Commercial Bank

Management Basics
Delivered by: Ms. Nouf Qureshi
Introduction
• Bank is a financial institution which accepts money from the public for the purpose of lending or investment
repayable on demand or otherwise withdrawable by cheques, drafts or order or otherwise.
• Basic Definition: A system of trading money which: provides a safe place to save excess cash, known ae
deposits. supplies liquidity to the economy by loaning this money out to help businesses grow and to allow
to purchase consumer products, homes, cars etc
• A bank is said to be a financial intermediary. It stands mid way between the savers and the users of fund.
There are different types of bank having some common and some special functions.
• Banks may be of various types such Central Bank, commercial banks, development banks, Cooperative
banks, rural banks etc. The Central Bank, the commercial banks and the development banks are of primary
importance.
• A commercial bank is a financial intermediary, Its central objective is commercial that is, profit making, It
takes money from a surplus unit by paying a low rate of interest and lends the same fund to a Deficit unit at
a higher rate of interest and thus makes profit.
• It is said to be a dealer in credit, It may be organized privately or by the Government
• The two primary functions of such a bank are Deposit function and Loan function, Deposits may be of three
types: Demand or current, Savings and Fixed or Time deposit.
Functions of commercial bank
What are the main functions of
bank?
• Functions of Commercial Banks: - Primary functions include accepting
deposits, granting loans, advances, cash, credit, overdraft and
discounting of bills. - Secondary functions include issuing letter of
credit, undertaking safe custody of valuables, providing consumer
finance, educational loans, etc.
• (a) Accepting Deposits:
• The banks borrow in the form of deposits. This function is important
because banks mainly depend on the funds deposited with them by
the public.
Deposits types
• Demand Deposits or Current Account Deposits:
• If a depositor deposits money in the bank in the current account (i.e., demand
deposits), he can withdraw it in part or in full at any time he likes without notice.
These accounts are generally kept by businessmen whose require­ments of making
business payments are quite uncertain. Usually no interest is paid on them,
because the bank cannot utilise these short-term deposits for lending purposes and
must keep almost cent per cent reserve against them.
• But in return for these current account deposits, the banks offer some facilities or
concessions to the account holders. The most important is the cheque facility made
available to them, that is, the account holders make payment to the parties
through cheques on these accounts. Further, on behalf of the holders of current
account deposits, banks collect cheques, drafts, dividend warrants, postal orders,
etc.
• Fixed Deposits or Time Deposits: These deposits are made for a fixed
period of time, which varies from fifteen days to a few years. These
deposits cannot, therefore, be withdrawn before the expiry of that period.
• However, a loan can be taken from the bank against the security of these
deposits within that period. A higher rate of interest is paid on the fixed
deposits. As the fixed deposits carry a good rate of interest, they are a
good source of investment by the people who are in a position to save.
• Savings Bank Deposits: In this case the depositor can generally withdraw
money usually once a week. Sometimes there are also restrictions as to
the total amount that can be withdrawn at one time and the total amount
that can be placed in one deposit.
• These deposits are generally made by the people of small means, usually,
people with fixed salaries, for holding their short-term savings. Like the
current account deposits, the saving bank deposits are payable on
demand and also they can be drawn upon through cheques.
Functions continued..
• (b) Advancing Loans:
• Another function of the bank is to give loans to others. If the bank does not lend the
deposited money to others, how can it pay the interest on the deposits to depositors?
Banks give loans to businessmen and firms usually for short periods only.
• This is so because the bank must keep itself ready to meet the demands of the people
who have deposited money for short period only. In advancing loans, the bank has to
shoulder a heavy responsibility.
• The bank makes profit by advancing loans. But the bank deals in other people’s money
and it has to keep some ready cash to meet the depositors’ demands. Hence a great care
has to be exercised in the matter of lending and keeping resources.
• The bank must strike a fine balance between liquidity and profitability. If it keeps its assets
in too liquid a form, it loses profit and if it tries to make too much profit, it may not be
able to meet the depositor’s demand. It must aim at both liquidity and profitability.
 Banks advance loans in the
following ways:
• (i) By allowing an overdraft:
• Those people who keep current account with the banks are sometimes given the right to overdraw their accounts. In other words, people
make arrangements with the banks that if a cheque has been drawn by them which is not covered by the deposit, then the bank should grant
the overdraft and honour the cheque.
• Thus under overdraft arrange­ments, people can get more than they have deposited but they have to pay interest on the extra amount which
has to be paid back within a short period. Overdraft facilities are generally granted to businessmen who can pay off the money after the sale of
the goods.
