Indicators In Banking System

The Role of Financial Indicators in Banking System AN ASSIGNMENT ON “THE ROLE OF FINANCIAL INDICATORS IN THE BANKING SYSTEM”

Submitted to: Ms. SONALI PATTNAIK Faculty, P.G. Deptt. of Finance, VISWASS

Submitted by: Ms. SHRADHANJALEE PANDA, MFC, 2nd Year Ms. SUBHADRA NYAYAPATHI, MFC, 2nd Year, and Mr. SANTOSH KUMAR SAHOO, MFC, 2nd Year

VIVEKANANDA INSTITUTE OF SOCIAL WORK AND SOCIAL SCIENCES (AFFILIATED TO UTKAL UNIVERSITY) BAPUJI NAGAR, BHUBANESWAR-751009

INTRODUCTION 1

The Role of Financial Indicators in Banking System India has had a long history of banking in so far as purveying of credit is concerned. There are references to lending for interest and the social-religious sanctions governing the norms relating to these activities even in the ancient Indian scriptures like Manusmriti and Arthasastra. However, some Madras-based officers of the East India Company as it is understood today attempted the establishment of banking of the western-type only as early as 1683. Today Indian banking has come a long way since then in terms complexity of operations and the elaborates of the structure. The Indian banking structure comprises a heterogeneous mass covering a wide spectrum ranging from the unorganized indigenous bankers at the one end to the foreign banks at the other. Unlike a small drop of water that has the ability to create waves on the entire surface of a pond, likewise there are some financial indicators that affect the total banking system and impact the operations and solvency of the banking industry. These indicators play an important role for the smooth and sustainable functioning and growth of the banking system as well as the economy as a whole.

FINANCIAL INDICATORS AND THEIR ROLE IN BANKING SYSTEM In this fast changing world of LPG (Liberalisation, Privatisation and Globalisation) where hundreds of “Lehman Brothers” became bankrupt within a fraction of moment, it has became necessary to look in to the financial market and towards the financial indicators to formulate proactive as well as reactive strategies. Some of the most effective indicators playing an important role in the banking system are: 1. The Cash Reserve Ratio (CRR) 2. The Statutory Liquidity Ratio (SLR) 3. The Bank Rate 4. Repo Rate and Reverse Repo Rate 5. Capital Adequacy Ratio 6. Prime Lending Rate (PLR) 7. Call Rate 8. Coupon Rate

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The Role of Financial Indicators in Banking System 9. The MIBID and MIBOR 10. Priority Sector Lending (PSL) 11. Gold Price 12. Gross Domestic Product (GDP) 13. Exchange Rate 14. Rate of Inflation 15. Rate of Savings 16. Stock Market Indices

The indicators and the role they play in the banking system are discussed below:

1. CASH RESERVE RATIO (CRR)  CRR is the amount of cash reserve that is required to be maintained by every bank in India, (other than a scheduled bank) by way of cash reserve either with itself or in current with RBI, SBI, or any other notified bank or partly with itself and partly in such current account.  It is computed as a percentage on the total Demand and Time Liabilities (DTL) of the bank.  It’s a statutory requirement stipulated under section 18 of the Banking Regulation Act, 1949.  Presently, the CRR is 5% as fixed by the RBI.  Role of CRR: •

If the RBI wants to put a check on credit expansion, it raises the CRR, conversely when it is required to induce, to facilitate credit expansion, the CRR is lowered. 3

The Role of Financial Indicators in Banking System •

The main purpose of the CRR is to safeguard the liquidity position of the banks in the interest of the depositors.

•

It’s a technique that is used by RBI as a monetary instrument to control the money supply in the economy.

•

At the time of inflation, to curtail money supply from the economy the CRR is increased and at the time of deflation to provide much money to the economy the CRR is minimized.

•

High CRR is resulting in impounding the cash resources of the banks and their ability to expand credit.

2. STATUTORY LIQUIDITY RATIO (SLR)  Statutory Liquidity Ratio or SLR refers to the amount that all banks require to maintain in cash or in the form of Gold (valued at a price not exceeding the current market price) or approved securities (Unencumbered approved securities like bond and shares of different companies including Government securities or Gilts priced by RBI).  The quantum is specified as some percentage of the total demand and time liabilities (i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one month’s time due to maturity) of the bank.  Presently the SLR is 24% with effect from 8 November, 2008.  SLR plays an important role; •

To restrict the expansion of bank credit.

•

To augment the investment of the banks in Government securities.

•

To ensure solvency of banks by maintaining liquidity.

