bbm notes - session 14 to 18

8/11/2019 BBM Notes - Session 14 to 18

1/24

Session 14

Treasury Operations:

Treasury operations can be broadly divided into the following two categories:

1. Domestic Treasury: Operations involving the Local Currency. In India, this is also referred to as

rupee treasury.

Domestic Treasury Operations have been detailed in Sections I and III of chapter 10 of the tet

book.

2. Forex Treasury: Forex Treasury Operations have been detailed in sessions 15 and 16.


2/24

Session 15:

Forex Treasury:

From inception, one of the major financial services offered by banks has been money changing viz.,

exchanging one currency for another. Exchange of currency is the basis of international trade.

To be able to deal in foreign exchange, banks in India have to apply to RBI for an authorisation to

deal in foreign exchange. Banks that have such authorisation are called Authorised Dealers (AD) in

Foreign Exchange. Only ADs are permitted to deal in foreign exchange.

All ADs have to obtain authorisations from RBI for all their branches which will be dealing in Foreign

Exchange. The branch authorisations could be for one of the following categories:

Category A: Offices and branches maintaining independent foreign currency accounts in their own

names.

Category B: Offices and branches not maintaining independent foreign currency accounts but havingpowers of operating on the accounts maintained abroad by their Head/Principal Office or any other

Category A branch of the bank. For instance, if Canara Bank, Mumbai is a Forex category A branch

and Pune, Nasik, Ahmedabad and Baroda branches of Canara Bank are Forex category B branches

which are linked to Canara Bank, Mumbai then all these branches will be authorised to make

payments in foreign currency to the debit of foreign currency accounts maintained by Canara Bank,

Mumbai.

Category C: All other offices and branches handling foreign exchange business through other offices

or branches in category A or B. In the example given above, if Rajkot and Surat branches are Forex

category C branches linked to Canara Bank, Ahmedabad these branches would carry out forex

transactions only through their Ahmedabad branch. Rajkot branch cannot authorise payments out offoreign currency accounts maintained by Canara Bank, Mumbai. Instead, it will have to request the

link Forex category B branch viz., Canara Bank, Ahmedabad to authorise such payments. As such, all

Forex category C branches can only carry out limited forex operations. All major transactions would

be carried out only by Forex category A and B branches.

Nostro Accounts:

As stated above only Forex category A branches/offices are allowed to maintain foreign currency

accounts with banks abroad. Such accounts are called Nostro Accounts.

Any payments in foreign currency made by banks in India would be done to the debit of their Nostro

accounts in the currency in which the payment is to be made. For instance, if Bank Of India, Mumbai

branch is a Forex Category A branch and maintains a current account in US Dollars (USD), with Bank

Of America, New York, all payments made by Bank Of India, Mumbai and all Forex Category B and C

branches of Bank of India linked to Bank Of India, Mumbai to would be to the debit of that USD

account.

Similarly, any credits in USD for Bank of India, Mumbai and all Forex Category B and C branches of

Bank of India linked to Bank of India, Mumbai to would be credited to that USD account.

Vostro Accounts:

With due authorisation from RBI, Foreign banks and their branches/offices located abroad can open

current accounts in Indian Rupees in India with branches/offices of Indian banks. Such accounts are


3/24

called Vostro accounts. For instance, a current account in Indian Rupees (INR) maintained by

Barclays Bank, London with Bank of Baroda, Mumbai, would be a Vostro account from Bank of

Baroda perspective. Barclays Bank, London can make INR payments to the debit of their account with

Bank of Baroda, Mumbai. Similarly, all INR credits to Barclays Bank, London would be credited into

their account with Bank of Baroda, Mumbai.

Please note that while the above account is a Vostro account from Bank of Baroda perspective, it

would be a Nostro account from Barclays Bank perspective.

Banks where Nostro accounts are maintained are called correspondent banks. In the first of the two

examples quoted above, Bank of America, New York would be the USD correspondent of Bank of

India, Mumbai.

In the second example, Bank of Baroda, Mumbai would be the Indian Rupee (INR) correspondent of

Barclays Bank, London.

Forex Treasury Sections:

There are three major sections in Forex Treasury as detailed below:

1. Front Office:

The front office is entrusted with the buying and selling of foreign exchange from/to customers of

various branches of the bank and from/to other banks.

Buying of forex from and selling of foreign currency or forex to customers is called merchant trade or

merchant deal. Here the bank virtually behaves like a merchant who buys and sells stuff, but the

commodity traded is forex.

Buying of forex from and selling of forex to other banks is called inter-bank trade orinter-bank deal.

Forex front office may resort to inter-bank trading to cover a merchant trade transaction carried out

with the banks customers. For instance, the front office may have bought say, USD 1 Million from an

exporter customer. If no Importer customer of the bank requires USD at that period, the front office

would have to sell the USD to another bank. Such a transaction would be an inter-bank trade

transaction and the process is called merchant covering.

Buying of forex from and selling of forex to other banks not to cover a merchant purchase or sale but

purely for speculative purposes with a view to earn profits in forex rate movements is called

proprietary (Prop) trade.

Cross Currency Deals:

Since forex traders (dealers) deal in forex, each transaction involves 2 currencies. Most forex trades

involve a home currencyand a foreign currency. For Indian banks, the home currency would of

course be INR. As such, most trades in India would involve INR on side and other currencies like

USD, Pound Sterling (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF), Australian Dollar

(AUD), Canadian Dollar (CAD), Hong Kong Dollar (HKD), Singapore Dollar (SGD) etc.

A forex trade not involving home currency is called a cross currency trade or cross currency deal.

