Tax Havens

In the wake of the economic crisis gripping much of the world today, so called tax havens have come into sharp focus, for their contributory role in the present crisis.

What is a tax haven?  A tax haven may be an independent country, or a dependency, or overseas territory, of a country, or a principality.   The general term applied to this goegraphical entity is “jurisdiction”.   It is a place where there are either no taxes like Municipal Tax, Wealth Tax, Sales Tax, VAT, etc, or the rates of these taxes are so low, as to attract people, especially non-residents from other countries to take advantage of these laws. at the cost of the home country.

For example, say an American national working for an oil company, in the Middle East, repatriates his earnings to the U.S., and is liable to pay certain tax on it.   However, by parking these funds in Switzerland, he does not pay any tax at all.  Hence the gentleman may be tempted to open a numbered account in a Swiss Bank, including one operating in the Middle East, and then transfer his earnings to that Bank.   In the process, the U.S. Government loses taxes on these funds, apart from the fact that these funds mights have, otherwise been invested in the United States, and generally speaking, contributed to the well being of America.

Another feature of a tax haven is that, they do not disclose the financial information relating to accounts maintained with their Banks, and Financial Institutions, to foreign tax and other authorities.   This presents the home country authoritites, problems in tracking illegal transfers of money, tax avoidance, stashing of ill-gotten wealth etc.   The tax havens actively discourage sharing of information relating to financial transactions of their overseas clients, through administrative practices and legislation that is aimed at protecting the privacy of such clients, even though such practices may cause harm and loss to the home countries, that is, the countries, to which the clients of the tax havens belong.

A third feature of tax havens is the lack of transparency in the legal and administrative processes, that makes it difficult for countries with a proper tax framework, to deal with such jurisdictions.   These countries find themselves at a disadvantage, vis a vis, the tax havens, on account of the obvious differences in approach to the issue of taxes on the one hand, and the concept of accountability and transparency on the other.

Tax havens, typically, do not engage in due diligence of their foreign clients, in respect of their identities, source of funds, etc, before establishing a relationship with them.   Further, they do not require overseas companies to have a local presence or even to have local introductions.   Practically, everything is “arranged” for a price.

Often, tax havens advertise themselves as such, through the media.   One can come across advertisements of tax havens, in financial journals in different countries.   It is not uncommon to encounter an advertisement of a tax haven in a particular edition of a journal, carrying  critiques of tax havens!

Future of Tax Havens:  It is difficult to predict the future of tax havens at this time.   Definitely, they are under pressure to “reform”.   The present economic cisis has led to several countries, notably the United States, coming out strongly against these jurisdictions, and acting to discourage their activities.

It remains to be seen what eventually happens to the tax havens given the complexities of the system.

LIBOR

Introduction:  LIBOR stands for London Interbank Offered Rate.   It is the rate at which Banks lend funds to each other in the London Interbank Market. It is published daily by the British Bankers Association (BBA)

Origin:  London is considered to be the largest interbank money market in the world, after New York.   As such, it has led the international financial markets in many respects, in terms of products and services.   Because of the availability of  high level of expertise in Banking and Finance, excellent communication facilities, a free market, apart from political stability, the London Interbank market grew tremendously, bringing in its wake, many new innovations in Banking and finance.

Alongwith New York, London gained prominence as an international financial center, and most of the big players in the banking and finance fields invariably have representation in these two markets.   Some of the most innovative market instruments that owe their origin to New York and London like Interest Rate Swaps, Forward Rate Agreements, Options, etc., became quite popular, and necessitated certain regulation to bring about uniformity in their operations, and to bring about stability to the market.

It is in this context that, the BBA, in association with the Bank of England, came up with certain standards for interest rate swaps transactions, called the BBAIRS, in 1985, which also included the ground rules for fixing of the BBA interest settlement rates, that later on evolved into the LIBOR in 1986.

How LIBOR is fixed:  The actual calculation of the LIBOR is done by Thomson Reuters, the financial information services company, and is published by the BBA everyday between 11.00 am and before noon, London time.   Libor is calculated for ten currencies viz US Dollar, Canadian Dollar, Australian Dollar, New Zealand Dollar, Pound Sterling, Euro, Japanese Yen, Swiss Franc, Swedish Krona, andDanish Krone.

Each currency has a panel of contributor Banks, who convey the interbank deposit rate offered by them, for maturities betweeen overnight and one year.   Thomson Reuters, then fix the LIBOR on the basis of the average of these rates.

Scope of LIBOR:  The LIBOR is the benchmark rate used by Bankers and others, for reference purposes, and not the final quoted rate.   For instance, say, an exporter approaches his Bank to have his export documents negotiated, his Banker would quote a rate that would comprise of the LIBOR, plus his margin.  Similarly a Bank lending funds to another in the interbank market would qoute a rate equal to LIBOR plus its margin.

LIBOR is commonly used as a benchmark rate for various financial instruments like:

1. Interest rate swaps, which is an agreement between two parties to exchange one stream of future interest payments for another, based on a specified principal amount.
2. Futures contracts, which is a contract to buy or sell a particular financial instrument, at a pre-determined rate in future.
3. Inflation swaps, which is a derivative product to hedge against inflation linked risks.
4. Syndicated loans, which are loans extended by a group of lenders to a single borrower.

Apart from the above, it is also applied to floating rate notes, variable rate mortgages, currencies, etc.

Criticism:  The LIBOR has come in for criticism from various quarters, for its unsuitability to various situations and instruments.   Notably the Wall Street Journal, came out with a study that suggested that Banks that had relied on LIBOR, would have presented an incorrect picture of their financial health.   This could give them undue leverage in raising funds from the market at competitive rates.

However, the BBA countered this criticism, justifying the reliability of LIBOR, even in times of financial crisis, as the one now underway.   Further the findings of the International Monetary Fund and the Bank for International Settlements, in this regard, were also supportive of the reliability of the LIBOR.

For the present, though, the LIBOR does not appear to be at risk of being dumped, and continues to be the reference rate in all the major currency markets of the world.

BANKS AND CAMELS!

Introduction:   What does a Bank have to do with CAMELS?   Plenty!   It could be the deciding factor in a Bank being allowed to function, or even being shut up.   The higher the Bank climbs up the CAMELS, more the chances of it being done in!   This is one score a Bank would do well to keep low!

