Volatile Liquidity Dependence Ratio Finance Essay - Free Essay Example

Banks being very significant financial institutions, operating within the economy and controlling it, have increasingly played a significant role in conditioning the economic factors such as assets and liabilities, which are strategically managed and manipulated for profit and social welfare. Financial sector reforms, which have brought rapid changes in the structure of financial market exposed banks to various risks such as Interest Rate Risk, Liquidity Risk, Credit Risk etc. The most significant element which integrates the markets and the institutions in a financial system is interest rate structure. Thus, interest rates should increasingly be allowed to perform their main function of allocating scarce loanable funds among alternative uses which necessitate the deregulation of interest rates. The various changes in the priorities and strategies that have been imposed on the banks due to the transition in the economy have required evaluation and analysis as beneficial to the banking sector. After deregulation of interest rate in India there was common debate among the bankers as to what will be the impact of this strategic move of Indian banking on the bank performance especially on advances, investments, spread, capital adequacy and earning of banks. Interest rate deregulation have been analysed from this strategic and practical angles in this study to assess how these various measures have affected the banking performance in the post reform period and to analyse the extent interest rate deregulation implemented by the RBI enable the banks to manage various performance parameters . Hence this analytical study of the banking sector in India has been conducted with the following objectives. Main objective To analyze and evaluate the impact of deregulation interest rates on bank performance. Sub Objectives The other objectives of the study are: To review the relevant research and literature on the subject. To identify the impact of deregulation of interest rate in the Spread and Burden of the banks. To evaluate the Interest Rate Risk Management of the banks. To ascertain impact of deregulation of interest rates on asset quality and measures taken by banks to manage credit risk. To analyze and evaluate the impact of deregulation on bank performance by studying FIVE dimensions of CAMEL. The present study was undertaken to know the behavoiur of six selected banks i.e. State Bank of India (SBI), Bank of Baroda (BOB), Punjab National Bank (PNB), ING Vysya bank, The Federal Bank and JK Bank, covering a period of 10 years ranging between 1998 to2008. It was particularly aimed at gaining insight into the impact of deregulation of interest rates on various aspects of banking operations. In this context, CAMEL parameters were analyzed to study influence of deregulation of int erest rates on the behaviour of capital adequacy, asset quality, management soundness, earnings and profitability, liquidity and sensitivity of share prices to market risk, so that bank management could be helped in formulating an effective spread, capital, earning and risk management policy. The findings of the present study are summarized as follows:- Capital Adequacy The total minimum capital requirements for credit, market and operational risks in banks is calculated using definition of regulatory capital as defined in Basel Accord II and risk weighted assets. While Tier II Capital is limited to 100% of Tier I Capital, the total Capital to Risk Weighted Assets must not be lower than 8%. The Risk Weighted Assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 and adding the resulting figure to the sum of risk weighted assets for Credit Risk. The analysis of Risk Weighted Capital Adequacy Ratio ensures that bank has adequate capital/cushion vis-Ã  -vis to perceived risks for on and off balance sheet exposures. The findings of Capital Adequacy are presented here under:- The Capital Adequacy ratio of all banks under study is more than the requisite standard of 8%. However, the percentage of equity share capital has deflated over the period of study but reserves position has witnessed sharp gr owth for all banks in the post reform period. This indicates that banks are following stringent dividend policy for maintained of risk weighted capital adequacy ratio (CRAR). The mean CRAR has been recorded at 13.10 percent, 12.53 percent, 11.18 percent, 14.25 percent, 10.90 percent and 17.42 percent for SBI, BOB, PNB, ING, Federal Bank and JK Bank respectively. The ratio clearly shows that banks are better placed in terms cushion for taking credit risk as the minimum prescribed ratio for banks in India is 8%. The leverage ratio of the banks have shown declining trend for all banks. This reveals that banks have shown reluctance on dependence on debt capital and have become selective in mobility the deposits became otherwise it is difficult for them to manage credit in post deregulatory period. The ratio of advances to assets is higher in case of private sector banks compared to public sector banks. This is also confirmed by the F-test, which indicated significant difference in this ratio. The ratio, however, reveals that banks have taken more credit risk which does not with commensurate increase in CRAR. The percentage of investment, in government securities is higher for private sector bank as compared within public sector banks. This manifests that private banks are mere concerned with insulation of positive spread and are more concerned within management of capital risks. Asset Quality A bank grants credit to produce profit and is one of the largest