Chapter

The Financial Services

Industry: Depository
Institutions

2-1

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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 engaged in the banking business
under the rules of banking

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Commercial Banks
Definition (Banking Companies Ordinance 1962)
Banking means the accepting deposits of money from the public
for the purpose of lending or investment, repayable on demand or
otherwise, and withdrawable by cheque ,draft, order or otherwise.
Banking Company means any company which transacts the
business of banking in Pakistan and includes their branches and
subsidiaries functioning outside Pakistan of banking companies
incorporated in Pakistan.
A bank is an institution which deals in debts of its own and others.
It receives deposits from the people who have surplus money and
lends to the people in need.

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Exempted

Any company which is engaged in the

manufacture of goods and carries on any trade
and which accepts deposits of money from the
public merely for the purpose of financing its
business as such manufacture or trader shall not
be deemed to transact the business of banking
within the meaning of this clause.

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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
- Commercial banks
- Specialised banks

NBFIs
- Modarabas
- Leasing companies
- Mutual funds
- Specialised financial (DFIs)
- Housing Finance Companies

Specialised Banks

Foreign Banks

Commercial Banks

Domestic Banks

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Functions of Commercial Banks

Commercial Banks

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

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The role of Commercial Banks in the Economic

Growth & development of a country

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
Credit creation
Agricultural development
Industrial development
Employment
Trade expansion
Help to government

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The role of Commercial Banks in the Economic

Growth & development of a country

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

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.

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Sources of Funds: Borrowed funds
Long term Sources

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
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