Actually, CAMELS is the acronym for the six factors that form the basis for an international Bank rating system.   These six factors are: Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risk.

Uner the CAMELS rating system, Banks are rated in relation to the quality of these six factors.   The strength of these six factors would determine the overall strength of the Bank.   The quality and strength of these six factors underlines the inner strength of the Bank and how far it can take care of itself against the market forces.   Further, it also enables the regulatory authorities to focus on the Banks that are not doing well and to pay special attention to them. 

The regulatory authorities not only study the financial statements of the Bank, but also carry out on site inspection, and thereafter rate the Bank.   The rating system is based on a scale of 1 to 5 with 1 being the highest score and 5 the lowest.   Banks scoring 1 would be considered as among the top bracket in regard to their financial soundness, and those scoring 5 would be seen to be at the bottom of the ladder.

Purpose:  The purpose of this rating system is to examine the financial and other soundness of the Bank, and  alert the top management of the Bank to take timely measures to address any deficiencies and stop the Bank from sliding to the bottom of the heap.

The CAMELS rating is carried out with reference to the following factors:

1)  Capital Adequacy:  Every Bank is expected to have sufficient capital to address its needs in relation to the risk it undertakes in its operations.   The ratio of the capital of a Bank in relation to its risk weighted assets must meet the minimum requirements.

The Basel II Accords promoted by the Bank for International Settlements, Basel, Switzerland, stipulates a minimum Capital Adequacy Ratio of 8%.   This is the bare minimum required, and Banks are strongly recommended to have a comfortable Capital Adequacy Ratio that takes care of any ontoward occurances.

The need for sufficient capital cannot be overestimated.   It is the base on which the Bank stands, and its strength can be guaged by the strength of its base.   The edifice of the Bank draws its strength and succour from the foundation of capital.

In line with the need for a strong capital base of a Bank, the Bank for International Settlements has come out with an elaborate set of erecommendations that are expected to put in place, a mechanism, that is proactive and responsive to the needs of the Bank in countering the threat to its well-being from the elements of risk.   For this purpose, weights are alloted to each type of risk the Bank faces in its day to day operations, and accordingly, the amount of capital required to face up to this risk is worked out.

2)  Asset Quality:  The term Asset Quality refers to the quality of the loan portfolio of the Bank.   Lending being one of the primary activities of a commercial Bank, the welfare of the Bank is dictated to a large extent, by the quality of its loan portfolio.   A sound loan portfolio means a steady income for the Bank, apart from adding to the solvency of the Bank and consequently its rating.

To ensure asset quality, the Bank has to follow a sound lending regimen that ensures compliance of all the related norms.   Some of the parameters for judging the soundness of a loan account are the components of safety, security, liquidity, purpose, profitability, etc.

In the process of lending, Bank has to take all reasonable precautions to ensure the safety of its funds.   The evaluation of credit proposals must focus on the technical feasibility and the financial viability of the project, or venture under consideration.   The purpose of the loan must be in consonance with acitivites that relate to productive application of capital.   The result of such application should be the generation of a stream of income necessary for repayment of the loan.   The quality of loan assets, to a large extent determines the viability of a Bank as a running concern.

3)  Management:  By Management is meant the art and science of accomplishing the goals of the institution by deploying all the necessary resources appropriately.   Management includes Planning, Organising, Staffing, Directing, and Controlling functions.

Planning is concerned with drawing up the blueprint for the objectives and goals of the Bank, and lay the path to reach them.   Planning is a all encompassing activity that touches upon all the activities of the Bank.

Organising is the next step after planning, and is concerned with putting in place the necessary infrastructure, including human resources to achieve the Bank’s corporate goals.

Staffing, as the term indicates, is concerned with filling up the various positions in the Bank with suitable people.

Directing means channeling the energies of the employees towards achieving the Bank’s corporate goals, by motivating the employees with rewards, both monetary, as well as in terms of their career goals.

Controlling is a function of management that involves establishing a performance standard for the employees and taking suitable steps in regard to the principle of reward and punishment.

A Bank that scores high in this area, namely, management, is bound to come up with a strong performance, and also contribute to the solidity of the Banking industry, as a whole.

4)  Earnings:  The earnings of a Bank refer to the net profit made by it.   Profit is the difference between income and expenditure.   The major sources of income for the Bank are interest earned on the loans and other income derived from general banking activities like, remittances, bills, etc.   Apart from these, related activities undertaken by the Bank like Bancassurance, etc, also contribute to the Bank kitty.

The expenditure of the Bank may relate, among other things, to salaries, wages, administrative overheads, rents, rates, taxes, etc.   The net surplus that remains after taking care of all the expenses is the net profit.

A healthy Bank should be able to generate decent profits regularly and keep itself, as well as its investors, in good health.

5)  Liquidity:  Liquidity is simply the ease with which an asset of the Bank can be encashed in times of need, or its fair value.   It is that quality of an asset,that enables a Bank to respond to any financial situation requiring urgent infusion of money or money’s worth.   This quality of the asset ensures that a Bank faces the minimum stress in dealing with such situations.

Apart from a financial cirsis or crisis like situations, liquidity is also required to meet regular financial obligations of the Bank, especially without dipping into its reserves.   Liquidity marks the ability of the Bank to field expected as well as unexpected financial problems and issues.

6)  Sensitivity to Market Risk:  Market forces are a major reason for shifts in the fortunes of businesses.    Favorable movements can boost the fortunes of a Bank, whiule  unfavorable ones can send the Bank packing to the cleaners.   Market forces generally relate to the changes in Interest Rates, Currency Rates, Commodity Rates, and Stock Prices.   Further these changes are inter-related in a complex way, and disturbances in one area are usually accompanied with the same in other areas.

A sound Bank is expected to hve  sound risk management practices in place, to take care of both known and unknown risks.   The asset-liability match of the Bank must be in consonance with risk management principles.

Conclusion:  The current Banking Crisis, which is quite unprecedented, underlines the importance of regulatory issues and the affects of incompetence in this area.

CAMELS, as a rating system for judging the soundness of Banks is a quite useful tool, that can help in mitigating the conditions and risks that lead to Bank failures.

