The Financial Services Industry: Depository Institutions

1. The Financial Services Industry: Depository Institutions

2. 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.

3. 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”

4. 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”.

5. 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

6. Structure of Financial Sector in Pakistan NBFIs Scheduled Banks - Modarabas (47) - Leasing companies - Commercial banks - Mutual funds - Specialised banks - Specialised financial (DFIs) - Investment banks - Housing Finance Companies Specialised Banks Commercial Banks Foreign Banks Domestic Banks (22) (25)

7. Functions of Commercial Banks Commercial Banks Primary Functions Agency Functions General Functions

8. 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

9. 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

10. 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

11. Functions of Commercial Banks • General Utility Functions • Issuance of Letter of Credit • Discounting of Bills • Issuance of Traveler’s Cheques • Lockers Facility • Foreign Exchange Transactions • Act as an under writer • Compile Statistics

12. 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 • Mobilization of savings • Credit creation • Agricultural development • Industrial development • Employment • Trade expansion • Help to government

13. 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.

14. 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

15. Bank Sources of Funds • Long term sources of funds • Bonds issued by the bank • Bank capital

16. 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

17. 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

18. 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 depositor’s point of view

19. 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.

20. 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.

21. Sources of Funds: Borrowed funds • Banks rely on the central bank’s 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 bank’s 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.

22. 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.

23. 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.

24. 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

25. Uses of Funds by Banks • Cash • Bank loans • Investment in securities • Federal funds sold (loaned out) • Repurchase agreements • Eurodollar loans • Fixed assets

26. 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.

27. 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

28. 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

29. 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.

30. 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.

31. 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.

32. 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.

33. 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

34. 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

35. 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 lender’s return, because the broker matching up the two parties charges a transaction fee.

36. Off-Balance sheet activities • Loan commitment • Standby letters of credit • Forward contract • Swap contracts

37. 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 firm’s request • The interest rate and purpose of the loan may also be specified • The bank charges a fee for offering the commitment

38. 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.