ADVANCED BANK MANAGEMENTCAÌÌB - Paper 1. UNÌT-1 Fundamentals of Economics, Microeconomics and Macroeconomics and Types of Economics STRUCTURE 1.0 Objectives 1.1 Economics ÷ an Ìntroduction 1 .2 Microeconomics and 1.3 Macroeconomics Types of Economies !.4 Market, Command, and Mixed Economies Let Us Sum Up Keywords 1.0 OBJECTIVES This chapter will be helpful in understanding: 1. Meaning and Definition of Economics 2. Concept of Microeconomics 3. Concept of Macroeconomics 4. Problems of Economic Organization 5. Market, Command and Mixed Economies 1.1 ECONOMICS — AN INTRODUCTION Economics deals with the production, allocation, and use of goods and services. Ìt is important to study how resources can best be distributed to meet the needs of the greatest number of people. As we are more connected globally to one another, the study of Economics becomes extremely important. Economics is 'the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.' Scarcity means that available resources are insufficient to satisfy all wants and needs. Ìn the absence of scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources. The essence of Economics is to acknowledge the reality of scarcity and then figure out how to organize society in a way which produces the most efficient use of resources. That is where Economics makes its unique contribution. Definitions Adam Smith, the father of modern Economics, in his book entitled An Enquiry into the Nature and Causes of the Wealth of Nations (published in 1776) defined Economics as a study of wealth. According to him, the subject matter of Economics is the study of how wealth is produced and consumed. Smith's definition is known as wealth definition. This definition was too materialistic. Ìt gave more importance to wealth than to man for whose use wealth is produced. 1. Marshalls Definition According to Prof. Alfred Marshall, the well-known English economist, 'Economics is a study of mankind in the ordinary business of life. Ìt is on the one side, the study of wealth and on the other and more important side, a part of the study of man.' Wealth here means any commodity, which gives man satisfaction or utility or welfare. Wealth is the means to welfare. The ultimate purpose or objective of Economics is to promote well-being or welfare. He viewed Economics as a science of human welfare. Hence his definition is known as welfare definition. !. Ro""inss Definition According to Lionel Robbins, 'Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.' This definition presents Economics as a study of 'means' and 'ends'. The means or resources are less in relation to their demand. How men use the scarce resources to fulfill their desires is the subject matter of Economics. Robbins's definition is known as scarcity definition. The definition of Robbins can be analyzed as follows: (a) Man has unlimited wants: 'Ends' refer to wants. Human beings have wants, which are unlimited. All economic activities are undertaken to satisfy human wants. Man experiences all types of wants such as food, clothing, shelter, education, entertainment, etc. There is no limit to man's wants. We cannot say that there will be a stage when all the wants of a person are fully satisfied. When one want is satisfied another arises. #"$ The means to satisfy the wants are limited: The multiplicity of wants alone will not create an economic problem. Ìf man has unlimited resources or means to satisfy them, there is no economic problem. But it is not so. The resources are scarce in relation to demand. The mere shortage of supply of a commodity does not make it scarce, if there is no demand for it. Thus rotten eggs, though much fewer than good ones, are not scarce in the economic sense. On the other hand there may be huge stocks of a commodity like wheat or coal in the world, yet it is considered scarce because the demand is even greater than the supply. #%$ Resources are not only limited but also have alternative uses: The scarce means can be put to alternative uses. Ìf a commodity could be put only to one use, no economic problem would arise in its use. Ìn actual life, however, we find that a commodity can be put to several alternative uses. With Rs.50 you can buy either a good pen or you can go for a movie. A piece of land can be put under paddy, sugarcane or wheat cultivation. Thus, the resources available to a person or to the community are not only limited but are capable of alternative uses. #&$ Man has to make a choice: Man has to make use of his limited resources to satisfy his unlimited wants. He cannot satisfy all his wants with the limited resources. These limited resources can be put to alternative uses. So every man has to decide which wants he will satisfy now and which he would postpone. Thus Economics is also called a science of choice. 1.! MICROECONOMICS AND MACROECONOMICS Adam Smith is considered to be the founder of the field of Mi%roe%ono'i%s, the branch of economics which today is concerned with the behaviour of individual entities such as markets, firms, and households. Ìn The Wealth of Nations (1776), Smith considered how individual prices are set, studied the determination of prices of land, labour and capital, and inquired into the strengths and weaknesses of the market mechanism. Most important, he identified the remarkable efficiency properties of markets and saw that economic benefit comes from the self-interested actions of individuals. Mi%roe%ono'i%s is a branch of economics that studies how households and firms make decisions to allocate limited resources, typically in markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and services, which determines prices; and how prices, in turn, determine the supply and demand for goods and services. Microeconomics analyses the market behaviour of individual consumers and firms in an attempt to understand the decision-making process of firms and households. The other major branch of economics is Ma%roe%ono'i%s, which is concerned with the overall performance of the economy. Macroeconomics did not exist in its modern form until 1936, when John Maynard Keynes published his revolutionary book titled General Theory of Employment, Interest and Money. At that time, England and the United States were still stuck in the Great Depression of the 1930s, with over one-quarter of the American labour force unemployed. Ìn his new theory, Keynes developed an analysis of what causes business cycles, with alternating spells of high unemployment and high inflation. Today, macroeconomics examines a wide variety of areas, such as how total investment and consumption are determined, how central banks manage money and interest rates, what causes international financial crises, and why some nations grow rapidly while others stagnate. Although macroeconomics has progressed far since his first insights, the issues addressed by Keynes still define the study of macroeconomics today. Ma%roe%ono'i%s is a branch of Economics that deals with the performance, structure and behaviour of a national or regional economy as a whole. Ìt is the study of the behaviour and decision-making of entire economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship among such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. Ìn contrast, Microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behaviour determines prices and quantities in specific markets. The two branches ÷ microeconomics and macroeconomics ÷ converge to form the core of modern Economics. 1.( T)*ES O+ ECONOMIES The Three *ro"le's of an E%ono'i% Or,ani-ation. Every human society ÷ whether it is an advanced industrial nation, a centrally planned economy, or an isolated tribal nation ÷ must confront and resolve three fundamental economic problems. Every society must have a way of determining what commodities are produced, how these goods are made, and for wham they are produced. Ìndeed, these three fundamental questions of an economic organization ÷ what, how and for whom ÷ are as crucial today as they were at the dawn of human civilization. Let us look more closely at them: 1. What commodities are produced and in what quantities? A society must determine how much of each of the many possible goods and services it will make and when they will be produced. Will we produce pizzas or shirts today? A few high-quality shirts or many cheap shirts? Will we use scarce resources to produce many consumption goods (like pizzas)? Or will we produce fewer consumption goods and more investment goods (like pizza-making machines), which will boost production and consumption tomorrow? 2. How are goods produced? A society must determine who will do the production, with what resources, and what production techniques they will use. Who farms and who teaches? Ìs electricity generated from oil, from coal or from the sun? Will factories be run by people or robots'? 3. For whom are goods produced'? Who gets to eat the fruit of economic activity? Ìs the distribution of income and wealth fair and equitable? How is the national product divided among different households? Are many people poor and a few rich? Do high incomes go to teachers or athletes or auto workers or venture capitalists? Will society provide minimal consumption to the poor or must people work if they are to eat'? 1.. MAR/ET0 COMMAND0 AND MI1ED ECOMIES What are the different ways that a society can answer the questions of what, how and for whom? Different societies are organized through alternative economic systems and Economics studies the various mechanisms that a society can use to allocate its scarce resources. We generally distinguish two fundamentally different ways of organizing an economy. At one extreme, government makes most economic decisions, with people on top of the hierarchy giving economic commands to those further down the ladder. At the other extreme, decisions are made in markets, where individuals or enterprises voluntarily agree to exchange goods and services, usually through payments of money. Let us briefly examine each of these two forms of economic organization. Mar2et E%ono'34Ca5italisti% E%ono'3 Ìn the United States, and increasingly around the world, most economic questions are settled by the market mechanism. Hence, their economic systems are called market economies. A market economy is one in which individuals and private firms make the major decisions about production and consumption. A system of prices, of markets, of profits and losses, of incentives and rewards determines what, how, and for whom. Firms produce the commodities that yield the highest profits (the what) by the techniques of production that are least costly (the how). Consumption is determined by individuals' decisions about how to spend the wages and property incomes, generated by their labour and property ownership (for whom). The extreme case of a market economy, in which the government does not interface in economic decisions, is called a 'laissez-faire' economy. So%ialisti% E%ono'34Co''an& E%ono'3 Ìn contrast, a command economy is one in which the government makes all important decisions about production and distribution. Ìn a command economy, such as the one which operated in the Soviet Union during most of the twentieth century, the government owns most of the means of production (land and capital); it also owns and directs the operations of enterprises in most industries; it is the employer of most workers and tells them how to do their jobs; and it decides how the output of the society is to be divided among different goods and services. Ìn short, in a command economy, the government addresses major economic questions by virtue of its ownership of resources and its power to enforce decisions. Mi6e& E%ono'3 No contemporary society or economy falls completely into either of these extreme categories. Rather, all societies are mixed economies, with elements of both market and command economies. There has never been a 100 per cent market economy (although nineteenth-century England came close). Today most decisions in the United States are made in the marketplace. But the government plays an important role in overseeing the functioning of the market; government passes laws that regulate economic life, produce goods and services, and control pollution. Most societies/nations today operate as mixed economies. Ìndia, right from the beginning of its economic planning, has been a mixed economy where public sector, private sector and joint sector coexist and complement each other. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion 1. A&a' S'ith &efine& E%ono'i%s as a: The %hoi%es are: 1. Study of welfare 2. Study of 'means' and 'ends' 3. Study of Wealth 4. None of these Ri,ht Ans8er: #($ St7&3 of ;ealth 97estion !. Ma%roe%ono'i%s &eals 8ith< The %hoi%es are: (1) Gross domestic product (2) Unemployment rate (3) Price indices (4) All the above Ri,ht Ans8er: #.$ All the a"o=e. 97estion (. ;ho is %onsi&ere& as the fo7n&er of the fiel& of Mi%roe%ono'i%s> The %hoi%es are: (1) Lionel Robbins (2) Amartya Sen. (3) Adam Smith (4) Prof. Alfred Marshall Ri,ht Ans8er: #($ A&a' S'ith 97estion .. Mi%roe%ono'i%s is %on%erne& 8ith the "eha=io7r of The %hoi%es are: (1) Gross domestic product (2) Ìndividual entities (3) Economy as a whole (4) None of the above Ri,ht Ans8er: #!$ In&i=i&7al entities. 97estion ?. En&s refer to The %hoi%es are: (1) Demand (2) Resources (3) Utility (4) Wants Ri,ht Ans8er: #.$ ;ants 97estion @. A 'ar2et e%ono'3 is one The %hoi%es are: (1) Ìn which individuals and private firms make the major decisions about production and consumption. (2) Ìn which the government makes all important decisions about production and distribution. (3) Both (1) and (2) (4) None of these Ri,ht Ans8er: #1$ In 8hi%h in&i=i&7als an& 5ri=ate fir's 'a2e the 'aAor &e%isions a"o7t 5ro&7%tion an& %ons7'5tion. 97estion B. In&ia is a The %hoi%es are: (1)Capitalistic Economy (2) Socialistic Economy (3) Mixed Economy (4) Laissez-faire economy Ri,ht Ans8er: #($ Mi6e& E%ono'3 97estion C. Daisse-Efaire e%ono'3 is The %hoi%es are: (1) The extreme case of a market Economy (2) The extreme case of a Command Economy #($ The e6tre'e %ase of a 'i6e& E%ono'3 (4) None of these Ri,ht Ans8er: #1$ The e6tre'e %ase of a 'ar2et E%ono'3 97estion F. Mar2et e%ono'3 is also 2no8n as The %hoi%es are: (1) Mixed Economy (2) Capitalistic Economy (3) Command Economy (4) Socialistic Economy Ri,ht Ans8er: #!$ Ca5italisti% E%ono'3 97estion10. ;hi%h of the follo8in, is Ca5italisti% E%ono'3> The %hoi%es are: (1) England (2) China (3) Ìndia (4) None of the above Ri,ht Ans8er: #1$ En,lan& Det Us S7' U5 Ì. Economics is the science that deals with the production, allocation, and use of goods and services. 2. Economics is 'the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. 3. Microeconomics is concerned with the behaviour of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. 4. Every society must answer three fundamental questions: what, how, and for whom'? What kinds and quantities are produced among the wide range of all possible goods and services? How are resources used in producing these goods? And for whom are the goods produced (that is, what is the distribution of income and consumption among different individuals and classes?) 5. A market economy is one in which individuals and private firms make the major decisions about production and consumption. A system of prices, of markets, of profits and losses, of incentives and rewards determines what, how, and for whom. 6. Ìn command economy, the government addresses the major economic questions by virtue of its ownership of resources and its power to enforce decisions. 7. No contemporary society/nation falls completely into either of these polar/extreme categories. Rather, all societies are mixed economies, with elements drawn from market and command economies. /e38or&s Wealth; Welfare; Ends and means; Microeconomics; Macroeconomics; Market Economy; Command Economy; Capitalistic Economy; Mixed Economy; laissez-faire economy END O+ CGA*TER 1 H ADVANCED BAN/ MANAIEMENTECAIIB *A*ER 1 ADVANCED BANK MANAGEMENT Unit-2 Supply and Demand STRUCTURE 2.0 Objectives 2.1 Ìntroduction 2.2 The Demand Schedule 2.3 Forces behind the Demand Curve 2.4 Shifts in Demand 2.5 The Supply Schedule 2.6 Forces behind the Supply Curve 2.7 Shifts in Supply 2.8 Equilibrium of Supply and Demand 2.9 Effect of a Shift in Supply or Demand 2.10 Ìnterpreting Changes in Price and Quantity Let s !um p Keywords !.0 OBJECTIVES This chapter will be helpful in understanding: 1. Concepts of Demand and Supply 2. Demand Schedule, Demand Curve, Market Demand 3. Supply Schedule, Supply Curve 4. Equilibrium of Supply and Demand 5. Price Mechanism !.1 INTRODUCTION Like weather, markets are dynamic, subject to periods of storm and calm, and constantly evolving. Yet, as with weather forecasting, a careful study of markets will reveal certain forces underlying the apparently random movements. To forecast prices and outputs in individual markets, you must first understand the concept of supply and demand. Economics has a powerful tool for explaining such changes in the economic environment. Ìt is called the theory of supply and demand. This theory shows how consumer preferences determine consumer demand for commodities, while business costs determine the supply of commodities. The increase in the price of petrol occurred either because the demand for petrol had increased or because the supply of crude oil had decreased. The same is true for every market, from food to diamonds to land: changes in supply and demand drive changes in output and prices. Ìf you understand how supply and demand works, you have gone a long way toward understanding a market economy. This chapter introduces the notions of supply and demand and shows how they operate in competitive markets for individual commodities. We begin with demand curves and then discuss supply curves. Using these basic tools, we will see how the market price is determined where these two curves intersect ÷ where the forces of demand and supply are just in balance. Ìt is the movement of prices ÷ the price mechanism ÷ which brings supply and demand into balance or equilibrium. This chapter deals with some examples of how supply-and-demand analysis can be applied. !.! TGE DEMAND SCGEDUDE Both common sense and careful scientific observation show that the amount of a commodity people buy depends on its price. The higher the price of an article, other things held constant; fewer the units consumers are willing to buy. The lower is its market price; the more units of it are bought. There exists a definite relationship between the market price of a good and the quantity demanded of that good, other things held constant. This relationship that exists between price and quantity bought is called the demand schedule, or the demand curve. Let us look at a simple example. Table 2.1 presents a hypothetical demand schedule for apples. At each price, we can determine the quantity of apples that consumers purchase. For example, at Rs.500 per box, consumers will buy 9 million boxes per year. At a lower price, more apples are bought. Thus, at a price of Rs.400, the quantity bought is 10 million boxes. At yet a lower price (P) equal to Rs.300, the quantity demanded (Q) is still greater, at 12 million. and so forth. We can observe that the quantity demanded increases with the fall in price as shown in Table 2.1. TABDE !.1 The Demand Schedule for Apple Price (Rupees per box) Quantity demanded (millions of boxes per year) A 500 9 B 400 10 C 300 12 D 200 15 E 100 20 At each market price, consumers will want to buy a certain quantity of apples. As the price of apples falls, the quantity of apples demanded will rise. The De'an& C7r=e The graphical representation of the demand schedule is the demand curve. We show the demand curve in Fig. 2. 