• (ii) Cash-Credit Loan:
• Under the cash-credit system, borrower is sanctioned a credit limit up to which he can borrow from the bank. But before granting a credit limit
the bank satisfies itself about the credit-worthiness of the borrower. However the actual utilisation of the credit limit by the borrower depends
on his withdrawing power.
• Withdrawing power of a borrower is determined by his current assets which consists of stocks of goods, that is, stocks of raw ma­terials, semi-
finished goods and his bargaining power. The interest payable by the borrower is a calculated on the amount of the credit limit actually drawn.
• (iii) Demand Loans:
• Demand loans granted by a bank are those loans which can be recalled on demand by the bank any time. The entire sum of a demand loan
granted to a borrower is paid in lump sum by crediting it to his account. Therefore, the interest is payable on the entire sum of the demand
loan granted. Demand loans are usually granted to stock-brokers whose need for credit fluctuates from day to day.
• (c) Discounting Bills of Exchange or Hundies:
• A very important function of a modern bank is to discount bills or hundies of businessmen. It is like this, a businessman buys goods and is
granted credit, say, for a month. The seller of the goods draws a bill of exchange which the purchaser is asked to sign.
• The bill orders the purchaser to pay a certain sum after the expiry of one month. If the seller goes on selling goods on this basis, he will soon
find that all his stock is gone and he has got only these hundies in his cash box.
• Unless these hundies are changed into cash, his business will come to a
standstill. He, therefore, does not keep these hundies with him till they mature
for payment. But he takes them to the bank and gets the present worth of the
hundies, leaving the bank to realise them when the date of payment comes.
This is called discounting a bill. It is obvious that the bank has advanced money
to the businessman for the period of the currency of the bill.
• Bill discounting is considered a very suitable investment for a bank. The bills are
certain to be paid on maturity. They can be rediscounted with the central bank,
if necessary. They set up a regular flow of incomings and outgoings of cash.
Being negotiable instruments, the bills do not create any difficulty at the time
of payment and do not involve the bank in any litigation.
• It represents a short-term investment, which suits the bank very well because
most of its deposits are also of short term. For all these reasons this form of
advance represents the most suitable investment from the bank’s point of view.
• That is why it is sometimes remarked that a good banker knows the difference
between a bill and a mortgage.
Functions continued…
• (d) Transfer of Money: Banks transfer money from one place to another for
their customers. Banks remit the funds of the people by means of a bank
draft or a cheque. This is a cheap as well as safe method of transferring
money from one place to another.
• (e) Miscellaneous Functions: A bank now-a-days serves its customers in
various other ways. It has lockers or ‘safe deposit vaults’. They are meant to
keep the valuables of customers in safe custody.
• Further, a bank collects interest on behalf of its customers as well as pays
dividends on behalf of joint-stock companies. It purchases and sells stocks
and shares of companies for its clients. It pays insurance premium on behalf
of their customers from their deposits. It executes the wills of deceased
customers and acts for them as a trustee.
Functions of State Bank of Pakistan
• The traditional functions, which are generally performed by central banks almost all over the
world, may be classified into two groups:
• (a) the primary functions including issue of notes, regulation and supervision of the financial
system, bankers’ bank, lender of the last resort, banker to Government, and conduct of
monetary policy, and
• (b) the secondary functions including the agency functions like management of public debt,
management of foreign exchange, etc., and other functions like advising the government on
policy matters and maintaining close relationships with international financial institutions.
• The non-traditional or promotional functions, performed by the State Bank include
development of financial framework, institutionalization of savings and investment, provision of
training facilities to bankers, and provision of credit to priority sectors.
• The State Bank also has been playing an active part in the process of islamisation of the banking
system. The main functions and responsibilities of the State Bank can be broadly categorized as
under.
REGULATION OF LIQUIDITY
• Being the Central Bank of the country, State Bank of Pakistan has been entrusted with the responsibility to
formulate and conduct monetary and credit policy in a manner consistent with the Government’s targets for growth
and inflation and the recommendations of the Monetary and Fiscal Policies Co-ordination Board with respect to
macro-economic policy objectives.
• The basic objective underlying its functions is two-fold i.e. the maintenance of monetary stability, thereby leading
towards the stability in the domestic prices, as well as the promotion of economic growth.

To regulate the volume and the direction of flow of credit to different uses and sectors, the Bank makes use of both
direct and indirect instruments of monetary management. Until recently, the monetary and credit scenario was
characterised by acute segmentation of credit markets with all the attendant distortions. Pakistan embarked upon a
program of financial sector reforms in the late 1980s.
