Chapter 3: Depository Institutions:

Activities and Characteristics

Definition:
Financial institutions take deposits from
savers and sanction loans to users are
known as depository institution. There
are some depository institutions those
take deposits and make direct
investment in other sectors.
3-1
 Asset/Liability problem of
depository institutions:
Depository institutions take deposits from surplus
group by granting interest and sanction the
deposited amount to deficit group as loans and
advances by charging interest. The difference
between interest grant and interest charged is the
spread income of the institution. A depository
institution seeks to earn a positive spread between
the assets it invests and the cost of its funds. The
spread is referred to as spread income or margin.
The spread income should allow the institution to
meet operating expenses and earn a fair profit on its
capital.
3-2
 Factors considered by depository institutions

(6) Interest rate risk: It means to change future market interest rate that will affect
ultimately the interest rate of the institution and spread income. The change that is
unfavorable or lowers the spread income.

Incease in dep rate, Decrease in Loan rate

(b) Liquidity concerns: Since depository institutions take deposits from savers they are liable
to meet up the withdrawal demand of the depositors. Depositors can place their withdrawal
demand any time during the allowable hour. There is no certainty about the timing of
withdrawal of deposited amount. Since institutions are bound to honor the depositors’
demand they will have to maintain a certain percentage or certain amount of total deposit.

3-3
 Commercial bank

The financial institution collects deposits from surplus group by sanctioning

interest and sanctions the amount to deficit group as loans and
advances by charging interest and fees from non funded activities for
earning profit and helping economic development is called commercial
bank. This commercial bank is formed and administered according to
Company Act and Banking Company Act.

3-4
 Islamic bank
Commercial banks set their objectives and
operations based on Qur’anic principles where all
services comply with the religious injunctions of
islam and free from riba (The Qur’an – Al-
Baqarah Sura 275-281), gharar and maysir are
known as Islamic bank. Profit-and-loss-sharing is
the method of resource allocation and financial
intermediation in case of all relevant banking
services instead of interest. This bank participates
in the yield resulting from the use of funds.
Depositors share in the profit of the bank
according to the predetermined ratio.
3-5
 Islamic bank
There is thus a partnership between the
Islamic bank and its depositors as well as
between the bank and its investment clients.
The following six principles drive the activities
of Islamic banks:
i. the prohibition of predetermined loan
repayments as interest (riba);
ii. profit-and-loss-sharing is at the heart of the
Islamic banking system’
3-6
 Islamic bank
iii. making money out of money is unacceptable and all financial
activities must be asset-based; Bank will not give the money
but purchase the required asset by paying directly to the
vendor.
iv. prohibition of speculative behavior; Storage
v. only shari’a approved contracts are acceptable;
vi. the sanctity of contracts i.e. transactions should be fair, honest
and just towards others (Islamic Finance in a Nutshell, Brian
Kettell, page 2-13).

3-7
 General Bank Services

1. Individual banking: Commercial banks provide various banking

services mainly to individuals are known as individual banking.
This service includes consumer lending, residential mortgage
lending, consumer installment loans, credit card financing,
automobile and boat financing, brokerage services, student
loans and individual-oriented financial investment services
such as personal trust.

3-8
 General Bank Services

2. Institutional banking: Services

provided to financial and nonfinancial
corporations like insurance companies
and leasing companies. By providing
different services bank can earn
interest income and fee income.
3-9
 General Bank Services

3. Global banking: Services provided by banks to similar

business organizations within or outside the country are known
as global banking. It covers a broad range of activities involving
corporate financing and capital market and foreign exchange
products and services.

Bank to bank. Within or outside country.

3-10
 Specific Bank Services

i) The primary operations

Take deposit and sanction loans

ii) Other types of bank services

Non funded services like clearing , general banking , fund remitting

iii) Foreign exchange services – Fund or importing exporting, foreign remmitance.

iv) Investment services – Taking dep bank foms large capital and invests the money in ortfolio form in the name of merchant
bank
v) Insurance services – Bank purchase insurance to protect depositors fund. Depositors money is insured.
vi) Other financial services – Solvency certificate, Bank Gurantee, Student loan, Special loan for special requirements.

3-11
 Bank funding
1. Deposits: There are several types of deposits accepted by banks like
demand/current deposits, savings deposits and time deposits/certificates of
deposit. Commonly – Current saving and fixed are the main three forms for taking
money form depositors. This is the main source of fund for a bank to run banking
operations.
2. Reserve requirements: The percentage of total deposit amount maintained as
reserve in cash and near cash asset form in the particular bank itself and to the
central bank is called reserve requirement. There are two types of reserves – Cash
reserve ratio and statutory liquidity reserve. SR
As a bank according to banking companies act must maintain three kinds of reserve. 1)
Cash Reserve Ratio (CRR) 2) statutory liquidity reserve (SLR) 3) statutory reserve
(SR)

The fund available in these three types will be in control of the bank to cater any
emergency. CRR & SLR is applicable on total deposited amount. SR is applicable on
earned profit. It is mandatory upto the point where reserve fund account balance
3-12
= paid up capital.
 Bank funding

3. Borrowing from central bank: Central bank provides funds as loans to commercial banks
against holding securities and other paper assets through discount basis.