1, which graphs the quantity of apples demanded on the horizontal axis and the price of apples on the vertical axis. Note that quantity and price are inversely related; that is, Q goes up when P goes down. The curve slopes downward, going from northwest to southeast. This important property is called the law of downward-sloping demand. Ìt is based on common sense as well as economic theory and has been empirically tested and verified for practically all commodities ÷ apples, petrol, computers etc. Law of downward-sloping demand: When the price of a commodity is raised (and other things being constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. Quantity demanded tends to fall as price rises for two reasons. First is the substitution effect. For instance, when the price of a particular good rises, Ì will substitute other similar goods for it (as the price of mutton rises, Ì eat more chicken). Second is the income effect. This comes into play when a higher price reduces quantity demanded. Because when price goes up, Ì find myself somewhat poorer than Ì was before. Ìf petrol prices double, Ì have in effect less real income, so Ì will naturally curb my consumption of petrol and other goods. Market Demand Our discussion of demand has so far referred to 'the' demand curve. But whose demand is it? Mine? Yours? Everybody's? The fundamental building block for demand is individual preferences. However, in this chapter we will focus on the market demand, which represents the sum total of all individual demands. The market demand is what is observable in the real world. The mar"et demand #ur$e is found %y addin& toðer the quantities demanded %y all indi$iduals at ea#h pri#e. Does the market demand curve obey the law of downward - sloping demand? Ìt certainly does. Ìf prices drop, for example, the lower prices attract new customers through the substitution effect. Ìn addition, a price reduction will induce extra purchases of goods by existing consumers through both the income and the substitution effects. Conversely, a rise in the price of a good will cause some of us to buy less. !.( +ORCES BEGIND TGE DEMAND CURVE What determines the market demand curve for apples or petrol or computers? A whole array of factors influences how much will be demanded at a given price: average levels of income, the size of the population, the prices and availability of related goods, individual and social tastes and special influences. 1. The a$era&e in#ome of consumers is a key determinant of demand. As people's income rises, individuals tend to buy more of almost everything, even if prices do not change. Automobile purchases tend to rise sharply with higher levels of income. 2. The size, of the market - measured, say, by the population - clearly affects the market demand curve. Mumbai's 21 million people tend to buy 1.5 times more apples and cars than do Chennai's 7 million people. 3. The prices and availability of related goods influence the demand for a commodity. A particularly important connection exists among substitute goods - ones that tend to perform the same function, such as apples and oatmeal, pens and pencils, small cars and large cars, or oil and natural gas. Demand for good A tends to be low if the price of substitute product B is low. 4. Ìn addition to these objective elements, there is a set of subjective elements called tastes or preferen#es. Tastes represent a variety of cultural and historical influences. They may reflect genuine psychological or physiological needs (for liquids, love, or excitement). And they may include artificially contrived cravings (for cigarettes, drugs, or fancy sports cars). They may also contain a large element of tradition or religion (eating beef is popular in America but taboo in Ìndia, while curried jellyfish is a delicacy in Japan but would make many Americans gag). 5. Finally, spe#ial influen#es will affect the demand for particular goods. The demand for umbrellas is high in rainy Mumbai but low in sunny Delhi; the demand for air conditioners will rise in hot weather. Ìn addition, expectations about future economic conditions, particularly prices, may have an important impact on demand. !.. SGI+TS IN DEMAND As economic life evolves, demand changes incessantly. Demand curves sit still only in textbooks. Why does the demand curve shift? Because influences other than the good's price change. Let us work through an example of how a change in a non-price variable shifts the demand curve. We know that the average income of Ìndians rose sharply during the economic boom of 2006-08. Because there is a powerful income effect on the demand for automobiles, this means that the quantity of automobiles demanded at each price will rise. For example, if average incomes rose by 10 per cent, the quantity demanded (of a car) at a price of Rs.2, 00,000 might rise from 10 million to 12 million units. This would be a shift in the demand curve because the increase in quantity demanded reflects factors other than the good's own price. The net effect of the changes in underlying influences is what we call an increase in demand. An increase in the demand for automobiles is illustrated in Fig. 2.2 as a rightward shift in the demand curve. Note that the shift means that more cars will be bought at every price. !.? TGE SU**D) SCGEDUDE Let us now turn from demand to supply. The supply side of a market typically involves the terms on which businesses produce and sell their products. The supply of tomatoes tells us the quantity of tomatoes that will be sold at each tomato price. More precisely, the supply schedule relates the quantity supplied of a good to its market price, other things being constant. Ìn considering supply, the other things that are held constant include input prices, prices of related goods and government policies. The supply schedule (or supply curve) for a commodity shows the relationship between its market price and the amount of that commodity that producers are willing to produce and sell, other things being constant. The S755l3 C7r=e Table 2.2 shows a hypothetical supply schedule for apples, and Fig. 2.3 plots the data from the table in the form of a supply curve. These data show that at an apples' price of Rupees 100 per box, no apples will be produced at all. At such a low price, apple cultivators might want to devote their resources to producing other types of products like cereals and pulses that earn them more profit than apples. As the price of apples increases, ever more apples will be produced. At ever-higher apples prices, cereal makers will find it profitable to add more workers and to buy more automated apples-stuffing machines and even more apples factories. All these will increase the output of apples at the higher market prices. TABLE 2.2 Supply Schedule for Apples Price (Re. per box) Quantity suppffied M11= of boxes per yaw) A 500 18 B 400 16 C 300 12 D 200 7 E 100 0 Figure 2.3 shows the typical case of an upward-sloping supply curve for an individual commodity. One important reason for the upward slope is 'the law of diminishing returns'. Edible oil will illustrate this important law. Ìf society wants more edible oil, then additional labour will have to be added to the limited farm suitable for producing edible oil crops. Each new worker will be adding less and of less extra product. The price needed to coax out additional edible oil output is therefore higher. By raising the price of edible oil, society can persuade edible oil producers to produce and sell more edible oil; the supply curve for edible oil therefore is upward-sloping. Similar reasoning applies to other goods as well. Ì Ì i 1 1.1 1 1 1 1 1 1 1 1 1 1 1 1 1 5 10 15 20 Quantities of Apples (Millions of boxes per year) +IIURE !.( Supply Curve elating Quantity Supplied to Prices !.@ +ORCES BEGIND TGE SU**D) CURVE Ìn examining the forces determining the supply curve, the fundamental point to grasp is that producers supply commodities for profit and not for fun or charity. One major element underlying the supply curve is the #ost of produ#tion. When production costs for a good are low relative to the market price, it is profitable for producers to supply a great deal. When production costs are high relative to price, firms produce little, switch over the production of other products, or may simply go out of business. Production costs are primarily determined by the pri#es of inputs and te#hnolo&i#al ad$an#es. The prices of inputs such as labour, energy or machinery obviously have a very important influence on the cost of producing a given level of output. For example, when petrol prices rose sharply in the 1970s, the increase raised the price of energy for manufacturers, increased their production costs and lowered their supply. By contrast, as computer prices fell over the last three decades, businesses increasingly substituted computerized processes for other inputs, for example, in payroll or accounting operations, this increased supply. An equally important determinant of production costs is te#hnolo&i#al ad$an#es, which consist of changes that lower the quantity of inputs needed to produce the same quantity of output. Such technological advances include everything from scientific breakthroughs to better application of existing technology or simply reorganization of the flow of work. For example, manufacturers have become much more efficient over the last decade or so. Ìt takes far fewer hours of labour to produce an automobile today than what it did just 10 years ago. This advance enables car-makers to produce more automobiles at the same cost. But production costs are not the only ingredient that goes into the supply curve. Supply is also influenced by the pri#es of related &oods, particularly goods that are alternative outputs of the production process. Ìf the price of one production substitute rises, the supply of another substitute will decrease. For example, auto companies typically make several different car models in the same factory. Ìf there is more demand for one model, and its price rises, they will switch over more of their assembly lines to making that model, and the supply of the other models will fall. Or if the demand and price for trucks rise, the entire factory can be converted to making trucks and the supply of cars will fall. Go$ernment poli#y also has an important influence on the supply curve. Environmental and health considerations determine what technologies can be used, while taxes and minimum-wage laws can significantly raise input prices. Ìn the local electricity market, government regulations influence both the number of firms that can compete and the prices they charge. Government trade policies have a major impact upon supply aspects. Finally, spe#ial fa#tors affect the supply curve. The weather exerts an important influence on farming and on the agro- industry. The computer industry has been marked by a keen spirit of innovation, which has led to a continuous flow of newer products. Market structure will affect supply, and expectations about future prices often have an important impact upon supply decisions. !.B SGI+TS IN SU**D) Businesses are constantly changing the mix of products and services they provide. What lies behind these changes in supply behaviour? When changes in factors other than a good's own price affect the quantity supplied, we call these changes as shifts in supply. Supply increases (or decreases) when the amount supplied increases (or decreases) at each market price. When automobile prices change, producers change their production and quantity supplied; however, the supply and the supply curve do not shift. By contrast, when other influences affecting supply change, supply changes and the supply curve shifts. We can illustrate a shift in supply for the automobile market. Supply would increase if the introduction of cost-saving computerized design and manufacturing reduced the labour required to produce cars, if autoworkers took a pay cut, if there were lower production costs in Japan, or if the government repealed environmental regulations on the industry. Any of these elements would increase the supply of automobiles in the country at each price. FÌGURE 2.4 Quantity of Supplied of Automobiles (Million per year) !.C E9UIDIBRIUM O+ SU**D) AND DEMAND Till now, we have been considering demand and supply in isolation. We know the amounts that are willingly bought and sold at each price. We have seen that consumers demand different amounts of apples, cars and computers as a function of these goods' prices. Similarly, producers willingly supply different amounts of these and other goods depending on their prices. But how can we put both sides of the market together? The answer is that supply and demand interacts to produce equilibrium price and quantity or market equilibrium. The market equilibrium comes at that price and quantity where the forces of supply and demand are in balance. At the equilibrium price, the amount that buyers want to buy is just equal to the amount that sellers want to sell. The reason we call this equilibrium is that, when the forces of supply and demand are in balance, there is no reason for price to rise or fall, as long as other things remain unchanged. Let us work through the example of apples as given in Table 2.3 to see how supply and demand determines market equilibrium; the numbers (figures) in this table come from Tables 2.1 and 2.2. To find the market price and quantity, we find a price at which the amounts desired to be bought and sold just match. Ìf we try a price of Rs.500 per box, will it prevail for long? Clearly not. As row A in Table 2.3 shows, at Rs.500 producers would like to sell 18 million boxes per year while demanders want to buy only 9. The amount supplied at Rs.500 exceeds the amount demanded, and stocks of apples pile up in markets. Because too few consumers are chasing too many apples, the price of apples will tend to fall, as shown in column (5) of Table 2.3. TABLE 2.3- How Supply and Demand Determines Market Equilibrium Possible price (Rupees per box) Quantity demanded (millions of boxes Quantity supplied (millions of boxes State of market Pressure on price 1 2 3 4 5 A 500 9 18 Surplus Downward B 400 10 16 Surplus Downward C 300 12 12 Equilibrium Neutral D 200 15 7 Shortage Upward E 100 20 0 Shortage Upward Let us try at Rs.200. Does that price clear the market? A quick look at row D shows that at Rs.200 consumption exceeds production. Apples begin to disappear from the stores at that price. As people scramble around to find their desired apples, they will tend to bid up the price of apples, as shown in column (5) of Table 2.3. We could try other prices, but we can easily see that the equilibrium price is Rs.300, or row C in Table 2.3. At Rs.300, consumers' desired demand exactly equals producers' production, each of which is 12 units. Only at Rs.300 will consumers and suppliers both be making consistent decisions. Market equilibrium comes at the price at which quantity demanded equals quantity supplied. At that equilibrium, there is no tendency for the price to rise or fall. The equilibrium price is also called the market-clearing price. This denotes that all supply and demand orders are filled, the books are 'cleared' of orders and demanders and suppliers are satisfied. EJ7ili"ri7' 8ith S755l3 an& De'an& C7r=es We often show the market equilibrium through a supply-and-demand diagram like the one in Fig. 2.5. This figure combines the supply curve from Fig. 2.3 with the demand curve from Fig. 2.1. Combining the two graphs is possible because they are drawn with exactly the same units on each axis. We find the market equilibrium by looking for the price at which quantity demanded equals quantity supplied. The equilibrium price comes at the intersection of the supply and demand curves, at point C. How do we know that the intersection of the supply and demand curves is the market equilibrium? Let us repeat our earlier experiment. Start with the initial high price of Rs.500 per box, shown at the top of the price axis in Fig. 2.5. At that price, suppliers want to sell more than demanders want to buy. The result is a surplus or excess of quantity supplied over quantity demanded, shown in the figure by the black line labeled 'Surplus.' The arrows along the curves show the direction that price tends to move when a market is in surplus. At a low price of Rs.200 per box, the market shows a shortage or excess of quantity demanded over quantity supplied, here shown by the black line labeled 'Shortage.' Under conditions of shortage, the competition among buyers for limited goods causes the price to rise, as shown in the Fig. 2.5 by the arrows pointing upward. We now see that the balance or equilibrium of supply and demand comes at point C, where the supply and demand curves intersect. At point C, where the price is Rs.300 per box and the quantity is 12 units, the quantities demanded and supplied are equal: there are no shortages or surpluses; there is no tendency for price to rise or fall. At point C, and only at point C, the forces of supply and demand are in balance and the price has settled at a sustainable level. The equilibrium price and quantity come where the amount willingly supplied equals the amount willingly demanded. Ìn a competitive market, this equilibrium is found at the intersection of the supply and demand curves. There are no shortages or surpluses at the equilibrium price. !.F E++ECT O+ A SGI+T IN SU**D) OR DEMAND The analysis of the supply-and-demand apparatus can do much more than tell us about the equilibrium price and quantity. Ìt can also be used to predict the impact of changes in economic conditions on prices and quantities. Let us change our example to the bread. Suppose that a spell of bad weather raises the price of wheat, a key ingredient of bread. That shifts the supply curve for bread to the left. This is illustrated in Fig. 2.6, where the bread supply curve has shifted from SS to S'S'. Ìn contrast, the demand curve has not shifted because people's sandwich demand is largely unaffected by farming weather. What happens in the bread market? The harvest causes bakers to produce less bread at the old price, so quantity demanded exceeds quantity supplied. The price of bread therefore rises, encouraging production and thereby raising quantity supplied, while simultaneously discouraging consumption and lowering quantity demanded. The price continues to rise until, at the new equilibrium price, the amounts demanded and supplied are once again equal. As Fig. 2.6 shows, the new equilibrium is found at E', the intersection of the new supply curve S'S' and the original demand curve. Thus a bad harvest (or any leftward shift of the supply curve) raises prices and, by the law of downward-sloping demand, lowers quantity demanded. We can also use our supply-and-demand apparatus to examine how changes in demand affect the market equilibrium. Suppose that there is a sharp increase in family incomes, so everyone wants to eat more bread. This is represented in Fig. 2.7 as a 'demand shift' in which, at every price, consumers demand a higher quantity of bread. The demand curve thus shifts rightward from DD to D'D'. The demand shift produces a shortage of bread at the old price. A scramble for bread ensues, with long lines in the bakeries. Prices are bid upward until supply and demand come back into balance at a higher price. Graphically, the increase in demand has changed the market equilibrium from E to E' in Fig. 2.7. For both examples of shifts ÷ a shift in supply and a shift in demand ÷ a variable underlying the demand or supply curve has changed. Ìn the case of supply, there might have been a change in technology or input prices. For the demand shift, one of the influences affecting consumer demand ÷incomes, population, and the prices of related goods or tastes ÷ changed and thereby shifted the demand schedule. !.10 INTER*RETINI CGANIES IN *RICE AND 9UANTIT) Let us go back to our earlier example of bread. Suppose that you go to the store and see that the price of bread has doubled. Does the increase in price mean that the demand for bread has risen or does it mean that bread has become more expensive to produce? The correct answer is that without more information, you do not know ÷ it could be either one, or even both. Let us look at another example. Ìf fewer airline tickets are sold, is the cause that airline fares have gone up or that demand for air travel has gone down? Economists deal with these sorts of questions all the time: When prices or quantities change in a market, does the situation reflect a change on the supply side or the demand side? Sometimes, in simple situations, looking at price and quantity simultaneously gives you a clue about whether it is the supply curve that is shifted or the demand curve. For example, a rise in the price of bread accompanied by a decrease in quantity suggests that the supply curve has shifted to the left (a decrease in supply). A rise in price accompanied by an increase in quantity indicates that the demand curve for bread has probably shifted to the right (an increase in demand). This point is illustrated in Fig. 2.8. Ìn both panel (a) and panel (b), the quantity goes up. But in (a) the price rises and in (b) the price falls. Figure 8(a) shows the case of an increase in demand or a shift in the demand curve. As a result of the shift, the equilibrium quantity demanded increases from 10 to 15 units. The case of a movement along the demand curve is shown in Fig. 2.8(b). Ìn this case, a supply shift changes the market equilibrium from point E to point E'. As a result, the quantity demanded changes from 10 to 15 units. But demand does not change in this case; rather, quantity demanded increases as consumers move along their demand curve from E to E' in response to a price change. Che%2 )o7r *ro,ress *i%2 the %orre%t Ans8er 97estion1. De'an& S%he&7le is the The %hoi%es are: (1) Relationship between demand and quantity bought (2) Relationship between price and quantity bought (3) Relationship between price and demand (4) None of these Ri,ht Ans8er: #!