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The Role of Financial Indicators in Banking System

3. BANK RATE  Bank Rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries.  Changes in the bank rate are often used by central banks to control the money supply.  A central bank adjusts the supply of currency within national borders by adjusting the bank rate.  When the central bank reduces the bank rate, it increases the attractiveness for commercial banks to borrow, thus increasing the money supply.  When the central bank increases the bank rate, it decreases the attractiveness for commercial banks to borrow, consequently decreasing the money supply.

4. REPO RATE AND REVERSE REPO RATE  Repo comes from the repurchasing agreement. Repos are classified as a money-market instrument that is usually used to raise short-term capital.  Whenever the banks have any shortage of funds they can borrow it either from Reserve Bank of India |RBI] or from other banks. The repo rate is the rate at which the banks borrow these excess funds. The borrowing bank mortgages its government securities to carry out this loan transaction.  A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.  A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". 5

The Role of Financial Indicators in Banking System  So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints.  In a reverse repo Reserve Bank borrows money from banks by lending securities. The interest paid by Reserve Bank in this case is called reverse repo rate.

5. CAPITAL ADEQUACY RATIO  Capital

adequacy

ratio (CAR),

also

called Capital

to

Risk

(Weighted)

Assets

Ratio (CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and are complying with their statutory capital requirements.  There are two types of capital which are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.  It can be calculated as:

 Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting the time liabilities and other risk such as credit risk, operational risk, etc.  In the most simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders.  Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.

6. PRIME LENDING RATE (PLR) 6

The Role of Financial Indicators in Banking System  Prime lending rate is the rate of interest at which banks lend to their credit-worthy or favoured customers. It is treated as a benchmark rate for most retail and term loans.  The RBI does not set these rates, but in a broad way stipulates the interest rates in the economy. The banks are at liberty to lend at a rate above or below the RBI’s.  The PLR is influenced by RBI’s policy rates — the repo rate and cash reserve ratio — apart from the bank’s policy. In simple words, availability of funds in the banking system and demand for credit by consumers (both retail and industrial) determine what the PLR should be.  Excessive money in the economy leads to inflationary trends. To control inflation, government may curb the money supply by increasing the lending rates or PLR. When RBI increases the PLR, banks may follow suit, making borrowing a costlier affair.  This hike in lending rates is bound to negatively impact businesses/industries which depend on banks for their working capital and expansion requirements.  A lower rate increases liquidity by making all loans (fixed or floating) less expensive and, therefore, easier to access.  Private Banks, which usually lend at rates higher than the nationalised banks are expected to follow suit. This cut reduces the cost of term loans for corporate houses.  Normally, deposit rates follow lending rates. When lending rates fall, one can expect a slash in deposit rates from banks too. So, risk-averse investors may soon have to look out for better return yielding investments, as bank deposits may lose sheen.

7. CALL RATE  Call Rate refers to the interest rate on short-term secured loans that can be called, or cancelled, by giving a 24-hour notice. It is the inter-bank interest rate on funds that are not deposited for a fixed period.  The fluctuations in the call rate makes the short-term credits cheap or costly ultimately affecting the corporate as well as the trading firms to charge more on their products as indirect cost. Hence, it increases the cost of production and the price of the product as well. 7

The Role of Financial Indicators in Banking System

8. COUPON RATE  The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a bondholder.  There is a direct relationship between bank deposits and the coupon rate. When the coupon rate at quite more, then people will not go for depositing their money in their saving accounts. Hence, the revenue of the banks hamper.  In the case where the coupon rate is quite low, no one will go for investing in debt instruments and will deposit in their bank accounts enhancing the liquidity of the bank.

9. THE MIBID AND THE MOBOR

 The MIBID stands for Mumbai Inter-Bank Bid Rate where as MIBOR stands for Mumbai Inter-Bank Offer Rate.

 The MIBID/MIBOR is a rate that is fixed by commercial banks for giving over-night credits from its surplus deposits to the banks which have deficit to balance the trading of the day. Generally, it is provided for a night (24 hours).

 These are used as bench mark rate for majority of deals struck for Interest Rate Swaps, Forward Rate Agreements, Floating Rate Debentures and Term Deposits.

10. PRIORITY SECTOR LENDING  Some areas or fields in a country depending on its economic condition or government interest are prioritized and are called priority sectors i.e industry, agriculture and banks are directed by the central bank or government that loans must be given on reduced interest rates with discounts to promote these fields. Such lending is called priority sector lending. 8

The Role of Financial Indicators in Banking System  Due to such provisions, the banks provide credit to the under-developed sectors at a lower rate which affects the profitability of the banks increasing their default/credit risk.  There is much possibility of NPA ( Non-Performing Asset) making the banks’ balance sheet not so attractive.  On a contrary, due to PSL the bank is able to catch all sectors of the economy by increasing its revenue and stability. It contributes a lot for the equitable and sustainable development of the economy.  If the PSL will be more then to divert the loss and risk occurred by such lending the banks may increase their bank rates that will ultimately affect the banking system making the borrowing more costly.