Thus deals carried out in India involving say, USD and EUR or CHF and JPY are cross currency

deals. A USD and EUR deal carried out in USA would not be a cross currency deal because USD is


4/24

the home currency of USA. Nor would it be a cross currency deal if it is done in a country in euro

currency area like Germany or France or Italy because EUR is the home currency of these countries.

Banks generally do a cross currency deal when they have two customers, one selling one currency

and another buying another currency against the home currency. For instance, an Indian Bank may

have an exporter customer selling USD 1 Million and an importer customer requiring say, EUR 1.2Million. In such a case, the bank may buy USD 1 Million from the exporter customer and pay him in

INR and do an inter-bank USD/EUR cross currency deal selling USD 1 Million and buying EUR 1.2

Million. The EUR would then be sold to the importer customer against INR.

2. Back Office:

Deal Settlement:All inter-bank trades have to be settled on the due date. The currency bought has

to be received and the currency sold has to be delivered. This is called settlement. Back office

handles settlement of all deals.

Deal Confirmation:Once a deal is done, it is also necessary to obtain a confirmation from the contra-

party bank viz., the bank with whom the front office has agreed to do the deal. Similarly, aconfirmation has to be sent to the contra-party. Issuing and obtaining confirmation with contra-parties

is also the responsibility of the back office.

Cash Management:Banks would be maintaining Nostro accounts in all currencies in which they

trade. Maintaining sufficient balance in all the Nostro accounts is also the responsibility of the back

office. This function is called cash management because it basically involves maintenance of

sufficient cash balance in all the Nostro accounts. Cash management also involves funding

operations viz., providing funds in Nostro accounts to meet requirements to settle trades on a day-to-

day basis and for future dates and deploying excess funds in Nostro accounts.

3. Mid Office:

Front office operations involve considerable risks. There have been instances where a single front

office trader has carried out trades which wiped out the entire net worth of the bank leading to its

bankruptcy.

Bank managements therefore insist on strict supervision of trades carried out by front office. This

function is carried out by the mid office. Generally, mid office functionaries do not report to any person

in treasury. They are under the direct control of the market risk department of the bank who are

deployed in treasury for controlling market risk.

The investment policy and risk management policy would have spelt out how much exposure is

permitted in a currency during the day (day-light) and at end of the day (overnight), how muchexposure is permitted for each dealer (dealer limit), against each contra-party (contra-party limit) etc.

Mid office ensures strict enforcement of such limits. It uses sophisticated software tools not only to

monitor exposure limits, but also to warn front office when a particular limit is nearing breach level.

For instance if the exposure limit for a dealer is say USD 5 Million and he has an exposure of USD 4.5

Million, mid-office would intimate him that he is almost reached the exposure limit and ask him to sell

or buy forex to reduce exposure to avoid breaching of the exposure limit.

Ready and Forward Trades:

In merchant trade transaction, a bank can either enter into a ready trade or a forward trade:

Ready Purchase:


5/24

When the foreign currency is already credited to a banks Nostro account for being converted into INR

and credited to a customers account and a deal is done with the customer to fix arate for converting

the foreign currency into INR, the deal is called a ready purchase deal.

For instance, USD 100,000/- may be credited to the USD Nostro account of a bank being the

proceeds of a payment order for credit of a customer of the bank. The front office trader then does a

deal with the customer where both parties viz, the bank and the customer agree to a rate say INR 62.

Now the customers account will be credited with INR 62 lakhs and the bank can then sell the USD

100,000/- to another customer or a bank.

Forward Purchase:

When a deal is entered with a customer agreeing to pay him/her INR today against receipt of foreign

currency at a later date, the deal is called a forward purchase.

For instance, a bank may purchase an export bill from a customer for USD 1 Million at say INR 61.5

per USD. Here the bank would have to credit INR 6.15 crores to the customers account today but the

USD 1 Million would be credited to the banks USD Nostro account at a later date viz., after the bill is

paid at the foreign centre.

Ready Sale:

In a sale of foreign currency, if the INR amount is collected today and the foreign currency amount will

be debited to the banks Nostro account at a later date, such a sale would be called a ready sale.

For instance, if a bank were to enter into a deal with a customer agreeing to make a payment of USD

10,000/- to a persons account in say, Chicago and the customer agrees to pay INR 62.5 per USD,

the customer would pay the INR 6.25 lakhs to the bank first and only thereafter would the bank send a

payment order to its USD correspondent to pay USD 10,000/- to the beneficiary.

Forward Sale:

When the foreign currency amount is first debited into the banks Nostro account and a deal is struck

with the customer for selling the foreign currency at a later date, the deal would be called a forward

sale.

For instance, a bank might have opened a letter of credit on behalf of its customer for USD 0.5 Million

favouring an exporter in Atlanta USA and the LC would have been advised with confirmation by the

banks USD correspondent. In such a case, the USD correspondent would have to pay the LC

amount of USD 0.5 Million to the beneficiary of the LC if he submits a bill drawn as per IC terms. Here

the Nostro account of the bank would be debited first and then a deal will be concluded with the

customer agreeing a rate of say, 63 per USD. The customer would then pay INR 3.15 crores to the

bank.

Types of Forex Rates:

Please refer Chapter 15, Section I of the text book.

Please note that

TT Buying is a ready purchase transaction

Bill buying is a forward purchase transaction

TT selling is a ready sale transaction and

Bill selling is a forward Sale transaction.


6/24

Bid and Offer Rates:

Please refer Chapter 15, Section I (Page 469) of the text book.


7/24

Session 16:

Trade Date & Value Date:

The day on which a trade is done is called the trade dateor deal date. The day on which the trade

will be settled is called value date.

For instance, if a deal is done on say, March 14, 2014 agreeing to buy on March 21, 2014 USD 1

Million against INR at 62 INR per USD, the trade date would be March 14, 2014 and the value date

would be March 21, 2014.