$ Relationshi5 "et8een 5ri%e an& J7antit3 "o7,ht 97estion !.Mar2et De'an& C7r=e o"e3s the The %hoi%es are: (1) Law of downward-sloping demand (2) Law of upward-sloping demand (3) Law of diminishing (4) None of these Ri,ht Ans8er: #1$ Da8 of &o8n8ar&Eslo5in, &e'an& 97estion (. +or%es "ehin& the &e'an& %7r=e The %hoi%es are: (1) Expectation about future economic conditions (2) Average Ìncome (3) Cost of production (4) Both (1) and (2) Ri,ht Ans8er: #.$ Both #1$ an& #!$ 97estion .. A &o8n 8ar& Slo5in, De'an& C7r=e relates J7antit3 &e'an&e& to The %hoi%es are: (1) Supply (2) Ìncome (3) Price (4) Demand Ri,ht Ans8er: #($ *ri%e 97estion ?. Shifts in S755l3 'eans The %hoi%es are: (1) When changes in factors other than goods own price affect the quantity supplied. (2) When changes in goods own price affect the quantity supplied. (3) Both (1) and (2) (4) None of these Ri,ht Ans8er: #1$ ;hen %han,es in fa%tors other than ,oo&s o8n 5ri%e affe%t the J7antit3 s755lie&. 97estion @. The EJ7ili"ri7' *ri%e is also 2no8 as The %hoi%es are: (1) Market price (2) Optimum price (3) Real price (4) Market-clearing price Ri,ht Ans8er: #.$ Mar2etE%learin, 5ri%e 97estion B. +or%es "ehin& the S755l3 C7r=e The %hoi%es are: (1) Cost of production (2) Technological advances (3) Government policies (4) All of the above Ri,ht Ans8er: #.$ All of the a"o=e C. S755l3 %7r=e relates J7antit3 s755lie& to The Choi%es are: (1) Supply (2) Ìncome (3) Price (4) Demand Ri,ht Ans8er: #($ *ri%e 97estion F. Mar2et eJ7ili"ri7' %o'es at the 5ri%e at 8hi%h J7antit3 &e'an&e& eJ7als to J7antit3 The %hoi%es are: (1) Produced (2) Supplied (3) Ìnventory (4) Demand Ri,ht Ans8er: #!$ S755lie& Det Us S7' U5 1. There exists a definite relationship between the market price of a good and the demanded quantity of that good, other things being constant. This relationship between price and quantity bought is called the demand schedule, or the demand curve. !. Law of downward-sloping demand: When the price of a commodity is raised (and other things are held constant) buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. (. The market demand curve is found by adding together the quantities demanded by all individuals at each price. .. When there are changes in factors other than a good's own price which affect the quantity purchased, we call these changes shifts in demand. Demand increases (or decreases) when the quantity demanded at each price increase (or decrease). ?. The supply schedule (or supply curve) for a commodity shows the relationship between its market, price and the amount of that commodity that producers are willing to produce and sell, other things held constant. @. When changes in factors other than a good's own price affect the quantity supplied, we call these changes as shifts in supply. B. Market equilibrium comes at the price at which quantity demanded equals quantity supplied. At that equilibrium, there is no tendency for the price to rise or fall. The equilibrium price is also called the market-clearing price. This denotes that all supply and demand orders are filled, the books are `cleared' of orders, and demanders and suppliers are satisfied. C. The equilibrium price and quantity come where the amount willingly supplied equals the amount willingly demanded. Ìn a competitive market, this equilibrium is found at the intersection of the supply and demand curves. There are no shortages or surpluses at the equilibrium price. F. When the elements underlying demand or supply change, this leads to shifts in demand or supply and to changes in the market equilibrium of price and quantity. /e38or&s Demand; Demand schedule; Supply schedule; Shifts in supply; Shifts in demand; Equilibrium of Supply and Demand. END O+ CGA*TER !E ADVANCED BAN/ MANAIEMENTE CAIIB *A*ERE 1 ADVANCED BANK MANAGEMENT UNÌT- 3 MONEY SUPPLY AND ÌNFLATÌON STRUCTURE 3.0 Objectives 3.1 What is Money? 3. 2 Money Supply 3.3 Ìnflation 3.4 Causes of Ìnflation 3.5 Measures of Ìnflation Let s !um p 'eywords (.0 OBJECTIVES This chapter will be helpful in understanding: 1. Definition and measures of money concept 2. Causes and measures of inflation (.1 ;GAT IS MONE) Money is anything which performs the following four functions: 1. Medium of Exchange; 2. A measure of value; 3. A store of value over time,; 4. Standard for deferred payments; Let us understand each of the above functions. 1. Me&i7' of E6%han,e: Ìndividual goods and services, and other physical assets, are 'priced' in terms of money and are exchanged using money. !. A Meas7re of Val7e: Money is used to measure and record the value of goods or services. (. A store of =al7e o=er ti'e: Money can be held over a period of time and used to finance future payments. .. Stan&ar& for Deferre& *a3'ents: Money is used as an agreed measure of future receipts and payments in contracts. (.! MONE) SU**D) Money supply refers to the stock of money in circulation in the economy at a given point of time. This is partly exogenous (decided by the government and the central bank) and partly endogenous.. Meas7res of Mone3 S755l3 The four most common measures of money supply, which are used in Ìndia, are as follows: (a) Narrow Money (M 1) is equal to Currency with the public plus Demand deposits with the banking system plus `Other' deposits with the RBÌ. (b) M2 is equal to M1 plus Savings deposits of post office savings banks M3 is equal M Ì plus Time deposits with the banking system J M4 is equal M3 plus All deposits with post office savings banks (excluding National Savings Certificates). 1. `Currency with the public' is currency in circulation less cash held by banks. 2. 'Demand deposits' include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/ guarantees, balances in overdue fixed deposits, cash certificates and cumulative/ recurring deposits, etc. 3. `Time deposits' are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, etc. (.( IN+DATION The concept of Ìnflation refers to a sustained rise in the general level of prices of goods and services in an economy over a period of time. Ìnflation leads to fall in purchasing power. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money ÷ a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, i.e. the annualized percentage change in a general price index over time. Ìnflation has both positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time, uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase further in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt. (.. CAUSES O+ IN+DATION There are many factors that can trigger inflationary pressure in an economy. The most important of these are: De'an&E*7ll Inflation 1. Ìt is a rise in general prices caused by increasing aggregate demand for goods and services. 2. Ìncreasing quantity of money in the hands of the people increases the aggregate demand for goods and services, and if aggregate supply does not follow the suit, prices rise. (Demand exceeding supply leads to shortage and hence, an increase in price) CostE*7sh Inflation 1. Ìt is a type of inflation caused by substantial increases in the cost of production of important goods or services where no suitable alternative is available. 2. For example, if prices of some key inputs like oil rise, producers will have to either adjust output supply or translate the higher costs into higher output prices. When output declines because of cost pressure on producers, there will be a shortage in output markets and as a result prices will rise. (.? MEASURES O+ IN+DATION Ìnflation denotes a rise in the general level of prices. The general price level is measured by a price index. When newspapers tell us 'Ìnflation is rising,' they are in fact reporting the movement of a price index. A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some designated base-year. Cal%7latin, Inflation 8ith *ri%e In&e6es Ìnflation is calculated by taking the price index from the year of interest and subtracting the base year from it, then dividing by the base year. This is then multiplied by 100 to give the percentage (%) change in inflation. Ìnflation is equal to (Price Ìndex in Current Year minus Price Ìndex in Base Year multiplied by 100 Price Ìndex in Base Year The most important price indexes are: 1. Wholesale Price Ìndex (WPÌ) 2. Food Ìnflation Ìndex 3. Consumer Price Ìndex (CPÌ) 4. GDP deflator ;holesale *ri%e In&e6 #;*I$ The WPÌ reflects the change in the level of prices of a basket of goods at the wholesale level. WPÌ focuses on the price of goods traded between corporations at the wholesale stage, rather than goods bought by consumers. WPÌ helps to monitor price movements that reflect supply and demand in industry, manufacturing and construction sectors. Ìn Ìndia WPÌ (Headline Ìnflation) is the official inflation index used for policy decisions. +oo& Inflation In&e6 Recently, it has been decided by government that WPÌ will be announced monthly. However the indices for the food group and fuel group will be announced weekly. Cons7'er *ri%e In&e6 #C*I$ The CPÌ reflects the change in the level of prices of a basket of goods and services purchased/consumed by the households. Ìt measures the prices at the retail level. This is the measure of inflation more relevant for the consumers. Ìt is the cost of living index popularly known as Core Ìnflation. We have four different index numbers of consumer prices. These are: 1. CPÌ for industrial workers (CPÌ-ÌW), 2. CPÌ for agricultural labourers (CPÌ-AL), 3. CPÌ for rural workers (CPÌ-RW) and 4. CPÌ for urban non-manual employees (CPÌ-UNME) CPÌ in Ìndia is released by Labour Bureau, Ministry of Labour and Employment, Government of Ìndia. ID* Deflator GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns. (Specifically, for GDP, the 'basket' in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good.) Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion 1. Mone3 S755l3 refers to The %hoi%es are: (1) The amount of money in banks (2) The amount of money with the people (3) The amount of money in circulation in an economy (4)None of the above. Ri,ht Ans8er: #($ The a'o7nt of 'one3 in %ir%7lation in an e%ono'3 97estion !. Narro8 Mone3 %onsists of The %hoi%es are: (1) Currency with the Public Demand Deposits, 'Other 'Deposits with the RBÌ (2) Currency with the Public, Time Deposits, `Other' Deposits (3) Time deposits, Demand Deposits, 'Other' Deposits with the RBÌ (4) Currency with the Public, Demand Deposits Ri,ht Ans8er: #1$ C7rren%3 8ith the *7"li% De'an& De5osits0 Other De5osits 8ith the RBI 97estion (. Ti'e De5osits are The %hoi%es are: (1) Paid on demand (2) Not paid on demand (3) Relatively less liquid than cash and demand deposits (4)Both (1) and (2) Ri,ht Ans8er: #.$ Both #1$ an& #!$ 97estion.. De'an& De5osits are The %hoi%es are: (1) Paid on demand (2) Not paid on demand (3) Relatively less liquid than cash and demand deposits (4) Both (1) and (2) Ri,ht Ans8er: #1$ *ai& on &e'an& 97estion ?. ;hi%h of the follo8in, state'ents is tr7e a"o7t KInflation>L The %hoi%es are: (1) A rise in the general level of prices (2) Leads to fall in purchasing power (3) Both (1) and (2) (4) None of the above Ri,ht Ans8er: #($ Both #1$ an& #!$ 97estion @. *ri%e In&e6 7se& in In&ia to %al%7late inflation for 5oli%3 for'7lation is The %hoi%es are: (1) Consumer price index (2) GDP deflator (3) Wholesale price index (4) Retail price index Ri,ht Ans8er: #($ ;holesale 5ri%e in&e6 97estion B. Cons7'er 5ri%e in&e6 'eas7res 5ri%es at The %hoi%es are: (1) Wholesale level (2) Retail level (3) Producer level (4) Consumer level Ri,ht Ans8er: #!$ Retail le=el Det Us S7' U5 Ì. Money performs four functions ÷ Medium of exchange, a measure of value, a store of value over time, Standard for deferred payments. 2. Sources of Money supply analyzed by the RBÌ, consist of the following: Net bank credit to the government, Bank credit to the commercial sector, Net foreign exchange assets of the banking sector, Government's Currency Liabilities to the Public, Net non- monetary liabilities of the RBÌ and the other banks. 3. The most common measures of money supply used in Ìndia are: Narrow Money (M1), Broad Money (M3), M2 is equal to M1plus demand deposits in post office savings accounts, M4is equal to M3 plus all deposits with post offices. 4. Ìnflation is a sustained rise in the general level of prices of goods and services in an economy over a period of time. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index over time. 5. The most important causes of inflation are: Demand-Pull Ìnflation, Cost-Push Ìnflation. Demand-Pull Ìnflation is a rise in general prices caused by increasing aggregate demand for goods and services. Cost-Push Ìnflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available. 6. Ìnflation denotes a rise in the general level of prices. The general price level is measured by a price index. The most important price indexes are: Wholesale price index, Consumer price index and GDP deflator. 7. The WPÌ reflects the change in the level of prices of a basket of goods at the wholesale level. The CPÌ reflects the change in the level of prices of a basket of goods and services purchased/consumed by the households. GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. /e38or&s Money; Money Supply; Measures of Money Supply; Narrow Money; Broad Money; Demand deposits; Time deposits; Ìnflation; Ìnflation Rate; Price index; Wholesale price index; Food inflation index: Consumer price index; GDP deflator. END O+ CGA*TER ( H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 4 -THEORY OF ÌNTEREST STRUCTURE 4.0 Objectives 4.1 Ìntroduction 4.2 Keynes' Liquidity Preference Theory of Rate of Ìnterest 4.3 Money Demand Curve 4.4 Determination of Rate of Ìnterest: Equilibrium in the Money Market 4.5 Effect of an Ìncrease in the Money Supply 4.6 Shifts in Money Demand or Liquidity Preference Curve 4.7 Hicks-Hansen Synthesis: ÌS-LM Curve Model 4.8 Derivation of the ÌS Curve 4.9 Derivation of the LM Curve from Keynes' Liquidity Preference Theory 4.10 The Slope and Position of the LM Curve 4.11 Ìntersection of the ÌS and LM Curves: Simultaneous Determination of Ìnterest Rate and Ìncome Let Us Sum Up eywords ..0 OBJECTIVES This chapter will be helpful in understanding: 1. Concept of Ìnterest 2. Keynes' Liquidity Preference Theory of Rate of Ìnterest 3. Hicks-Hansen Synthesis: ÌS-3. LM Curve Model 4. Determination of Ìnterest Rate and Ìncome ..1 INTRODUCTION Interest Ìnterest is a payment made by a borrower for the use of a sum of money for a period of time; it is one of the four types of income, the others being rent, wages, and profit. Three elements can be distinguished in interest: (1) payment for the risk involved in making the loan; (2) payment for the trouble involved; (3) pure interest, that is a payment for the use of the money. At any particular time there is a prevailing rate of interest, which many regard as a price determined like other prices in markets, by the demand to borrow in relation to the supply of loanable funds. This is pure interest. Differences in the rate of interest on different loans made during the same period of time must, therefore, be due to differences in the risk or trouble involved. Thus, the rate of interest charged by a moneylender on an unsecured loan will be higher than the rate charged by a bank to one of its customers who can offer satisfactory collateral security. Similarly, the government has generally to offer a higher rate of interest on a long-term than on a short-term loan. ..! /E)NESL DI9UIDIT) *RE+ERENCE TGEOR) O+ RATE O+ INTEREST Ìn his epoch-making book, The General Theory of Employment( Interest and Money, J.M. Keynes gave a new view of interest. According to him, the rate of interest is a purely monetary phenomenon and is determined by demand for money and supply of money. The theory is known as Liquidity Preference Theory. The De'an& for Mone3 in a T8oEAsset E%ono'3: Ìn order to explain the demand for money and interest-rate determination, Keynes assumed a simplified economy where there are two assets which people can keep in their portfolio balance. These two assets are: (1) money in the form of currency and current deposits in the banks which earn no interest, (2) long-term bonds. Ìt is important to note that rate of interest and bond prices are inversely related. When bond prices go up, rate of interest rises and vice versa. The demand for money by the people depends upon how they decide to balance their portfolios between money and bonds. This decision about the portfolio balance can be influenced by two factors. First, the higher the level of nominal income in a two-asset economy, more the money people would want to hold in their portfolio balance. This is because of transactions motive according to which at the higher level of nominal income, the purchases by the people of goods and services in their daily life will be relatively larger, which require more money to be kept for transactions purposes. Second, the higher the nominal rate of interest, the lower the demand for money for speculative motive. This is firstly because a higher nominal rate of interest implies a higher opportunity cost for holding money. At higher rate of interest, holders of money can earn more incomes by holding bonds instead of money. Secondly, if the current rate of interest is higher than what is expected in the future, the people would like to hold more bonds and less money in their portfolio. On the other hand, if the current rate of interest is low (in other words, if the bond prices are currently high), the people will be reluctant to hold larger quantity of bonds (and instead they could hold more money in their portfolio) because of the inherent fear that bond prices would fall in the future causing capital losses to them. ..( MONE) DEMAND CURVE Ìt follows from above that quantity of money demanded increases with the fall in the rate of interest or with the increase in level of nominal income. At a given level of nominal income, we can draw a money demand curve showing the quantity of money demanded at various rates of interest. As demand for money is inversely related to the rate of interest, the money demand curve at a given level of income, say will be downward- sloping, as is shown by the curve LP₁, in Fig.4. 