The ‘ABC’ of the Important Pillars of Banking Industry
Posted in Finance Articles, Total Reads: 2473
, Published on 17 July 2014
The term “Bank” is derived from an old Italian word ‘banca’ or from French word ‘Banque’ both meaning a Bench or money exchange table. Banking industry plays a crucial role in the development of an economy. Banks are an institution of money exchange also acts as a ‘Safety Vault’ where one can park their excess funds and get assured returns with a good interest rate. The structure of the banking industry is also vast- from scheduled commercial banks to scheduled co-operatives, which are further divided into public sector banks, private sector banks, foreign banks etc.
Despite this structural variance, certain key parameters remain the same for any bank that operates in India. The following alphabetical description will give an insight into those parameters which form important pillars on which banks operate and contribute to the economic prosperity.
Assets - An asset is an item of economic value which is capable of generating income. Business entities function with the aim of maximizing their assets which could be cash, equipments and machinery etc. The biggest asset for the banking industry is their Loans and Advances on which they get assured returns along with the interest rate charged on the principal amount.
Basel Norms - The Basel guidelines have been formulated by the Basel Committee on Banking Supervision (BCBS) which focuses on risks to banks and financial institutions. Till date three Basel accords have been framed: Basel I, Basel II and Basel III. Basel II is a refined version of Basel I with more risk sensitivity, recognition of credit risk and maintenance of minimum capital. Now Basel III norms have been formulated which aim to improve the banking sector’s ability to absorb potential losses, improve risk management and governance and strengthen transparency and disclosures. Basel III is proposed to be implemented in India by January 2019.
Capital Adequacy – It is a measure of financial strength of a bank and is defined as the amount of capital relative to its assets. It stipulates that banks should hold a certain minimum equity capital relative to the risk weighted assets. Capital adequacy standards are laid down by the Basel Committee.
Deposits - Deposits refer to the money placed in the bank for safekeeping. Banks have a variety of deposit accounts to meet the requirements of customers. Broad categories of deposits include Demand Deposits and Time Deposits. Individuals who hold deposit accounts in banks earn a fixed interest as stipulated by the RBI or the bank itself.
Equated Monthly Instalment (EMI) - Banks prefer lending money to those customers from whom they can expect fixed and timely returns. Borrowers pay back the borrowed amount in the form of equated monthly instalments (EMIs). An EMI is a fixed amount of payment made by the borrower to the lender on a fixed date of each month. An EMI has two essential components: A fixed Principal and Interest on the principal amount.
Financial Inclusion - Financial Inclusion is the delivery of banking and financial services at affordable costs to the poor and disadvantaged sections of the society. It has been given utmost priority by the RBI and government of India because even today, 60% of the population is deprived of the banking services.
Guarantor - When bank grants loan to the needy customers, it also requires a promise that the borrower will repay the principal amount along with the interest within the specified time. Here comes the role of a guarantor who, on behalf of the borrower guarantees the bank to pay back the amount in case he defaults on the loan.
Hurdle Rating – Customers have to achieve a minimum rating to become eligible for a loan. This is known as ‘Hurdle Rating’ criterion to be achieved by the new borrower. Hence the hurdle rate is defined as the bank’s minimal rate of return in extending a loan or in making investments.
Interest Rate - For every loan extended by the bank, interest is charged on the principal amount which could be fixed or floating in nature. Similarly for every savings or term deposits, the bank pays a fixed interest rate. Thus interest rate is the percent charged or paid for the use of assets.
Know Your Customer (KYC) guidelines - For opening any deposit account, banks have to follow certain due diligence process under ‘Know Your Customer’ guidelines. These guidelines have been issued for customer identification to determine their true identity, source of funds, and nature of customer’s business. KYC guidelines have been issued by the Reserve Bank of India in the context of Anti-Money Laundering and Combating Financing of Terrorism.
Liability Management – For banks, deposits and money secured from other investors constitute liabilities. Liability management involves equilibrium between interest rates on deposits and loans and maintaining the gap between the maturity of assets and liabilities.
Maturity – Banks are the most trusted places where one can park their excess funds in the form of demand deposits or time deposits. The term maturity is used in the context of time deposits such as fixed deposits, recurring deposits etc. Maturity is the time period at which the amount of the deposits has to be returned to the investors.
Non- Performing Assets (NPAs) - NPAs have become the darkest clouds hovering over the finance and banking industry today. This has deeply eroded the health of the banking sector. An asset of a bank becomes an NPA when it fails to generate income for the bank. Subsequently, an asset is classified as NPA if any interest or principal instalments remain overdue for more than 90 days.
Online Banking – Online banking or internet banking or e-banking is an innovative tool which enables the customers to access banking services 24*7. It is an electronic system or a website operated by the institutions to facilitate real-time access to banking services.
Principal Amount – Banks deal with the vast amount of money that is either invested in the form of deposits or lent in the form of loans. The principal amount is the face amount of any financial instrument on which interest accrues.
Reserve Bank of India - The big ‘R’ word in the Indian banking industry is the Reserve bank of India (RBI) which is the central bank of the country. It is also known as ‘Banker of the Banks’ as it regulates the commercial banks in the country by holding a part of their demand and time liabilities in the form of Cash Reserve Ratio, Statutory Liquidity Ratio and other provisions. Apart from this, it also determines key policy rates by framing the monetary policy, issue currency of any denomination, controls the money supply and supervises banks as well.
SARFAESI Act - SARFAESI Act is known as Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. It is an effective tool for NPA recovery and is applicable where NPAs are backed by collateral securities. Upon default on the loans, banks can seize the securities without intervention of the court. This tool has been very effective as banks have been able to recover 18,500 Crore through the mortgage or sale of securities that were backing NPAs.
Tier Capital – Bank capital is often defined in tiers such as Tier 1, Tier 2, and Tier 3. Tier 1 capital is the core capital, which includes common stock and retained earnings while Tier 2 capital represents supplementary capital.
Wilful Default – Wilful default occurs when the party defaults in making payment, even when it has the capacity to pay or when it diverts the finances away from the purpose for which it was availed. Wilful default has gained limelight due to cases of Kingfisher Airlines. Wilful default attract some penal measures such as denied accessibility to the market, banks and financial institutions, lists of the wilful defaulters being submitted to the credit information bureau if the outstanding amount exceeds 25 lakhs.
Yield – Yield in banking signifies the percentage of return earned by a loan portfolio. It can be calculated by multiplying the outstanding amount by the effective interest rate paid by the borrowers.
Zero Balance account – Also known as ‘no- frills’ account, zero balance account is an initiative taken by the RBI to promote financial inclusion. Such type of accounts requires nil or very low minimum balance to be kept in the account. This move has been taken to reach out to the people living below the poverty line.
The banking industry is an ever growing industry and forms the backbone of the economy. The soundness of an economy depends on the health of its banking sector. Banking industry contributes nearly 10% to the GDP of our country. The new bank licenses, financial and banking sector reforms and other measures to strengthen banks would enable banking industry to reach the ‘zenith’ of success.