Chapter

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The Financial Services Industry: Depository Institutions

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Definitions of Bank

The word BANK is derived from Latin word BANKO/BANCUS which means a bench. Derived from a German word BACK which means joint stock fund. A bank can be classified into several types on the basis of functions, ownership, status and domicile.

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Definitions

Professor Gilbert A bank or banker is a dealer in capital, or, more properly a dealer in money. He is an intermediary party between the borrower and the lender.

Professor Kinly A bank is an institution which receives deposits and advances loans According To English Finance Act 1915 Bank is the institution which is engage in the banking business under the rules of banking

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Commercial Banks
Definition (Banking Companies Ordinance 1962)

A bank is an institution which deals in debts of his own and others. It receives deposits from the people who have surplus money and lends to the people in need. Banking means the accepting deposits from the public for the purpose of lending or investment, repayable on demand and with drawnable by cheques ,drafts, order or otherwise.

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Commercial Banks
Largest depository institutions are commercial banks measured by size. Accept deposits and make loans.

Major source of funding is Deposits

Loans are Consumer , Commercial , International and Real Estate loans. http://www.sbp.org.pk/f_links/index.asp

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Structure of Financial Sector in Pakistan

Scheduled Banks (47) - Commercial banks - Specialised banks NBFIs - Modarabas - Leasing companies - Mutual funds - Specialised financial (DFIs) - Investment banks - Housing Finance Companies

Specialised Banks

Commercial Banks

Foreign Banks (22)

Domestic Banks (25)

Functions of Commercial Banks

Commercial Banks

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Primary Functions

Agency Functions

General Functions

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Primary Functions
1. RECEIVING DEPOSITS Commercial banks receive deposits from the people who have surplus money and willing to deposit with banks for the purpose of safety and interest etc.

To meet the needs of people the banks offer following deposit schemes: Current Account Saving Account Fixed Deposit (Term Deposits) Profit and Loss Sharing (PLS) accounts Foreign Currency Accounts

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Primary Functions
2. ADVANCING LOANS Commercial bank lend the money collected from the people under different accounts, to the borrowers. The bank provide loans in the following shapes.
Cash credit Over draft Call loans Discounting of bills Investment loans
Short-term loans Medium-term loans Long-term loans

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Functions of Commercial Banks

Agency Functions
Collection & Payment Services Purchase & Sale Service Execution of Standing Instructions Collection of Dividends and Interest on Securities Transfer of Funds Bank as Guarantor Income Tax Facility Collection of Zakat

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Functions of Commercial Banks

General Utility Functions

Issuance of Letter of Credit Discounting of Bills Issuance of Travelers Cheques Lockers Facility Foreign Exchange Transactions Act as an under writer Compile Statistics

The role of Commercial Banks in the Economic Growth & development of a country

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Mobility of savings The banks by launching a vigorous campaign both in the villages and cities can mobilize the idle savings and can increase the investment rate in all sectors which leads to economic growth of a country. Capital formation Generation of savings Mobilization of savings Credit creation Agricultural development Industrial development Employment Trade expansion Help to government

The role of Commercial Banks in the Economic Growth & development of a country

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Help to central bank Promotion of savings Income distribution :Commercial banks borrow from the people of the
higher-income group and lend it to the people of the lower income group. Poverty alleviation :Commercial bank help the poor people by lending money so as to improve their standard of life Creation and distributors of money: They purchases securities and allow money to play an active role in the economy. Influencing economic activity: Commercial banks influence economic activity in two ways. First by lowering the interest rate. Secondly , by making the capital available to the investors. Export promotion cell: To boost up exports, banks have established export promotion cells to provide information and guidance to exporters. Through this, export volume increases, which fetches more foreign exchange.

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Bank Sources of Funds

Deposit Accounts
Transaction deposits Savings deposits Time deposits Money market deposit accounts

Borrowed Funds
Federal funds purchased (borrowed) Borrowing from the central bank Repurchase agreements

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Bank Sources of Funds

Long term sources of funds

Bonds issued by the bank Bank capital

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Sources of Funds: Deposit Accounts

Transaction deposits
Demand deposit account
Require a small minimum balance and pays no interest

Negotiable order of withdrawal

Provide checking services as well as interest services

Saving deposits

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Sources of Funds: Deposit Accounts

Time deposits
Deposits that cannot be withdrawn until a specified maturity date

Certificates of deposits (Retail CDs)

Requires a minimum amount of funds to be deposited for a specified period of time Annualized interest rates offered on CDs vary among banks, and even among maturity types at single bank Some FIs have begun to offer CDs with a callable features No organized secondary market

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Sources of Funds: Deposit Accounts

Negotiable Certificates of Deposits
Some large banks offer to companies Similar to retail CDs Secondary market does exist The level of large time deposits is much more volatile than that of small time deposits

Money Market Deposit Accounts

Different from conventional time deposits in that they do not specify a maturity More liquid than retail CDs from the depositors point of view

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Sources of Funds: Borrowed funds

Federal funds purchased (Borrowed)

This allows depository institutions to accommodate the short term liquidity needs of other financial institutions federal funds purchased represent a liability to the borrowing bank and an asset to the lending bank sells them
Loans in the federal funds market are typically for one to seven days. A bank may act as a lender of federal funds on one day and as borrower shortly thereafter, as its funds balance changes every day.

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Sources of Funds: Borrowed funds

Interest rates charged in the federal funds market is called federal fund rate If many banks have excess funds and few banks are short of funds, the federal funds rate will be low.