1. When the level of money income increases, (suppose from Y₁and Y₂) the curve of demand for money shifts upward to the new position LP₂ ... DETERMINATION O+ RATE O+ INTEREST: E9UIDIBRIUM IN TGE MONE) MAR/ET The rate of interest, according to Ì.M. Keynes, is determined by demand for money (Liquidity Preference) and supply of money. The factors which determine demand for money has been explained above. The supply of money, at a given time, is fixed by the monetary authority of the country. Ìn Fig. 4.2, LP is the demand curve for money at a given level of nominal income. MS is the money supply curve which is a vertical straight line showing that Rs.200 crone is the money supply fixed by the monetary authority. Ìt will be seen that quantity of money demanded equals the given money supply at 10 per cent rate of interest. So the money market is in equilibrium at 10 per cent rate of interest. There will be disequilibrium if rate of interest is either higher or lower than 10 per cent. Suppose the rate of interest is 12 per cent. Supply of money exceeds the demand for money. The excess supply of money reflects the fact that people do not want to hold as much money in their portfolio as the monetary authority has made it available to them. The people holding assets in the present two-asset economy would react to this excess money supply with them by buying bonds and thus replace some of money in their portfolios with bonds. Since the total money supply at a given moment remains fixed, it cannot be reduced by buying bonds by individuals. Such bonds-buying spree would lead to the rise in prices of bonds. The rise in bond prices mean the fall in the rate of interest. As will be seen from the Figure with the fall in the interest rate from 12 per cent to 10 per cent, quantity demand of money has increased to become once again equal to the given supply of money, and the excess supply of money is entirely eliminated and money market is in equilibrium. On the other hand, if the rate of interest is lower than the equilibrium rate of 10 per cent, say it is 8 per cent, and then (as will be seen from Fig. 4.2) there will be excess demand for money. As a reaction to this excess demand for money, people would like to sell bonds in order to obtain a greater quantity of money for holding at lower rate of interest. The stock of money remaining fixed, the attempt by the people to hold more money balances at a rate of interest lower than the equilibrium level through sale of bonds will only cause the bond prices to fall. The fall in bond prices implies the rise in the rate of interest. Thus, the process that started as a reaction to the excess demand for money at an interest rate below the equilibrium will end up with the rise in the interest rate of the equilibrium level. ..? E++ECT O+ AN INCREASE IN TGE MONE) SU**D) Let us now examine the effect of increase in money supply on the rate of interest. Ìn Fig. 4.3 LP is the money demand curve for satisfying various motives. To begin with, ON is the quantity of money available. Rate of interest will be determined where the demand for money is in balance or equal to the fixed supply of money ON. Ìt is clear from the figure that demand for money is equal to ON quantity of money at Or rate of interest. Hence, Or is the equilibrium rate of interest. Assuming no change in expectations and nominal income, an increase in the quantity of money (through buying securities by the central bank of the country from the open market), will lower the rate of interest. Ìn Fig. 4.3, when the quantity of money increases from ON to ON', the rate of interest falls from Or to Or' because the new quantity of money ON' is in balance with the demand for money at Or' rate of interest. Ìn this case, we move down on the curve. Thus, given the money demand curve or curve of liquidity preference, an increase in the quantity of money brings down the rate of interest. Let us see how increase in money supply leads to the fall in the rate of interest. With initial equilibrium at Or, when the money supply is expanded from ON to ON', there emerges excess supply of money at the initial Or rate of interest. The people would react to this excess quantity of money supplied by buying bonds. As a result, the bond prices will go up which implies that the rate of interest decline. This is how the increase in money supply leads to the fall in rate of interest. ..@ SGI+TS IN MONE) DEMAND OR DI9UIDIT) *RE+ERENCE CURVE The position of money demand curve depends upon two factors: (1) the level of nominal income and (2) the expectations about the changes in bond prices in the future which implies change in rate of interest in future. As has been explained above, a money demand curve is drawn by assuming a certain level of nominal income. With the increase in nominal income, money demand for transactions and precautionary motives increase causing an upward shift in the money demand curve. Shifts in 'one3 %7r=e &e'an& %7r=e (or what Keynes called liquidity preference curve) can also be caused by changes in the expectations of the people regarding changes in bond prices or movements in the rate of interest in future. Ìf some changes in events lead the people on balance to expect a higher rate of interest in the future than they had previously supposed, the money demand or liquidity preference for speculative motive will increase which will bring about an upward shift in the money demand curve or liquidity preference curve and this will raise the rate of interest. Ìn Fig. 4.4, assuming that the quantity of money remains unchanged at ON, the rise in the money demand or liquidity preference curve from LPÌ to LP, the rate of interest rises from Or to Oh because at Oh, the new speculative demand for money is in equilibrium with the supply of money ON. Ìt is worth noting that when the liquidity preference curve rises from LP₁ to LP₂, the amount of money held does not increase; it remains ON as before. Only the rate of interest rises from Or to Oh to equilibrate the new liquidity preference or money demand with the available quantity of money ON. ..B NIC/S EGANSEN S)NTGESIS: ISEDM CURVE MODED Renowned economists, Sir John Richard Hicks and Alvin Hansen, have brought about a synthesis between the Classical and Keynes' theories of interest and have thereby succeeded in propounding an adequate and determinate theory of interest through the intersection of what are called ÌS and LM curves. They are of the opinion that the classical and loanable funds theories amount to the same thing. According to them, the difference between these two theories, i.e. classical and loanable funds, lies only in the meaning of savings. Through derivation, the ÌS curve from the classical theory and LM curve from Keynes' liquidity preference theory, they have brought about a synthesis between the classical and Keynes' theories of interest to provide an adequate and determinate theory of the rate of interest. From the classical theory they get a family of saving curves at various income levels. From these various saving curves at various income levels together with the given investment demand curve, the ÌS curve is derived. This ÌS curve tells us what will be the various rates of interest at different levels of income, given the investment demand curve and a family of saving curves at different levels of income. On the other hand, from Keynes' formulation, the LM curve is obtained from a family of liquidity preference curves corresponding to various income levels together with the given stock of money supply. This is because as the level of income increases, people would like to hold more money under the transactions motive. That is, the higher the level of income, the higher would be the liquidity preference curve. With the given supply of money, the different levels of liquidity preference curves corresponding to various levels of income would determine different rates of interest. This yields LM curve, which depicts the various combinations of interest and income level, at which money market is in equilibrium. Now, Hicks and Hansen show that with the intersection of Ì S and LM curves, both the interest and income are simultaneously determined. Thus the classical and Keynes' theories taken together help us in obtaining an adequate and determinate theory of interest. Ìn what follows we explain how the ÌS curve is derived from the classical theory, and the LM curve from Keynes' theory. Further, we will explain what factors determine the shape and the levels of ÌS and LM curves. ..C DERIVATION O+ TGE I S CURVE Ìn Fig. 4.5, as the income rises, the savings curve shifts to the right and the rate of interest, which equalizes savings and investment, falls. Ìn Fig. 4.6, we measure income (Y) on the X-axis and plot the corresponding rates of interest determined by the equality of savings and investment on the Y-axis. Thus, when income is Y₂ the relevant savings curve is S₂Y₂ and the corresponding rate of that equalizes equalizing savings and investment is r₄. Similarly, for other levels of income rates of interest that equalize savings and investment can be obtained and plotted. Since, as income increases, rate of interest falls, the ÌS curve slopes downward. Thus, Ì S curve relates the rates of interest with the levels of income at which intended savings and investment are equal. Ìn other words, the ÌS curve depicts the various combinations of levels of interest and income at which, intended savings equal investment; goods-market is in equilibrium. Since with the increase in income the savings curve shifts to the right, its intersection with the investment demand curve will lower the rate of interest, the level of income and rate of interest are inversely related. That is, the ÌS curve slopes downward, as shown in Fig. 4.6. Further, the steepness of the ÌS curve depends upon the elasticity or sensitiveness of investment demand to the changes in rate of interest. Ìf the investment demand is highly elastic, that is, very sensitive to the changes in the rate of interest, a given change in interest will produce a large change in investment and thereby cause a large change in the level of income. Thus when investment demand is greatly elastic or highly sensitive to the rate of interest, the ÌS curve will be flat (i.e. less steep). On the other hand, when investment demand is not very sensitive to the changes in rate of interest, the ÌS curve will be relatively steep. Now, what determines the position of ÌS curve and what would cause changes in its level. Ìt is the level of autonomous expenditure such as government expenditure, transfer payments, autonomous investment which determines the position of the ÌS curve. Ìf the government expenditure or any other type of autonomous expenditure increases, it will increase the equilibrium level of income at the given rate of interest. This will cause the ÌS curve to shift to the right. How much does the ÌS curve shift following an increase in expenditure depends on the size of multiplier. A reduction in government expenditure or transfer payments will shift the ÌS curve to the left. ..F DERIVATION O+ TGE DM CURVE +ROM /E)NES DI9UIDIT) *RE+ERENCE TGEOR) The LM curve can be derived from the Keynesian liquidity preference theory of interest. Liquidity preference or demand for money to hold depends upon transaction motive and speculative motive. Ìt is the money held for transactions motive which is a function of income. The greater the level of income, the greater the amount of money held for transactions motive and, therefore, the higher the level of liquidity preference curve. Thus, we can draw a family of liquidity preference curves at various levels of income. Now, the intersection of these various liquidity preference curves, corresponding to different income levels with the supply curve of money fixed by the monetary authority, would give us the LM curve that relates the rate of interest with the level of income as determined by money-market equilibrium corresponding to different levels of liquidity preference curve. The LM curve tells us what the various rates of interest will be (given the quantity of money and the family of liquidity preference curves) at different levels of income. But the liquidity preference curves alone cannot tell us what exactly the rate of interest will be. Ìn Fig. 4.7 (a) and (b), we have derived the LM curve from a family of liquidity preference curves. As income increases, liquidity preference curve shifts outward and therefore the rate of interest, which equates supply of money with demand for money, rises. Ìn Fig. 4.7 (b) we measure income on the X-axis and plot the income levels corresponding to the various interest rates determined at those income levels ÷ through money-market equilibrium by the equality of demand for and supply of money in Fig. 4.7 (a). ..10 TGE SDO*E AND *OSITION O+ TGE DM CURVE Figure 4.7 (b) shows that the LM curve slopes upward to the right. This is because with higher levels of income, demand for money (that is, the liquidity preference curve) is higher and consequently the money market equilibrium, that is, the equality of the given money supply with liquidity preference curve occurs at a higher rate of interest. This implies that rate of interest varies directly with income. Ìt is important to know which factors determine the slope of the LM curve. There are two factors on which the slope of the LM curve depends. First, the responsiveness of demand for money (i.e. liquidity preference) to the changes in income. As the income increases, say from Y₁ to Y₂, the liquidity preference curve shifts from LP₁ to LP₂, that is, with an increase in income, demand for money would increase for being held for transactions motive, L is equal to f multiplied by Y. This extra demand for money would disturb the money-market equilibrium, and in order to restore the equilibrium the rate of interest will rise to the level where the given money supply curve intersects the new liquidity preference curve corresponding to the higher income level. Ìt is worth noting that in the new equilibrium position, with the given stock of money supply, money held under the transactions motive will increase whereas the money held for speculative motive will decline. The greater the extent to which demand for money for transactions motive increases with the increase in income, the greater the decline in the supply of money available for speculative motive. Given the liquidity preference schedule for speculative motive, the higher the rise in the rate of interest the steeper the LM curve consequently. According to Keynes' liquidity preference theory, r is equal to f (M₂, L₂) where M₂ 'S the stock of money available for speculative motive and L₂ is the money demand or liquidity preference function for speculative motive. The second factor which determines the slope of the LM curve is the elasticity or responsiveness of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of interest. The lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be the LM curve. On the other hand, if the elasticity of liquidity preference (money-demand function) to the changes in the rate of interest is high, the LM curve will be relatively flat or less steep. Another important thing to know about the Ì S-LM curve model is to know what brings about shifts in the LM curve. As seen above, an LM curve is drawn with a given stock of money supply. Therefore, when the money supply increases, given the liquidity preference function, it will lower the rate of interest at the given level of income. This will cause the LM curve to shift down and to the right. On the other hand, if money supply is reduced, given the liquidity preference (money; demand) function, it will raise the rate of interest at the given level of income and therefore cause the LM curve to shift above and to the left. The other factor that causes a shift in the LM curve is the change in liquidity preference (money demand function) for a given level of income. Ìf the liquidity preference function for a given level of income shifts upward, this, given the stock of money, will lead to the rise in the rate of interest. This will bring about a shift in the LM curve above and to the left. On the contrary, if the liquidity preference function for a given level of income declines, it will lower the rate of interest and will shift the LM curve down and to the right. ..11 INTERSECTION O+ TGE I S AND DM CURVES: SIMUDTANEOUS DETERMINATION O+ INTEREST RATE AND INCOME The Ì S curve and the LM curve relate to the two variables: (a) income, and (b) the rate of interest. Ìncome and the rate of interest determined together at the equilibrium rate of interest are, therefore, determined together at the point of intersection of these two curves, i.e. E in Fig. 4.8. The equilibrium rate of interest thus determined is Or₃ and the level of income determined is OY₃. At this point, income and the rate interest stand in relation to each other such that (1) investment and saving are in equilibrium, and (2) the demand for money is in equilibrium with the supply of money (i.e., the desired amount of money is equal to the actual supply of money). Ìt should be noted that LM curve has been drawn by taking the supply of money as fixed. Thus, a determinate theory of interest is based on: (1) the investment-demand function, (2) the saving function (or, conversely, the consumption function), (3) the liquidity preference function, and (4) the quantity of money. We see, therefore, that according to Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the monetary factors, that is, the demand for money (liquidity preference) and supply of money play a part in determining of the rate of interest. Any change in these factors will cause shift in Ì S or LM curve and will therefore change the equilibrium level of the rate of interest and income. Che%2 )o7r *ro,ress Tick the Correct Answer Question1. Pick odd man out: The choices are: (1) Rent (2) Ìnterest (3) Wages (4) Money Right Answer: (4) Money Question 2. According to J.M.Keynes rate of interest and bond prices are related The Choices are: (1) Ìnversely (2) Directly (3) Parallel (4)Horizontal Right Answer: (1) Ìnversely Question 3. Keynes explained interest in terms of The choices are: (1) Real forces (2) Economic forces (3) Monetary forces (4) Social forces Right Answer: (3) Monetary forces Question 4. The initials LM stand for The choices are: (1) Liquidity Model (2) Liquidity preference and Money supply equilibrium (3) Liquidity and Money Model (4) Liquidity and money Right Answer: (2) Liquidity preference and Money supply equilibrium Question 5. Ì S curve is derived from The choices are: (1) Classical theory. (2) Keynesian liquidity preference theory of interest (3) Law of diminishing marginal utility (4) Law of equimarginal utility Results: (1) Classical theory. Question6. LM curve is derived from The choices are: (1) Classical theory (2) Keynesian liquidity preference theory of interest (3) Law of diminishing marginal utility (4) Law of equimarginal utility Right Answer: (2) Keynesian liquidity preference theory of interest Det Us S7' U5 1. Ìnterest is one of the four types of income, the others being rent, wages, and profit. Three elements can be distinguished in interest: (i) payment for the risk involved in making the loan; (it) payment for the trouble involved; (iii) pure interest, that is a payment for the use of the money. 2. Supply-and-demand analysis explains the rate of interest as a price determined by the demand for money and the supply of loans. 3. According to Keynes, rate of interest is determined by liquidity preference or demand for money to hold and the supply of money. The theory is known as Liquidity Preference Theory. Ìnterest is a reward for parting with liquidity for a specified period. 4. Ìn two-asset economy the demand for money by the people depends upon how they decide to balance their portfolios between money and bonds. 5. The position of money demand curve depends upon two factors: (1) the level of nominal income, and (2) the expectations about the changes in bond prices in the future which implies change in rate of interest in future. 6. Keynes asserted that it is not the rate of interest which equalizes saving and investment. But this equality is brought about through changes in the level of income. 7. Hicks and Hansen have brought about a synthesis between the Classical and Keynes' theories of interest and have thereby succeeded in propounding an adequate and determinate theory of interest through the intersection of what are called ÌS and LM curves. 8. Ì S curve tells us what will be the various rates of interest at different levels of income, given the investment demand curve and a family of saving curves at different levels of income. 