CHAPTER- I

NTRODUCTION

1.1. Background of the Study:

The economic development of a country mostly depends on the function of the financial intermediation. The intermediaries mobilize fund from the surplus sector of the economy to the deficit sector and thus achieving a reasonable amount of profit after meeting the cost of fund administration. Unless the fund management function is efficiently planned and executed, none of the commercial banking function can achive their maximum potentials profit for the bank. A well-conceived fund management strategy bring together policies in the areas of loans, deposits, investments, capital and relates each to the other so that the decisions taken in one area reinforce those in each of the other areas. The specific objectives of funds management in a commercial banks are: (i) to maximize earnings for the shareholders; (ii) to provide adequate liquidity and cash; (iii) to manage the loan and investments portfolios in the best possible manner so as to ensure profitability; (iv) to maintain a reserve for contingencies and (v) to manage the banks other activities with the prudence appropriate to a person acting as custodian of the funds of others.

Portfolio management is an integral part of bank management at the macro level in general and branch level in particular, as it affects profitability and viability of the banking system as a whole. Portfolio management is the term used to describe the allocation of fund among investment alternatives. Applied to commercial bank, the term refers to the allocation of funds among the loan and investment. The obvious solution to the funds allocation problem facing the bank management is to deploy funds amongst those assets that promise the highest rate of return for the level of risk that a bank management is prepared to assume. The major portion of the liabilities of a commercial bank is payable within a short period of time i.e.. either on demand or with only short notice. Demand deposits are, of course, payable at the request of the depositor, and while prior notice of withdrawal may be necessary on time and savings deposits, banks generally regard savings deposits as payable on demand. Infact, in determining the portfolio composition, a bank balances its desire for income against its requirement for liquidity. In so doing, banks hold a portfolio of assets in relation to the characteristics and distribution of its liabilities to yield the greatest return and to provide for the needed liquidity. It is, therefore, evident that the pattern and distribution of liabilities and assets are very closely related and there exists a set of interrelationships. However, it is an admitted fact that the relationships are complex and are influenced by the factors external to banking as well, such as prevailing economic conditions of the country, general economic activities, net credit demands, changing perceptions of and attitudes towards risk and regulatory constraints. Any prudent bank management has to take the above factors into cognizance in managing its portfolio. What should be the appropriate size of the loan portfolio is a question that is constantly faced by bank management. However, no categorical answer exists to what is the optimum size of a banks loan portfolio. Every bank operates within an environment of its own. It is as difficult to say how large the loan portfolio should be as it is to determine the amount of liquidity

a bank should maintain. The size of a loan portfolio must. Since these priorities vary, it is impossible to lay down hard and fast rules regarding the size of the loan portfolio of an individual bank or the banking system as a whole. Nevertheless, a number of important factors influencing the loan portfolio of a bank are: (i) Capital position: (ii) Risk and profitability of various types of loans: (iii) Tenure of deposits: (iv) Credit environment: (v) influence of monetary and fiscal policies: (vi) Ability and experience of bank personnel to handle loan portfolio: and (vii) Credit needs of the area covered. The capital of a bank serves as a cushion for the portion of the depositors fund. The size of capital in relation to deposits influences the amount of risk that a bank can afford to take. Banks with relatively adequate capital can make loans of longer maturities and greater risk. Bank management must decide what types of loan would be best for the bank. Some of the important consideration in making this decision are the risk associated with the various kinds of loan, The need for diversification to spread the risk, the types of customer the bank want to serve, the capabilities of bank personnel and certainly, the relative profitability of various kinds of loans. To the extent that is practicable, the bank should diversify their loan portfolio among the various broad categories of loan such as agriculture, commercial lending, industry etc. and strive also for considerable diversification within each of these broad categories to spread the risk. The type and tenure of deposits have an important bearing in the determination of the loan portfolio of a bank. After adequate provision has been made for liquidity reserves, banks can the engage in lending. The prevailing economic conditions and investment environment are no doubt influential in deciding the loan portfolio of a bank. The loan creating ability of banks is greatly influenced by the monetary and fiscal policies of a country. If additional reserves are made
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available to the commercial banking system, the lending ability of banks is increased. Whether there are adequate expertise of the lending personnel of a bank is question often raised at the time of firming up the loan portfolio? An obvious factor influencing a commercial banks loan portfolio is the area it serves through the network of branches. The loan portfolio should be balanced in a manner so that the various credit needs of the different communities and areas are accommodated. In Bangladesh, portfolio management in commercial banks has assumed a new dimension in the event of the introduction of the financial sector reforms, which include the revision of the interest rate policy, and the procedures of loan classification and provisioning. In the changed context, the management of individual commercial banks are expected to undertake more in-depth exercise than ever before in determining the loan portfolio in order to make the quality loans for ensuring safety of the funds as well as higher profitability. So far investment portfolio is concerned, the banks invest funds in those securities wherein they are to go under compulsion to comply with the liquidity reserve requirements. The planning of investment portfolio by a commercial bank o its own on the basis of higher yield commensurate with the calculated risks is hardly done.