• A number of fundamental changes have since been made in the conduct of monetary management which
essentially marked a departure from administrative controls and quantitative restrictions to market-based monetary
management.
• A reserve money management programme has been developed. In terms of the programme, the intermediate
target of M2 would be achieved by observing the desired path of reserve money - the operating target. While use in
now being made of such indirect instruments of control as cash reserve ratio and liquidity ratio, the program’s
reliance is mainly on open market operations.
ENSURING THE SOUNDNESS OF
FINANCIAL SYSTEM:
• REGULATION AND SUPERVISION
One of the fundamental responsibilities of the State Bank is regulation and supervision of
the financial system to ensure its soundness and stability as well as to protect the interests
of depositors. The rapid advancement in information technology, together with growing
complexities of modern banking operations, has made the supervisory role more difficult
and challenging. The institutional complexity is increasing, technical sophistication is
improving and technical base of banking activities is expanding.
• All this requires the State Bank for endeavoring hard to keep pace with the fast-changing
financial landscape of the country. As a response to these challenges and considering the
international best practices, SBP has adopted a fully Risk Based Supervisory approach.
• The supervisory activities are now being conducted through supervisory teams which
encompasses off-site supervision, on-site assessments and enforcement actions. The
intensity of supervisory activities commensurate with the risk profile of supervised
institutions.
• EXCHANGE RATE MANAGEMENT AND BALANCE OF PAYMENTS
One of the major responsibilities of the State Bank is the maintenance of external value of the currency. In this regard, the Bank is required,
among other measures taken by it, to regulate foreign exchange reserves of the country in line with the stipulations of the Foreign Exchange
Act 1947. As an agent to the Government, the Bank has been authorised to purchase and sale gold, silver or approved foreign exchange and
transactions of Special Drawing Rights with the International Monetary Fund under sub-sections 13(a) and 13(f) of Section 17 of the State Bank
of Pakistan Act, 1956.
• The Bank is responsible to keep the exchange rate of the rupee at an appropriate level and prevent it from wide fluctuations in order to
maintain competitiveness of our exports and maintain stability in the foreign exchange market. To achieve the objective, various exchange
policies have been adopted from time to time keeping in view the prevailing circumstances. Pak-rupee remained linked to Pound Sterling till
September, 1971 and subsequently to U.S. Dollar. However, it was decided to adopt the managed floating exchange rate system w.e.f. January
8, 1982 under which the value of the rupee was determined on daily basis, with reference to a basket of currencies of Pakistan’s major trading
partners and competitors.
• Adjustments were made in its value as and when the circumstances so warranted. During the course of time, an important development took
place when Pakistan accepted obligations of Article-VIII, Section 2, 3 and 4 of the IMF Articles of Agreement, thereby making the Pak-rupee
convertible for current international transactions with effect from July 1, 1994.
• After nuclear detonation by Pakistan in 1998, a two-tier exchange rate system was introduced w.e.f. 22nd July 1998, with a view to reduce the
pressure on official reserves and prevent the economy to some extent from adverse implications of sanctions imposed on Pakistan. However,
effective 19th May 1999, the exchange rate has been unified, with the introduction of market-based floating exchange rate system, under
which the exchange rate is determined by the demand and supply positions in the foreign exchange market.
• The surrender requirement of foreign exchange receipts on account of exports and services, previously required to be made to State Bank
through authorized dealers, has now been done away with and the commercial banks and other authorised dealers have been made free to
hold and undertake transaction in foreign currencies.
• As the custodian of country’s external reserves, the State Bank is also responsible for the management of the foreign exchange reserves. The
task is being performed by an Investment Committee which, after taking into consideration the overall level of reserves, maturities and
payment obligations, takes decision to make investment of surplus funds in such a manner that ensures liquidity of funds as well as maximises
the earnings.
• These reserves are also being used for intervention in the foreign exchange market. For this purpose, a Foreign Exchange Dealing Room has
been set up at the Central Directorate of State Bank of Pakistan and services of a ‘Forex Expert’ have been acquired.
DEVELOPMENTAL ROLE OF
STATE BANK
• The responsibility of a Central Bank in a developing country goes well beyond the regulatory duties of
managing the monetary policy in order to achieve the macro-economic goals. This role covers not only the
development of important components of monetary and capital markets but also to assist the process of
economic growth and promote the fuller utilisation of a country’s resources.