9. The ÌS curve and the LM curve relate the two variables: (a) income and (b) the rate of interest. Ìntersection point of these two curves is the equilibrium rate of interest. /e38or&s< Ìnterest; Liquidity preference; The Demand for Money in a Two-Asset Economy; Money Demand Curve; Determination of Rate of Ìnterest: Equilibrium in the Money Market; Effect of an Ìncrease in the Money Supply; Shifts in Money Demand or Liquidity Preference Curve; ÌS and LM curves END O+ CGA*TER . H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT-5 Business Cycles STRUCTURE 5.0 Objectives 5.1 Ìntroduction 5.2 Characteristics of a Business Cycle 5.3 Phases of a Business Cycle Det Us S7' U5 ?.0 OBJECTIVES This chapter will be helpful in understanding: 1. Concept and characteristics of business cycle 2. Phases of a business cycle ?.1 INTRODUCTION The term "7siness %3%le (or e%ono'i% %3%le) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (expansion or boom), and periods of relative stagnation or decline (contraction or recession). Business cycle simply means the whole course of business activity which passes through the phases of prosperity and depression. A business cycle is not a regular, predictable, or repetitive phenomenon like the swing of the pendulum of a clock. Ìts timing is random and, to a large degree, unpredictable. The business cycles influence business decisions. The cycles affect not only the economy in general, but each individual business firm. ?.! CGARACTERISTICS O+ A BUSINESS C)CDE 1. A "7siness %3%le is s3n%hroni%. The upward and downward movements tend to occur at almost the same period in all industries. The wave of prosperity or depression in one industry will soon generate a wave in other industries. !. A "7siness %3%le sho8s a 8a=eEli2e 'o=e'ent. The period of prosperity and depression can be alternatively seen in a cycle. (. C3%li%al fl7%t7ations are re%7rrin, in nat7re. The various phases are repeated. A boom is followed by depression and the depression again is followed by boom. .. There can be no indefinite depression or eternal boom period. ?. Business cycles are pervasive in their effects. @. The up and down movements are not symmetrical. The downward movement is more sudden and violent than the upward movement. ?.( *GASES O+ A BUSINESS C)CDE A business cycle is identified as a sequence of four phases, viz., recovery, boom, recession and depression. Boo' During the boom phase production capacity is fully utilized and also products fetch an above-normal price which gives higher profit. This attracts more and more investors. To manufacture more number of products entrepreneur purchases new machines and also employees work at higher wage rate. The increasing cost tendency of the factors of production leads to a continuous increase in product cost. The fixed income group or the salaried class finds it difficult to cope with this increase in prices. As their income does not increase accordingly, they are now compelled to reduce their consumption. The demand is now more or less stagnant or it even decreases. Thus the boom or prosperity reaches its peak. Re%ession Once economy reaches the peak the course changes. A downward tendency in demand is observed. But the producers who are not aware of this trend go on producing. The supply now exceeds demand. Now the producers come to notice that their stocks are piling up. They are compelled to give up future investment plans. The order for new equipments and raw materials are cancelled. A businessman even cuts down his existing business. Workers are retrenched. Bankers insist on repayment, stocks accumulate, business failure increases, investment ceases and unemployment expands. Unemployment leads to fall in income, expenditure, prices, profits and industrial and trade activities. Desire for liquidity increases all around. Producers are compelled to reduce price so that they can find money to meet their obligations. Consumers who expect a still further decline in prices postpone their consumption. Stocks go on piling up. Some firms are forced into bankruptcy. The failure of one firm affects other firms with whom it has business connections. There is general distress. This phase of the business cycle is known as the crisis. Ìt is the utmost suffering for a business. De5ression Underemployment of both men and materials is a characteristic of this phase. General demand falls faster than production. Producers are compelled to sell their goods at a price which will not even cover the full cost. Manufacturers of both capital goods and consumers' goods are forced to reduce the volume of production. As a consequence, workers are thrown out. The remaining workers are poorly paid. The demand for bank credit is at its lowest which results in idle funds. The interest rates also decline. The firms that cannot pay off their debts are wound up. Prices of shares and securities fall down. Pessimism prevails in the economy. The less-confident investors are not ready to take up new investment projects. The aggregate economic activity is at its bottom. Re%o=er3 Depression phase does not continue indefinitely. Depression contains in itself the germs of recovery. The idle workers now come forward to work at low wages. As the prices are at their lowest, the consumers, who postponed their consumption expecting a still further fall in price, now start consuming. The banks, with accumulated cash reserves, now come forward to give loans at easier terms and lower rates. As the demand increases, the stocks of goods become insufficient. The economic activity now starts picking up, investment picks up, and employment and output slowly and steadily begin to rise. Ìncreased income leads to increase in demand, resulting in rise in prices, profits, further investment, employment and incomes. The wave of recovery once initiated soon begins to feed upon itself. Stock markets become alive thus hastening the revival. Optimism develops among the entrepreneurs. Bank loans and demand for credit start rising. The depression phase then gives way to recovery. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er: 97estion1.B7siness C3%le is also 2no8n as The %hoi%es are: (1) Entrepreneur cycle (2) Economic cycle (3) Vicious circle (4) None of the poverty Ri,ht Ans8er: #!$ E%ono'i% %3%le 97estion !. *i%2 o&& 'an o7t The %hoi%es are: (1) Boom (2) Depression (3) Slowdown (4) Recovery Ri,ht Ans8er: #($ Slo8&o8n 97estion. ( Un&ere'5lo3'ent of "oth 'en an& 'aterials is a %hara%teristi% of 8hi%h 5hase> The %hoi%es are: (1) Depression (2) Boom (3) Recovery (4) Recession Ri,ht Ans8er: #1$ De5ression 97estion .. ;hi%h 5hase of the "7siness %3%le s also 2no8n as the %risis> The %hoi%es are: (1) Boom (2) Depression (3) Recovery (4) Recession Ri,ht Ans8er: #.$ Re%ession Let Us Sum Up Ì. Business cycle refers to economy-wide fluctuations in production or economic activity over several months or years. 2. Business cycle simply means the whole course of business activity which passes through the phases of prosperity and depression. 3. A business cycle is identified as a sequence of four phases, viz., recovery, boom, recession and depression. END O+ CGA*TER ? H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 6- Ìndian Economy and Various Sectors of the Economy STRUCTURE 6.0 Objectives 6.1 Ìntroduction 6.2 Various Sectors of the Economy 6.3 Structural Changes in Ìndian Economy Det Us S7' U5 /e38or&s @.0 OBJECTIVES This chapter gives an overview of: 1. Ìndian Economy !. Various Sectors of the Economy (. Structural Changes in Ìndian Economy @.1 INTRODUCTION In&ian E%ono'3: A Brief O=er=ie8 Ìn the first five decades of the twentieth century, till we got our independence in 1947, the per capita GDP in Ìndia was stagnant. The trend growth in GDP during this period was 0.9 per cent with population growing by about 0.8 per cent. As compared with the near stagnant growth in the first half of the twentieth century, the annual growth, averaging at around 3.5 per cent during the period 1950 to 1980, was comparatively better. The average growth rate of the Ìndian economy over a period of 25 years since 1980-81 was about 6.0 per cent ÷ a significant improvement over the annual growth rate of the earlier three decades. Ìn the new millennium, the GDP growth rate has further accelerated averaging 7.2 per cent during the seven-year period 2000-01 to 2007-08, with the growth rate in the last five years (2003-04 to 2007-08) averaging 8.8 per cent. Over the years, while the GDP growth has been accelerating, the population growth rate has moderated, giving a sharp impetus to the growth in per capita income. The strengthening of economic activity in the recent years has been supported by a sustained increase in the gross domestic investment rates from 22.8 per cent of GDP in 2001-02 to 35.9 per cent in 2006-07. Ìt may also be noted that over 95 per cent of the investment during this period was financed by domestic savings. Since independence, the inflation rate, in terms of the wholesale price index (WPÌ), on average basis, was above 15 per cent in only five out of fifty years and was in single- digit for thirty-six of these years. On most occasions, high inflation was due to food or oil shortages. The inflation rate accelerated steadily from an annual average of 1.7 per cent during the 1950s to 6.4 per cent during the 1960s and further to 9.0 per cent in the 1970s before easing marginally to 8.0 per cent in the 1980s. The inflation rate declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during the second-half of 1990s. Ìn recent years, inflation rate has averaged around 5 per cent. An important characteristic of the recent growth phase of over a quarter century is the country's resilience to shocks. During this period, we have witnessed only one serious balance of payments crisis, triggered largely by the Gulf war in the early 1990s. The Ìndian economy, in the later years, could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, the Russian crisis during 1997-98, sanction-like-situation in post-Pokhran scenario, the border conflict during May-June 1999 and Sub-prime Crisis. Viewed in this context, this robust macroeconomic performance, in the face of recent oil as well as food shocks, demonstrates the vibrancy and resilience of the Ìndian economy. Ìt is necessary to note that, despite the recent encouraging performance, the Ìndian economy faces several severe challenges. These relate, in particular, to poverty, education, health, environment, physical infrastructure, and fiscal issues. @.! VARIOUS SECTORS O+ TGE ECONOM) A,ri%7lt7re Agriculture is one of the most important sectors of Ìndian economy. Agriculture (including allied activities) accounted for 17 per cent of the Gross Domestic Product (GDP-at constant prices) in 2008-09 as compared to 21.7 per cent in 2003-04. Notwithstanding the fact that the share of this sector in GDP has been declining over the years, its role remains critical as it accounts for about 52per cent of the employment in the country. Apart from being the provider of food and fodder, its importance also stems from the raw materials that it provides to industry. The prosperity of the rural economy is also closely linked to agriculture and allied activities. One of the biggest success stories of independent Ìndia is the rapid strides made in the field of agriculture. From a nation dependent on food imports to feed its population, today Ìndia is not only self-sufficient in grain production but also has substantial food reserves. Dependence of Ìndia on agricultural imports and the crises of food shortage encountered in 1960s convinced planners that Ìndia's growing population, as well as concerns about national independence, security, and political stability, required self- sufficiency in food production. This perception led to a programme of agricultural improvement called the Green Revolution. Ìt involved bringing additional area under cultivation, extension of irrigation facilities, the use of improved high-yielding variety of seeds, better techniques evolved through agricultural research, water management and plant protection through judicious use of fertilizers, pesticides and cropping practices. All these measures had a salutary effect and the production of wheat and rice witnessed a quantum leap. However, there are still a host of issues that need to be addressed regarding Ìndian agriculture. Ìndian agriculture is heavily dependent on monsoons. The monsoons play a critical role in determining whether the harvest will be rich, average, or poor. The structural weaknesses of the agriculture sector are reflected in the low level of public investment, exhaustion of the yield potential of new high yielding varieties of wheat and rice, unbalanced fertilizer use, low seeds replacement rate, an inadequate incentive system and post-harvest value addition. There is an urgent need for second green revolution in Ìndian agriculture. Following steps need to be taken to achieve this objective: 1. Doubling the rate of growth of irrigated area; 2. Reclaiming degraded land and focusing on soil quality; 3. Ìmproving water management, rain water harvesting and watershed development; 4. Bridging the knowledge gap through effective extension services; 5. Diversifying into high value outputs, fruits, vegetables, flowers, herbs and spices, medicinal plants, bamboo, bio-diesel, but with adequate measures to ensure food security; 6. Providing easy access to credit at affordable rates. In&7str3 Ìndustry accounts for 19 per cent of the GDP in 2008-09. About one-third of the industrial labour force is engaged in simple household manufacturing only. The different industry sectors of Ìndia witnessed astronomical growth over the last 19 years. This growth of the different industry sectors of Ìndia is attributed to the Government of Ìndia's liberal economic policy. Previously, the Ìndian economy was of closed type and the government enterprises controlled all Ìndian market. The post-1990 Government of Ìndia economic policy endorsed a complete different economic policy and opened its market for foreign investments. This saw a lot of FDÌ coming to Ìndia. As a result, different industry sub-sector made huge progress, both technologically and economically. Central Statistical Organization (CSO) classifies the industrial sector into 3 segments: Mining and Quarrying, Manufacturing and Electricity, Gas and Water Supply. Mi%ro an& S'all Enter5rises #MBEs$ As per the data on micro and small enterprises (MSEs) in the Annual Report of Ministry of Micro, Small and Medium Enterprises, 2006-07, the sector accounted for around 39 per cent of total industrial production, 34 per cent of the exports in the industrial sector and around 35 per cent of total employment among units engaged in manufacturing and services. The sector registered a robust annual average growth in value of output, exports and employment at 16.8 per cent, 20.0 per cent and 4.4 per cent, respectively during the expansionary phase of 2003-07, before showing signs of slowing down in 200708 particularly in respect of employment growth to 2.9 per cent. The problems cited by MSE borrowers in obtaining access to bank finance are insistence on collaterals/ guarantees, limited outreach of banks, rigid approaches, high interest and other costs, complex documentation, lack of supporting business development services and so on. From the banker's point of view, the critical factors affecting credit delivery to this sector are low equity base, absence of marketing tie up, diversion of funds, poor management and book keeping, higher NPAs, mounting of receivables due to delay in payment of bills especially during downturn. Measures to increase flow of credit leading to almost three fold increase in the credit to this sector from public sector banks from Rs.67,600 crore as on March 31, 2005 to Rupees 1,90,958 crore as on March 31, 2009. The major policies in regard to credit delivery to this sector are as follows. 1. Ìnclusion of MSE (as per revised definition) in priority sector with sub limits for the micro units. 2. Stipulation that collateral should not be taken for loans up to Rs.5 lakh to MSE units. 3. Providing credit guarantee for collateral free loans from the Credit Guarantee Trust Fund administered by SÌDBÌ. Micro, Small And Medium Enterprises Development (MSMED) Act, 2006 1. The MSMED Act, 2006 classifies enterprises broadly into two categories, viz., (1) manufacturing enterprises; and (2) service enterprises. These broad categories are further classified into micro enterprises, small enterprises and medium enterprises, depending upon the level of investment in plant and machinery and equipment as the case may be. 2. The existing provisions of the Ìnterest on Delayed Payment Act, 1998 to small scale and ancillary industrial undertakings have been strengthened under the MSMED Act. 3. The Act also provides for constitution of a National Board for Micro, Small and Medium Enterprises under the chairmanship of the Union Minister for MSME, with wide representation of stakeholders. Ser=i%es The Service Sector now accounts for about two third of Ìndia's GDP: 64 per cent in 2008-09. This sector has gained at the expense of both the agricultural and industrial sectors through the 1990s. The rise in the service sector's share in GDP marks a structural shift in the Ìndian economy and takes it closer to the fundamentals of a developed economy (in the developed economies, the industrial and service sectors contribute a major share in GDP while agriculture accounts for a relatively lower share). Some economists caution that if the service sector bypasses the industrial sector, economic growth can be distorted. According to them service sector growth must be supported by proportionate growth of the industrial sector; otherwise the service sector grown will not be sustainable. Ìt is true that, in Ìndia, the service sector's contribution in GDP has sharply risen and that of industry has fallen. Phenomenal growth has been noticed in selected service sector segments like ÌT/ÌTES, telecom, banking, insurance and real estate, and civil aviation. @.( STRUCTURAD CGANIES IN INDIAN ECONOM) The Ìndian economy has registered an impressive growth in recent times with GDP recording an average of 7.2 per cent growth rate in the current decade from an average growth of 5.7 per cent in the 11990s. A comparison with the earlier period since the beginning of the last century brings out the extent of economic transformation far more clearly (Table 6.1). During the first 50 years of the nineteenth century, the average GDP growth rate has been just 0.7 per cent, which picked up to 3.5 per cent (popularly called as 'Hindu rate of growth') in the three decades after independence, before progressing to higher growth path in the recent decades. Concomitantly, the per capita income grew from a mere 0.2 per cent in 1900-1950 and 1.1 per cent in 1951-1980 to 3.2 per cent in the 1980s and 3.6 per cent in the 1990s and further to 5.4 per cent in the current decade. TABLE 6.1 Structural Changes in GDP (Growth Rate in 1900- 1950 1951-80 1980s 1990s 2000-09 Agriculture & allied activities NA 2.1 4.4 3.2 2.8 Ìndustry NA 5.4 6.4 5.7 6.5 Services NA 4.5 6.3 7.1 9.0 GDP 0.7* 3.5 5.6 5.7 7.2 *Angus Maddision (2007): The World Economy, OECD. NA: Not Available TABLE 6.2 Structural change in GDP (share in GDP)New series (Base:1999-2000) 1950-51 1960-61 1970-71 1980.81 1990.91 2008-09 Agriculture & allied activities 55 51 44 38 31 17 Ìndustry 11 13 15 17 20 19 Services 34 36 41 45 49 64 Transformation of the economy is quite apparent from the noticeable changes that have occurred in the sectoral composition of output. The share of services in the national income has steadily increased with corresponding fall in the contributions of agriculture and industry over the years. Services sector now accounts for nearly two-third of total output as against less than half in the early 1980s and the 1990s. Share of industry declined marginally to 19 per cent from 20 per cent whereas share of agriculture registered steep decline from 55 per cent to just 17 per cent (Table 6.2). Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er. 97estion 1. The a=era,e ,ro8th rate of In&ian e%ono'3 o=er a 5erio& of !? 3ears sin%e 1FC0EC18as a"o7t The %hoi%es are: (1) 3 to 4 per cent (2) 6 per cent (3) 9 per cent Ri,ht Ans8er: #!$ @ 5er %ent 97estion !. ;hat se%tor is %alle& as *ri'ar3 Se%tor in In&ia> The %hoi%es are: (1) Ìndustrial Sector (2) Service Sector (3) External Sector (4) Agricultural Sector Ri,ht Ans8er: #.