11. GOLD PRICE  As Indians have a sentimental relation with gold, a mare fluctuation in gold price affects the entire economy.  When people find that the gold price is at a minimum stage, they buy gold by using the savings account balance even if by taking loans.  So at this point of time, by considering other points the banks may regulate their rates and policies to cope such situation.

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GROSS DOMESTIC PRODUCT (GDP)

 GDP is a basic measure of a country's economic performance and is the market value of all final goods and services made within the borders of a nation in a year.  It is a fundamental measurement of production and is very often positively correlated with the standard of living.  It can be calculated as: 9

The Role of Financial Indicators in Banking System GDP = private consumption + gross investment + government spending + (exports − imports)  More GDP indicates better standard of living. It Shows that there is much more production in the economy and the economic condition of the people is good.  If so, then no one will go for taking loan from banks. Ultimately, the banks will go for reducing the bank rate as there is a little demand for taking loans in the market.  In a nut-shell, the revenues of the banks will reduce, but there is a possibility of increase in long term loans for growth and development.

13. EXCHANGE RATE  The Exchange Rate (also known as the Foreign-exchange rate or Forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency.  As now-a-days monetary transactions are made in the global financial market under international participation, all the economies are now connected with each other.  When the exchange rate reduces indicating appreciation in the home currency, the banks will find it cheap to bring money from the overseas. As a result the liquidity position and availability of cash will increase with the bank increasing its solvency and credit giving capacity.  At the time of appreciation of home currency, the importers find it the right time to settle their outstanding with foreign parties. So the banks should make provision for excess amount to face the situation. 14.

RATE OF INFLATION

 The inflation rate is a measure of inflation, the rate of increase of a price index (for example, a consumer price index).It is the percentage rate of change in price level over time. 10

The Role of Financial Indicators in Banking System  In case of inflation, there is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services.  Consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.  In the case of high inflation, people need more money for their livelihood. So more people will go for taking loan.  Controversially, at the time of inflation there is much more money in the economy than the demand. So, no one will go for loan. So to attract borrowers, the bank has to think to reduce the bank rate.  On the other hand, if there is deflation when there is a scarcity of money in the economy to purchase the products, to cope with the situation the interest rate on deposites is increased to attract more and more deposites.  In case of high deflation, the banks have to take loans from the central bank and act as a stimulator by providing finance to all the suffered sectors to tackle the unfavourable economic condition.

15. THE SAVINGS RATE  Savings Rate refers to the amount that a common man saves per Rs.100 of his earnings.  If the savings rate will be more, then a huge liquidity can be found out in the economy. As everyone have some savings, people will not go to banks to take loans. As a result, the interest rate on various loans will decrease by making the bank loans cheap.  To attract more savings to be deposited in it, the banks increase the interest rate on deposits.  If the saving rate is high, it can be concluded that the consumption has been minimized. It means there is a increase in the exports if the production remains constant. Ultimately 11

The Role of Financial Indicators in Banking System due to more export the foreign reserve will increase and the exchange rate of the foreign currencies will decrease due to appreciation of the Indian Rupee.  Due to this appreciation the commercial banks can avail foreign currency loans at a cheaper rate.  On the other hand, if the savings rate is very low/negative, it means people spent more than their income then the banks will increase their interest rates to give loans as people want much money to spent. 16. STOCK MARKET INDICES  A common man holding a bag full of cash while going to the bank to deposit in his account if finds that the stock market is growing and there is a possibility of getting much return by investing on that; he is a full who believes that the man will deposit with the bank after knowing that.  When the stock market indices show a bullish trend, people hesitate to deposit in bank accounts with a nominal return. It affects the Cash inflow of the bank.  At the time of bearish trend, investors don’t want to loose more. They used to close their position and safeguard their investment in their bank accounts. It increases the cash inflow of the bank.  Corporate houses similarly when found that the market is booming, they hesitate to take long-term loans from banks for their expansion and diversification. Rather they go for fresh issue of equity shares at a high premium.

CONCLUSION As a grape-vine, all the financial indicators are inter-linked with each other and affect the entire banking system directly as well as indirectly. A small fluctuation in any of them impacts the economic and monetary position of the banks. Therefore, it can rightly be said that the complex banking system that we see never stand in a vaccume. To make the two sides parallel and to merge the individual objectives of the banking system and the economy, it is a necessity to look in to certain barometers those can indicate the temperature of the entire financial 12

The Role of Financial Indicators in Banking System system, by playing a lion’s role for its growth and development. In this sense, it is quite difficult to find anything else other than these financial indicators to act like barometers…!!

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