BANKING AND FINANCE: DERIVATIVES

Introduction to Derivatives:  ”Necessity is the mother of invention”.   Humans have always been inventive through their sojourn in this world, and have come up with innumerable inventions that have made their lives comfortable.   Sometimes, though, they have done themselves and their world a lot of harm with their inventions.

While many of the human inventions fave fulfiled a genuine need, some inventions have served only their contrived needs, and yet  others have catered to the baser instincts of man, primarily, greed.

Into which of these above categories does the financial instrument called derivatives fit in?   Does it serve a genuine need or a contrived one, or only serves to pander to man’s greed?   In the light of the present Banking crisis, said to be triggered by the housing mortgage crisis, it would appear that derivatives fall in the last category, that is , to pander to man’s greed.

Be that as it may, it is worthwhile to study the subject of derivatives, if only to avoid such pitfalls in the future.

Definition:  A derivative is a kind of financial instrument that does not have a value of its own, but derives it from an underlying base.   This base may be an asset, or an index, or even a phenomenon.   In a way, a derivative resembles a parasite that feeds off its host.

Derivatives do not have an independent existence of their own.   They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc.;  or indices relating to the stock market, consumer prices, exchange rates, etc;  or even phenomena like the weather conditions.   They derive their values and standing from the above assets etc, as listed above.

Purpose and Scope:  There are several purposes for which derivatives are put to use.   Sometimes it relates to genuine business transactions and the related risks, and sometimes to plain profit making.   Sometimes it is dictated by necessity, sometimes by inclination.   Some of the major purposes of derivatives are:

Risk Management:  The major purpose of having derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally.   It is also called Hedging.   Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another.   A forward contract in a foreign exchange transaction like export and import is an example of hedging.  

Suppose an exporter of wheat based in Chicago exports a consignment of wheat to the United Kingdom, and expects the rate of the British Pound to decline against the U.S. Dollar, he may book a forward contract and sell his pounds at current rates against future delivery of wheat to the U.K.

Speculation:  Another purpose for which derivatives are used may be to book extra profits, or profits out of the ordinary, by taking advantage of the favorable movement of the value of the underlying asset.   Here the purpose of using derivatives is not hedging, or countering risk, but to scoop up additional profits.   This activity is called speculation.

Arbitrage:  Yet another purpose of derivatives is called as arbitrage, that is taking advantage of a lower current market value vis a vis future value of an asset.

Whereas the use of derivatives to counter business risks related to genuine busines transactions, may serve the purpose of utilizing derivatives, the same cannot be said of speculative activities, that have cause mayhem in the markets, more than once, in different parts of the world, notably the United States.

Types of Derivatives:  Like there are two types of medicines, viz, over the counter, and prescription ones, so also there are basically two types of derivatives, the Over-The-Counter derivatives(OTD), and the Exchange-Traded-Derivatives(ETD).

Based on these two classes of derivatives, there are three kinds of them like Futures, Options, and Swaps, that are briefly discussed below.

Futures and Forwards:  These are financial contracts with a committment to buy or sell an asset within a certain future date at today’s price.  That is future buy/sell at current rates.   While a forward contract is an examle of an OTC derivative, a futures contract is an example of an ETD.

Options:  These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell).   The option to buy relates to the call option and that to sell relates to the put option.  The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price.   Another feature of this contract is the maturity date.   Here again, there are two options- the European option, and the American option.   Uner the European option, the owner may specifry maturity date only as date of Sale;  whereas in the American option, Sale is allowed to take place on any date upto the maturiey date.

Swaps:  Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

As can be seen from the foregoing, derivatives may be used to either hedge one’s risk, or to make super profits, or just settle for arbitrage.   As these instruments do not have a vlaue of their own, they are vulnerable to any kind of shift or change in the value of the underlying.   As such they may not be very reliable in countering risks unless the issues affecting the values of the underlying are properly understood and provided for.

It is pertinent to note here, how the derivatives have played havoc in the U.S. housing mortgage sector, that is the major reason for the current American Banking Crisis.   Based as they are, more on mathematical calculations than solid assets, or money’s worth, the derivatives, as financial instruments, were always a weak and vulnerable proposition for risk management, and when the first strong winds hit the derivatives market, they started spinning out of control, taking the whole banking industry with them.

From the way the derivatives market crashed, it has given rise to suspicions as to the competence of the ‘experts’ and ’specialists’ who spun out these instruments seemingly through a ‘divine’ combination of their super brains and computers.

As for the regulators, perhaps, they did not want to look like fools before the derivative whizkids, by posing mundane and ’stupid’ questions about what exactly these instruments were composed of, how they were valued, and indeed the necessity and viability of these financial instruments as a tool of risk management.   In the end, the regulators have ended up looking like bigger fools for not doing their mundane and ’stupid’ jobs.

BANKING ON BASEL II

Introduction:  The Basel Accords, as they are popularly known, are recommendations on Banking laws and regulations relating to the capital of a Bank vis a vis the risk faced by the Bank in its various activities, like Credit, Market or Investment, and Operations.

These Accords are the outcome of the deliberations of the Basel Committee on Banking Supervision, comprising of the Central Banks of the United States of America, the United Kingdom, Canada, Germany, France, Japan, Switzerland, Sweden, Italy, Belgium, the Netherlands, and Luxembourg, under the auspices of the Bank for International Settlements, Basel, Switzerland.

The Basel II Accords were initially mooted in 2004 to become operational from March, 2006, although certain countries like India, were granted more time to comply with them.

Purpose And Scope:  The purpose of these recommendations is to put in place, a practice of aligning the capital of a Bank with its risk exposure.   That is, the quantum of a Bank’s capital would have to be in line with the quantum and nature of the risk the Bank is exposed to, in its various operations, divided into Credit, Market, and Operations.   Simply speaking, more the risk the Bank is exposed to, more the capital required to be maintained by it.

A significant addition in the Basel II Accord, compared to its predecessor, the Basel I Accord, is the application of the Bank’s internal risk assessment processes in arriving at the required quantum of capital and reserves to address or counter the threat of risk to the Bank’s well being from its credit, market or investment and operational exposures. 

The focus of the new Accord is on Risk and Risk mitigation issues and techniques.   It is expected that such risk management practices, when become entrenched in the Banking system, would contribute immensely to the stability of the system.

