Why do Banks Invest
What is Banking?
Banking can be defined as the business activity of accepting and safeguarding money owned by other individuals, and for earning profit they lend this money. But as the time passes by the activities covered by banking business have widened and now various other services are also offered by banks. Banking services issue debit and credit cards, which provide safe custody of worthy assets, lockers, ATM services and online transfer of funds across the globe.
Banks are one of the financial intermediaries that carry out the task of helping the transfer of funds from surplus units to deficit units. Banks basically make money by lending money at a higher rate of the cash they give. Generally, banks gather premiums from credits and payments from the securities of debt owned by them, and pay interest on Credit Deposit Ratios, and borrowings from short terms.
Why Do Banks Invest
Banks are ultimately businesses. Hence, it is imperative on their part to strive for profitability. There are numerous channels that the banks use for the purpose of investment and this helps them earn money which eventually helps in the running of their business.
Following are some of the reasons why banks invest:
- To comply with SLR requirements
- To ensure adequate liquidity
- Low CD ratio (Credit Deposit Ratio)
- To increase overall average return on assets
- For better ALM (Asset Liability Management)
- To increase non interest income through trading
To meet the SLR requirements standards :
SLR (Statutory Liquidity Ratio) is the amount a commercial bank has to maintain in the form of cash, or gold or Bonds which are approved by securities before providing credit to its customers. This is well looked after and maintained by the Reserve Bank of India (RBI) for controlling expansion of bank credit.
SLR is determined as the percentage of total demand and time liabilities percentage. These are the liabilities every bank is liable to pay to the customers every time they demand.
Every bank continues in India at the end of business consistently, a base extent of their Net Demand and Time Liabilities as fluid resources as money, gold and approved securities.
With the Statutory Liquidity Ratio (SLR), the RBI ensures to have a solvency of commercial banks. It helps controlling the expansion of the credits by banks. RBI monitors the bank credit expansion by changing the Statutory Liquidity Ratio rates. SLR helps RBI to compel the banks to invest in government bonds and other government securities.
Banks are needed to follow the instructions for purchase/sale of securities through SGL account under the Delivery Versus Payment system wherein the transfer of securities takes place simultaneously with the transfer of funds.
To ensure adequate liquidity:
Liquidity for a bank is the ability to meet its financial aspects as and when required. Bank lends finances investments generally in less liquid assets, but mostly it funds its short term liabilities. Hence the main challenge for a bank is to ensure its liquidity under all possible circumstances and possibilities.
In the setting of the accounting report of a bank the term liquidity has two understandings. In the first place, it alludes to the capacity of the bank to respect the cases of the investors. Second, it suggests the capacity of the bank to change over its non-money resources into money effortlessly and without loss.
Every commercial bank has altogether different way to manage the liquid money in different ways. Few of the banks draw their funds mainly from customer deposits. These banks can increase their assets by giving loans to tiny enterprises. Borrowers are easily available to these sort of banks. They put the overabundance supports in the advantages which eventually provides a high liquidity similar to that of the Federal Funds. It is also known as Asset Management Banking through which the assets can be turned into cash whenever needed.
Normally it happens that the huge banks sometimes run short of sufficient deposits to fund the their primary business which requires to manage similar tie ups, other money related establishments, and some individual persons with a high wealth. Some of the banks have to borrow the necessary funds if needed from different lenders either by short term or long term liabilities which should be in a continual basis. This particular approach of liquid generation is known as Liability Management. Although it is a bit riskier mode of banking than the asset management, it is widely adopted means by almost all the banks. In order to briefly differentiate between the two it can be said that Asset Management is important for the small banks. These small banks can be hampered in terms of income if the asset management goes wrong. Similarly Liability Management is also important for larger banks and hence a small error in functioning of liability management may cause trouble for a larger bank.
In case there is demand for liquidity for both depositors and borrowers then the costs will be traded off as well as the benefits. This will help to decide how much liquid assets and cash to hold on. However there is a window for the banks who keep the discounts to a lower level.
Low CD ratio (Credit Deposit Ratio) :
Credit Deposit Ratio is the ratio by which it is measured that a bank lends out of the deposits it has accumulated. From this ratio it can be inferred that the amount of the core funds of a bank are being lent which also indicates the main activity of the bank Although a minimum or maximum ratio is not set by the RBI , a very low ratio is not recommended for a bank. It suggests that a bank is not utilising its resources to its optimum level.
