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Week 3: Commercial Banks

I. Core Concepts & Functions

1. Definition & Role

  • Commercial Banks are financial intermediaries that accept deposits and provide loans to individuals and businesses1111.

  • Primary Goal: To facilitate fiscal transactions (monetary and credit) and drive economic growth/stability2222.

  • Distinction from other Banks:

    • Commercial Banks: Prioritize common services like deposits/credit for people/companies (e.g., State Bank of India, JPMorgan Chase)3333.

    • Investment Banks: Specialize in corporate finance, trading, M&A (e.g., Goldman Sachs)4.

    • Central Banks: Manage money supply and regulate the banking system5.

2. Major Functions

  • Accepting Deposits:

    • Savings Accounts: For earning small interest while safely storing money6.

    • Checking Accounts: For easy access to money for regular expenses7.

    • Certificates of Deposit (CDs): Time-bound deposits with higher interest rates8.

  • Loan Financing:

    • Profit Mechanism: Banks charge a higher interest rate on loans than they pay on deposits; this margin ensures sustainability9.

    • Types: Home loans (real estate), business loans (capital projects, machinery), car loans10.

  • Money Creation (Fractional Reserve Banking):

    • Definition: Banks keep a portion of deposits as reserves and lend the rest11.

    • Multiplier Effect Example: If a depositor puts in ₹1000 and the bank lends ₹900, the economy now has ₹1900 circulating12.

  • Clearing Checks:

    • Acts as a clearinghouse to ensure funds transfer accurately from payer to recipient13131313.

  • Electronic Banking:

    • Includes NFT, RTGS, stop payment services, and passbook updates14.

3. Specialized Financial Services

  • Wealth Management: Personalized planning and investment advice, primarily for affluent individuals15151515.

  • Investment Services: Helping customers invest in stocks, bonds, and mutual funds based on risk appetite16.

  • Foreign Exchange:

    • Facilitates international trade and hedging17.

    • Supports mark-to-market transactions for intraday trading18.

  • Safe Deposit Boxes: Secure storage for valuables (jewelry, documents)19191919.

II. Role in Economic Development

  • Mobilization of Savings: Transforms "dormant funds" into active capital for productive investment20.

  • Credit Allocation:

    • Strategic lending to priority sectors (infrastructure, healthcare, technology) prevents liquidity shortages21.

  • Trade Facilitation:

    • Letter of Credit (LC): A guarantee that a seller will receive payment.

    • Example: An Indian company importing machinery from Germany uses an LC to reduce cross-border risk22.

  • Monetary Policy Implementation:

    • Banks adjust lending rates in response to Central Bank interest rate changes to control inflation/money supply23.

  • Infrastructure Development: Funding large-scale projects (roads, power plants) to lower business costs and improve connectivity24242424.

III. Types of Commercial Banks (Classification)

A. Scheduled vs. Non-Scheduled

  • Scheduled Commercial Banks:

    • Included in the Second Schedule of the RBI Act, 193425.

    • Must maintain minimum capital and reserve ratios26.

  • Non-Scheduled Banks:

    • Do not meet RBI Second Schedule criteria27.

    • Usually smaller, region-specific, and do not maintain the same cash reserve ratios28.

B. Categories of Scheduled Banks

  1. Public Sector Banks (PSBs):

    • Ownership: Government holds majority equity29.

    • Focus: Financial inclusion, priority sectors (agriculture, SMEs)30.

    • Examples: State Bank of India (SBI), Punjab National Bank (PNB), Bank of Baroda, Canara Bank31313131.

  2. Private Sector Banks:

    • Ownership: Private individuals/corporations32.

    • Focus: Profitability, efficiency, innovation, technology33.

    • Examples: HDFC Bank, ICICI Bank, Axis Bank, Kotak Mahindra Bank34.

  3. Foreign Banks:

    • Definition: Branches/subsidiaries of banks HQ'd outside India35.

    • Focus: International business, global standards36.

    • Examples: Citibank, HSBC, Standard Chartered Bank37.

  4. Regional Rural Banks (RRBs):

    • Focus: Agriculture and rural economy38.

    • Sponsorship: Sponsored by Public Sector Banks39.

C. Specialized & Niche Banks

  • Co-operative Banks:

    • Model: Cooperative (members have a say in governance)40.

    • Focus: Community-focused, local level41.

    • Example: Pune District Central Co-operative Bank42.

  • Small Finance Banks:

    • Mandate: Financial inclusion for underserved sections (MSMEs, small farmers)43.

    • Examples: Ujjivan Small Finance Bank, Equitas Small Finance Bank44.

  • Payment Banks:

    • Restriction: Cannot undertake traditional lending activities45.

    • Services: Accept deposits, remittance, issue debit cards46.

    • Examples: Paytm Payments Bank, Airtel Payments Bank47.

  • Development Banks:

    • Focus: Long-term credit for capital-intensive projects (infrastructure, industry)48484848.

    • Examples: NABARD (Agriculture), SIDBI (Small Industries)49.

IV. Organizational Structure

Key Levels

  • Board of Directors: Accountable to shareholders; approves policies and strategic initiatives50505050.

  • Executive Management:

    • CEO: Main communication point between Board and Ops51.

    • CFO: Budgeting, forecasting, financial reporting52.

    • COO: Efficiency in service delivery53.