Apart from the above, these new methods prescribed under Basel II are expected to contribute solidity to the Banking industry, and help prevent Bank failures.   As the capital reserves of a Bank move up in alignment with the risk faced by the Bank, the threat to the well-being of the Bank is effectively countered.   The net effect of this process would be to increase the strength and solvency of the Banking system.

Application:  The Basel II Accords, as we have seen, are concerned basically with providing sufficient capital support to the risk undertaken by the Bank in the areas of Credit, Market or Investment, and Operations.   The two areas where these Accords are applicable are Capital and Risk, and the same are discussed below in some detail.

Capital:   A Bank’ s Capital is divided into three parts according to its nature and purpose.   They are:

Tier I Capital:  The tier one capital of the Bank is composed of the core capital.   And the core capital is made up of the Capital proper, the shareholders’ contribution, Reserves, and Surpluses.   That apart, it also comprises of Perpetual Non-Cumulative Preference Shares, Investment Fluctuation Reserve, and Innovative Perpetual Debt Instruments.

Tier II Capital:  This part of the Capital consists of Undisclosed Reserves, Revaluation Reserves, General Provisions and Loss Reserves, and Subordinated Term Debt.   The tier two capital is also referred to as Supplementary Capital.

Tier III Capital:  This portion of the Capital is earmarked to meet the market risks faced by the Bank.   It is made up of Short Term subordinated Debt.   Not all Central Banks of the World have made this type of capital compulsory for their Banks.

Framework of Basel II Accord:  The Basel II Accord framework rests on 3 Pillars as it were-Minimum Capital Requirement, Supervisory Review of the Capital Adequacy, and Market discipline or disclosure.

Pillar I:  Minimum Capital Requirement:  The capital requirement of the Bank is fixed in relation to three types of risks that a Bank faces: Credit Risk, Market Risk and Operational Risk.   Each of these risks is  evaluated and accepted according to one of the three approaches specified,  namely, Standardized Approach, Internal Risk Based Approach, and Advanced Internal Rating Based Approach.   An appropriate approach is adopted to determine each type of risk.   The three types of risks are discussed below:

Credit Risk:  The capital to be allocated against the credit risk faced by the Bank is determined either with the help of Standardized approach or Internal Ratings Based Approach.   The Standardized Approach requires assignment of Risk Percentage to various kinds of exposures taken by the Bank.   For instance, the risk percentage assigned to Bank’s exposure to entities like the World Bank is Zero, whereas exposures against the security of commercial real estate would be awarded a risk percentage of upto 125%.

Apart from the Standardized Approach, there is the Internal Ratings Based Approach, that again may be a Foundation Approach, or the Advanced one.   These approaches are based on Bank’s internal systems of assessing risks arising to the Bank’s interests from various sources.

Market Risk:  Market Risk Assessment is based on the Standardized Approach and the Model Approach.

Operational Risk:  Operational Risk is assessed for the purpose of capital allocation on the Basic Indicator approach, the Standardized Approach, and the Advanced Measurement Approach.

The Pillar I of the Basel Accords II specifies a minimum capital requirement of 8%, after going through the above process of assigning risk percentages for various exposures of the Bank.

The Formula for calculating the Capital Adequacy Requirement is the Capital of the Bank, divided by the Credit Risk+Market Risk+Operations Risk.   The Result of this Equation must be 8%.

Pillar II:  Supervisory Review of Capital Adequacy:  “When the cat’s away, the mice will play!”   In order to ensure the well-being of the Bank, and guarantee its solvency, it is not enough to just prescribe ways and means to do it.   It is equally important to supervise and ensure compliance of the required laws by the Bank.

It is towards this end that the Second Pillar of the Basel Accords II is intended.   The Supervisory Review of Capital Adequacy is based on four principles,  namely:

1)  Banks must have in place, a mechanism to ensure that capital of the Bank is always sufficient to cover the corresponding risks.

2)  Constant vigial, measurement, and mitigation is expected to ensure compliance of the rules.   Supervisors must not be found wanting on this score.

3)  Not only the minimum capital requirement should be maintained by the Bank, but Bank must operate above the threshold level.   This is to ensure a safety margin in case of need.

4)  Timely intervention by Supervisors as soon as danger signals are noted, is  a critical requirement for success in this regard.   Supervisors are expected to be proactive in their approach.

Pillar III:  Market Discipline:  This Pillar addresses the need for the Bank to observe discipline in the matter of its Market operations, and the role it plays in the capital requirement of the Bank.   This is sought to be ensured through a system of semi-annual Disclosure relating to the underlying factors, such as the Tier I, Tier II, Tier III capital and its components.   Secondly, the approaches adopted by the Bank in relation to risk assessment and such other issues are taken into account.

Conclusion:  From the brief study above, of the Basel II Accords, it may be said that, in view of the current crisis in the Banking Industry, especially in the West, the importance of these recommendations, and their application by the Banking system is very much required.

RETAIL BANKING PART II

 In this article, we study the impact of the loans extended to the corporate client and the retail clients, by the Bank, by analyzing certain situations assumed as under.

Let us assume and analyze two situations applicable to Dolphin Paints Corp. and its employees, in respect of their individual loans from the Bank, and what implications it has for the Bank and its welfare.

In the first situation, let us assume that the company is in trouble. On account of unfavorable economic conditions, and the resulting market swings, the company has lost some of its standing in the market, and is not able to sustain operations at the earlier level, necessitating the laying off of about 500 employees. That apart, the company has initiated several steps to cope with the drop in business.

One of the most serious consequences of the above situation is that the company is finding it hard to service the debt it owes the ABC, and there is a risk of default on their part, that might force the Bank to reschedule the said debt. As a consequence, the Bank would have to make provisions for the loan outstanding against this company in their books, which is a nightmare to any Banker. The sum involved here is about USD: 8.00 million, assuming that the company had repaid USD: 2.00 million of the original loan of USD: 10.00 million. In other words, the Bank is now staring at a possible default of a loan to the tune of USD: 8.00 million by the company.

Now, let us take a look at the impact of this crisis on the employees of this company, and what implications it has for the Bank, in relation to the loans extended by it, to them.