on balance sheet items. In the process of granting loans also assume and accept risks. In evaluating risks, banks should assess the likely downside scenarios and their possible impact on the borrowers and their debt serving capacity. Two types of losses are possible in respect of any borrower or borrower class-expected and unexpected losses. Expected losses affect the asset quality because budgeted for and prevision held to offset their adverse effects. However, unexpected losses have more severe impact on banks but are unpredictable and can be cushioned by holding adequate capital. The quality of assets is, therefore, ascertained in terms of loan losses and expected losses. This parameter is important to gauge the strength of the bank in per and post deregulated period. Since the loan portfolio is always interest sensitive and is always affected by interest rate changes, thus study of asset quality was sine-quonon for present study. The Gross NPAs ratio for private sector banks was very high in pre deregulation period compared to post deregulation period starting from 2000-01, when particle deregulation started. Similar picture is not different for public sector banks. The ratio of Gross NPAs has touched to lowest level for all public and private sector banks in 2007-08. This phenomenon reveals that deregulation of rates has been effectively utilized by the bank and has positively influenced the borrowers repayment capacity because of lower and market driven interest rate on loans. The ratio of Net NPSs to Net Advances is depicting the picture of banks that have well been able to predict the expected losses of the credit portfolio and have created required provisions for the same. The ratio has witnessed the same behaviour as was recorded for the Gross NPA ratio in case of both public and private sector banks. This verily indicates that banks have been either able to maintain and impro ve the quality of credit portfolio in post deregulation period of interest rated. The ratio of Net NPAs and Gross NPAs to Total Assets have shown declining trend for both private and public sector banks in post deregulation period compared to pre-deregulation. This further reveals that banks have been able to maintain credit as healthy asset in the total asset portfolio of assets during the deregulation period. It was expected that any action of credit enforcement (recalling the advances made or instituting foreclosure proceeding including legal proceeding) which were taken in hand in post deregulation period and decrease in interest rate on bank credit may severely erode the already thin profit margin on the credit transaction and will put pressure on asset quality. However, after deregulation of interest rates the asset quality of bank have improved to greater extent and have influenced the bank profitability positively, which is revealed by profitability analysis of bank. Management Soundness The management of the companies works for the owners who are the shareholders, why doesnt the management get fired if it doesnt in the shareholders best interest? In theory, the shareholders pick the corporate board of directors and the board in turn picks the management. Unfortunately, in reality the system frequently works the other way around. Therefore, it is necessary to analyse soundness of management and their efficiency while utilization of bank funds. In this context, in present study, efficiency in terms of bank productivity has been analysed. For this purpose three important productivity ratios i.e, Net Income to Number of Employees, Profit per Employee and Business per Employee have been utilized. These ratios are intentionally used because they show how efficiently management has utilized employee for generating healthy income, profit and business in post deregulation period of interest rates, when interest margins have squeezed due to market driven interest rates. The findings of productivity analysis are:- Placing greater confidence in management, it can be said that SBI, BOB, PNB, ING Vysya, Federal Bank and JK bank Net Total Income per Employee has best growth during the post deregulation period of interest rates. The SBI (0.21 %) amongst public sector banks and JK Bank (0.27 %) amongst private sector banks have witnessed phenomenal growth in net income per employee productivity during 2007-08 compared to 0.07 % and 0.07 % for both banks in 1998-99. However, compared to Public Sector Banks under study Private Sector Banks have witnessed better performance in this front. The Profit per Employee has witnessed either stability or minor growth in terms of percentage for all public and private sector banks, which are under study. This means though profit in absolute terms have increased but it has witnessed simultaneous increase in number of employees. Therefore, management efficiency in controlling the wage bill has been dismal in case of b oth public and private sector banks and this situation is also due to thin margin available to banks in case of fund based business after deregulation of interest rates. The business per employee ratio has been very healthy for private sector banks and was recorded between 2% to 4.25% for ING Vysya, 1.90% to 3.82% for Federal Bank and 0.12% to 5.16% for JK Bank in post deregulation period. Similarly, for Public Sector Banks it was witnessed between 1.60% to 3% in case of SBI, 1.66% to 4.00% in case of BOB and 1.42% to 3.31% for PNB during the same period. From this analysis it can be deduced that management of bank have by and large performed nicely while developing business portfolio of the bank. However, it is worth nothing that in spite of growth in