Depending on the value date, forex trades can be classified as Cash, Tom, Spot and Forward trades.

Cash Trades:

In Cash Trades, the trade and value dates are the same. In the above transaction, if the trade had to

be settled on March 14, 2014 itself, then it would be a cash trade.

Cash trades are done only on exceptional basis because the settlement has to be done on the samedate. The back office settlement desk will have to complete issuing and obtaining confirmation with

the contra-party, arrange for funds in the payment currency and settle the trade all on the same day.

In the above example, trade confirmation will have to be issued to the contra party and obtained from

them, USD 1 Million has to be arranged in the USD Nostro Account and a payment order for USD 1

Million has to be sent to the USD correspondent bank in New York well before closure of Inter Bank

Payments in New York.

As East Asian and Australian markets close earlier than Indian markets, cash trades are avoided in

currencies like SGD, HKD, JPY and AUD.

Tom Trades:

In Cash Trades, the value date is the next working day after the trade date. In the above transaction,

if the trade had to be settled on the next working day after March 14, 2014, then it would be a cash

trade.

The next working day would take into accounts holidays at both settlement centres. In a USD/INR

Tom trade the settlement centre for USD would be New York and INR would be Mumbai. Any holiday

in either centre would result in postponement of the settlement day.

In the above example, if the trade was for Tom value, since the trade date viz., March 14, 2014 was a

Friday and forex markets the world over are closed on Saturdays and Sundays, the value date would

have been March 17, 2014 which would be a Monday. However, since Mumbai markets would beclosed on March 17, 2014 for Holi, the value date would be March 18, 2014.

Spot Trades:

In Cash Trades, the value date is the second working day after the trade date. In the above

transaction, if the trade had to be settled on the second working day after March 14, 2014, then it

would be a cash trade. While reckoning the value date, holidays at both settlement centres would

have to be taken into account.

In the above example, if the trade was for Spot value, since the trade date viz., March 14, 2014 was a

Friday and forex markets the world over are closed on Saturdays and Sundays, the value date would

have been March 18, 2014 which would be a Tuesday. However, since Mumbai markets would beclosed on March 17, 2014 for Holi, the value date would be March 19, 2014.


8/24

Please note that even if March 18, 2014 were to be holiday in New York, spot vale for the trade would

still be March 19, 2014. This is because March 19, 2014 would be the second working day after the

trade date at both centres since March 17, 2014 would be a working day in New York and March 18,

2014 would be a working day in Mumbai.

Spot trades are the most popular trades in the inter-bank forex market. Most of the forex rate quotes

would be for spot rates only and rates for other value dates are derivatives of the Spot rate. When a

trader has to dispose a long or short position, (s)he would opt for a spot trade since spot quotes and

contra parties would be readily available.

It is also to be noted that only in interbank trades, settlement at both ends is done on the same value

date. In merchant trades, the customer end of the transaction which would invariably involve INR

would be settled on cash basis. For instance, in an export bill purchase of USD 1 Million at say, INR

61.5 per USD, the bank would credit INR 6.15 crores to the customers account today itself, even

though the USD 1 Million would be credited to the banks USD Nostro account at a later date.

Similarly, in a trade involving issue of a JPY 1 Million payment order at INR 62 for 100 JPY, the

customers account will be debited with INR 62 lakhs today itself even though the payment order for

JPY 1 Million can be effected only on the next working day in Tokyo since Tokyo markets would haveclosed by the time the trade is done today. The exception to this rule is in forward trades which are

discussed below.

Forward Trades:

Trades involving value dates beyond spot are called forward trades.

A trade done on March 14, 2014 which has to be settled on March 27, 2014 would be a forward trade.

In merchant forward trades, the settlement for both the bank and the customer would be on the

agreed forward date.

For instance, on March 14, 2014, if a bank agrees for a forward purchase of USD 1 Million from anexporter customer at say, 62.50 INR per USD, for settlement on April 04, 2014, the customers

account will be credited with INR 6.25 crores not on March 14, 2014 but on April 04, 2014.

Customers enter into forward purchase and sale contracts as a hedge against forex rate movements.

For instance, a garment manufacturer may have received trade enquiries from a foreign buyer for

export of 1000 shirts at USD 10 per shirt for delivery on June 20, 2014. The garment manufacturers

costing shows that a shirt costs INR 550/-. If forward rates for USD/INR value June 20, 2014 are

ruling at say, 62.25 INR per USD, the manufacturer would be earning INR 622.50 per shirt on June

20, 2014 which would earn him/her a profit of INR 62.50 per shirt. If the profit margin is acceptable,

the manufacturer would enter into a forward trade contract value June 20, 2014 with his/her bank

agreeing to sell USD 10,000/- against INR 6.25 lakhs.

Please note that this would be a USD forward sale contract from the customers perspective and a

USD forward purchase contract from the banks perspective. However since we are learning banking,

we would always be speaking from the banks perspective.

Similarly, a trader importing goods say, Royal Gala apples would be looking forward to buying 5000

KGs of apples at INR 125 per KG so that he could sell them at INR 180 per KG and earn a net profit

of INR 20 per KG after accounting for storage, marketing etc. Exporters in USA are offering to deliver

these apples at USD 2 per KG for deliveries on June 20, 2014. If forward rates for USD/INR value

June 20, 2014 are ruling at say, 62.5 INR per USD, the trader would enter into a forward trade

contract value June 20, 2014 with his/her bank agreeing to buy USD 10,000/- against INR 6.25 lakhs.

With the USD 10,000/= (s)he would be able to buy 5000 KGs of apples at USD 2 per KG or INR 125

per KG.