As we have seen, the company had laid off 500 workers on account of its current problems. Let us assume, that out of these 500 employees, 400 of them had borrowed from the Bank, and are currently out of a job. The total amount of money lent to these 400 persons would come to USD: 1.20 million, and the Bank faces a similar situation here, as in the case of the company, in that, it has to consider rescheduling the loans to these 400 employees, and making provisions for the same. The difference, however, is the amount involved is much smaller, and the number of borrowers is much larger, and the amount of provision to be made is correspondingly less. Also, many of these laid off workers may get alternative employment soon, and start repaying their loan instalments. Whereas, it may not be that easy for the company to turn the corner, and regain its earlier health within a short span of time.

Now, in the second situation, let us assume the opposite of the earlier one. That is, the company is now doing exceedingly well, on account of a combination of favorable market conditions, and with a order book flowing and glowing bright, the company is now cash rich beyond its expectations.

In the above situation, it may not be wise for the company to continue to have such a big Bank loan of USD: 8.00 million and to pay interest on it, thereby affecting its bottomline. Rather, the company may want to repay the entire loan, or at least the major portion of it, to avoid paying interest on it.

This can present a ticklish problem for the lending Bank. On the one hand, it is happy to get back its money alongwith the interest, of course. But it had not factored for such early repayment of the loan, and as such, its expected revenues from this transaction have taken a hit. That apart, it may also affect the Bank’s asset liability equation, as the loan to the company was not expected to be repaid so soon. Therefore, the Bank has to take several steps, some of them expensive, to deal with the situation arising out of the company repaying its loan much earlier than as scheduled.

Coming to the employees of the company, who, let us assume, have all been given a raise on account of the exellent performance posted by the company, the Bank does not face the possibility, or the risk of all the 4500 employees who borrowed from it, prepaying their loans. So it does not have to take any special steps, as in the case of the company prepaying their loan, thus saving the Bank a lot of trouble and expenses.These are some of the differences in serving the corporate and the retail client for the Bank.

Other features of Retail Banking:  Retail Banking, as we have seen, is the provision of Banking services at the retail level, the individual level, as against the corporate or organizational level.   It follows logically, therefore, that Banks have to modify their approach and methods, while dealing with these different customer groups, in view of their different requirements and capacities.  

The nature and type of banking products required by a corporate are a bit different from those required by the retail client.   For example, whereas a corporate may require finance for purchase of plant and machinery for the manufacture of the products of their choice, and working capital to meet day to day expenses of running the business, the retail client may require loans for the purchase of consumer durables, like a music system, TV, Refrigerator;  or a home loan, or a car loan, or an educational loan,  etc.   Whereas the amount of loan in the case of the corporate would be huge, the loan required by the retail customer would be small.   Whereas the number of corporate clients may be less, the number of retail clients would be relatively large.

It is to be noted that some of the services and the delivery channels for such services extended to both the retail and the wholesale or corporate clients may be similar.

Conclusion:  Retail Banking, as a service, as well as a source of recurring revenues to the Bank, has  gained in importance, and is being rightly patronized by the Banking industry in earnest.   As corporate banking becomes more and more competitive, and the appetite of the corporates for concessional services grows without check, retail banking would become more and more attractive to the Banks.

 

 

 

 

 

 

RETAIL BANKING PART I

Introduction:  Banking, as a business of money lending, has been around for millenia.   Indigenous systems of Banking have long existed in societies, across the world, providing a vital service to communities, though the aggressive lending techniques adopted by the indigenous Banker had never been popular with anyone.   And like other services, Banking has also evolved over the centuries, reshaping itself time and again to acquire the present shape.   Today, banking, as a financial service caters to all kinds of financial needs  and services required by the community.

Typically, a commercial Bank is engaged in the business of accepting deposits for the purpose of extending loans, among other things.   Banks cater to practically every segment of society, and there is probably no member of society, that is not influenced by services offered by a Bank, in some way or the other.   It is, in fact, difficult to imagine a modern society, without commercial Banks occupying an important position, as facilitators of the myriad financial products and services demanded by modern society, in order to enjoy the creature comforts of life, of course, at a price.

Competition, the great leveller, has ensured, that Banks, that initially catered to the rich and the haves, were gradually forced to offer their services to one and all, resulting in the percolation of such benefits to society at large.   Also, Governmental regulations relating to non discriminatory business practices, and fair competition legislations have contributed to this process of the liberalization of high brow banking.   All these have made banking a viable proposition to the middle and lower classes, who now form the chunk of the business of a commercial Bank.

Even though niche Banking does exist today, catering to exclusive groups and interests, the fact is that the regular Commercial Bank is an egalitarian institution, servicing the collective mass of communities across the country.   Moreover, the attraction of servicing the corporates to the virtual exclusion of the small customer has diminished over time, and today, the small customer occupies an important place in the scheme of things of  Commercial Banks, who are wooing them like never before.   In fact, a distinct class of banking has emerged, called Retail Banking, which is the subject of this article.

Definition:  Retail Banking may be defined as the provision of a package of financial products and services to masses of people, through a network of convinient delivery channels.   In other words, the process of delivering a variety of financial services and products, through various media, to a mass of people, rather than catering to an exclusive group of people or organizations.

Typically, retail Banking involves offering various deposit products running accounts and fixed deposit accounts, and also different loan products like consumer loans, housing loans, car loans etc.   That apart, it also involves offering other products like Bancassurance, etc., in order to maximize revenues.  

The idea is to offer every possible facility to the smaller customers in a convinient and flexible package, to make life easier for them.   The USP of retail banking is the delivery of all kinds of financial products and services in one attractive package, making it easy for the retail customer to avail of them without much of a bother.  

Basically, Banks do the same things in retail banking, like offering deposit and loan products, apart from other services like insurance etc.   The difference lies in the size of the transactions, which is smaller when compared to those involving a Bank’s corporate clients apart from the different requirements of the respective category of the customers, who may require different products on account of their respective constitutions, their tax liabilities, and such other things.

As an example, supposing there is a paint manufacturing company in the city of Seattle, by name, Dolphin Paints Corp, that has a workforce of 5000.   Let us assume that this company has borrowed USD: 10 Million from the American Banking Corporation(ABC)  for the acquisition of plant and machinery, at an interest rate of 2.50% p.a.   On the other hand, the ABC has also extended personal loans to 4500 of the  staff of the company(Dolphin Paints Corp) according to their eligibility, with reference to their financial status, earnings, etc.   Let us assume, that the average loan amount to each of these 4500 employees works out to USD:3,000.00.   That means a total loan amount of USD: 13.50 Million.   And the Bank is charging these employees 3.25% rate of interest on their loans.