• Ever since its establishment, the State Bank of Pakistan, besides discharging its traditional functions of
regulating money and credit, has played an active developmental role to promote the realisation of macro-
economic goals. The explicit recognition of the promotional role of the Central Bank evidently stems from a
desire to re-orientate all policies towards the goal of rapid economic growth. Accordingly, the orthodox
central banking functions have been combined by the State Bank with a well-recognised developmental role.
• The scope of Bank’s operations has been widened considerably by including the economic growth objective in
its statute under the State Bank of Pakistan Act 1956.
• The Bank’s participation in the development process has been in the form of rehabilitation of banking system
in Pakistan, development of new financial institutions and debt instruments in order to promote financial
intermediation, establishment of Development Financial Institutions (DFIs), directing the use of credit
according to selected development priorities, providing subsidised credit, and development of the capital
market.
 Commercial bank statements
A typical balance sheet consists of the core accounting equation, assets
equal liabilities plus equity. Under these accounts, non-banking
companies may have other large classes such as PP&E, intangible assets,
current assets, accounts receivables, accounts payables, and such.
A bank, however, has unique classes of balance sheet line items that
other companies won’t. The typical structure of a balance sheet for a
bank is:
Assets
Property
Trading assets
Loans to customers
Deposits to the central bank
Liabilities
Loans from the central bank
Deposits from customers
Trading liabilities
Misc. debt
Equity
Common and preferred shares
Commercial bank balance sheet
added items
• Loans and Deposits to Customers: The main operations and source of revenue for banks
are their loan and deposit operations. Customers deposit money at the bank for which
they receive a relatively small amount of interest. The bank then lends funds out at a
much higher rate, profiting from the difference in interest rates.
• As such, loans to customers are classified as assets. This is because the bank expects to
receive interest and principal repayments for loans in the future and thus generate
economic benefit from the loans.
• Deposits, on the other hand, are expected to be withdrawn by customers or also pay out
interest payments, generating an economic outflow in the future. Deposits to customers
are, thus, classified as liabilities.
• Trading Assets and Liabilities: Banks may hold marketable securities or certain currencies
for the purposes of trading. These will naturally be considered trading assets. They may
have trading liabilities, which consists of derivative liabilities and short positions.
 Income statement
Non-interest Revenue
Non-interest revenues consist of ancillary revenue the bank makes in supporting its
services. This can consist of: Broker fees, Commissions and fees from products and
services, Underwriting fees, Gain on sale of trading assets, Other customer fees (NSF
fees, swipe fees, overdrawn fees)
These revenues come from anything that does not constitute interest revenue.
Interest Revenue
Interest revenue captures the interest payments the bank receives on the loans it issues.
Sometimes, this line item will only state gross interest revenue. Other times, this line will
consolidate gross interest revenue and deduct interest expense to find net interest
revenue. This interest expense is the direct interest expense paid to the deposits used to
fund the loans, and does not include interest expense from general debt.
Credit Loss Provisions
Just like accounts receivables and bad debt expense, a company must prepare in the
event that borrowers are not able to pay off their loans. These bad pieces of credit are
written off in the income statement as a provision for credit loss.
Commercial Bank Balance sheet
Bank balance sheet Source of
funds
Bank balance sheet Source of
funds
Uses of funds
Bank balance sheet Uses of
funds
• Cash (primary reserves) is the banker’s first line of defense againts
withdrawals by deposits and customer demand for loans
• Commercial banks hold securites (mostly short-term) acquired in the
open market as an investment and as a secondary reserves to help
meet short-term cash needs.
• Loans are among the highest yielding assets a bank can add to its
portfolio, and they often provide the largest portion of traditional
banks’ operating revenue
Bank balance sheet Uses of
funds Loans pricing
Deposits & money creation
Basic operation of a bank:
Deposits or Money creation
• Banks have the power to create money in the form of new checkable deposits,
credit card lines, debit cards, and other immediately spendable funds.
• The banking system as a whole can create a volume of money equal to a
multiple of any excess reserves deposits with it simply by making loans and
purchasing securities.
• Each bank reserves may divided into 2 categories: Required reserves & Excess
reserves.
• The distinction between excess and required reserves is important because it
plays a key role in the growth of credit in the economy and the creation of
money in the banking system. When all excess reserves extended (making
loans), the banking system is called “loaned-up”.
General Principle of Bank
Management
 Liquidity management
o Make sure enough cash to meet deposit withdrawal
o Too much cash is costly
 Assets management
o Acquiring assets with low risk
o Diversifying assets holdings
 Liability management
o Acquiring funds with low cost
• Capital management
o Maintain capital adequacy
Liquidity management Either
fail to meet deposit withdrawal
• Banks need to maintain adequate reserves to meet deposit
withdrawal and reserve requirement.