9/24


10/24

Day-Light limitsare limits upto which a currency can be overbought or oversold during the daily

trading hours. Overnight limitsare limits upto which a currency can be overbought or oversold after

closing of trading on any given day. Overnight limits are more stringent because the bank would be

exposed to forex movements overnight when the bank would be closed for business.

Banks would not mind leaving a cash position open if the position pertains to a future date because

such an open position would not result in losses as there is no forex exposure. However, banks are

very sensitive to exchange positions because they involve forex rate exposures. The following

example will illustrate cash and exchange position:

Let us presume that A Bank Ltd has a Mumbai branch which is a Forex Category A branch

maintaining several Foreign Currency Nostro Accounts abroad including a USD account with JP

Morgan Chase, New York.

On March 14, 2014 the forex dealing room attached to Mumbai branch opens with a near square

exchange position in USD of USD 100. A branch serviced by Mumbai Branch reports an export

transaction involving negotiation of a bill for USD 1 Million under Letter of Credit. The interbank

USD/INR spot rate is 62.20/21. In other words the bid rate for USD is 62.20 viz., other banks would atpresent buy USD at 62.20.

The dealing room concludes the merchant deal at 61.90. The customers account will be credited with

INR 6.19 crores on the same day.

The USD Merchant Position would appear as follows:

Details Bought Sold Position

Opening Balance 100

Export bill negotiation at 61.90 1,000,000 1,000,100

Thus the bank would be overbought by USD 1,000,100. If the position is carried by the bank and the

interbank USD/INR spot rate falls below 61.90, the bank would make a loss. So the dealer squares

the USD position by selling USD 1 Million outright value spot in the interbank market at 62.20 to B

Bank Ltd whose USD Correspondent is Bank of America, New York. With this deal, the USD

exchange position will be near square as shown below:


Opening Balance 100


Sold spot value to B Bank Ltd at 62.20 1,000,000 100

However since the proceeds of the USD 1 Million bill negotiated by the bank is expected to be

credited only by March 28, 2014, the Cash Position for USD as on spot viz., March 19, 2014 (the

projected balance in their Nostro Account with JP Morgan Chase, New York) would now be oversold

by USD 1 Million of as shown below:

Cash position as on: 19.03.14 28.3.2014

Expected balance Overbought (Credit Balance) 100 (-)999,900

Less Spot sale to B Bank Ltd 1,000,000

Expected balance Oversold (overdrawn - Debit Balance) (-)999,900

Add Proceeds of negotiated bill 1,000,000Expected balance Overbought (Credit Balance) 100


11/24

Since on March 14, 2014 the bank sold USD 1 Million value spot to B Bank Ltd, and spot value for

trades done on March 14, 2014 is March 19, 2014 on that day they would have to ask JP Morgan

Chase, New York to remit USD 1 Million to Bank of America, New York for credit of B Bank Ltds

Nostro account with them which would result in their viz., A Bank Ltds Nostro account being

overdrawn by USD 999,900 from March 19, 2014 till March 28, 2014.

To correct this, A Bank Ltd cannot buy USD value spot out right because any such purchase would

square the cash position but again create a merchant overbought position of USD 1,000,100 as

shown below:


Opening Balance 100



Bought in interbank market at 62.21 1,000,000 1,000,100

To avoid this, the bank would have to do a swap transaction with say C Bank Ltd, where A Bank Ltdwould buy USD 1 Million at 62.21 value spot from C Bank Ltd and sell USD 1 Million at 62.21 value

March 28, 2014 to C Bank Ltd.

Now the exchange position on March 14, 2014 and the cash position as on March 19, 2014 and

March 28, 2014 would all be near square as shown below:


Opening Balance 100



Bought spot value from C Bank Ltd at 62.21 1,000,000 1,000,100

Sold value March 28, 2014 to C Bank Ltd at 62.21 1,000,000 100

Cash position as on: 19.03.14 28.3.2014

Expected balance Overbought (Credit Balance) 100 100

Less Spot sale to B Bank Ltd 1,000,000

Add Spot purchase from C Bank Ltd 1,000,000

Expected balance Overbought (Credit Balance) 100

Add Proceeds of negotiated bill 1,000,000

Less sale value to March 28, 2014 C Bank Ltd 1,000,000

Expected balance Overbought (Credit Balance) 100

Thus on March 19, 2014, A Bank Ltd will pay USD 1 Million to B Bank Ltd and Receive INR 6.22

crores from B Bank Ltd. It will also receive USD 1 Million from C Bank Ltd and pay INR 6.221 crores

from C Bank Ltd.

On March 28, 2014 A Bank Ltd will pay USD 1 Million to C Bank Ltd and Receive INR 6.221 crores

from C Bank Ltd.

The profit earned by A Bank Ltd would be INR 6.22 crores received from B Bank Ltd on March 19,

2014 less INR 6.19 crores credited to the customers account on March 14, 2014 viz., INR .03 crores

or 3 Lakhs.

Forward Premium and Discount:


12/24

In a currency pair, all other factors being constant, the forward rates would be determined by the

interest rates ruling on each currency. The currency which carries a higher interest rate would

depreciate and the currency which carries a lower interest rate would appreciate.

The following illustration would help understand the phenomenon:

Let us say that as on date, USD/INR is at INR 60 per USD and INR interest rate is 12% p.a and USDinterest rate is 4% p.a.

If one were to exchange USD 1 Million for INR, one would get INR 6 crores. In three months, USD 1

Million would grow to USD 1.01 million because the interest on USD is 4% p.a or 1% per quarter.

Meanwhile, INR 6 crores would have grown to 6.18 crores because interest on INR is 12% p.a. or 3%

per quarter. Thus three months later, USD 1.01 Million would be equal to INR 6.18 crores or 1 usd

would fetch INR 6.18 crore/1.01 Million = INR 61.1881.

