Banking is the process of sourcing or gathering savings (excess of earnings over consumption) of individuals and entities and using or lending or investing funds so saved or deposited to individuals and entities (who do not have enough owned funds) for creating assets (like residential houses) or for businesses (creating fixed or current assets). It is also the process of monitoring timely payback of the funds so lent or invested, and channelizing them back to individuals and institutions who had deposited their savings with the banking institutions when they need to withdraw them from the banking system.

There are largely two kinds of banking. One is to lend funds as debt and earn interest out of it. The other is to invest funds in equity and enjoy appreciation of value over a period of time. The former is referred to as commercial banking and the latter as merchant or investment banking.

Islamic or Sharia banking conforms to Islamic prohibition against interest rates. In other words, it does not charge or receive interest on funds lent to their borrowers. Here, borrowers pay fees upfront and later share profits from the activity being funded with lenders instead of paying interest. Banks following Islamic banking norms do not lend to alcohol or gambling businesses. Islamic banks avoid certain kinds of risky asset classes.

Merchant banking raises capital for and advises smaller, usually unlisted companies, firms and high net worth individuals through private equity investments and private placements. They also provide mezzanine funding, bridge financing, and corporate credit products. Investment banking raises capital for and advises larger, usually listed or about to be listed companies through initial public offerings, and also facilitating large mergers and acquisitions.

In general, funds can be deposited by any individual, trust, association, society, association, institution, firm, company or government department or agency with government issued identification (Passport, Aadhaar, Driving License, Certification of Incorporation, etc.), verifiable permanent and / or communication address and Permanent Account Number (so that incomes from the deposit may be taxed or exempted as per provisions of the prevalent Income Tax Act).

There are largely two kinds of deposits or liabilities – demand and term. Demand deposits include savings bank and current accounts which are payable on demand, while term deposits are fixed (hence also called fixed deposits) for a period of time or a specific tenure.

Generally, current accounts do not earn any interest for depositors. Term deposits earn higher rates of interest (5-7%, depending on tenure) that is closely comparable to the going rate of inflation prevalent from time to time. Savings bank deposits earn interest that is moderate, between current accounts and term deposits (3-4%).

A bank earns interest on the funds lent, commission or fee on advising credit sanctions, handling remittances and on non-fund-based assistance, as well as appreciation on its investment portfolio (either held to maturity or for shorter term trading).

A bank’s major expense is interest outgo on its deposits raised from individuals and institutions. Another major expense would be provision for non-performing assets. Other large items expenses would include staff salaries, allowances and perquisites, establishment expenses like rentals on leased or rented premises, electricity bills, etc.

An NPA is a loan asset that is in default or in arrears, that is, when repayment of either interest or principal or both is delayed or stopped. It is classification of loan asset used by the banking regulator (Reserve Bank of India, in India) and all banks and financial institutions monitored by RBI wherein either interest servicing has not been done for a period of time, or repayment of principal amount is delayed beyond a period of time, or both, or when there is not enough routing of turnover through the account to cover interest and charges applied in the last 90 days. The period of time for classification as an NPA is usually 90 days, though for crop loans it is associated with crop cycles up to 180 days. In other words, an NPA is a loan asset in the books of the lender that not only stops earning interest income but also puts the un-repaid part of the principal at risk of default.

The lender’s source of funds is usually depositors’ monies. Depending on the agreement the depositor has with the lender, these monies are repayable either on demand or on maturity after the contracted tenure. The lender earns an income by lending these monies, at a rate higher than the rate payable on the deposits, and uses part of that operating revenue in staff and administrative expenses, thereby earning an operating profit. If a loan becomes an NPA, the cycle is disrupted and in extreme situations banks may find it difficult to repay depositors’ monies, and become bankrupt. An NPA, therefore, is a major problem in lending business. However, regulators stipulate and lenders use many checks and balances to ensure that depositors’ monies are repaid in due time and the lender continues its business profitably.

Usually, NPA are classified into three categories: Sub-Standard, Doubtful and Loss.

