risk in Financial Institutions LH 6 POST RAJ POKHAREL M.Phil. (TU) 01/2010) 196 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

50 UNIT VIII: Interest Rate Risk Management in Financial Institutions LH 6 Overview of Interest Rate Risk Overview of Interest Rate Risk Management. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Insolvency Risk Management. The asset transformation function performed by financial institutions (FIs) often exposes them to interest rate risk FIs use (at least) two methods to measure interest rate exposure the repricing model ( the funding gap model) examines the impact of interest rate changes on net interest income (NII) the duration model examines the impact of interest rate changes on the overall market value of an FI and thus ultimately on net worth Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. The repricing or funding gap is the difference between those assets whose interest rates will be repriced or changed over some future period and liabilities whose interest rates will be repriced or changed over some future period Quarterly reporting of commercial bank assets and liabilities is detailed by maturity bucket (or bin) one day more than one day to 3 months more than 3 months to 6 months more than 6 months to 12 months more than 1 year to 5 years more than 5 years 199 The gap in each bucket or bin is measured as the difference between the rate-sensitive assets (RSAs) and the rate-sensitive liabilities (RSLs) rate-sensitivity measures the time to repricing of an asset or liability The cumulative gap (CGAP) is the sum of the individual maturity bucket gaps The cumulative gap effect is the relation between changes in interest rates and changes in net interest income 200 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

51 Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. The change in net interest income for any given bucket i ( NII i ) is measured as: NII i = (GAP i ) R i = (RSA i RSL i ) R i where GAP i = the dollar size of the gap between the book value of rate-sensitive assets and rate-sensitive liabilities in maturity bucket i R i = the change in the level of interest rates impacting assets and liabilities in the ith maturity bucket A common cumulative gap of interest to commercial bank managers is the one-year repricing gap estimate: NII = 1 year i= 1 day RSA i 1 year i= 1 day RSL R i i where NII is the cumulative change in net interest income from all rate-sensitive assets and liabilities that are repriced within a year given a change in interest rates R i Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change NII i = (RSA i x R RSA ) (RSL i x R RSL ) 203 Question Assets Liabilities and Equity Cash $10 Overnight Repos $170 1 month T-bills (7.05%) 75 Subordinated debt 3 month T-bills (7.25%) 75 7-year fixed rate (8.55% year T-notes (7.50%) 50 8 year T-notes (8.96%) year munis (floating rate) (8.20% reset every 6 months) 25 Equity 15 Total Assets $335 Total Liabilities & Equity $335 a. What is the funding or repricing gap if the planning period is 30 days? 91 days? 2 years? Recall that cash is a noninterest-earning asset. b. What is the impact over the next 30 days on net interest income if all interest rates rise 50 basis points? Decrease 75 basis points? c. The following one-year runoffs are expected: $10 million for two-year T-notes, and $20 million for eight-year T-notes. What is the one-year repricing gap? d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates rise 50 basis points? Decrease 75 basis points? 204 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

52 Questions a. What is the funding or repricing gap if the planning period is 30 days? 91 days? 2 years? Recall that cash is a noninterest-earning asset. Funding or repricing gap using a 30-day planning period = = -$95 million. Funding gap using a 91-day planning period = ( ) = -$20 million. Funding gap using a two-year planning period = ( ) = +$55 million. b. What is the impact over the next 30 days on net interest income if all interest rates rise 50 basis points? Decrease 75 basis points? Net interest income will decline by $475,000. NII = FG( R) = -95(.005) = -$0.475m. Net interest income will increase by $712,500. NII = FG( R) = -95(-.0075) = $0.7125m. The following one-year runoffs are expected: $10 million for two-year T-notes, and $20 million for eight-year T-notes. What is the one-year repricing gap? Funding or repricing gap over the 1-year planning period = ( ) = +$35 million. d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates rise 50 basis points? Decrease 75 basis points? Net interest income will increase by $175,000. NII = FG( R) = 35(0.005) = $0.175m. Net interest income will decrease by $262,500, NII = FG( R) = 35( ) = -$0.2625m. 205 Assets $ Rate Liabilities & Equity $ Rate Rate sensitive $3, % Rate sensitive $2, % Nonrate sensitive 1, Nonrate sensitive 2, Nonearning 500 Equity 1,000 $5,000 $5,000 a. Calculate the expected net interest income at current interest rates and assuming no change in the composition of the portfolio. What is the net interest margin? b. Assuming that all interest rates rise by 1 percentage point, calculate the new expected net interest income and net interest margin. a. Net interest income = $3,000 (.10) + $1,500 (.09) $2,000 (.08) $2,000 (.07) = $435 $300 = $135 Net interest margin = $135/$4,500 = 0.03 or 3.0% b. Net interest income = $3,000(0.11) +$1,500(0.09) $2,000(0.09) -$2000*(.07)= $145 Net interest margin = $145/$4,500 = = 3.22% 206 Assets Liabilities and Equity Cash $60 Demand deposits $140 5-year treasury notes$60 1-year Certificates of Deposit $ year mortgages $200 Equity $20 Total Assets $320 Total Liabilities and Equity $320 What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or decrease in interest rates? Explain why? M A = [0*60 + 5* *30]/320 = years, and M L = [0* *160]/300 = Therefore the maturity gap = MGAP = = years. Nearby bank is exposed to an increase in interest rates. If rates rise, the value of assets will decrease much more than the value of liabilities. County Bank has the following market value balance sheet (in millions, annual rates): Assets Liabilities and Equity Cash $20 Demand deposits $ year commercial 10% 5-year 6% interest, interest, balloon payment $160 balloon payment $ year 8% interest, 20-year 7% interest $120 monthly amortizing $300 Equity $50 Total Assets $480 Total Liabilities & Equity $480 a. What is the maturity gap for County Bank? b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1 percent? c. What will happen to the market value of the equity? d. If interest rates increased by 2 percent, would the bank be solvent? Post Raj Pokharel, M.Phil, Ph.D. Scholar,