1.2. Objective of the study:

The specific objective of the research has been as follows1. 2. 3. To investigate the present status of Portfolio management of banks in Bangladesh . To identify the most profitable types of loans and To highlight the major problem of the Portfolio advances of the banks in their loan portfolio. management of Banks.

4.

To make recommendation and suggestion regarding the

Portfolio management of banks.

1.3. Methodology of the study: a) Sources of data & data collection:

Data for the purpose of the study were collected from the secondary sources. the secondary sources of data and information are publication of Bangladesh bank, The annual report of these banks, Different published journals, Reading materials, Compilation and Books etc.

b) Time preference:
The period of 4 years i.e., for 1996-2000 has been taken for the purpose of making analysis of the Portfolio management.

c) Data processing and analysis:

Data processing has been done manually after checking and editing. Statistical techniques like average, percentage differences and financial analysis techniques like ratios were used to interpret the data and draw inference whatever applicable.

d) Sample design:
Total number of banks in Bangladesh (PCBs & NCBs) are nearly 30. It is not possible to survey all the banks within this time frame. So here we use purposive sampling to design our sample size. Two National

Commercial Banks(NCBs) and Two Private Commercial Banks(PCBs) were selected as sample for the purpose of the study.

1.4. Limitation of the study:

Although the selection of the banks for our research was cried out in order to make it as representative as possible but new private banks may differ from it. For time limitation, much more in depth analysis could not be done. If duration of the study were longer period, much more detailed analysis could be done.

CHAPTER- TWO

2.1. Asset, Liabilities and other portfolios of banks in NCBs & PCBs:
The particular services each bank offers and the overall size of the banking financial institutions is reflected in its financial statements. Three financial statements of banks, we find in any annual reports are the balance sheet, the profit and loss account, and the cash flow statement. Among this trio first two is very important. In USA, they are known as the balance sheet of report of condition and the income statement or report of income. The balance Sheet shows the amount and composition of funds sources (financial inputs) the banks has drown upon to finances its leading and investing activities and how much has been allocated to loans, securities, and other fund uses (financial outputs) at any given time. In other words, all the assets, liabilities, equity capital (owners funds) held by or invested in the bank on any given date are shown in the balance sheet. Items in the balance sheet of any bank in Bangladesh differ from those of USA or other countries that have mature money and capital markets. In this research paper, typical items found in the balance sheet of a bank scheduled under Bangladesh Bank have been introduced.

2.1.1 Bank Assets

The claims of a banking company on its creditors constitute banking assets. Major asset items found in bank balance sheet are:

1) Cash Assets:
This is the most liquid among all the assets that generates lowest or no return. It is the cash in hand and in banks comprises of items like notes and conies, balances with BB, balances with SB, balances with other banks, balances with other financial institutions, foreign currency notes in hand, balances with BB, wage careers account, etc. Items in this category have almost no risk exposure.

2) Money at Call and Short Notice:

It is the deposit kept by the bank in other banks and other financial institutions. Return, maturity, denomination, etc. varies from bank to bank and is in the pure discretion of the parties involved. These items possess almost no exposure to risk.

3) Investments:
Usually constitutes 10 to 25% of total asset portfolio of a bank. Items clubbed under this category are treasury bills, different government approved savings certificates, investments in bonds, debentures, and shares of autonomous & semiautonomous bodies, other financial & non-financial institutions, private enterprises, deposit money banks local authorities, etc. It also includes foreign investments. Rate of retur5n varies instruments to instruments. It has higher risk exposure than cash items but lower risk exposure than advances.

4) Advances:
It constitutes largest share of the asset portfolio of a bank (around 50%75%). It generates most of the revenue for the bank. Cash credits, loans, and over drafts are three forms of advances. Items that fall into this category are advances to government deposit money banks other financial & non-

financial institutions, local authorities, private sectors. Classified loans also fall into this category. Items (except advance to government) have the risk exposures.