When facing difficulty a bank can obtain fund from central bank by selling financial assets on
discount. XYZ holds a FA of 6000 croe. They can sell at a 5% discount.

4. Other non-deposit borrowing: One commercial bank can borrow funds from another commercial
bank when it faces severe liquidity crisis. It can also borrow funds from other financial
institutions.
Interbank borrowing. Bank can borrow from other banks. During EID there is pactice of
Stborrowing through call money market.

5. Funds from market: A bank can raise funds from the market by issuing different types of
financial instruments. For forming large amount of capital as a source of fund.
They can issue common share, pref share, bond, debenture, CP to the common people forraising
capital.
3-13
 Regulation
1. Ceilings imposed on the interest rate that can be paid on deposit accounts
MAX or highest level of IR that can be offered to the depositor. Currently it is capped at 6%.

2. Geographical restrictions on branch banking

Limitations on the number of branches to control competition. Pemission from CB is reuired showing estimated
profit and deposit collection.

3. Permissible activities for commercial banks

Cannot involve in any activity that is not permissible under their license. As per banking companies act there ar
specific services that bank can provide. Other than these every thing else are prohibited.

28different services can be performed by banks

4. Capital requirements for commercial banks

Out of total risk weighted assed at least 10% must be contributed by the bank. This is called capital equiremen

BIS has assigned a set risk weight for different assets

3-14
 Risk Weights of different asset
category

Category 1: 0% - cash, bank balance, reserves,

trading account, treasury & agency securities,
govt. reserve securities.
Category 2: 20% - due from banks, domestic
deposit institutions, repurchase agreements,
govt. sponsored agency securities, state &
municipal securities, collateralized mortgaged
obligation, municipal general obligation bonds.
3-15
 Risk Weights of different asset
category

Category 3: 50% - municipal revenue bonds,

residential mortgages, collateralized mortgaged
obligation backed by mortgage loans, real estate family
loans. , Personal Loan
Category 4: 100% - commercial loans & commercial
mortgages, corporate bonds, LDC loans, leases,
allowance for loan & lease loss, premises, equipments,
other investments, other assets.

3-16
Example of capital requirements

Risk Assets Book value Product

weight (CroreTk.) (Crore Tk.)
0% Treasury securities 100 0
20% Municipal bonds 100 20
50% Residential mortgages 500 250
100% Commercial loans 300 300
Total 1000 570

3-17
Example of capital requirements

Core capital (Tier – 1) is 5% of risk weighted

assets is (570X0.05) Tk.28.5 core.
Supplementary capital (Tier – 2) is also 5% of
risk weighted assets is (570X0.05) Tk.28.5
core. The minimum total capital requirement is
10% of total risk weighted assets is
(570X0.10) Tk.57.0 core.

3-18
 COMPONENTS OF CORE CAPITAL
(TIER -1) CAPITAL
Paid up Capital
Non-repayable Share premium account
Statutory Reserve
General Reserve
Retained Earnings
Minority interest in Subsidiaries
Non-Cumulative irredeemable Preference Shares
Dividend Equalization Account
Perpetual pref share

3-19
COMPONENTS OF SUPPLEMENTARY
CAPITAL (TIER -2) CAPITAL

General provision maintained against unclassified

loans
Assets Revaluation Reserves
All other Preference Shares
Perpetual Subordinated debt
Exchange Equalization A/C
Redeemable Pref Share

3-20
Problem on Calculating Tier-1 &
Tier-2 capital

Instruments Tk. (‘000)

Treasury securities 1000
Municipal bond 1500
Residential mortgage 2000
Real estate family loans 3000
Cash and bank balance 2500
Commercial loan 4500
Total 14500
3-21
 Particulars Amount Particulars Amount
(Tk. (Tk.
000) 000)
Savings bank deposits 32500 Share capital 200000
Current deposits 12500 Statutory reserve 90000
Borrowing from other banks 40000 Profit & loss A/C balance 65000
Borrowing from central bank 10000 Share premium 10000
Bills purchased and discounted 10000 Retained earnings 25000
Cash credit, overdraft & demand Redeemable preference
loan 25000 share 142500
Term Loan 142500 Subordinated debenture 127500
General provision maintained   Perpetual preferred stock 147500
against unclassified loans 127500 Minority interest 25000
Assets Revaluation Reserves 147500 Dividend equalization fund 10000
All other Preference Shares 25000 General Reserve 37500
Perpetual Subordinated debt 7500 Fixed deposits 150000
3-22
Exchange Equalization A/C 8000
 Other institutions
 Savings and Loan Associations: Its an
association that’s assets are mortgages, mortgage-
backed securities and treasury securities whereas
sources of funds are savings and time deposits.
 Savings banks: An association is formed by
contributing fund by owners and then collecting
savings from depositors. From this fund the
association sanctions loans to potential borrowers
within or outside the association.
3-23
 Other institutions

Credit unions: Credit unions are depository

institutions that have a ‘common bond’
requirement for membership. They are owned
by their members and their assets are primarily
small consumer loans to their members and
credit card loans.

3-24