Thus INR which has a higher interest rate would depreciate against USD which has a lower interest

rate. In other words INR would be at a discount against USD in the forex forward market and USD

would command a premium against INR.

Please note that forward premium and discount of a currency can be stated only in relation to another

currency. For instance, one cannot say USD is enjoys a premium or is at a discount. However, one

can say that USD enjoys a premium against GBP and is at a discount vis--vis JPY.


13/24

17:

Financial Inclusion:

The banking industry has shown tremendous growth in volume and complexity during the last few

decades. Despite making significant improvements in all the areas relating to financial viability,

profitability and competitiveness, there are concerns that banks have not been able to include vastsegment of the population, especially the underprivileged sections of the society, into the fold of basic

banking services.

Financial exclusion can be thought of in two ways.

One is exclusion from the payments systemi.e. not having access to a bank account.

The second type of exclusion is from formal credit markets, requiring the excluded to approach

informal and exploitative markets.

Who are the excluded?

The financially excluded sections largely comprise marginal farmers, landless labourers, oral lessees,

self-employed and unorganised sector enterprises, urban slum dwellers, migrants, ethnic minorities

and socially excluded groups, senior citizens and women. While there are pockets of large excluded

population in all parts of the country, the North East, Eastern and Central regions contain most of the

financially excluded population

Reasons for financial exclusion

There are a variety of reasons for financial exclusion.

In remote, hilly and sparsely populated areas with poor infrastructure, physical access itself acts

as a deterrent.

From the demand side, lack of awareness, low incomes/assets, social exclusion, illiteracy act as

barriers.

From the supply side, distance from branch, branch timings, cumbersome documentation and

procedures, unsuitable products, language, staff attitudes are common reasons for exclusion.

All these result in higher transaction cost apart from procedural hassles.

On the other hand, the ease of availability of informal credit sources like money lenders makes

these popular even if costlier.

The requirements of independent documentary proof of identity and address can be a very

important barrier in having a bank account especially for migrants and slum dwellers.

Consequences of Financial Exclusion

Consequences of financial exclusion will vary depending on the nature and extent of services denied.

It may lead to increased travel requirements, higher incidence of crime, general decline in investment,

difficulties in gaining access to credit or getting credit from informal sources at exorbitant rates, and

increased unemployment, etc. Small business may suffer due to loss of access to middle class and

higher-income consumers, higher cash handling costs, delays in remittances of money. According to

certain researches, financial exclusion can lead to social exclusion. Financial inclusion is an initiative

which aims to address this problem.

What is Financial Inclusion?

Financial inclusion is delivery of banking services at an affordable cost to the vast sections of

disadvantaged and low income groups.


14/24

Unrestrained access to public goods and services is the sine qua nonof an open and efficient

society.

As banking services are in the nature of public good, it is essential that availability of banking and

payment services to the entire population without discrimination be the prime objective of the

public policy.

Scope of financial inclusion:

The scope of financial inclusion can be expanded in two ways.

State-driven intervention by way of statutory enactments. When bankers do not give the desired

attention to certain areas, the regulators have to step in to remedy the situation. This is why RBI is

placing a lot of emphasis on financial inclusion.

Voluntary effort by the banking community for evolving various strategies to bring the large strata

of society within the ambit of the banking sector.

Benefits of financial inclusion

Limited access to affordable financial services such as savings, loan, remittance and insurance

services by the vast majority of the population in the rural areas and unorganised sector is

believed to be acting as a constraint to the growth impetus in these sectors.

Access to affordable financial services - especially credit and insurance - enlarges livelihood

opportunities and empowers the poor to take charge of their lives.

Such empowerment aids social and political stability.

Apart from these benefits, FI imparts

Formal identity,

Access to the payments system and

Savings safety nets like deposit insurance. FI is considered to be critical for achieving inclusive growth, which itself is required for ensuring

overall sustainable overall growth in the country.

Till the advent of the new millennium, banks and RBI looked at Financial Inclusion as a non-profitable

activity more in the nature of fulfilling a social obligation through the following measures:

1. Expansion branches in Rural and Sub-urban areas

2. Low cost credit for Agriculture and Rural Industries

3. Providing support to rural co-operative credit structure etc.

But financial inclusion has undergone a sea change since then.

It all began with Self Help Groups (SHG) and Micro Finance Institutions. Self-help groups were piloted

by NGOs in India in the mid-1980s, in order to provide financial services to poor people. What started

as a pilot programme has now become a movement for social empowermentparticularly for rural

poor women. The number of SHGs linked to banks has increased from about 500 in the early 1990s

to more than 2.2 million representing 33 million members.

Many self-help groups, under NABARD's SHG Bank Linkage program, borrow from banks once they

have accumulated a base of their own capital and have established a track record of regular

repayments. This model has attracted attention as a possible way of deliveringmicro-finance services

to poor populations that have been difficult to reach directly through banks or other institutions. By

aggregating their individual savings into a single deposit, self-help groups minimize the bank's
http://en.wikipedia.org/wiki/Micro-financehttp://en.wikipedia.org/wiki/Micro-finance


15/24

transaction costs and generate an attractive volume of deposits. Through self-help groups the bank

can serve small rural depositors while paying them a market rate of interest

Similarly, Micro Finance Institutions (MFI) started looking at financing of poor people, especially in the

rural areas as not a social service as a financially viable business proposition. MFIs raised funds for

rural lending not from banks or financial institutions. Instead, they resorted to the equity markets to

raise the resources.