5)

Bills Discounted and Purchased:

Export and other foreign bills, import and inland bills fall into this

category. It generates mainly fee incomes. Risk exposure varies from 0% to 100%.

6)

Off Balance Sheet Assets:

It is the contingencies received by the bank. It can be exercised by the

initiative of he bank (there the beneficiary). Examples are financial guarantees, stand by letter of credit (SLC), sale and repurchase agreement, performance bonds, bid bonds, SLC related to a particular transaction, documentary letters of credit and other trade financing transactions, undrawn overdraft and credit card facilities, etc.

7)

Other Assets:
Items that do not fall under any of he above category constitute other

assets. It includes fixed assets, contingent assets as per contra, valuation adjustments, expenditure account, etc. They generate no revenue; instead incur expenses.

2.2.2. Banking Liabilities

Liabilities are the financial claims held by businesses, households, and governments against the bank. They are the source of funds for the bank. Some principal liability categories has been described briefly underneath:

1)

Short Term Debt:

Bank time borrows funds for less than one year of maturities. These

funds are known as short-lern debts. They incur interest expense for the bank.

2)

Deposits:
The major share of source of fund for any bank in Bangladesh comes

from deposits. There are varieties of deposit items, such as. i) Current Account: It is a non-interest-bearing deposit accounts for which bank pays no interest generally. Depositors can withdraw money from the balances in those accounts without prior notice. ii) Savings bank Account: It usually bears very low interest rates and deposit or can withdraw money from their account via issuing checks without prior notice. But some banks allow their customers to withdraw money upto certain limit without prior notices. Interest is calculated on monthly, half-yearly or yearly basis and issuing checks are permitted upto certain numbers (for example, not more than two in a week) during a stipulated time horizon. If depositors exceed the limit in issuing checks then bank will not pay interest for that time period of the balance held. iii) Fixed Deposit: It carries a fixed maturity or term period (generally one year or more) and a stipulated interest rate. It may be of and denominations, maturities, and rates agreed upon by the bank and its depositors.

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iv) Other Deposits:

There may be other types of deposit accounts that vary bank to bank. Some of them are: Foreign Currency Deposit, Deposit from Other Banks, Deposits under Schemes, Sundry Deposit, Security Deposits, Money Market Deposits, etc.

3) Borrowing from Other banks:

A bank borrows from the banks to meet the emergency need of funds, Interest rates, maturities, denomination varies and are determined by the concern parties. Inter-bank borrowing or money at call and short notice accounts are example of this category.

4) Bills Payable:
Bank issues Pay-Order, Demand Draft, Telegraphic Transfer, Pay Slip, Transfer Certificate, etc, in order to facilitate funds from one branch/bank to another branch/bank. These are the claims of the purchasers of the bills against the issuing bank. Bank earns fees income and it cost some transaction cost for the bank.

5) Other liabilities:
There are lost of other liability instruments such as Credit Card, Profit Receivable, and Profit Payable Provision for Taxation, Provision for Bonus/Provident Funds/etc. Adjusting Account Credit, Exchange Equalization Account, etc.

6)

Off Balance Sheet Liabilities:

These are the contingencies given by the bank to a third party in the

request of its customers. These off balance sheet liabilities generate

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revenues (with upfront and/or periodic fees or margins calculated as percentages of outstanding balance) instead of incurring cost. They do no generate immediate risk exposures, as there is no outflow of funds at origination. Items are same as discussed in off balance sheet assets.

7) Equity Capital:
They are the insiders claims against the bank company. They represent owners or shareholders share in the business. They act as cushion for losses for the bank. It comprises of issued, Paid Up Capital, General Reserves and Other Reserves, Statutory Reserves, Reserve for Dividends, etc. bank are to pay dividends to its share holders as a percentage of the face value of a share issued by it and as has been agreed in the annual general meeting.

2.3. Risk in Banking

Risk to a banker means the uncertainty that is perceived by it with some event. The word uncertainty associated with the word unexpected change. So, we can say that, risk for a banker arises from any unexpected change in some event or outcome. Bankers may be most interested in achieving high stock values and high profitability, but can fail to pay attention to the risks they are accepting as well. The six principal banking risks are:
1)

Credit Risk:
The probability of substantial losses on loans and other assets

due to borrower default.

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2) Liquidity Risk:
The uncertainity of running short of immediately spendable fund when required.

3) Interest Rate Risk:

Potential damages to the banks spread between interest income and interest expense due to interest rate fluctuations.