Borrowing from the central bank

Central bank also provide short term loans to banks (as well as to some other depository institutions) This is called borrowing at discount window. Interest rate charged on these loans is known as discount rate.

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Sources of Funds: Borrowed funds

Banks rely on the central banks fund market for normal short term financing, and use of discount window as a last resort. Loans from the discount window are short term , commonly from one day to a few weeks.

Banks that wish to borrow at that discount window must first obtain the central banks approval.
Discount window is mainly used to resolve a temporary shortage of funds. This is the source of funds for banks that experience unanticipated shortages of reserves.

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Sources of Funds: Borrowed funds

Repurchase Agreements
REPO represents the sale of securities by one part to another with an agreement to repurchase the securities at a specified date and price.
Banks often use a REPO as a source of funds when they expect to need funds for just few days.

The bank simply sells some of its government securities to a corporation with a temporary excess of funds and buys those securities back shortly thereafter.

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Sources of Funds: Borrowed funds

The government securities involved in the REPO transaction serve as security for the corporation providing funds to the bank. REPO transactions occur through a telecommunication network connecting large banks, other corporations, government securities dealers, and federal funds brokers. The federal funds brokers match up firms or dealer that need funds with those that have excess funds.

The yield on REPO agreements is slightly less than the federal funds rate at any given point in time because the funds loaned out are backed by collateral.

Sources of Funds: Borrowed funds Long term Sources

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Bonds issued by the bank

Fixed assets (land, building, etc.) of banks are usually financed by the issuance of bonds Such bonds are purchased by the households and various financial institutions.

Bank capital

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Uses of Funds by Banks

Cash Bank loans Investment in securities Federal funds sold (loaned out) Repurchase agreements Eurodollar loans Fixed assets

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Uses of Funds: Cash

Cash
Bank must hold some cash as reserves to meet the reserve requirement enforced by the central bank

Banks also hold cash to maintain some liquidity and accommodate any withdrawal requests by depositors.
Bank do not earn income from cash, they hold only as much cash as is necessary to maintain a sufficient degree of liquidity.

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Uses of Funds: Bank Loans

Bank loans
Working Capital Loan ( self liquidating loan) Term loans
Used primarily to finance the purchase of fixed assets Assets purchased with the borrowed funds may serve as partial or full collateral on the loan Contains Protective agreements because of long term

Direct lease loan

Bank can purchase the asset and leasing them to the firm in need

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Uses of Funds: Bank Loans

Bank loans
Informal line of credit
Which allow the business to borrow up to specified amount within a specified period of time This useful for the firms that may experience a sudden need for funds but do not know precisely when The interest rate charged on any borrowed funds is typically adjustable in accordance with the prevailing market rates. Banks are not legally obligated to provide funds to the business, but they usually honor the arrangement to avoid harming their reputation

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Uses of Funds: Bank Loans

Revolving credit line
Which obligates the bank to offer up to some specified maximum amount of funds over a specified period of time ( typically less than five years) Bank charge a commitment fee on any unused funds

Loan Participation
Some large corporation wish to borrow a large amount of funds than any individual bank is willing to provide. To accommodate a corporation, several banks may be willing to pool their available funds in what is referred to as loan participation.

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Uses of funds by banks

Most common form, one of the banks serves as the lead bank by arranging for the documentation, disbursement, and payment structure of the loan. The main role of the other banks is to supply funds that are channeled to the borrower by the lead bank. The borrower may not even realized that much of the funds have been provided by other banks. As interest payments are received, the lead bank passes the payment on to the other participants in proportion to the original loan amounts they provided.

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Uses of funds by banks

The lead bank receive fees for servicing the loan in addition to its share of interest payments. All participating banks are exposed to credit risk.

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Uses of funds by banks

Loans supporting Leveraged buyouts

Some commercial banks finance leveraged buyouts LBO financing is the relatively high loan rate that can be charged.

Collateral requirements on business loans

Commercial banks are increasingly accepting intangible assets (patents, brand name) as collateral for commercial loans. This is important to service oriented companies that do not have tangible assets.

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Uses of funds by banks

Types of consumer loans

Installment loans
Commercial banks provide installment loans to individuals to finance purchase of cars and household products Periodic payments Credit cards Interest rate on credit card loans and personal loans ID typically much higher than the cost of funds

Real estate loans

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Investment in securities

Bank purchase Treasury securities as well as securities issued by agencies of the federal government.
Banks also purchase corporate bonds

Risk and Returns

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Federal funds sold

Some banks often lend funds to other banks in the federal funds market. The fund sold or lent out, will be returned at the time specified in the loan agreement, with interest

The loan period is typically very short, such as a day or few days
If the transaction is executed by a broker, the borrowers cost on a federal funds loan is slightly higher than the lenders return, because the broker matching up the two parties charges a transaction fee.

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Off-Balance sheet activities

Loan commitment Standby letters of credit Forward contract Swap contracts

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Off-Balance sheet activities

Loan commitment
A loan commitment is an obligation by a bank to provide a specified loan amount to particular firm upon the firms request The interest rate and purpose of the loan may also be specified The bank charges a fee for offering the commitment

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Off-Balance sheet activities

Standby Letters of Credit Forward Contract Swap Contract

Banks also serve as intermediaries for interest rate swaps, where by two parties agree to periodically exchange interest payments on a specified estimated amount of principal Bank receives a transaction fee for its services If it guarantees payments to both parties, it is exposed to the possibility that one of the parties will default on its obligation.

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End of Chapter Thank you