business the insulation of better profits was not due to this declining margin during deregulation period. This, therefore, reveals that banks profitability have been affected because of deregulation of interest rates but damage wa s controlled by management to large extent. Earning Analysis In the earning perspective, the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the most used approach to interest rate risk assessment taken by many banks. Variation in earnings is an important focal point for interest rate analysis because reduced earnings or outright losses can threaten the spread insulation and financial stability of an institution by undermining its capital adequacy and by reducing its market confidence. In this context, spread analysis (i.e. difference between interest earnings interest earnings and interest expended has received more attention in banking crises because it directly and easily develop link to change interest rates). In addition, to burden and profitability analysis also focuses on impact of deregulation of interest rate on bank efficiency. The findings of these analyses are outlined here under:- Spread Analysis The ratio of Interest Income to Total Assets of the banks under study has witnessed marginal decline in the post deregulation period. Its mean ratio was recorded at 84.46 percent, 85.13 percent, 83.87 percent, 82.28 percent, 86.10 percent, and 80.40 percent for SBI, BOB, PNB, ING, FB and JK Bank respectively. This reveals that deregulation of interest rate has really tightened screws for higher spread insulation for banks. The ratio of Interest Expenses to Total Income has shown declining trend in post deregulation period starting from 2000-01 for almost all bank under study. The ratio is lower than the international benchmark of 60% (Report; 2005)Â  [1]Â  . This is positive sign of deregulation of interest rates because banks are now free to fix their own interest rates on deposits depending on the market acceptability. The ratio of Interest Expenses to Total Assets has witnessed similar behavoiur as has been marked incase of Interest Expenses to Total Income ratio. Net In terest Margin (i.e. spread) for private Indian banks are normally higher than public sector banks. However, one important revelation of this study speaks that deregulation of interest rate have squeezed the NIM for Indian banks though banks have tried their best to manage spread. The results of spread analysis are corroborating with finding of (Mohan, 2005)Â  [2]Â  . The situation of JK Bank in last year of study shows more impact on spread insulation because it declined compared to FB and ING Vysya. Burden Analysis Due to thin margin available of credit portfolio in post deregulation period, banks in India started located new partners so as to earn income other than the fund based income. The concentration was towards fee based income. If bank is able to cover non interest income from non interest expenditure banks ensure high profitability is least risk taking. The present analysis was done to ascertain the impact of deregulation of interest rate on bank profitability vis-Ã  -vis to burden. The findings of the study are:- The ratio of Non-Interest Income to Total Income has witnessed increasing trend income of both private and public sector banks up to few early years of deregulation period. However, since 2001-02 banks perhaps realized that only way to maintain and increase profitability is put control/check on non interest expenses. The ratio has shown sharp decline for all the banks under study during the period from 2003-04 to 2007-08. This mean bank have become cost conscious in the post deregulatory period. The ratio of Non-Interest Income to Non-interest expenses and ratio of Non-Interest Income to Average Working Funds witnessed surge in the post deregulation period compared to pre deregulation period. Thus banks have concentrated surely on fee based income instead of fund based income during deregulation period. They are of the opinion that during deregulation of interest rates, when interest rate are market driven, only way to maintain and increase profitability is to put check over Burden ratio, which otherwise during regulatory period had taken back seat. This surely is positive out come of deregulation. Profitability Analysis The effect of financial innovation and interest rate deregulation has been to expand banks balance sheets in both quality and size assets. The proportion of Net Profit to Total Income of the selected banks in the Post-Reform Period reveals that the banks have earned a higher rate of return. Profits as a percentage to assets declined in most cases, when balance sheet expanded and as competition put pressure on profitability. Private Sector Banks have responded to the new challenges of competition, as reflected in the increase in the share of these banks in the overall profit of the banking sector. Although bank profitability depends on a number of factors such as asset quality, interests rates and growth, the deregulation of interest-rate ceilings appears to have had only minor effects on profits. The banks profitability whether measured by Return on Assets (ROA) or Return on Equity (ROE). ROA has declined over two years. However, the fall-off appears more directly related to the asset quality problems experienced by a number of large banks than to the accelerated trend towards interest rate deregulation. The public sector banks still mainstay, accounting for nearly three-fourth of assets and income. It is also important to note that public sector banks have responded to the new challenges of competition, as reflected in the increase in the share of these banks in the overall profit of the banking sector. From the position of net loss in the mid-1990s in recent years the share of public sector banks in the profit of the commercial banking system has become broadly commensurate with their share in assets, indicating a board convergence of profitability across various bank groups. This suggests that, with operational flexibility, public sector banks are competing relatively with private sector and foreign banks. Public sector banks managements are now probably more attuned to the market consequences of their activities (Mohan, 2005)Â  [3]Â  . 