Now, let us analyze the above situation, from the Bank’s angle with regard to the various issues involved, like safety of Bank funds and the revenues expected from the loans extended to the corporate client, Dolphin Paints Corp., and the 4500 employees of the company respectively, who form the retail segment of business for the Bank from the particular company.  

 As seen above, Bank has lent an amount of USD: 10 Million to the company at only 2.50% rate of interest, whereas, it has lent a total of USD: 13.50 Million to the 4500 employees at a higher rate of interest at 3.25%.   On balance, it is evident here, that the Bank has gained more from lending to the employees, that is the retail segment, than by lending to the corporate.   The major reason being the higher rate of interest that it charges the retail customer, compared to the corporate client. 

The reason for this discriminatory interest regime is that, the corporate client, by virtue of its size, is able to command a more favorable interest rate from the Bank.   Apart from the favorable interest rate, the corporate is also able to squeeze out many concessional terms for the loan availed by it from the Bank.   Whereas the retail customer, being a small guy, is forced to accept the terms and conditions laid down by the Bank, and has limited scope for negotiating a better deal.   The bigger customer always seems to get a better deal compared to the smaller guy.   

However, when we examine the pros and cons of lending to the big and the small customer respectively, we come to know certain home truths that are enlightening.  

We shall study the interesting contrasts that present before the Bank in respect of its lending decisions, one relating to its corporate client, and the other to its retail segment in the next article.

                                                                               To be continued.

FINANCE: CREDIT CARDS PART I

Introduction: Activities related to  Trade and Commerce are as old as mankind.   They have evolved over time and space, from the very rudimentary to more and more sophisticated practices.   Today, we have reached a stage where one could buy practically anything from anywhere in the world, online.   A comuter system, with internet connection is all one needs, to access the world’s markets, apart from the local ones, of course.

Now, when we talk of buying things, whether online, or otherwse, the most important thing that comes to mind is the payment aspect, apart from other issues like delivery of goods, etc.

How does one make payments for purchases made?   One way, of course, is to pay by cash.   And then there are other ways like cheques,  drafts, etc.   But if one has to pay a large sum of money for purchases made, it may not be convinient to carry so much cash, apart from it being unsafe.   Moreover, the seller of the goods and services may not always accept personal cheques, or even drafts, because they take time to realize.   That is they are not immediately encashable, which results in interest loss to the seller.   Also, it may not be practicable for the buyer to purchase a draft each time he makes a purchase.

This is where the Credit Card comes into the picture, to facilitate payment and smoothening the rough edges of the transaction.

Definition of Credit Card:   A Credit Card is simply a Card that enables the owner to purchase goods and services on Credit.   A credit card transaction involves the issuer, the agents or facilitators, the card owner and the member establishment, or the merchant that sells the goods and services to the card holder.

The system operates like this.   There are companies that issue cards, through their agents, the Banks, to eligible customers, who fulfil the criteria laid down by them.   Among other things, the Banks evaluate the creditworthiness of the card applicants, before deciding to grant them the facility of the Credit Card.   Two of the most famous and popular credit card companies are the Mastercard and Visa.

Normally, Banks grant two types of credit limits to the card holders.   One, the overall credit limit, the other, a cash limit as part of the overall limit.

As an example, say, American Banking Corporation(ABC), on behalf of Mastercard, issues a credit card to Mr. John Walters.   After evaluating Mr. Walters’ financial status, ABC determines that he is worthy of extending a overall  credit line of USD: 20,000.00 through his credit card.  And a cash limit of USD: 5000.00 within the overall limit.   That means, Mr. Walters can buy goods and services for the value of USD: 20,000.00.   Or he may buy goods and services in the value of USD: 15,000.00 and draw cash advance of USD: 5,000.00.   Or he may avail of a cash advance of USD:5,000.00, the remaining limit of USD: 15,000.00 remaining unutilized.   That is, at any given point of time, Mr. Walters would not be eligible to spend more than USD: 20,000.00 using his credit card.

Using the Credit Card:   Supposing Mr. Walters wants to buy a pair of sunglasses.   He visits a local optician, and having checked out a dozen pairs, zeroes in on a pair of Prada sunglasses, that he thinks would fit him perfectly well.   The cost of the sunglasses is USD: 199.00.   After making his choice,  Mr. Walters hands over his credit card to the Cashier, who swipes the card through what is called a reader.   This electronic device is programmed to do the job of obtaining the necessary authorisation from the card issuing Bank, in this case, ABC, thus sealing the transaction, as it were.   Once the authorisation is recieved by the optician’s establishment, the goods, the Prada sunglasses are delivered to Mr. Walters, who is now the legitimate owner of the same.   The optician would then have to deposit the authorisation slip in his own bank, to get the credit from the card issuing Bank.   As this process takes a day or so, the optician, or the merchant, usually charges a small commission on the sale, to compensate himself for the delay in receiving credit into his account.   Once the credit is received in the Merchant’s account, that is the end of the transaction as far as he is concerned.

Now, let us assume, that, after selecting the pair of sunglasses, Mr. Walters finds that he has lost his wallet containing the credit card among other things.   An embarrasing situation, no doubt.   But by following a relatively simple procedure, Mr. Walters can be up and about with a duplicate card within a short time.

Normally in a case as above, the careholder is expected to fill out the relevant forms available with any Merchant, giving details of his card etc., and informing the same to his Bank, and the card issuer.   Further, he has to report the loss/theft to the local police authorities.   Upon receiving this requisition from the cardholder, the Bank and the card issuer take suitable steps to prevent the misuse of the card by passing on this information throughout the network of their merchants and others concerned.   After satisfying themselves about the genuinness of the cardholder’s claim regarding his lost/stolen card, the Bank issues a duplicate card to him.   By acting promptly according to procedures, the cardholder can save himself a lot of trouble, not to speak of monetary loss.