4) Exchange Rate Risk:

Potential losses or variations in earnings due to fluctuation in exchange rate. It is sometimes considered as part of market risk.

5) Market risk:
Adverse change in the value of a bank assets and liabilities.

6) Solvency Risk:
The possibility of bank failure. It is also identical to the credit risk incurred by the counterparties of the bank. All risks generate potential losses. The ultimate protection for such lowwes is capotal. Capital should be adjusted to the level required to make it capable of absorbing potential losses generated by all risks. A major challenge of risk management is to implement these principles and define quantitative measures required to obtain the adequate capital, or derive which levels of risk are sustainable given the capital constraints. Regulation has provided simple answers to those issues. The minimum level of capital required is a function of risks. The management of risks and profitability are closely related this is because risk taking is a necessary condition of future profitability. In the banking universe the usk-reward tradeoff in constantly present. Risk taking generates higher expected earnings through various mechanisms. The goal of risk management is to optimize the risk-reward trade . The relationship is multidisciplinary, just as the risks are but it should always be considered.

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Besides the above principal banking risks there are some other risk measures in banking. A broad classification of banking risks can be understood from the following table:

Bank Characteristics Balance Sheet

Risk Class Financial risks

Risk Category Credit risk Liquidly risk Interest rate risk Leverage risk Exchange rate risks Operational risk Technological risk New product risk Strategic risk Delalcation risk Economic risk Competitive risk Regulatory risk

Financial services

Delivery risks

Environment

Environmental risks

Financial risks are associated with balance sheet: it could be quantited and managed regularly. Following chart has explained how it poossible. Financial Risk Credit risk Traditional Measures Loan Assets Non loans Loans off/Loans Lead Measures Loan management Technique Credit analysis Credit controls risk growth documentation lending Credit

performing conecentration Loans Loan write- High

rates Provision to Special assessment

Provision for bad non-performing & doubtful loans / loans Liquidity risk Loans Loans/Deposits Liquid Purchased funds

Liquidity

plan

assets/ Borrowing

cost Contingency plan

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Deposits

Liquid assets Borrowings deposits

Cost models

pricing of

Development funding scores buckets Dynamic gap management

interest rate risk

Interest sensitive Gap asset Gap interest Duration

sensitive liability Dynamic Gaps

Duration analysis Interest rate hedging Capital planning

Leverage risk

Equity/ Deposits Equity/ Assets Capital/Assets

Risk-adjusted assets vs.

Equity Sustainable in Dividend Risk policy adjusted

Growth in assets growth analysis growth equity

Exchange risk

rate Foreign currency Growth assets currency liabilities open position foreign international

capital adequacy in Currency hedging

assets Growth in Net off balance sheet businesses

The risk of portfolio is generally less than or equal to the sum of the risks of its subportfolios. This is because the standalone risk of a transaction is its intrinsic risk when it is considered independently of any portfolio. Diversification (an ancient and basic rule in banking) makes the risks of a portfolio drastically lower than the su of the standalone risk of all the transactions. Risk management is part of portfolio management in a bank and it is based on quantitative measures of risks. There are a number of quantitative indicators of risks that are commonly used. They can be grouped into three categorics:

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1) Sensitivity, which captures the deviation of the target variable generated by a unit movement of single market rate (for instance, an interes rate shift of 1%) 2) Volatility, which captures the variations around the average of any random parameter or target variable, both upside and downside. 3) Downside measures of risk, which focus on adverse deviations only. They are experessed as a worst case value of some target variable, such as earnings, with some probability attached to that value. This measure of risk is the most comprechensive, it integrates the other two measures of risks with the adverse effect of uncertainty. 4) Sensitivity is the ratio of the variation of earnings, such as interest margins or changes of market values of instruments, to a given variation of the underlying random parameters that generates this variation. Examples of underlying parameters are interest rates, exchange rates, and stock prices. Formula to measure sensitivity is as follows: Sensitivity (value) **** Sensitivity *** The sensitivity is only an approximation as it gives the change in value for a small variation of the underlying parameter. It is a local measure. This means the sensitivity changes for other values of the interest rate. As sensitivity is very easy to calculate and to interpret, it is widely used. Volatility is a common statistical measure of the dispersion around the average of any random variable such as market parameters, earnings or market values. Volatility is the standard deviation of the values of these variables. Standard deviation is the square of the variance of a random variable. Both can be obtained from time series of observations. Any scientific calculator can calculates the variance and standard deviation if

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only data is given. The relationship between the volatility over periods and the volatility over a unit period is ****

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