4. The e ffect of control on burden ratio and spread managed by banks witnessed in the earlier analysis has been evidently reflected in the increased profitability ratio of both public and private sector banks during the post deregulation period of interest rates. Liquidity Banks need liquidity to meet deposit with drawls and to fund loan demand. The variability of loan demand and variability of deposit determine banks liquidity needs. Liquidity is essential in all banks to compensate the expected and unexpected Balance Sheet fluctuations and to provide funds for growth. The price of liquidity is a function of market conditions and market perceptions of the risk, both interest rate and credit risk reflected in the banks balance sheet and off balance sheet activities. If liquidity needs are not taken care off, banks may be forced to restructure or acquire additional liabilities under market conditions. It is believed that under deregulation interest rate this problem is evident to arise for banks, therefore present analysis was made to study liquidity in pre and post deregulation period. The findings of this analysis are:- The ratio liquid assets to total assets show the proportion of liquid assets to total assets. It indicates the overall liquidity position of the bank. The ratio indicates a negative trend in case of all the selected banks. On an average, the ratio for banks is recorded at 19.07 percent, 17.19 percent, 13.77 percent, 15.12 percent, 11.72 percent, and 15.94 percent for SBI, BOB, PNB, ING, FB and JK Bank respectively. The ratio depicts that the liquidity position of Public Sector Banks is sound as compared to Private Sector Banks. Further the liquidity in pre-deregulation is better than liquidity in post-deregulation period. This indicates that pressure put on liquidity position of banks. Private Sector Banks has out performed Public Sector Banks as the ratio of Liquid Assets to Total Deposits is higher for private sector banks compared to public sector banks. However, negative trend is also visualized in case of this ratio. The results reveal significant difference the liquidity positions of the banks only in terms of one liquidity ratio (i.e. Inter bank deposits/Total deposits). The overall conclusions of this analysis shows that banks have managed the liquidity properly during post deregulation period and have maintained ALM in terms liquidity gaps and duration. Volatile Liquidity Dependence Ratio Excess of Liquid Funds or Deficiency of Liquid Funds is not favourable for the banks as excess and Deficit Liquidity Crisis will adversely affect the profitability of banks. In order to avoid the liquidity crises, the RBI has prescribed prudential norms that the negative mismatch in 1 14 and 15 28 days time bucket should not exceed 20 percent of the total outflow. As a part of ALM strategy, Liquidity is traced through maturity or cash flow mismatches in the banks. Selected banks are not facing any liquidity crunch by the end of the period of the study and the banks were able to reduce there bad credit during the Reform-Phase. As the SLR and CRR requirements prescribed by the RBI gradually got reduced during the Post-Reform Phase, the banks were able to lend a high portion of their deposits for lending purpose, but CD Ratio is below 60 percent shows the reluctance of the banks to deploy funds for advances liberally. Asset Liability Management The business of banking involves the identifying, measuring, accepting and managing the risk, the heart of banks financial management is risk management and one of the most important risk management functions in banking is Asset Liability Management (ALM). Traditionally, administered interest rates were used to price the assets and liabilities of banks. However in the deregulated environment, competition has narrowed the spreads of banks and has affected share price of banks in stock exchange with profit becoming a key factor, it has now become imperative for a bank to move away from partial asset management, credit and non-performing asset and liability management towards an integrated balance sheet management where all components of balance sheet i.e. Working funds, Total assets, Liabilities and its difference. Other Findings Banks are reluctant to expand lending activities have deployed more funds in investment in deregulation Period. Even though the interest expense has increased and interest income decreased, by reducing the non-interest expenses and by increasing the non-interest income banks could reduce the proportion of total expenses to total income during the post deregulated period. The profitability performance of all the banks irrespective of sector has increased in the Post-Reform Period. The shift in policy from social-oriented banking to profit-oriented banking in the post deregulation period has been objective of the banks. Banks have been able to reduce the Burden but have not succeeded in increasing the Spread as a result of deregulated interest rate in the Post-Reform Period. Thus with a reduction in