Even after changing interest rates in excess of 30%, they were able to attract lots of borrowers

because the alternative source of credit for the unbanked rural population was the ubiquitous rural

money lenders who charged usurious rates of interest, indulged in various financial malpractices and

resorted to strong arm tactics for loan recovery.

In spite of the tremendous success SHGs and MFIs, financial inclusion was still a means of

dispensing credit to poorer sections of the society, especially in the rural areas. Bur real financial

inclusion means making available all financial services to the unbanked sections of the society and

this can only be provided by banks and other financial intermediaries like insurance companies.

However, banks found that opening of branches in every nook and corner of the country was notfinancially sustainable for the following reasons:

1. Opening of Branches is an expensive activity. At least one officer and 2 clerical staff and 2

subordinate staff would have to be deployed. The Cost to Company (CTC) for a staff complement

of 5 would be more than Rs 20 lakhs per annum. Volumes of business at rural branches would

never support such CTC levels in addition to establishment expenses such as premises rent,

power, telecom, computer maintenance, networking charges etc.

2. Manning the branches would be very difficult. At the outset, it would be difficult to recruit officers

who would be ready to be deployed in rural hamlets. Even if an officer is posted in such branches,

(s)he would have to be compulsorily transferred after three years and finding a replacement would

be very difficult.

3. The kind of network connectivity, continuous and reliable power supply, computer maintenance

services required for upkeep of modern core bank connected branch terminals is not available in

rural areas.

Using Technological Innovation to extend Financial Services to Unbanked Areas:

Innovative use of technology is now enabling banks and other financial institutions to reach out to the

unbanked sector of the economy without opting for the unviable option of opening branches in rural

areas. This has become possible because of the following innovations:

1. Banking Correspondents (BC)

Banks are now expanding financial inclusion in a big way by offering services through agents called

Banking Correspondents. BCs could be kirana shops, unemployed youth or even housewives in rural

areas. BCs act as agents of banks by opening accounts, accepting deposits, allowing withdrawals

and offering other basic banking services. Other financial service providers like Insurance Companies,

Mutual Funds etc., are also planning to use BCs to extend financial services to unbanked areas.

Each BC will have a current account with the sponsor bank which will be used to account for cash

received/paid and other transactions carried out by the BC.

2. Biometric Cards:

As the customers serviced by BCs would not be personally visiting branches of banks, they would be

non-face-to-face customers. As there would be many illiterate customers, specimen signature cannot


16/24

be used as a means for authenticating transactions authorised by such customers. Unsophisticated

rural customers would not be comfortable with use of Personal Identification Numbers (PIN).

Biometric cards solve the problem. When a customer is introduced by a BC, along with identity and

address proof documents and photograph of the customer, his/her finger prints would also be

captured using biometric enabled Point of Sale (POS) terminals. All the documents and the electronic

file containing biometric information would be sent to the bank.

The bank would create a core bank account for the customer and also mail a biometric card to his/her

mailing address. The customer would now be identifiable biometrically identifiable for authentication of

transactions authorised by him/her.

3. Biometric Enabled Point of Sale (POS) Terminals:

Each correspondent would be provided with a biometric enabled Point of Sale (POS) terminal which

would be used for authentication of customer requests. This POS terminal would be like those used

for authentication of credit and debit card transactions with the difference that instead of keying in of

PIN, they would require the customer to place his/her thumb impression for biometric identification.

Hardware and Communication Layout:

The following diagram illustrates the layout of hardware devices and communication lines for

connecting the POS terminals to servers at the bank end:

POS Terminal FI Web Server Firewall

Core Bank System FI Application Server

Transaction Flow:

When a customer requires to deposit funds into his/her account, (s)he approached the BC and hands

over the deposit amount to the BC who allows him/her access to the POS terminal. The customer

inserts the biometric card in the POS terminal and identified him/herself by placing his/her thumb on

the biometric pad on the terminal.

GPRS


17/24

The card information extracted from the card and the thumb impression is relayed over the GPRS

network to the FI Webserver of the bank which is separated from the rest of the bank servers by a

firewall to protect banks server from the GPRS network. The webserver relays the information to the

FI application server which has the customer card information, biometric data and the core bank

account number allotted to the customer and the BC.

If the customers biometric information agrees with the biometric data in the FI application server,

(s)he is allowed to carry out transactions. The customer can now enter the amount to be deposited

into his/her account. The information is relayed to the FI application server which sends a message to

the core bank system (CBS) of the bank requesting that the BCs account be debited and the

customers account be credited. If the transaction is successful, the CBS forwards the balance in the

customers account after the credit to theFI application server which in turn relays it to the POS

terminal where the balance is displayed.

If the customer wants to withdraw cash, the entire process stated above is carried out except for the

following:

The FI application server sends a message to the core bank system (CBS) of the bank requestingthat the BCs account be debited and the customers account be credited. If there is sufficient balance

in the customers account, the CBS forwards the balance in the customers account after the debit to

the FI application server which in turn relays it to the POS terminal where the balance is displayed.

The above arrangement is secure because:

a. No one other than the customer can authorise the transaction because the customer is identified

biometrically.

b. The BC cannot misuse amounts deposited by the customers because whenever the BC receives

cash, his/her core bank account is debited.

This system would ultimately result in extension of financial services to all the unbanked areas once a

few outstanding issues listed below are addressed:

1. GPRS network is yet to be extended to cover all parts of the country

2. The BCs account may be fully drawn in case of continuous credits by customers on a given day.

Similarly, the BC may run out of cash if there are continuous withdrawals by customers on a given

day.

RBI, individual banks and financial service providers are trying to put in place a fully developed FI

ecosystem to address the above issues in the near term. Once this is done, no citizen of this country

would be denied basic financial services irrespective of his/her financial status or physical location.