$ A,ri%7lt7ral Se%tor 97estion (. CSO %lassifies the In&7strial Se%tor in to ho8 'an3 se,'ents> The %hoi%es are: (1) Three (2) Four (3) Six (4) Two Ri,ht Ans8er: #1$ Three 97estion .. MSE 'eans The Choi%es are: (1) Medium and Small Enterprises (2) Micro and Small Enterprises (3) Medium State Enterprises (4) None of the above. Ri,ht Ans8er: #!$ Mi%ro an& S'all Enter5rises 97estion ?. Ser=i%e Se%tor is also %alle& as The Choi%es are: (1)Primary Sector (2) Secondary Sector (3) Tertiary Sector (4) None of the above Ri,ht Ans8er: #($ Tertiar3 Se%tor 97estion @. The share of ser=i%es in the national in%o'e fro' the last 10 3ears is The %hoi%es are: (1) decreasing (2) Constant (3) Ìncreasing (4)Nominal Ri,ht Ans8er: #($ In%reasin, Det Us S7' U5 1. The Ìndian economy has registered an impressive growth in recent times with GDP recording an average of 7.2 per cent growth rate in the current decade from an average growth of 5.7 per cent in the nineties. 2. From a nation dependent on food imports to feed its population, Ìndia today is not only self-sufficient in grain production but also has substantial food reserves. 3. Ìndian agriculture is heavily dependent on monsoons. 4. The different industry sectors of Ìndia witnessed astronomical growth over the last 19 years. This growth of the different industry sectors of Ìndia is attributed to the Government of Ìndia's liberal economic policy. 5. CSO classifies the industrial sector into 3 segments: Mining and quarrying, Manufacturing and Electricity, gas and construction. 6. The service sector now accounts for two third of Ìndia's GDP. Phenomenal growth has been noticed in ÌT/ÌTES, telecom, banking, insurance and real estate, and civil aviation. /e38or&s Ìndian Economy; Agriculture Sector; Ìndustrial Sector; Service Sector; MSEs ;Hindu Rate; Structural Change in Ìndian Economy. END O+ CGA*TER @E ADVANCED BAN/ MANAIEMENTE CAAIB *A*ER 1 ADVANACED BANK MANAGEMENT UNÌT 7- Economic Reforms STRUCTURE 7.0 Objectives 7.1 Ìntroduction 7.2 Transformation 7.3 Economic Transformation ÷ Real Sector 7.4 Economic Transformation ÷ Financial Sector 7.5 Economic Transformation ÷ Ìntegration with the Global Economy 7.6 Do We Deserve Accolades? 7.7 Ìssues 7.8 Way Forward Let s !um p 'eywords B.0 OBJECTIVES This chapter will be helpful in understanding: 1. How the economic reforms brought about transformation in different sectors of the economy? 2. Economic transformation ÷ Real Sector 3. Economic transformation ÷ Financial Sector 4. Economic Transformation ÷ Ìntegration with the Global Economy 5. Financial Ìnclusion B.1 INTRODUCTION Structural reforms, during last two decades, have unambiguously altered the economic landscape of the country. However, there are certain questions/concerns that have always been a source of discomfort and have acquired a new relevance as economy moved to a higher growth trajectory in recent years. For instance, how inclusive our growth process is? Are we moving towards affording a decent standard of life to people at large? How the reforms brought about transformation in different sectors of the economy? B.! TRANS+ORMATION Transformation of the economy is quite apparent from the noticeable changes that have occurred in the sectoral composition of output. The share of services in the national income has steadily increased with corresponding fall in the contributions of agriculture and industry over the years Services sector now accounts for nearly two third of total output as against less than half in the early 1980s and the 1990s. Share of industry declined marginally to 19 per cent from 20 per cent whereas share of agriculture registered a steep decline from 38 per cent to just 17 per cent. This positive performance seems to be an outcome of reforms encompassing a range of measures that led to transformation spreading over all the sectors of economy. Transformation brought in higher degree of sophistication and efficiency in operations of almost all the sub-segments of real as well as financial sectors. Moreover, domestic economy has become far more integrated with rest of the world which is visible not only in terms of growing trade volumes; financial flows from and to the outside world have also been steadily growing. There are some experts who argue that Ìndia's economic transformation needs to be attributed to change in policy orientation of 1980s rather than the reforms undertaken during 1990s. Although they do recognize the possibility that improvement in 1980s might have run out of steam without further reforms undertaken in the nineties. While academic debate as to what triggered the economic transformation might still be unresolved; there is a near consensus with regard to the important role of liberalization process initiated in the early nineties in placing the economy on a higher growth path. The economic reforms that ushered in 1991 put forward some important political questions. The first question that comes to our mind is about the timing of the reforms, i.e. why the reforms were started only in 1991 and why not earlier? How the process of reforms continued despite changes in ruling party at the centre? How the direction of reforms sustained and remained irreversible despite various hurdles and hiccups? The answers to these questions, to a large extent, lie in the transformation in political spectrum of the Ìndian electoral democracy. As one avid follower of Ìndia's economy puts it, the greatest change has been in the positive attitude towards reforms Besides brewing up of twin economic imbalances, i.e. fiscal crisis and external payment crisis, the timing of reforms may have been the outcome of international and domestic political events. Ìnternationally, two major events questioned the basic premise of our earlier social consensus regarding the development strategy. First was the collapse of erstwhile USSR and the East European socialist regimes and their march towards market oriented economic system. Second, the spectacular success of 'socialist market economy' of China with the aggressive opening up since 1978 and its associated success in poverty reduction raised concerns about the efficacy of Ìndia's inward orientated strategy. Domestically, the appreciable growth performance of 1980s which was induced by hesitant liberalization efforts strengthened the hands of pro- liberalization minority in the bureaucracy and in the Government that has been instrumental in systemic reforms in the 1990s. The continuation of reform process and irreversibility of its direction could be explained with three interlinked political developments. First is the emergence of regional parties and their increasing holds in national politics. Second is the beginning of the era of coalition Government at the centre. Third is the growing and widespread acceptance of the need for rapid economic growth that can be achieved by the market-oriented reforms. Besides, competing claims of various states on benefits of economic reforms has also helped in sustaining the momentum of reform process in Ìndia. During the reform period some states have performed well while others have been lagging. This has been the effect of policy environment and the quality of governance at the state level. Those states, which reorganized their policies in favour of market oriented reforms in tune with national economic policy framework and provided hassle free investment environment to entrepreneurs, have reaped more benefits of economic reforms in terms of high growth and per capita income. Let us now see how the reform process has brought about transformation in each of sub-sectors of the economy. B.( ECONOMIC TRANS+ORMATION E READ SECTOR Real Sector Policy measures mainly focused on the manufacturing sector in the early stages of reform process. Deregulation of industry by way of eliminating licensing requirement, overhauling of public enterprises, enhanced role for private sector, abolition of M R T P Act, automatic approval route for foreign investment, elimination of quantitative import restrictions and reduction in tariff rates crated a conducive environment to gear up the industry to face growing domestic as well as external competition to which it was exposed by the reform process. Another area where reforms came about at a later stage related to de-reservation of large number of items that were earlier meant to be produced exclusively in the small scale sector. Measures were further supplemented with liberalization of foreign direct investment not only in terms of scope and proportion of foreign ownership but also with regard to procedural details. Ìndustry responded to reforms by undertaking massive restructuring of its operations by upgrading their technologies, expanding to more efficient scales of production, resorting to mergers and acquisitions both within and outside the country and refocusing their activities to the core competence. While manufacturing became more competitive and efficient, major impact occurred with respect to services sector. Entry of private sector and foreign direct investment that introduced competition and state of the art technology brought a sea change in the services sector. For instance, there was a time when telephone was a luxury and customers had to queue up for years to get a connection. Now it is available on demand. Mobile phones have reached to the lowest rung of the society and have played a key role in integrating the far flung areas to the mainstream. Synergies provided by the manufacturing sector, liberalization of financial sector with entry of private sector in areas hitherto restricted to public sector and policy initiatives with regard to information technology led to surge in growth of services sector. The boom in information technology (Ì T) and Ìnformation Technology and Enabled Services (Ì T E S) sector essentially led to an era of 'services-led growth' as Ìndia emerged as global hub for B P O/K P O services in the world. This shift in the pattern of off-shoring services to Ìndia was mainly due to inherent advantages of Ìndian Ì T/Ì T E S sector. Advantage of the low wage structure, flexibility due to time zone differences and access to a larger and better talent pool provide globally active companies, Ìndia as an ideal place, to look for off-shoring services. Ìn the last two decades, the Ìndian Ì T/Ì T E S industry has contributed significantly to Ìndian economic growth in terms of GDP, foreign exchange earnings and employment generation. Ìndian Ì T/Ì T E S sector's contribution to the country's GDP has been steadily increasing. Socio-economic dimension, that lends uniqueness to Ìndia's pattern of growth and economic transformation, is evident in the relative surge in the growth of industrial and services sectors vis-a-vis primary segment. Ìndia seems to have skipped the stage of development that emphasizes growth in labour intensive industries with absorption of surplus labour from the agricultural sector. As transformation of industrial as well as services sector has overwhelmingly been based on capital intensive techniques requiring skilled manpower, relative shift in sectoral incomes have been devoid of any commensurate relocation of surplus labour and more than three-fifth of population continued to draw its livelihood from the primary sector. While foregoing has been the reason for general perception about relative isolation of the agricultural sector from the reform process; keeping with the growing openness, a series of policy initiatives transformed this sector as well. Measures relating to free movement of agricultural commodities, A P M C Act permitting farmers to bypass the mandatory requirement of sale in regulated markets and relaxation of restrictions under Essential Commodity Act, 1955 along with introduction of future trading brought major change in the pricing mechanism. National commodity futures markets discover price rather manipulation by local traders. Banks in association with professionally managed godowns extend credit to farmers against warehouse receipts. Large consumer goods companies directly source agricultural produce from the farmers. While, these developments have worked towards improving the terms of trade (T O T) for the agriculture sector, this trend in T O T was also strengthened by lowering of protection for the manufacturing sector and market determined price of foreign exchange. With economic growth and rising disposable incomes, the consumption basket has changed significantly. Growing demand for milk, poultry products and horticulture products, has induced substantial diversification towards allied activities which now account for nearly three-fifth of total primary sector output. B.. ECONOMIC TRANS+ORMATION — +INANCIAD SECTOR Financial sector reforms have been carried out in accordance with the recommendations made by basically three committees: (a) Narasimham committee report on financial sector reforms (1992) (b) Narasimham committee report on banking sector reforms (1998) and (c) S. H. Khan report of the working group for harmonizing the role and operations of Development Financial Ìnstitutions and banks Reforms in financial sector complemented the real sector developments. Transformation of financial sector not only assisted in sharp pick-up in services sector growth, it helped the manufacturing sector to progress from a high cost to internationally competitive segment of the economy. Ìt was a clear recognition of the role of market forces in price discovery process. Prior to these reforms, pricing of financial resources whether it is bank lending to corporate or borrowings by the government or the foreign exchange, each of these was determined broadly on the basis of regulator's decision or an administrative fiat rather than its opportunity cost. Cost of resources hardly reflected the underlying situation of a capital scarce economy. Along with free pricing, removal of constraints in terms of participation, type of instruments, market infrastructure and policy environment instilled life in severely underdeveloped financial market segments. While measures were taken to bring financial markets at par with international best practices, it was a conscious decision to go slow on derivative products, a stand amply vindicated by the current global crisis and relative immunity of Ìndia's financial sector. Mone3 Mar2et Reforms in money market were essentially aimed at providing avenues for the market players to deploy or access to short-term funds and a platform to the monetary authority to modulate liquidity in the system. Liberalization measures in money market preceded the overall reform process as steps related to deregulation of interest rates and introduction of new instruments were initiated in the late 1980s itself. A series of steps over the years, viz., freeing of interest rates on call and other money market instruments, introduction of Commercial Paper and Certificate of Deposit, exemption of inter-bank lending from reserve requirement, introduction of screen-based trading and rupee derivatives such as Ìnterest Rate Swaps (Ì R S) and Forward Rate Agreements (FRA), enlarging the scope of Repo market by expanding the repo-able securities and eligible participants in the repo market and introduction of tripartite repo, i.e. Collateralized Borrowing and Lending obligation C B L O to create pure inter-bank call money market, led to pick up in activity and volumes across the instruments unlike in the past when volumes remained concentrated in call money market. With steps towards making call market a pure inter-bank market, turnover progressively switched from call money market to repo and C B L O market as daily average volumes in call market got almost half in 2008-09 from Rupees 23,161 crore in 1999-2000. Volumes in case of market repo, on the other hand, rose by two-fold during the period and in case of C B L O increase has been four-fold during 2004-05 to 2008-09. Volumes in other market segments such as C P and C D rose as well. Besides, reforms also lent stability to the market as volatility in call market got reduced by nearly half in the current decade from levels prevailing in the 1990s. Io=ern'ent Se%7rities Mar2et Till mid-1980s or the early 1990s, government had been borrowing at sub-market rates, a system sustained by captive market created by statutory reserve requirement. As a part of reforms, concessionary financing was eliminated with introduction of market auction system and phasing out of automatic monetization with Ways and Means Advances (W M A). As yields became market related and government started competing with the private sector in the market for funds, it had the desired impact on G-Sec market as evident by rising secondary market activity and near emergence of market yield curve. The annual turnover in the market has grown from about Rupees 2.8 lakh crore in 1998-99 to Rupees 56.3 lakh crore in 2007-08. Yields on G-Sec now provide benchmark for pricing of securities in other markets. With reforms, G-Sec is no longer a captive market. Ìnvestment in G-Sec by the banks is based on their commercial judgement rather than being dictated by the reserve requirement. Since late nineties, banks' holding of G-Sec have been far in excess of the reserve requirement with ratio going up to near 42 per cent of net demand and time liabilities. Ìmportantly, since April 2006, Reserve Bank of Ìndia does not participate in the primary segment of the G-Sec market that not only provide leeway to R B Ì in implementing monetary policy, the pricing of Government securities has also become far more market-oriented. Beside these core aspects, development of the market was sustained by up-gradation of technology and market infrastructure with regard to settlement systems and trading systems and amendment of legislative provisions. +orei,n E6%han,e Mar2et Prior to reforms, foreign exchange market was virtually absent. Exchange earners were required to surrender/purchase foreign exchange from Reserve Bank at the reference rate. Ìn this highly regulated system, very few transactions used to take place among the authorized dealers and trades were required to be squared off by the close of the day. Ìntroduction of market-based exchange rate regime, adoption of current account convertibility and relaxation on capital account, inter-alia, in terms of permission to run open positions, to hold investments abroad and to retain foreign exchange along with introduction of hedging tools (derivatives) led to emergence of active and vibrant foreign exchange market. Now exchange rate is flexible and market determined; and capital account is also effectively convertible for the nonresidents. Ìt is interesting to note that with significant liberalization on the capital account and given that market forces play a predominant role in determining external value of the rupee, there has not been large volatility in this market barring few mild episodes related to turbulence in global markets. Ca5ital Mar2et Like other market segments, there have been far-reaching changes in both the primary and secondary market segments of capital market. Primary market witnessed a significant movement away from Controller of Capital Ìssues (C C Ì) regime imposing primary issuance at sub-market rates to free pricing and book-building system along with mandatory disclosures as prescribed by S E R Ì. Ìn the secondary market, corporatization of exchanges, screen-based trading replacing open outcry system, introduction of options and futures replacing erstwhile Badla System, rolling settlement replacing 14-day settlement cycle, dematting of securities with depository system created state-of-the- art infrastructure comparable to best international practice. This not only integrated stock markets across the country, capital market became far more efficient as could be observed in terms of various parameters. Cre&it Mar2et Prior to reforms, banking operations both on the assets and liabilities side were governed by the guidelines set out by the regulator. With guidelines that ensured banks' margin on cost-plus basis, competition was virtually absent with no incentive to cut cost, raise efficiency or upgrade credit assessment skills. While broad approach to reforms in this market has been to bring more competition along with higher flexibility and operational autonomy to the banks, stability of the players at the same time was intended to be ensured by emphasizing building up of risk management capabilities and introduction of prudential regulation and supervision in line with best international practices. Moreover, widening of ownership due to stock market listing and associated disclosure requirements brought greater market discipline and transparency in the bank management. These measures transformed the banking sector which could be discerned in measures of efficiency and soundness. There has been steady decline in intermediation cost of banks from 6.24 per cent in 1991-92 to 3.43 per cent in 2006-07. Data Envelopment Analysis (D E A) based estimates of efficiency and productivity indicates sharp improvement in operations of public sector banks and is now comparable to their counterparts in the private sector. Growing soundness of the banking sector is also evident in falling N P As from 7.7 per cent in 1995-96 to about 1 per cent in 2006-07. While banks' operations became more efficient, there has been considerable progress in terms of business volumes reflecting growing economy and reach of the banking sector. Over the past 11 years, on an average, deposits of scheduled commercial banks have risen at a compound growth rate of 17.7 per cent and advances grew by 21 per cent. Growth has been higher for urban and semi-urban branches compared to rural branches. Ìn terms of advances to various sectors of the economy banks' portfolio has been quite diversified. Since 1998-99, while share of advances to agriculture sector remained around 12 per cent, there has been progressive diversification from industrial and wholesale credit to segments such as professionals, personal loans, etc. *a3'ent S3ste's The rapid developments in the Payment Systems and technology have led to the deeper penetration in terms of increase in the number of direct and indirect participants and market players in the payment systems. Among the major developments in recent times, the enactment of the Payment and Settlement Systems Act, 2007 empowering the Reserve Bank to regulate and supervise payment and settlement systems, lay down policies and providing a legal basis for multilateral netting and settlement finality, is of great significance. Another recent development has been to make free the use of other bank ATMs with effect from 1 April 2009 (since changed). The service charges for 'Electronic Payment Products' and outstation cheque collection have also been rationalized. 