    • CRO (Chief Risk Officer): Identifying and mitigating risks54.

Departments

  • Retail Banking: Personal loans, mortgages, savings55.

  • Corporate Banking: Commercial loans, trade finance56.

  • Treasury/ALM: Manages liquidity, funding, and interest rate risk57.

  • Risk Management: Stress testing, risk reporting58.

Structural Models

  • Functional: Organized by function (e.g., risk, retail). Con: May lead to silos59.

  • Divisional: Organized by product or geography. Pro: Flexible/Responsive60.

  • Matrix: Combines both. Pro: Collaboration. Con: Reporting complexities61.

V. Risk Management (High Priority for MCQs)

Image of Risk Management Framework in Banks

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1. Credit Risk (Default Risk)

  • Definition: Borrower fails to meet obligations62.

  • Mitigation Strategies:

    • Credit Scoring: Analyzing financial history (Used by HDFC Bank)63.

    • Collateral: Seizing assets upon default (Used by SBI)64.

    • Loan Syndication: Multiple banks financing a single loan to spread risk65.

    • Credit Derivatives: Using Credit Default Swaps (CDS)66.

    • Early Warning Systems: Real-time tracking of loan performance (Used by ICICI Bank)67.

2. Market Risk (Price Volatility)

  • Definition: Losses due to market variables (Interest rates, Forex, Equity prices)68686868.

  • Mitigation Strategies:

    • Hedging: Using futures/forwards/swaps (Used by Axis Bank for Forex)69.

    • Value at Risk (VaR): Statistical model measuring maximum potential loss (Used by Yes Bank)70707070.

    • Asset-Liability Management (ALM): Matching asset/liability durations (Used by Kotak Mahindra Bank)71.

3. Liquidity Risk (Cash Flow Mismatches)

  • Definition: Inability to meet short-term obligations (e.g., withdrawals)72.

  • Mitigation Strategies:

    • Liquid Reserves: Holding government bonds/cash (Used by HDFC Bank)73.

    • Liquidity Coverage Ratio (LCR): Mandatory holding of High-Quality Liquid Assets (HQLA) to survive a 30-day stress scenario (Used by PNB)74.

    • Diversified Funding: Using domestic and foreign markets (Used by Kotak Mahindra Bank)75.

4. Operational Risk (Internal/External Failures)

  • Definition: Systems failure, human error, fraud, cyberattacks76.

  • Mitigation Strategies:

    • Internal Audits: (Used by Bank of Baroda)77.

    • Business Continuity Plans (BCP): Disaster recovery (Used by IDFC First Bank post-COVID)78.

    • Cybersecurity: AI fraud detection (Used by ICICI Bank)79.

5. Compliance & Reputational Risk

  • Definition: Penalties for non-adherence to laws; damage to public image80808080.

  • Mitigation Strategies:

    • KYC & AML: Anti-Money Laundering software (Used by Axis Bank)81.

    • Whistleblower Policy: Reporting unethical behavior (Used by SBI)82.

VI. Asset-Liability Management (ALM)

Concept

  • Purpose: To manage risks arising from mismatches between assets (loans) and liabilities (deposits)83.

  • Goal: Optimize Net Interest Margin (NIM) and Profitability84.

Tools & Techniques

  1. Gap Analysis:

    • Compares Rate-Sensitive Assets (RSA) vs. Rate-Sensitive Liabilities (RSL)85.

    • Positive Gap (RSA > RSL): Bank benefits if interest rates increase86.

    • Negative Gap (RSA < RSL): Bank benefits if interest rates decrease87.

    • Example: HDFC Bank monitors gaps to align loan structures88.

  2. Duration Matching:

    • Matching the sensitivity of assets and liabilities to interest rate changes89.

    • Example: ICICI Bank uses this to balance maturity of loans/deposits90.

  3. Funds Transfer Pricing (FTP):

    • Allocating costs/revenues to different units based on funding costs91.

    • Example: ICICI Bank uses FTP to allocate risk between lending and deposit divisions92.

  4. Scenario Analysis & Stress Testing:

    • Simulating extreme conditions (e.g., market crash)93.

    • Example: Yes Bank conducts stress testing for interest rate spikes94.

Regulatory Framework

  • Basel III: Sets standards for capital adequacy and liquidity95.

  • Statutory Liquidity Ratio (SLR): Mandates % of Net Demand and Time Liabilities (NDTL) kept in liquid assets (Govt securities)96.

Digital Transformation

  • UPI (Unified Payments Interface): Instant, real-time payments97.

  • Blockchain/DLT: For transparent record-keeping and smart contracts98.

  • AI & ML: Used for chatbots, fraud detection, and personalized recommendations99.

  • Robotic Process Automation (RPA): Streamlines repetitive tasks like data entry100.

Financial Inclusion

  • Jan Dhan Yojana: Govt program triggering millions of basic savings accounts101.

  • Microfinance: Credit for low-income groups102.

New Products & Models

  • Buy Now, Pay Later (BNPL): Popular in e-commerce for installment payments103.

  • Open Banking: Sharing financial data via APIs with third parties104.

  • Green Banking (ESG): Financing renewable energy/sustainable projects105.

  • Partnerships: Banks partnering with Fintechs (e.g., ICICI + Fintechs for instant loans)106.