Once every citizen of this country is provided access to financial services, they would be able to

1. Deploy their savings in a variety of savings products like bank deposits, insurance annuities,

mutual funds pension funds etc.

2. Invest excess funds in products offering high returns like shares, bonds etc.

3. Avail of credit facilities at competitive rates of interest.

4. Pay Utility bills, purchase train, bus and air tickets online.

5. Remit and receive funds online.

6. Purchase goods and avail of services online.

7. The list is endless, limited only by ones imagination.

There is also the exciting possibility of BCs operating in urban areas also, thus completely removing

cash handling from banks.


18/24

Session 18:

Settlement of Debit Card, Credit Card and E-Commerce Transactions:

1. Cash withdrawals from ATMs using Debit Cards:

a. Where ATM belongs to the card issuing bank:

The following diagram illustrates the layout of devices involved in the process:

When a customer draws cash from the ATM of the Bank which has issued the Debit the process

would be as follows:

The customer enters the ATM premises by swiping (In the case of Magnetic Swipe Cards) or

inserting (In the case of Chip based smart cards)

Once access in provided the card is swiped or inserted

The ATM prompts for language preference

Once the preferred language option is selected

The ATM prompts for entering the Personal Identification Number (PIN) which consists of 4

numerals The customer is then asked to select the transaction type

On selecting cash withdrawal, the customer is prompted for the amount to be withdrawn (There

are fast cash and account type options which may vary from ATM to ATM and Bank to Bank)

On entering of the amount to be withdrawn, the ATM sends the following information to the ATM

Controller

Debit card number extracted from the card

PIN entered by customer

Amount to be withdrawn

The controller verifies whether the

Card Number is genuine

Card has not been hot listed on account of

The card being reported to have been lost or stolen

Misuse of card by the card holder

PIN entered is correct

In case of verification failure, the ATM controller sends the appropriate error code to the ATM

which is displayed on the ATM Screen

If the transaction passes verification, the ATM Controller extracts the actual account number in

the Core Bank System (CBS) with which the card is associated and sends a message to the CBS

requesting debiting of the amount to be withdrawn from the CBS account of the cardholder

The CBS attempts to debit the cardholders account

If the balance is insufficient, an error message is sent to the ATM controller which relays it to the

ATM which is displayed on the ATM Screen

ATMATM

Controller Core Bank

System


19/24

If there is sufficient balance in the cardholders account, the amount to be withdrawn is debited

and CBS sends a message to the ATM Controller indicating the balance in the account after the

withdrawal which is relayed by the ATM Controller to the ATM

The ATM dispenses the cash and prints a receipt showing the balance in the cardholders

account after the withdrawal.

b. Where ATM does not belong to the card issuing bank:


As shown above, the transaction flow involves the ATM Controllers of the ATM Owing bank and the

Card Issuer bank. The ATM controllers are connected to each other through a Switch belonging to a

service provider like the National Payments Corporation of India (NPCI). Instead of the CBS of the

ATM Owing bank, the CBS of the Card Issuer bank is involved. The transaction flow differs from that

shown in 1 a. above in the following respects:

The card and PIN verification is not done by the ATM Controller of the ATM Owning Bank, but by

the ATM Controller of the Card Issuer bank. Similarly, the debiting of the cardholders account is

done by the CBS of the Card Issuer bank.

2. Point Of Sale (POS) Transactions at Merchant Establishments using Debit Cards:

Debit cards can be used to settle bills at merchant establishments like Department stores & Shopping

Malls, Cafes, Restaurants & Hotels, Travel Agencies, Airlines and Bus Booking counters etc.


ATM

Controller

ATM SwitchATMController

Card Issuer

Bank

Card Issuer

Bank CBS

ATM


20/24

As seen in the above diagram, a minimum of five devices will be involved in the process namely a

POS Terminal at the merchant establishment, the merchant acquirer banks server, a card association

switch system, the card issuing banks server and CBS.

The merchant acquirer bank is a bank that acquires the transaction from the merchant. The card

association would have both the merchant acquirer bank and the card issuer bank as its members.

The most popular card associations are MASTERCARD and VISA.

The transaction flow is as follows:

After completion of selection of goods or availing the service, the card holder hands over the card

to the merchant for payment processing

The merchant swipes (In the case of Mag Stripe Cards) or inserts the card (In the case of CHIP

based smart Cards) in a Point Of Sale (POS) Terminal provided by the merchant acquirer bank

and enters the amount due from the card holder. In the case of smart cards, the card holder may

be prompted to enter the PIN also

The information is forwarded by the POS Terminal over phone or mobile links to the merchant

acquirer bank server.

The merchant acquirer bank server forwards the information to the card association server.

The card association server relays it to the card issuer bank server. This server verifies whether

the

Card Number is genuine

Card has not been hot listed on account of

The card being reported to have been lost or stolen

Misuse of card by the card holder

PIN entered is correct.

In case of card verification failure, the card issuer bank server sends the appropriate error code to

the card association server which relays it to the merchant acquirer bank server which in turn

relays it to the POS Terminal which displays a message that the transaction has been refused.

If the card verification is successful, the card issuer bank server extracts the actual account

number in the Core Bank System (CBS) with which the card is associated and sends a message

to the CBS requesting debiting of the amount to be withdrawn from the CBS account of the

cardholder.

POS

Terminal

Merchant

Acquirer

Bank Server

Card Issuer

Bank CBSCard Issuer Bank

server

Card

Association

Server


21/24

If the balance is insufficient, an error message is sent to the card issuer bank server which relays

it to the POS Terminal via the card association server and the merchant acquirer bank server.