'Speed Clearing' has been introduced to reduce the time taken for Realisation of outstation cheques to T+1 or T+2 basis. 'Cheque Truncation System (C T S)' has been introduced in cheque clearing since July 2008 in New Delhi. The coverage of Electronic Clearing System (E C S) has been increased to ÌS centers and 89 banks with 55,225 branches are participating in National Electronic Funds Transfer (N E F T) system. Ìn terms of payment systems growth, the Real Time Gross Settlement System (R T G S) volume has gone up from a modest 17.67 lakh in 2005-06 to 133.6 lakh in 2008-09, and the value has gone up from Rupees 1,15,40,836 crore to Rupees 3,22,79,881 crore in the corresponding period. The retail Electronic Clearing volume has gone up from 8.3 crore in 2005-06 to 28.06 crore in 2008-09, and the value has gone up from Rupees 1,06,598 crore to Rupees 4,16,419 crore in the corresponding period. The M Ì C R Cheque Clearing volume has gone up from 101.59 crore in 2005-06 to 114.04 crore in 2008-09, and the value has gone up from Rupees 54, 01,429 crore to Rupees 58, 49,642 crore in the corresponding period. The spread of A T Ms has increased from 34,789 in March 2008 to 43,651 in March 2009 and the volume of A T M transactions has increased from 17,797 lakh in 2007-08 to 23,530 lakh. These data suggest that the payment systems in Ìndia are robust, sound and have been growing at a steady pace. B.? ECONOMIC TRANS+ORMATION — INTEIRATION ;ITG TGE IDOBAD ECONOM) Another aspect of developments in Ìndia's economic arena that facilitated the process of transformation by enabling rapid growth of services sector and change in character of manufacturing sector in terms of efficiency and sophistication with considerable outward orientation, relates to its growing integration with rest of the world. The most common measure of country's integration with the global economy is its openness, i.e. its participation to international trade and capital flows. Ìn Ìndia, the share of merchandise exports to GDP increased from 5.8 per cent in 1990-91 to 15.1 per cent in 2008-09, the share of merchandise imports as percentage to GDP, on the other hand, increased from 8.8 per cent to 25.5 per cent during the same period. On the import side, Ìndia's demand for primary products, viz., raw materials and energy has increased since 1990s, which may be linked to its rapid economic growth. Ìn 2007, Ìndia was the 7th largest oil importer of the world. While, Ìndia's merchandise trade has grown many folds in the current decade, during 2008, Ìndia ranks 26th in the world with a share of 1.1 per cent. However, in terms of commercial services exports, Ìndia ranks much higher at 9th in the world with a share of 2.7 per cent. Ìn terms of capital flows, Ìndia has emerged as one of the most favoured destinations of global investment among the developing and emerging market economies. Net capital inflows increased from US $ 7.1 billion in 1990-91 to $45.2 billion in 2006-07, and further to $108.0 billion during 2007-08. The gross volume of capital inflows, however, amounted to $428.7 billion in 2007-08 as against an outflow of $320.7 billion. This growing integration of Ìndian economy with rest of the world was essentially an outcome of reform measures triggered by balance of payments crisis in 1991. Apart from a swift transition to a market determined exchange rate regime, other important reforms measures included dismantling trade restrictions, moving towards current account convertibility, liberal inflows of private capital, removal of restrictions on all inflows and related outflows, as also, gradual liberalization of certain restrictions on outflows. Tra&e Di"erali-ation De-licensing of virtually all intermediate inputs and capital goods, progressive reduction in tariff rates along with permission for all current business transactions, expenses for education and medical and foreign travel enabled Ìndia to accept ÌMF Article 8 obligation thereby making rupee convertible on current account as early as in 1994. Further liberalization with regard to import licensing for consumer goods and reduction of tariff rate below 10 per cent (barring few exceptions, such as automobiles) considerably enhanced the outward orientation of Ìndian economy. Ca5ital A%%o7nt Although the external payment crisis of 1991 brought to the fore the need for debt- dominated capital account financing, the move towards full capital account liberalization has been calibrated with extreme caution. The broad approach that characterized the policy framework for capital inflows involved supplementing debt capital with non-debt capital with a clear prioritization in favour of the latter. +orei,n Dire%t In=est'ent The major policy thrust towards attracting foreign direct investment (F D Ì) began in the early 1990s by introduction of automatic approval route that empowered R B Ì to approve equity investment up to 51 per cent in select 34 priority industries. Currently, unless there is specific restriction contained in F D Ì policy, 100 per cent foreign investment is permitted under automatic route. A very limited number of activities fall under this category, viz., retail trading, atomic energy, lottery business, gambling and betting. Again, the list for F D Ì cap below 100 per cent is also quite short including broadcasting, print media, defence, insurance, asset reconstruction, investment companies, petroleum and air transport. *ortfolio In=est'ent Portfolio investment both in primary and secondary market by Foreign Ìnstitutional Ìnvestor (F Ì Ì) was opened up in 1992. At the same time, Ìndian companies were permitted to raise equity finance through issue of G D R and A D R in Europe and American markets. Policy with regard to F Ì Ì investment was progressively liberalized with total F Ì Ì share in equity being raised from 24 per cent to total sectoral cap on foreign investment. For majority of sectors this cap is 100 per cent. Besides, F Ì Ì are permitted to invest in debt instruments issued by both private corporate and the Government, and they can operate in forward market to hedge their currency risks E6ternal Co''er%ial Borro8in,s #E C B$ Permission to access E C B further contributed to integration of Ìndia's financial sector with rest of the world with corporate increasingly compared the cost of financing and switched between E C B and the domestic bank credit. Ìn the recent years, corporate have increasingly accessed commercial borrowings from abroad with net inflow on account of E C B rising from U S $5 billion in 2004-05 to more than U S $22 billion in 2007-08. However, the policies towards E C B that, inter alia, include bank loans, buyers' credit, suppliers' credit have been guided by the overall consideration of prudent external debt management by keeping the maturities long, cost low and priority for projects in the infrastructure and core sectors. O7t8ar& +lo8s Ìn line with liberalized regime with regard to inflows, outward capital flows were also progressively relaxed for both individuals and the corporate sector. Firms can invest abroad up to their net worth plus E E F C holdings and also the foreign exchange raised through A D R/G D R. This has been a key policy feature that enabled emergence of Ìndian MNCs in the recent years. B.@ DO ;E DESERVE ACCODADES> Structural transformation of almost all the segments of the economy during past two decades has brought discernible improvement in terms of efficiency, competitiveness and productivity. This reflects in economy moving over to higher growth trajectory with far greater integration with the rest of the world in terms of diversification of goods and services as well as destinations to which exports are being made. Of course, we take pride in these achievements and we together deserve it. But, there are enough reasons that we must not get complacent with regard to transformation process. We need to ask ourselves a few relevant questions. How far the benefits of economic progress have percolated down? Whether standard of living of the population has uniformly improved? Can we say economic transformation has brought prosperity to public at large and could we make dent in poverty? B.B ISSUES *o=ert3 Ìn terms of incidence of poverty measured on the basis of consumption expenditure, there is a definite improvement over the years, both in rural and urban areas. There is about 7 to 8 percentage points decline in poverty ratio in 2004-05 over 1993-94 and improvement being more predominant in the rural areas. While these numbers seem to suggest satisfactory improvement, divergence in income distribution has worsened further since the early nineties. Gini Coefficient, a standard measure of income/expenditure inequality, has further deteriorated from 32.9 per cent in 1993 to 36.2 per cent in 2004. Per capita spending in absolute terms would suggest that there is lot more to be done to fend off hunger and malnutrition. As per N S S 61st round, per capita consumption expenditure of more than 60 per cent population was less than Rupees 20 per day in 2004-05. So%ioEE%ono'i% De=elo5'ent Human Development Ìndex (H D Ì), a widely used indicator of socio-economic conditions has placed Ìndia at 132 out of 179 countries in the world in the year 2006 ÷ deterioration from a relatively better ranking of 121 in the year 1990. However, in terms of pure index, Ìndia's position did improve from 28 in 1990 to 61 in 2006, which implies countries in the world have grown and improved their lot much faster than Ìndia. This slip in ranking is broadly reflective of poor performance in terms of health and education services as shown by their respective individual rankings. Gealth Since a transition from high mortality to a state where people generally lead a long and ailment-free life is a desirable social goal, Ìndia's policies have been focused on this aspect since beginning and there has been significant improvement over the years in terms of various demographic indicators such as life expectancy, infant and child mortality and maternal mortality rates. However, in terms of international comparison. Ìndia slipped further in terms of ranking and continues to lag behind otherwise comparable countries in the world. Resources devoted to health services are much lower in Ìndia compared to other countries, even if both public and private sector expenditure is taken into account. Per capita expenditure on health services in Ìndia in 2006 has been lowest among select countries ÷ just half of that spent by Sri Lanka and a bit lower than that spent by Nigeria. While poor infrastructure is reflective of a small share of G D P devoted to health services, perhaps efforts need to be made in terms of public-private partnership and appropriate supervision of these services particularly in the public sector. To quote Report of the National Commission on Macroeconomics and Health (2005), 'The existing system of primary health care has collapsed in several parts of the country, for reasons other than under funding.' E&7%ation Ìndian Constitution had set the goal of free education for all children aged up to 14 years by 1960 and recently 86'h constitutional amendment has made free and compulsory education to all children of 6 to 14 years of age a fundamental right. Given the enormity of task, Government envisaged to shoulder primary responsibility for provision of elementary education. Overall there is improvement as discernible from gross enrolment ratio, but as per one survey conducted in 2006, 8.9 per cent of children of age 6-14 years in rural areas still remain out of school. Although in terms of public spending on education, there has been some marginal improvement from 3.6 per cent of G D P in 1993 to 4.1 per cent of G D P in 2002, reasons for poor outcome lies in sub- optimum performance of Government sector. Teacher absenteeism and achievement level (test score) are worse than low-end private schools. As per one estimate made in 2006, overall teacher absenteeism has been at 25 per cent in Ìndia, compared with 16 per cent in Bangladesh and 29 per cent in Uganda. Apart from these, quality of education is another area of major concern. As revealed by a recent survey assessing quality of education, less than 9% of student in First and Second grade could read their respective text books. Nearly half of the 51h grade students are unable to read level 2 texts. Ìmproving quality of education and skill formation is important, if we want to encash demographic dividend and retain our edge in services sector. B.C ;a3 +or8ar& Our discussion of process of transformation, its achievements as well as failures do throw up some issues which need to be addressed to ensure that economic progress is sustainable and it is percolating downwards for the benefit of the masses. More thrust on inclusive growth and redistribute justice with emphasis on the deprived society will have to be pursued. Without proper distribution of economic wealth, economic liberalization remains meaningless. A,ri%7lt7ral In=est'ent While structural transformation from agriculture to services-led growth is a positive feature, corresponding movement in terms of population dependent on respective sectors has not occurred. The share of agriculture in total income has dropped to 17 per cent; still more than 60 per cent of population continues to draw its livelihood from this sector. This workforce also accounts for sizeable proportion of poor in the country. There is an urgent need to enhance investment in this sector not only to raise crop productivity, but also to create employment opportunities outside the farming. There is a need to effectively integrate rural sector with urban economy by creating needed infrastructure, viz., roads in rural areas; electricity; major and minor irrigation projects; and cold-storage chains to provide farm producers access to urban markets. Besides, there is also a requirement felt for bringing legal reforms with regard to tenancy rights that would give a boost to contract farming and higher productivity in farming activity particularly when individual farm size is rapidly dwindling. Da"o7r Refor's The topic of Labour Laws Reforms in Ìndia has always been a matter of debate. The issue here is not to argue whether the Ìndian labour laws are rigid or liberal, but to find out whether the existing laws are helping in bringing market efficiency and productivity. We have to analyse whether the present laws are encouraging and promoting the growth of the entrepreneurs, creating a positive investment environment and opportunities. There is a need to ensure relativity in the rights of management and workers to promote healthy milieu for growth and progress. A liberal exit policy can only coexist with generous unemployment, retraining benefits and severance pay. One may also need to examine and rationalize some extant labour regulations and provisions. For instance, let us see the pension laws where the workers get the right of pension only after having devoted a minimum numbers of years in the job which in fact restrain them from availing the best opportunities in the market. The disparity between the organized and the unorganized sectors in terms of working condition and protection of employees' rights also needs to be bridged. There is a need to enhance protection of workers in the unorganized sector with provision of insurance, pension schemes, medical facility and vocational training. Ìn recent times, it has been witnessed that those countries, especially the emerging market economies where the labour laws have been rationalized and more awareness has been created in the unorganized sectors, have achieved higher growth rate of economic development. Ìf we are able to address these issues successfully, we will be deriving manifold benefits of the economic development. De'o,ra5hi% Di=i&en& Besides technology, a key factor that has immensely added to Ìndia's economic potential is its demographic advantage popularly called as 'demographic dividend'. Share of the working age group (15-64) in the population has been increasing since the 1980s and has been projected to be in the range of 62 to 68 per cent during first quarter of current century. However, for these demographic changes to provide upward push to economic growth, it needs to be accompanied by process of skill formation and employment opportunities. This would require larger investment in human capital formation and encouragement to entrepreneurial activities by creating conducing environment. Current performance of the education sector particularly in terms of quality leaves much scope for improvement. +inan%ial In%l7sion While financial sector has performed appreciably in the past two decades with gains in terms of efficiency and productivity, it has grown many folds in terms of volumes and thereby supporting overall growth in the economy. However, it is increasingly being felt that benefits of growth have not percolated down to the underprivileged sections. While a number of steps have been taken to achieve inclusive growth through various Financial Ìnclusion initiatives, these are constrained by several factors. High operating cost in remote areas, small ticket size, lack of collaterals and illiteracy have obstructed the steps towards financial inclusion. Today, availability of banking technology has brought the realization that poor are bankable with good business prospects and hence our efforts should be in the direction of using technology in such a fashion to make the transaction cost cheaper and affordable for the poor. The recent initiatives taken by the RBÌ and banks to promote financial inclusion are laudable though much has to be accomplished in the years to come. Che%2 )o7r *ro,ress. Ti%2 the Corre%t Ans8er. 97estion 1. Refor's 8ere starte& in The %hoi%es are: (1) 1981 (2) 1991 (3) 1971 (4) 1995 Ri,ht Ans8er: #!