In other words the Credit Deposit Ratio can be expressed as the total advances divided by the total deposits which is again expressed as percentage. For instance for the Indian banking industry the CD ratio was recorded to be 78% at the end of financial year 2013. But as the trend suggests in the recent past due to a high inflation this ratio has been decreased to 75%. To be more specific by 6th September’13 there was a CD ratio of 78.5%. This means banks are lending a total amount of Rs 78.5 for every deposits of Rs 100.
One of the very important reasons for the low Credit Deposit Ratio is inflation as the trend clearly says. So Government also has to play a part in this regard to increase the overall CD ratio. This is why most of the banks go for investing. Country’s financial savings also has to play a role over here.
To increase overall average return on assets :
The return on assets is an indicator of the profitability of the banks in bringing about revenues.
Return on Assets = Net Income / Avg. Total Assets
The profitability of banks is vulnerable to interest rate fluctuations. So, in order to counter the dependency on interest rate fluctuations, banks look for other avenues of investments to generate substantial revenues. During the calculation of RoA of banks, we have to be cognizant of the fact that they are highly leveraged. This means, even a small RoA like 1% would refer to earning huge profits. In the banking sector, firms try to achieve a return on asset which is greater than or equal to 1.5%.
For better Asset Liability Management :
Asset Liability Management (ALM) is a framework for mitigating the risks of a bank which might surface as a result of discrepancies between the assets and liabilities. It is about organizing the management of assets and liabilities of a bank in order to earn substantial returns.
When compared to the assets or liabilities of a firm, the bank’s capital is very small. Hence, even if the percentage of assets or liabilities undergoes minimal variations, it could result into substantial capital percentage variation. Deposits, life insurance policies, annuities, etc are some of the liabilities that the banks undertake. From the proceeds gained through the liabilities, the banks invest in assets. Loans, bonds, real estate are some of the assets that the banks invest in. However, there were risks associated with the structuring of assets and liabilities as well as the way markets were moving. In order to address these issues, ALM and market value accounting was recommended.
Strategic balance sheet management is what ALM takes care of. Integrated balance sheet management is necessary to mitigate the issues of profitability and long-term solvency of banks. The purpose of ALM is to fortify the bank’s short term profits, long term earnings and long term substance.
The 3 main pillars for implementation of ALM are :
- ALCO ( Asset Liability Management Committee)
- ALM Information Systems
- ALM Process
A liquidity risk tolerance has to be communicated by the bank for its business strategy
• A bank should actively Monitoring and controlling of liquidity risk exposures and funding needs within and across legal entities has to be proactively done by the banks taking into consideration the legal, regulatory and operational limitations to liquidity transferability.
• Collateral positions have to be managed by the banks actively.
• Disclosure of information on a regular basis has to be carried out by the banks publicly to facilitate market participants to make informed decisions.
• Information related to bank’s liquidity developments has to be regularly monitored by ALCO and BoD has to be reported regarding this on frequently.
To increase non-interest income through trading :
In the Indian banking sector, the significant constituents of non-interest incomes include trading, brokerage and commission, sale and revaluation of investments, exchange transactions, sale of land and buildings and other miscellaneous sources such as advisory, etc.
Due to the lower risk adjusted profits associated with the trading revenue, increasingly banks are inclined towards these sources of non-interest income. Net interest margins have been facing increased pressure in the banking sector. Thus, to deal with diminishing margins, non-interest income through trading has become an effective way.
Trading income is generated by banks through the trading activities in financial products viz. bonds, equities/shares and derivative instruments. Banks also act as market makers or dealers in the above mentioned financial products and even take up proprietary positions for conjectural roles. To measure the risks associated with trading activities, VaR or value-at-risk method is used by many banks.
Banks have become a very important financial intermediary in the contemporary economic setup. There are various aspects which need to be looked as far as investments made by banks are concerned. Profitability, maintaining liquidity, security are some of the factors that affect the investment decision of the banks. The role of regulatory bodies in this regard is of utmost importance. Also, the end customers, investors, promoters and all the other stakeholders have an impact on the kind of investments made by the banks. We have tried to explore the various avenues through which banks can generate revenues from as well as the reasons behind the choice of those avenues. We also found the changing trends in the investment pattern of firms over the years. In the Indian banking sector, over the last 15 years there has been an increased inclination towards achieving non-interest income. Along with private banks and several foreign banks, the various public sector Indian banks are also starting to follow this trend.
To sum it up, we looked at the need of banks for investing, the various options to make money, the stakeholders involved in the process, the regulatory frameworks and the opportunities of growth in the various investment avenues.