• If a bank has ample reserves, a deposit outflow does not necessitate
changes in other parts of its balance sheet.
• What if a bank holds insufficient reserves? Either fail to meet deposit
withdrawal or fail to meet required reserves -> penalty
• What that bank will do in this situation?
• It can either borrow from other banks (fed funds in US and PUAB in
Indonesia),or sell securities (T-bills/bonds),or borrow from the central
bank (discount rates).
Assets management
• Maximizing profits by seeking the highest returns possible for loans and
securities, reduce risk, and make adequate provisions for liquidity by holding
liquid assets
• Four ways in accomplishing these three goals:
1. Find borrowers who will pay high interest rates and unlikely to default – the
role of bank’s loan officers.
2. Purchase securities with high returns and low risk.
3. Diversifying assets portfolio (short, long-term) to lower risk – “do not put your
eggs into one basket”.
4. Manage liquidity of the assets, easy to get cash to meet reserve requirement –
how much excess reserves must be held to avoid cost from a deposit outflow.
Liability management
• Managing the source of funds, from deposits, to CDs, to other debt –
banks no longer depends primarily deposits - When see loan
opportunities, borrow or issue CDs to acquire funds
• So a bank can target goals for their assets growth and acquire funds
by issuing liabilities in the money market or by borrowing from
another bank (interbank money market – o/n federal funds in the US
market).
• Flexibility in the liability management and the search for higher profits
have stimulated banks to increase proportion of loans (which earn
higher income) in their total assets.
Capital management
Capital Management continued..
• Trade off between safety (high capital) & ROE
• Banks also hold capital to meet capital adequacy
• Strategies for Managing Capital
1. Sell or retire stock
2. Change dividends to change retained earnings
3. Change asset growth
Off-balance sheet activities
• In today’s more competitive environment, off-balance sheet activities have grown to be a source of
bank’s profit – activities that affect bank profits but do not appear on the bank balance sheets.
• Off-balance activities generate income: Fee income from Foreign exchange trades for customers
i. Servicing mortgage-backed securities
ii. Guarantees of debt
iii. Backup lines of credit
o Financial futures and options
o Foreign exchange trading
o Interest rate swaps
o Loan sales
• All these activities involve risk
• Payments services on behalf of customers – low risk
Measuring Bank Performance
• Four dimensions of bank performance today:
The bank’s market value or stock price
The bank’s rate of return or profitability ratios
The bank’s risk exposure
The bank’s operating efficiency.
• Much like any business, measuring bank performance requires a look at the income
statement. For banks, this is separated into three parts:
i. Operating Income
ii. Operating Expenses
iii. Net Operating Income
• Note how this is different from, say, a manufacturing firm’s income statement.
 Selected banking performance
indicators
• Capital adequacy ratio (CAR) – capital/risk weighted assets
• Earning assets quality ratio – classified earning assets/total earning assets
• Return on assets ratio – annual profit before taxes/average assets
• Operations expenses to operations income ratio
• Liquid asset to liquid liabilities ratio
• Loan to deposit ratio (LDR) – total credit/third party funds (deposits)
• Non-performing loan ratio (NPL) – credits that are sub-standard , doubtful
and loss/ total credits
• Net interest margin (NIM) ratio –net interest income/average earning
assets
Fiscal and Monetary policy
• The two most frequently used stabilization policies are fiscal policy and monetary policy. Fiscal Policy: This
policy makes use of government spending and/or taxes, the two components of the government's "fiscal"
budget. When government increases or decreases spending, especially by changing the quantity of gross
domestic product purchased, then aggregate production, employment, and national income are also
affected. Government can change the amount of taxes collected from the public, as well, which then affects
the amount of income available to purchase gross domestic product. This also triggers changes in aggregate
production, and national income.
• What is Fiscal Policy? FISCAL policy is the use of government spending and taxation. Governments use policy
to promote strong and sustainable growth and reduce poverty
• Monetary Policy: This policy involves the total amount of money in circulation throughout the economy, as
well as interest rates in financial markets. By changing the amount of money in circulation, the public has
more or less of an ability to purchase gross domestic product, which then triggers changes in overall
economic activity. Money supply changes also invariably cause changes in interest rates, which subsequently
affect the willingness and ability to borrow the funds used for expenditures.
• Monetary Policy refers to the credit control measures adopted by the central bank of a country. Monetary
policy "as policy employing central bank's control of the supply of money as an instrument for achieving
achieves of general economic policy.”