As for the cardholder, he has, no doubt, got delivery of the sunglasses.   But then, he has to make good the amount of  money advanced to him by his Bank, to purchase the pair of sunglasses, within the stipulated time.   Some Banks may afford the option of paying the minimum amount of dues, instead of the full amount, with the rest payable within a certain period of time.   It is upto the cardholder to pay off the entire dues in one go.   He may also instruct his Bank to effect such payments through his account.   In the above example, where Mr. Walters purchased a pair of sunglasses for USD: 199.00 , supposing the Bank requires payment of a minimum amount of due, say, USD: 50.00, within 15 days from the date of purchase, and the remaining amount, within another 25 days.   Let us assume this transaction took place on the 15th of March.   In this case, Mr. Walters would have to pay USD: 50.00 by the 30th of March, and the remaining amount of USD: 149.00 by the 14th of April.

It is a standard practice for the card issuing Bank to charge penal interest on dues that are not cleared within the stipulated time.   And interest is charged on the full amount of the transaction, and not on the overdue amount alone.   In the above example, if Mr. Walters pays USD: 50.00 within time, but fails to pay the remaining balance, his Bank would charge penal interest on the entire amount of USD: 199.00, till the time of its repayment in full.  

An important point to note here is that, the interest rates charged by Banks for defaults in credit card payments are probably the highest for any kind of  transaction.   In fact this is a sore point with the cardholders in most of the countries.   Even the interest charged on the regular credit, availed of, by the cardholder, attracts a very high rate of interest.  

Complaints galore against the alleged unethical practices of Banks and card companies in milking the cardholders at the slightest pretext.   Unjust enrichment is a very common compliant against the card issuers and their agents.

The intense competition among the card companies has led to several unfair trade practices where card companies lure new customers with goodies that eventually land the carholder into avoidable and unneccessary trouble.   One such common ruse used by the card companies is to offer attractive gifts upon signing up for the card.   It is only much later that the poor carholder realizes the ‘real value’ of the gift, in the form of exhorbitant bills and aggressive recovery procedures.

In the second part of this article, we shall discuss the advantages and disadvantages of the credit card.

                                                                                        To be continued.

COMMERCIAL BANKING: NOMINATION IN ACCOUNTS

Introduction:  Many a time, we come across cases of people, including siblings, fighting each other, over the property, or estate of a deceased relation, may be a parent, a aunt, or a grand father.   The commonest reason for this being the absence of a will, of the deceased.   A will, properly executed, would prevent arguments, fights , and worse, among the heirs of the deceased person.   The will would clarify as to who would inherit the estate(property, etc.) of the deceased, and to what extent and value, resulting in a peaceful division of the estate amongst the heirs.  

 In the same way, a person, having deposit accounts in a Bank must nominate beneficiaries of the deposit accounts in the event of his death, so that his heirs inherit the moneys in the form of deposits, and do not face any legal or administrative hassles.   This article discusses the issue of nomination in Bank accounts, primarily deposit accounts.

Nomination-Definition:  Nomination is a facility, or a mechanism, recognized in law, to ensure the smooth passage of the rights over the deposits, in deposit accounts, and the articles, valuables etc, in a safe deposit locker account, or safe custody of the Bank, standing in the name of the deceased Bank customer to his nominee, that is, the beneficiary of the nomination.

As an example, supposing one Mrs. Ruth Walters, a widow, has a deposit account with the American Banking Corporation, with a credit balance of USD:250,000.00, and Mrs. Walters has nominated her son, Mr.John Walters, in this account.   Upon her death, Mr.John Walters would be entitled to receive the balance in Mrs. Walters’ account, by complying with a simple procedureof satisfying the Bank about his identity.

In the absence of the above nomination, normally, Mr. John Walters would be expected to make a legal claim on the balance in Mrs. Walters Bank account, and go through the process of Court procedure, before getting access to the said deposits.   That would cost Mr Walters, money, apart from taking up his time.

Important Features of Nomination:  Some of the important features of the nomination facility availble in Bank Accounts is discussed below:

Nomination facility in Bank deposit accounts is available only to individuals.   That means, institutions are not eligible to utilize this facility.

In the example above, we have seen Mrs. Ruth Walters had exercised her right to nominate her son in her Bank account, in her individual capacity.   Supposing she had an account with the American Banking Corporation in the name of M/s. Walters’  Diner, and she were the sole owner of this firm, she would still be eligible to nominate her son , or for that matter, any one else, in her Bank account.   However, if this firm of M/s. Walters’  Diner were to be a partnership firm, with Mrs. Walters as one of the partners, she would not have the right to nominate her son, in this account.   The Bank would reject her request for such a nomination.

In the same way, even the nominee in the Bank account has to be an individual, and not an institution, like a Company, or trust etc.   In Mrs. Walters’ example, she would have the right to nominate her son, or a person of her choice, in her Bank account, but not her Church, or Alma Mater, or any other institution.   Again her Bank would not accept such a nomination.

Another point to be noted is that, there can be only one nominee in a deposit account.   In Mrs. Walters’ case, let us assume, she has a son John, and a daugher, Sally.   She would be able to nominate, either John or Sally in her Bank account, and not both of them.   However, Mrs. Walters can, at any time, change the nomination in the Bank account, at her sweet will.   And normally, there is no restriction on the number of times that a nomination may be changed.   Supposing, Mrs. Walters had nominated her son, John in her Bank account, on say, Jan. 01, 2009, and replaced John, with her daugher, Sally, on Feb. 01, 2009, and then again replaced Sally with her son, John on Mar. 01, 2009, that would be perfectly OK.   Her Bank would have no objection to this and allow it without demur.

Nomination has to be effected in each of a person’s Bank accounts seperately.   The law does not assume that nomination made in one Bank account of the customer, would automatically apply to all the other Bank accounts standing in the name of such customer.   In Mrs. Walters’ example, if she had two deposit accounts, and he had nominated John in one of the accounts, while the other account remained without any nomination, it does not automatically follow that John would be the nominee in the second deposit account also, and would receive the funds in the second account in the event of his mother’s death.   Nomination has to be done specifically in each of the Bank accounts.   Supposing Mrs. Walters died, and John approached the Bank for claiming the funds in the second deposit account, the Bank would not entertain such a request from John.

In case of a change in the constitution of the Bank account, the existing nomination would become void, and a fresh nomination would have to be made.   In Mrs. Walters’ example, where she nominated her son, John, in her deposit, of USD:250,000.00, supposing she requests her Bank to add the name of her daughter, Sally, as a co-depositor, along with her.   Upon her Banker complyting with her request,  John’s nomination in that particular deposit would cease to be, and would have to be re-done.