53 a. What is the maturity gap for County Bank? M A = [0* * *300]/480 = years. M L = [0* * *120]/430 = 8.02 years. MGAP = = years. b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1 percent? If interest rates increase one percent, the value and average maturity of the assets will be: Cash = $20 Commercial loans = $16*PVIFA n=15, i=11% + $160*PVIF n=15,i=11% = $ Alternatively, =-D(Change in Y/1+y) = Where Duration, D = 8.12 years Mortgages = $2.201,294*PVIFA n=360,i=9% = $ M A = [0* * *30]/( ) = years The value and average maturity of the liabilities will be: Demand deposits = $100 CDs = $12.60*PVIFA n=5,i=7% + $210*PVIF n=5,i=7% = $ Debentures = $8.4*PVIFA n=20,i=8% + $120*PVIF n=20,i=8% = $ M L = [0* * *108.22]/( ) = 7.74 years The maturity gap = MGAP = = years. The maturity gap increased because the average maturity of the liabilities decreased more than the average maturity of the assets. This result occurred primarily because of the differences in the cash flow streams for the mortgages and the debentures. c. What will happen to the market value of the equity? The market value of the assets has decreased from $480 to $ , or $ The market value of the liabilities has decreased from $430 to $409.61, or $ Therefore the market value of the equity will decrease by $ $20.69 = $17.239, or percent. d. If interest rates increased by 2 percent, would the bank be solvent? The value of the assets would decrease to $409.04, and the value of the liabilities would decrease to $ Therefore the value of the equity would be $ Although the bank remains solvent, nearly 65 percent of the equity has eroded because of the increase in interest Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Duration measures the interest rate sensitivity of an asset or liability s value to small changes in interest rates % in the market value of a security D = R /(1 + R) The duration gap is a measure of overall interest rate risk exposure for an FI To find the duration of the total portfolio of assets (D A ) (or liabilities (D L )) for an FI first determine the duration of each asset (or liability) in the portfolio then calculate the market value weighted average of the duration of the assets (or liabilities) in the portfolio 210 Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. The change in the market value of the asset portfolio for a change in interest rates is: A = A ( D R ) (1 + R) Similarly, the change in the market value of the liability portfolio for a change in interest rates is: R L = L ( D ) L (1 + R) A Finally, the change in the market value of equity of a FI given a change in interest rates is determined from the basic balance sheet equation: A = L + E A = L + E By substituting and rearranging, the change in net worth is given as: R E = ( D kd ) A A L (1 + R) where k is L/A = a measure of the FI s leverage Post Raj Pokharel, M.Phil, Ph.D. Scholar,

54 Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. The effect of interest rate changes on the market value of equity or net worth of an FI breaks down to three effects the leverage adjusted duration gap = (D A kd L ) measured in years reflects the duration mismatch on an FI s balance sheet the larger the gap the more exposed the FI to interest rate risk the size of the FI the size of the interest rate shock Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model. Difficulties emerge when applying the duration model to real-world FI balance sheets duration matching can be costly as restructuring the balance sheet is time consuming, costly, and generally not desirable immunization is a dynamic problem duration of assets and liabilities change as they approach maturity the rate at which the duration of assets and liabilities change may not be the same duration is not accurate for large interest rate changes unless convexity is modeled into the measure convexity is the degree of curvature of the price-yield curve around some interest rate level 215 Calculation of Duration As a management trainee assigned to the bank s Asset/Liability Management committee, you have been asked to calculate the duration of each of the following loans: a. $20,000 principal, $4,500 payments per year for five years. b. $20,000 principal, $4,200 payments per year for five years Assume that the bank s current required return on these types of loans is 8%. ANSWER: a. Present Present Value Adjusted Value of Adjusted Year Cash Flow Cash Flow Factor Cash Flow 1 $4,500 $4, $4, ,500 9, , ,500 13, , ,500 18, , ,500 22, ,322 $51,151 Duration = $51,151/20,000 = 2.56 years. b. Present Present Value Adjusted Value of Adjusted Year Cash Flow Cash Flow Factor Cash Flow 1 $4,200 $4, $3, ,200 8, , ,200 12, , ,200 16, , ,200 21, ,301 $47,741 Duration = $47,741/$20,000 = 2.39 years. 216 Post Raj Pokharel, M.Phil, Ph.D. Scholar,

55 Question: Suppose DA = 3 years, DL = 6 years, k =.8, and A = $100million. What is the effect on owners net worth if R/(1 + R) rises 1 percent? (E = $1,800,000) 219 Insolvency Risk Management To ensure survival, an FI manager must protect against the risk of insolvency The primary protection against the risk of insolvency is equity capital capital is a source of funds capital is a necessary requirement for growth under existing minimum capital-to-asset ratios set by regulators Managers prefer low levels of capital in order to generate higher return on equity (ROE) the moral hazard problem exacerbates this tendency the result is an increased likelihood of insolvency 220 Post Raj Pokharel, M.Phil, Ph.D. Scholar,