The POS Terminal displays a message that the transaction has been refused.


and CBS sends the approval information with a transaction reference number to the card issuer

bank server which relays it to the POS Terminal via the card association server and the merchantacquirer bank server. The POS Terminal displays a message that the transaction has been

accepted.

The merchant prints the approval message with the transaction reference number in duplicate

and asks the card holder to sign the original and retain the duplicate as proof of payment along

with the bill for the goods purchased or service availed.

The merchant is expected to verify the card holders signature on the original approval message

with the specimen signature on the reverse of the card to ensure that the card is being used by

the card holder him/herself.

Even though the CBS debits the customer before approving the transaction, the amount is held

with the card issuer bank.

The merchant establishment submits all its approved authorizations, in a "batch" normally at

end of day, to the acquiring bank server for settlement.

Theacquiring bank server relays it to the issuer bank server through the card association server.

Normally on the next day the card issuer bank makes the payment to the acquiring bank. This is

generally a net settlement process because most banks act as both merchant acquirers and card

issuers and as such they would be submitting claims (as merchant acquirers) forwarded by the

merchants serviced by them and accepting claims (as card issuers) submitted against them.

On receipt of the claims, the merchant acquirer banks credit the account of the merchant

establishment.

3. Cash withdrawals from ATMs using Credit Cards:

a. Where the ATM belongs to the credit card issuer bank:



The process of gaining access to the ATM and entering the amount to be withdrawn is as detailed

in 1 a. above.

The ATM controller however forwards the transaction details directly to the server processing

credit card transactions.

The credit card server performs card verification process as detailed in 2. Above.

ATMATM

ControllerCard Issuer Bank

server


22/24

However since it is a credit card transaction, the transaction is not forwarded to the CBS after

successful verification.

Each credit card holder is allotted a credit limit which is a type of line of credit. The limit is arrived

on the basis of the earning capacity of the card holder and his/her past transaction record. Each

credit card holder is also allotted a cash withdrawal limit which is lower than the credit limit for

purchase transactions. The credit card server has the details of credit limit and cash withdrawal limit granted to and credit

and cash withdrawals utilised by each credit card holder.

After successful card verification, the credit card server reduces the amount to be withdrawn from

the balance in the cash withdrawal limit of the credit card holder. If the balance is not sufficient,

the transaction is refused.

If there is sufficient balance is available, the amount to be withdrawn is reduced from the balance

in the cash withdrawal limit and an appropriate message with the available balance is relayed to

the ATM through the ATM Controller.

The rest of the cash dispensing process is similar to that detailed in item 1 a. above.

b. Where the ATM does not belong to the credit card issuer bank:


The transaction flow is similar to that detailed in 3 a. above with the following difference:

Since the card is not issued by the bank owning the ATM, the ATM controller forwards the

transaction to the card issuer bank server through the card association server.

The card issuer bank server relays the appropriate message with the available balance to the

ATM via the card association server and the ATM Controller.

The settlement between ATM owning banks and credit card issuer banks is carried on net

settlement basis at discrete intervals.

4. Point Of Sale (POS) Transactions at Merchant Establishments using Credit Cards:

ATM

ATM

Controller Card

Association

Server

Card Issuer Bank

server


23/24


It will be obvious from a comparison of the above layout with that shown in item 2. above that the only

difference between Point Of Sale (POS) Transactions at Merchant Establishments using Debit and

Credit Cards is that whereas in the case of debit cards, the transaction amount is deducted from the

account of the card holder in the CBS, in the case of credit card holders the transaction amount is

deducted from the cash withdrawal limit of the credit card holder.

5. E-Commerce Transactions using Debit Cards:

E-Commerce transactions are carried out by logging into merchant sites on the net.


Internet

Customer using

Web Browser

POS

Terminal

Merchant

AcquirerBank Server

Card

Association

Server

Card Issuer Bank

server

Merchant

Webserver

Merchant

Payment

Gateway

Merchant

Acquirer

Bank Server

Card

Association

Server

Card Issuer

Bank CBSCard Issuer Bank

server


24/24


The customer uses a web browser to connect to the merchants webserver over internet

Since internet is not a secure communication medium a secure browser protocol called HTTPS is

used and a secure communication channel called in Secure Socket Layer (SSL) is created

between the customers browser and the merchants webserver.

The customer selects the goods and services and billing process is completed online.

Once the bill amount is finalised the customer is asked to provide his/her debit card particulars.

The particulars provided along with the bill amount to be debited to the customers account are

forwarded by the merchant webserver to the merchant payment gateway.

The payment gateway forwards the transaction to the merchant acquirer bank server.

The merchant acquirer bank server forwards the transaction to the card association server.

The card association server forwards the transaction to the card issuer bank server.

The card issuer bank server performs card verification.

If verification is successful the card issuer bank server extracts the actual account number in the

Core Bank System (CBS) with which the card is associated and sends a message to the CBS

requesting debiting of the amount to of the merchant transaction from the CBS account of the

cardholder.


and CBS sends the approval information with a transaction reference number to the card issuer

bank server which relays it to the Merchant webserver via the various server listed above.

The merchant completes the sale transaction and carries out delivery of the goods or services.

The merchant claim settlement process is similar to that detailed in item 2. Above.

6. E-Commerce Transactions using Credit Cards:


Internet

Customer using

Web Browser

From a perusal of the above diagram, it would be clear that e-commerce transactions involving credit

cards is very similar to that involving debit cards, the only difference being that instead of debiting the

amount demanded by the merchant to the CBS account of the card holder, it would be reduced from

the credit card limit of the cardholder which is maintained in the card issuer bank server.

Merchant

Webserver

Merchant

Payment

Gateway

Merchant

Acquirer

Bank Server

Card Issuer Bank

server

Card

Association

Server

bbm notes - session 14 to 18

Documents