Burden, the decline in the spread is compensated and banks could improve the profitability in the Post-Reform Period. In the Post-Reform Period banks are not facing any shorta ge of liquidity. But banks are facing the Embedded Option Risk which will affect the liquidity of the banks. Flushed with funds as a result of reduction in SLR and CRR, banks are forced to deploy the huge funds without proper risk assessment which have resulted increase in NPA marginally. Capital Adequacy Ratio (CRAR) acts as a good barometer to check Credit Risk as it prevents deploying funds in risky advances. The banks have developed a tendency to invest huge amount in safe investments like Government and Approved Securities and this reduce credit and interest rate risk. Suggestions Banks must have an adequate internal control over their interest rate risk management process in deregulatory regime. The main element in this context would be regular independent reviews and evaluations of the effectiveness of the system and where necessary ensuring that appropriate revisions or enhancements to internal control are made. The outcome of such an exercise should be made available to the relevant supervisory authorities. Proper watch should be exercised by supervisory authorities on interest rate risk. In this connection, an appropriate account of the range of maturities and currencies in each banks portfolio including off-balance sheet items, as well as relevant factors such as distinction between trading and non-trading activities. Capital of the banks should be in commensurate with the level of interest rate risk, credit risk and operational risks. In this context, banks should have separate and professionally trained department who will ascertain capital nee ds on regular basis which can act as real cushion for adverse movements of interest rate fluctuations. Banks should identify and manage interest rate sensitivity and credit risk in all their products and activities. They should ensure that the risks of all new services and activities are subject to adequate risk management procedures and control before their introduction. Banks should ensure the credit portfolio is properly managed and the credit exposures are within levels consistent with prudential standards. This needs proper strategy so that asset quality of maintained with minimal possible limit. Supervisory authorities should develop effective system in place to identify, measure maintain and control credit risk as a part of an overall approach to asset quality management. Potential future changes in economic conditions should be considered while assessing credit, credit portfolios and credit quality by using stress testing. The board of directors and top manage ment should establish proper and scientific management over right and governance over the interest rate movements associated with various interest sensitive assets and liabilities including the establishment of specific accountability, policies and continues to manage positive interest spread insulation. Frequent changes in management at top level, change in key policies and the lack of succession planning need to be viewed with suspicion. Management of credit quality and net interest margin is key to integral the health of any banking institution. A consistent year to year growth in profitability overview should be done to provide an acceptable return to shareholders and retain resources to find future growth. Return on average assets, which measures a banks growth and decline in earnings in comparison with its balance sheet expansion and contraction should be the permanent excessive of banks. Net interest margin, difference between interest earned and interest paid and burden ratios should used to maintain positive spread insulation and burden of other expenses on interest spread. The degree of reliance upon interest income compared with fees earned, heavy dependence on certain sectors and the sustainability of income stream are relevant factor which every bank should consider. The banks management should approve the strategy and significant policies to execute the strategy and significant policies to execute liquidity management effectively. Regular review of limit on the size of liquidity position over particular time horizon should be made. For liquidity management banks should seriously review and analyse funding risk, time risk, call risk, mismatch risk, currency risk and embedded risk. In this context, banks may develop a back up liquidity strategy for all currencies. Sensitivity of the variation of earnings, asset quality and capital adequacy due to interest margin a change of the market-to-market value of assets and liabilitie s should be analysed. Further, underlying random parameter that generates thin variation shall be properly evaluated and analysed. For this purpose technique like VaR, CAR, Variance analysis and potential loan analysis may be used. Scope for Further Research Interest rate deregulation in banking is an on going process that is linked with an evolving strategy at one end and the issues of practical banking on the other. Hence, it requires a continuous assessment and evaluation with regard to the banking performance. This significant aspect of interest rates makes the continuous evaluation and research in this area very vital and necessary for functioning of the banking sector in addressing the challenges of today as well as tomorrow. Further, impact of deregulation of interest rates requires analysis parameter wise and keeping other parameters constant. Therefore, it requires in-depth analysis of deregulation of interest rate vis-Ã  -vis to each parameter.