One important aspect of nomination in Bank accounts that need to be borne in mind is that, the nominee may or may not be the legal heir of the depositor.   Where the nominee happens to be also the legal heir, then, upon the death of the depositor, when proceeds of the Bank accounts pass on to the nominee, it would not be accompanied by any dispute or drama for the Bank, or the nominee.

However, where the nominee, and the legal heir, are two different persons, then, there is a potential of disputes between the two parties, even though, the Bank, in such a case, would not be put to any trouble as it had acted in compliance with the customer’s mandate.

Conclusion:  To sum up, the importance of nomination in Bank accounts cannot be overestimated.   To ensure a hassle free inheritance of one’s Bank deposits, by their chosen ones, nomination is a must, by the depositor.   What’s more, the procedure for nomination in Bank accounts is really simple, and the system is flexible enough to accomodate multiple changes too.  

The laws and rules applicable to nomination in Bank accounts may vary from country to country, and are dictated to an extent by local customs and practices. 

COMMERCIAL BANKING: GUARANTEES

Introduction:  Commercial Banks extend various types of credit facilities to their constituents, to enable them carry out their business activities.   These facilities may be broadly divided into two categories-Funded and Non Funded facilities.

Funded facilities are those, where Banks actually part with money.   For example, a Bank sanctions a Term Loan to a Paper Manufacturing Company, for purchase of machinery.   The Bank would normally make payment to the supplier of this machinery, on behalf of its borrower.   In turn, the supplier delivers the machinery to the Paper Manufacturer.   Similarly, the Bank may grant working capital to its borrower, to meet the day to day expenses of running the business.

Non funded facilities, on the other hand, are those where the Bank does not actually part with money, but promises to do so, contingent upon the occurance of certain events.   Which means, unless the said event eccurs, the Bank will not be called upon to part with money.   The most common non funded facilities offered by Banks are Letters of  Guarantee and Letters of Credit.

Definition of Guarantee:  A Guarantee is a contract, a legally binding agreement, given by one person, on behalf of another, to carry out or perform the task of the latter, in case of his default.   In the same fashion, it may also relate to the promise of discharging the liability of one person, by the other in case of the former’s default.

Types of Guarantees:  There are two types of Guarantees, taken up for discussion in this article, namely, Financial and Performance Guarantees.  Apart from these, there is athird type of Guarantee called the Deferred Payment Guarantee, which will be discussed at a later date.

Performance Guarantee:  This guarantee, as can be seen, relates to performance.   In this type of guarantee, the Bank undertakes to either ensure the performance of the contract by its customer, on whose behalf it has issued the guarantee, or to make good, the loss suffered by the third party, or the beneficiary under the guarantee,  on account of the non performance by the Bank customer.

As an illustration, say, M/s. A Wind Power(AWP) contracts with the State of Arizona to supply and set up 500 wind mills across the State for a consideration of USD:1 Million.   American Banking Corp.,(ABC) the Banker to M/s. A Wind Power, gives a guarantee, favoring the State of Arizona, on behalf of their client, that AWP would supply and set up the 500 wind mills in Arizona, as per the terms of the contract between AWP and the State of Arizona.   Further, in the event of AWP faililng to execute the contract, the American Banking Corp. would reimburse the State of Arizona, a sum of USD:1 Million in lieu of their client’s failure to execute the said contract.

In the above example, ABC, have issued a Performance Guarantee, on behalf of their client AWP, favoring the State of Arizona.   In this example, two scenarios may emerge.   One, the AWP executes the contract as per the terms, and gets paid by the State of Arizona and everything ends peacefully.   All the three parties to the Guarantee are happy.   The Bank has collected its commission/fees from the client, the State of Arizona have their wind mills in place, and the Bank client have received their payment from the State.

In the second scenario, however, the Bank client, i.e. AWP, on whose behalf the Bank had issued the guarantee, may either not perform the contracted work, or may not perform it according to the terms of the contract.   In that event, the State of Arizona may invoke the guarantee, and demand payment of the guaranteed amount of USD:1 Million.   And ABC would be obliged to make the payment, without demur.

Financial Guarantee:  This type of guarantee relates to money, as against performance.  Under this guarantee, the Bank undertakes to make good a payment, on behalf of its client, to a third party, upon default of its client, to do so.  

As an illustration, say, the World Bank floats a international Bid or Tender for the supply of 500 wind mills to be set up in the African State of Mali.   The value of the Bid is USD:1 Million.  According to the terms of the bid, the competing companies are expected to deposit a sum of USD:100,000.00 with the World Bank, as Earnest Money, to be eligible to participate in the Bid.   M/s. A Wind Power (AWP), a competing company, approaches its Bankers to issue a guarantee in favor of the World Bank, on its behalf, for the stated amount.   The Bank agrees to comply with the request of its client, subject to certain conditions, as per Bank policies.   This type of guarantee is called a Financial Guarantee.

In the above case, the Bank has issued a guarantee in lieu of a cash deposit that its client would have had to keep with the World Bank.   This enables the company to participate in the bid without having to shell out the USD:100,000.00, which might affect its liquidity adverserly.   This is just one example of a Financial Guarantee.   If AWP wins the bid, but refuses to accept the contract, then the World Bank would invoke the guarantee, and keep the Earnest Money deposit of USD:100,000.00.   Then the ABC would be left with the alternative of recovering the money from their client.

Both types of Guarantees, discussed above, lay down the respective rights, and responsibilities of the parties to the guarantee.   The amount of the guarantee is specified.  The validity of the Guarantee is specific.    So also the time time limit for invoking the guarantee.   Grace period, if any, is also specified in the Guarantee document.   Limitations, if any, are also laid down in precise terms to avoid confusion and conflict.

Conclusion:  Guarantees are one of the major financing options available to Banks, to assist their clients engaged in trade and commerce.   Banks do not extend this facility to all and sundry, but only to creditworthy clients.   Even though, this facility is a contingent liability to the Bank, that is, it crystallizes only upon the happening of a certain event, in this case, the default of the client, a prudent Bank assumes a default on part of its client, while considering granting of this facility.   

« Previous Page — Next Page »