Under prudential norms prescribed by RBI prevalent currently, a loan asset becomes an NPA usually after 90 days from initial default or after staying past due or in arrear for 90 days (the norm varies in case of an agricultural loan). A prudential provision has to be made even for Standard assets (at the rate of 0.25% to 1.00%, depending on the sector or business activity). For NPAs, provisions have to be made on the lender’s Profit and Loss statement. So, in addition to booking interest income of, say 10-15% on the outstanding per annum, the lender has to provide a bit for the outstanding loan amount. Generally speaking, Sub-Standard assets are provided for at the rate of 25% during the first year after slippage, Doubtful assets at 25% to 100% between the next 3 years and Loss assets at 100% beyond 4 years from initial slippage. This is a regulated accounting norm. In the end, procedures for recovery are initiated to get back whatever is feasible as per applicable laws out of primary securities, collateral securities and personal guarantees.

Major services banks provide are:

• (1)

  Banks keep deposits from depositors – demand deposits as well as time deposits. With the deposits they raise, they provide loans to borrowers.

• (2)

  Banks remit funds at the request of their depositors from one account to another, to beneficiaries maintaining their accounts within the same bank or with other banks, through internal transfers or through electronic ways of transfers (IMPS, NEFT, RTGS in India) as well as through cheques drawn on their demand deposit (savings bank and current) accounts or through demand drafts (intercity) and banker’s cheques (intra-city or within the same clearing house) wherein funds are transferred to the paying bank first to be held until the draft or cheque is presented for clearing at the designated center. Remittances may also be made across borders in various currencies (other than home or base currency) too.

• (3)

  Banks provide loans to individuals for education (of children) or for consumption purposes (building a house, buying a car, etc.), to be repaid from salaries and incomes of borrowing individuals, or to entities who do not have enough owned funds for procuring fixed (long term) or current (short term) assets, to be paid back from profits.

• (4)

  Banks also provide non-fund-based assistance in the form of letters of credit and bank guarantees. Letters of credit are used to procure raw materials (for manufacturers) and stocks-in-trade (for traders) while bank guarantees can be used as bid bonds or as pure financial guarantees or as performance guarantees usually by large entities with projects and milestones with timelines for delivery and satisfactory procurement, erection and commissioning.

When a lender disburses a loan sanctioned to a borrower, it is usually done after creating charge on some tangible securities. Primary securities are those assets which are created out of the loans disbursed. E.g., fixed assets are primary securities for term loans and current assets are primary securities for working capital loans. Collateral securities, on the other hand, are additional securities which the lender may fall back on in case the account becomes an NPA and recovery is required to be made out of these assets too charged to the lender. E.g., shares in the name of the promoters pledged to the lender or equitable mortgage of the promoters’ residential properties are collateral securities.

A bank monitors any working capital exposure through monthly Statements of Stocks and Book Debts and through Financial Follow-up Reports, as well as through periodic inspections of the borrowers’ books of accounts, manufacturing facilities, godowns, warehouses, etc.

Export oriented units enjoy subsidized working capital finance, with a view to make pricing of our exports more competitive in the international market. Pre-shipment finance is referred to as Export Packing Credit (EPC) and post-shipment finance is referred to as Foreign Bill Discounted or Purchased (FBD / FBP). While EPC and FBD / FBP are offered in INR (Indian Rupees), pre-shipment and post-shipment credit may also be offered in Foreign Currency as Packing Credit Foreign Currency (PCFC) and Post Shipment Credit Foreign Currency (PSFC).

Creditworthiness is a lender’s evaluation of how worthy a new (or existing) applicant is for debt. Usually, this is judged for fresh debt, but it could be for additional debt too. A lender usually tries to evaluate the probability of default before a decision about release of fresh / additional debt to the applicant is made. The lower the probability of default, the higher the creditworthiness will be.

Credit risk, or probability of default of an existing or new loan application, is usually an aggregation of scores gauged on four or five different sets of parameters. For working capital exposures, these are: promoter or management risk, industry risk, business risk and financial risk. For projects or term loans: project risk is added to the initial four. The higher the aggregate score as per the lender’s parameters, the lower the probability of default, therefore risk.

It is quantitative analysis of information or data contained in a firm’s or company’s financial statements. Ratio analysis helps in understanding various financial as well as operating aspects of an enterprise.