$ 1FF1 97estion !. T8in e%ono'i% i'"alan%es e6iste& &7rin, 1FF0 The %hoi%es are: (1) Fiscal crisis and external payment crisis (2) Fiscal and monetary crisis (3) Monetary and external payment crisis (4) None of the above Ri,ht Ans8er: #1$ fis%al %risis an& e6ternal 5a3'ent %risis 97estion(. Real Se%tor *oli%3 'eans fo%7s on 6 6 6 in the earl3 sta,es of refor' 5ro%ess. The %hoi%es are: (1) Mining and quarrying (2) Electricity (3) Manufacturing sector (4) None of the above Ri,ht Ans8er: #($ Man7fa%t7rin, se%tor 97estion.. E65an& I T E S. The %hoi%es are: (1) Ìnformation Technology and Electronic Services (2) Ìnformation Technology and Enabled Services (3) Ìnformation Technology and Efficient Services (4) None of the above Ri,ht Ans8er: #!$ Infor'ation Te%hnolo,3 an& Ena"le& Ser=i%es. 97estion ?. E65an& ; M A (1) Wealth and Means Advances (2) Wealth and Monetary Advances (3) Ways and Monetary Advances (4) Ways and Means Advances. Ri,ht Ans8er: #.$ ;a3s an& Means A&=an%es. 97estion@. E1*AND N E + T. The %hoi%es are: (1) Nominal Electronic Funds Transfer (2) National Electronic Funds Transfer (3) National Electronic Funds Transformation (4) None of the above Ri,ht Ans8er: #!$ National Ele%troni% +7n&s Transfer Det 7s S7' U5 To sum up, the reform process that began economic transformation since the early 1990s has been based on a broad political and intellectual consensus in the country that explains as to why there has never been any policy reversal since then. At times we have been accused to be slow in taking up reforms in certain sectors, but our stance with regard to pace and timing of reforms have been vindicated by our ability to ward off each of the crises that occurred in the global economy. Transformation of the economy, which is discernible in the form of improved competitiveness, efficiency and productivity across all the sectors, has led the economy to a higher growth trajectory. Consequent shift in relative contribution of various sectors to national income, however, brought to fore the concerns for sustainability of the transformation process and the need for an 'inclusive growth'. This would require greater focus towards investment in the sectors namely, agriculture and allied activities, small and micro enterprises, and infrastructure. The use of technology to make available 'affordable' financial and banking services to the underprivileged sections of our society for achieving inclusive growth is also our noble but critical objective. Finally, economic transformation is an ongoing process that needs to be pursued with perseverance and consensus while keeping in view their aptness to the domestic economy. Let us hope that this process continues and gains pace in the coming years. Keywords Structural reforms; Economic transformation÷Real Sector; Economic Transformation Financial Sector; Money Market; Government Securities Market; Foreign Exchange Market; Capital Market; Credit Market; Economic Transformation - Ìntegration with the Global Economy; Trade Liberalization; Capital Account; Foreign Direct Ìnvestment; Portfolio Ìnvestment; ECB; Financial Ìnclusion. END OF CHAPTER 7- ADVANCED BANK MANAGEMENT- CAÌÌB PAPER1 ADVANCED BANK MANAGEMENT UNÌT 8 ÷ Monetary Policy and Fiscal Policy STRUCTURE 8.0 Objectives 8.1 Ìntroduction 8.2 Tools of Monetary Policy 8.3 How did Monetary Policy in Ìndia Respond to the Global Financial Crisis 8.4 Fiscal Policy 8.5 F R B M Act Let Us Sum 75 eywords C.0 OBJECTIVES This chapter will be helpful in understanding: 1. Concept of Monetary Policy 2. Tools of Monetary Policy 3. Fiscal Policy, F R B M Act C.1 INTRODUCTION Monetary Policy is the process by which the government, central bank or monetary authority of a country controls: (1) the supply of money, (2) availability of money and (3) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. C.! TOODS O+ MONETAR) *ODIC) Ban2 Rate Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply. However, the role of the bank rate as an instrument of monetary policy has been very limited in Ìndia because of these basic factors: (a) The structure of interest rates is administered by RBÌ ÷ they are not automatically linked to the bank rate; (b) Commercial banks enjoy specific refinance facilities, and not necessarily rediscount their eligible securities with RBÌ at bank rate; and (c) The bill market is under-developed and the different sub-markets of the money market are not influenced by the bank rate. Cash Reser=e Ratio #C R R$ The present banking system is called a "fractional reserve banking system", as the banks are required to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for ensuring safety and liquidity of deposits. The Cash Reserve Ratio refers to this liquid cash that banks have to maintain with the Reserve Bank of Ìndia (R B Ì) as a certain percentage of their net demand and time liabilities. For example if the C R R is 10%, then a bank with net demand and time deposits of Rupees 1,00,000 will have to deposit Rupees 10,000 with the RBÌ as liquid cash. Go8 is C R R 7se& as a Tool of Cre&it Control> CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank deposits, however over the years it has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBÌ feels that the money supply is increasing and causing an upward pressure on inflation, the RBÌ has the option of increasing the CRR thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation. Stat7tor3 DiJ7i&it3 Ratio #S D R$ Statutory Liquidity Ratio refers to the amount that all banks require maintaining in cash or in the form of Gold or approved securities. Here, by approved securities we mean dated securities, government bonds and shares of different companies. This Statutory Liquidity Ratio is determined as percentage of total demand and time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on their anytime demand. The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are also considered as time liabilities. Ìn Ìndia, Reserve Bank of Ìndia always determines the percentage of Statutory Liquidity Ratio. There are some statutory requirements for temporarily placing the money in Government Bonds. Following this requirement, Reserve Bank of Ìndia fixes the level of Statutory Liquidity Ratio. At present, the minimum limit of Statutory Liquidity Ratio that is set by the Reserve Bank is 25 per cent. There are some reasons behind introducing Statutory Liquidity Ratio. The main objectives for maintaining the Statutory Liquidity Ratio are the following: 1. Statutory Liquidity Ratio is maintained in order to control the expansion of Bank Credit. By changing the level of Statutory Liquidity Ratio, Reserve bank of Ìndia can increase or decrease bank credit expansion. 2. Statutory Liquidity Ratio, in a way ensures, the solvency of commercial banks. 3. By determining Statutory Liquidity Ratio, Reserve Bank of Ìndia, in a way, compels the commercial banks to invest in government securities like government bonds. Mar2et Sta"ili-ation S%he'e #M S S$ To understand this we need to take a look at the year 2004 when F Ì Ìs (Foreign Ìnstitutional Ìnvestors) started bringing in dollars to buy Ìndian stocks. This has resulted in an oversupply of US dollars in the Ìndian market. R B Ì bought dollars, thus creating an equivalent amount of rupees. As a response to the large-scale capital inflows and the consequent problems faced in managing liquidity, the Reserve Bank introduced the Market Stabilization Scheme after consulting the Government of Ìndia for mopping up liquidity of a more enduring nature in March 2004. Under this scheme, the government would issue existing instruments, such as, Treasury Bills and/or dated securities by way of auctions under the M S S, in addition to the normal borrowing requirements, for absorbing liquidity from the system. The intention of M S S is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilization from the day-to-day normal liquidity management operations. Ìn order to provide transparency and stability to the financial markets, an indicative schedule for issuance of Treasury Bills/dated securities on a quarterly basis is being announced. Re5o Rate Repo (Repurchase) rate is the rate at which the R B Ì lends shot-term money to the banks. When the repo rate increases borrowing from RBÌ becomes more expensive. Therefore, we can say that in case, RBÌ wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Bank lending rates are determined by the movement of Repo Rate. Re=erse Re5o Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBÌ. The RBÌ uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the RBÌ will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBÌ. Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in to the banking system by RBÌ, whereas Reverse repo rate signifies the rate at which the central bank absorbs excess liquidity from the banks. O5en Mar2et O5erations #O M O$ Under the OMO, the RBÌ buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system. C.( GO; DID MONETAR) *ODIC) IN INDIA RES*OND TO TGE IDOBAD +INANCIAD CRISIS> As the crisis intensified, the Reserve Bank of Ìndia, like most central banks, took a number of conventional and unconventional measures to augment domestic and foreign exchange liquidity, and sharply reduced the policy rates. Ìn a span of seven months between October 2008 and April 2009, there was unprecedented policy activism. For example: (1) the repo rate was reduced by 425 basis points to 4.75 per cent, (2) the reverse repo rate was reduced by 275 basis points to 3.25 per cent, (3) the cash reserve ratio (C R R) was reduced by a 400 basis points to 5.0 per cent, and (4) the actual/potential provision of primary liquidity was of the order of Rupees 5.6 trillion (10.5 per cent of G D P). There are, however, some key differences between the actions taken by the Reserve Bank of Ìndia and the central banks in many advanced countries: 1. First, in the process of liquidity injection, the counter-parties involved were banks; even liquidity measures for mutual funds, NBFCs and housing finance companies were largely channeled through the banks. 2. Second, there was no dilution of collateral standards which were largely government securities, unlike the mortgage securities and commercial papers in the advanced economies. 3. Third, despite large liquidity injection, the Reserve Bank's balance sheet did not show unusual increase, unlike global trend, because of release of earlier sterilized liquidity. 4. Fourth, availability and deployment of multiple instruments facilitated better sequencing of monetary and liquidity measures. 5. Finally, the experience in the use of procyclical provisioning norms and counter- cyclical regulations ahead of the global crisis helped enhance financial stability. By synchronizing the liquidity management operations with those of exchange rate management and non-disruptive internal debt management operations, the Reserve Bank of Ìndia ensured that appropriate level of liquidity was maintained in the system, consistent with the objective of price and financial stability. The policy stance clearly reflected the forward-looking undertone, particularly the expectations of more prolonged adverse external conditions in the face of no visible risks to inflation. While the magnitude of the crisis was global in nature, the policy responses were adapted to domestic growth, inflation and financial sector conditions. R B IS Monetar3 *oli%3 Ai's to a%hie=e the +ollo8in, O"Ae%ti=es: 1. Monitor the 'global' and 'domestic' economic conditions and respond swiftly as required. 2. Ensure higher bank credit expansion to achieve higher growth but at the same time protect the credit quality. 3. Maintain price stability and financial stability. 4. Give thrust on Ìnterest Rate Management, Ìnflation Management and Liquidity management. C.. +ISCAD *ODIC) Ìn Economics, fiscal policy is the use of government spending and revenue collection to influence the economy. Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can have impact on the following variables in the economy: 1. Aggregate demand and the level of economic activity; 2. The pattern of resource allocation; 3. The distribution of income. Fiscal policy refers to the overall effect of the budget outcome on economic activity. Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. C.? + R B M ACT< The history of the Fiscal Responsibility and Budget Management Act may be summarised as follows. A committee headed by Dr. E. A. S. Sarnia was set up in January 2000 to recommend draft legislation on fiscal responsibility. This report was submitted in July 2000. The bill was introduced in Parliament in December 2000, and enacted as law in August 2003, after a period of extensive discussion and analysis. ;hat the A%t ReJ7ires The F R B M Act has four main requirements. First, it requires the Government to place before Parliament three statements each year along with the Budget, covering Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework. The content is prescribed in the Act and the format in the Rules. Second, the Act lays down fiscal management principles, making it incumbent on the Centre to 'reduce the fiscal deficit' (no target is mentioned in the Act, but the Rules prescribe 3 per cent of GDP) and, more categorically, to 'eliminate revenue deficit' by 31 March 2008. Ìt requires the government to set a ceiling on guarantees (the Rules prescribe 0.5 per cent of G D P). The Act provides that the ceilings may be exceeded on grounds of "national security or national calamity or such other exceptional grounds as the Central Government may specify." Third, in its most stringent provision, the Act prohibits the Centre from borrowing from the Reserve Bank of Ìndia ÷ that is, it bans 'deficit financing' through money creation. The R B Ì is also barred from subscribing to primary issues of Central Government securities. Temporary Ways and Means advances to tide over cash flow problems are permitted. This provision will not apply till April 2006. Exceptions are also allowed whenever the Government declares an exceptional situation, as mentioned earlier. Fourth, the Finance Minister is required to keep Parliament informed through quarterly reviews on the implementation, and to take corrective measures if the reviews show deviations. The Act provides that no deviation shall be permissible 'without the approval of Parliament'. The main theme of F R B M Act is to reduce the dependence of the Government on borrowings and help to reduce the fiscal deficit in a phased manner. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion 1. Ban2 rate is also referre& to as The %hoi%es are: (1) Discount rate (2) Subsidy rate (3) Marginal rate (4) None of the above Ri,ht Ans8er: #1$ Dis%o7nt rate 97estion !. E65an& C R R The %hoi%es are: (1) Credit Reference Rate (2) Credit Reserve Ratio (3) Cash Reserve Ratio (4) Cash Reserve Rate Ri,ht Ans8er: #($ Cash Reser=e Ratio 97estion(. E65an& S D R (1) Statutory Leverage Ratio (2) Statutory Liquidity Ratio (3) Statutory Liquidity Rate (4) Static Liquidity Ratio Ri,ht Ans8er: #!$ Stat7tor3 DiJ7i&it3 Ratio 97estion.. E65an& O M O (1) Open Market Operations (2) Open Market Organization (3) Open Monetary Operations (4) None of the above Ri,ht Ans8er: #1$ O5en Mar2et O5erations 97estion?. E65an& + R B M A%t The %hoi%es are: (1) Fiscal Responsibility and Business Management Act (2) Fiscal Role and Budget Management Act (3) Fiscal Role and Business Management Act (4) Fiscal Responsibility and Budget Management Act Ri,ht Ans8er: #.$ +is%al Res5onsi"ilit3 an& B7&,et Mana,e'ent A%t 97estion @. + R B M A%t ena%te& in The %hoi%es are: (1) 2001 (2) 2003 (3) 2004 (4) 2000 Ri,ht Ans8er: #!$ !00( Det Us S7' U5 1. Monetary policy is the process by which the government, central bank or monetary authority of a country controls: (i) the supply of money, (ii) availability of money and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. 2. Tools of Monetary Policy- Bank rate is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Cash Reserve Ratio (C R R) refers to the liquid cash that banks have to maintain with the Reserve Bank of Ìndia (R B Ì) as a certain percentage of their net demand and time liabilities. 4. Statutory Liquidity Ratio or S L R refers to the amount that all banks require maintaining in cash or in the form of Gold or approved securities. 5. Repo (Repurchase) rate is the rate at which the R B Ì lends shot-term money to the banks. Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the R B Ì. 6. Under the O M O, the RBÌ buys or sells government bonds in the secondary market. 7. Ìn Economics, fiscal policy is the use of government spending and revenue collection to influence the economy. /e38or&s Monetary policy; Expansionary policy; Contractionary policy; Tools of Monetary Policy ÷ Bank Rate; Cash Reserve Ratio; Statutory Liquidity Ratio; Repo (Repurchase) rate; Reverse Repo rate; O M O; Fiscal Policy; F R B M act. END O+ CGA*TER C H ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT UNIT F EID* Con%e5ts STRUCTURE 9.0 Objectives 9.1 Ìntroduction 9.2 Computation 9.3 Utility Det Us S7' U5 /e38or&s F.0 OBJECTIVES This chapter will be helpful in understanding: (1) GDP Concepts (2) Methods of computing G D P (3) Utility F.1 INTRODUCTION I D * Con%e5ts !ross "omestic #roduct $! " #%: Ìt is the total market value of all the final goods and services produced within the territorial boundary of a country, using domestic resources, during a given period of time, usually one year. !ross &ational 'ncome $! & '% at Market #rices is equal to G D P at market prices plus taxes less subsidies on production and imports (Net receivable from abroad) plus Compensation of Employees (Net receivable from abroad) plus property income ( Net receivable from abroad) Gross National Product (G N P) is equal to G D P plus total capital gains from overseas investment minus income earned by foreign nationals domestically. G N P is equal to G D P plus N R (Net income from assets abroad (Net Ìncome Receipts) F.! I D * COM*UTATION According to the National Ìncome Accounting, there are three ways to compute G D P: () *+penditure ,ise: Calculating the total expenditure of all the entities. -) 'ncome wise: Calculating the total incomes received by factors of production minus land, labour, capital and entrepreneur. .) #roduct wise: Calculating the total production. 1. E65en&it7re Metho& G D P is equal to consumption plus Gross investment plus Government spending plus (Exports minus Ìmports) and the formula is: G D P is equal to C plus Ì plus G plus (X minus M). /onsumption: This includes personal expenditures pertaining to food, households, medical expenses, rent, etc. !ross 'nvestments: Business investment as capital which includes construction of a new mine, purchase of machinery and equipment for a factory, purchase of software, expenditure on new houses, buying goods and services, but, investments on financial products is not included as it falls under savings. !ross spending: Ìt is the sum of government expenditures on final goods and services. Ìt includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. Ìt does not include any transfer payments, such as social security or unemployment benefits. *+ports: This includes all goods and services produced for overseas consumption. 'mports: This includes any goods or services imported for consumption and it should be deducted to prevent from calculating foreign supply as domestic supply. !. In%o'e A55roa%h G D P from the income is the sum of the following major components: 1. Compensation of employees 2. Property income 3. Production taxes and depreciation on capital /ompensation of *mployees: Ìt represents wages, salaries, and other employee supplements. #roperty income: Ìt constitutes corporate profits, proprietor's incomes, interests, and rents. ! " # at market prices measures the value of output at market prices, after adjusting for the effect of indirect taxes and subsidies on the prices. Market price is the economic price, for which goods or service is offered in the market place. ! " # at factor cost measures the value of output in terms of the price of factors used in its production. Factors of production are land, labour, capital and entrepreneur; they get remunerations in the form of rent, wages, salaries, interest and profits respectively. G D P at factor cost is equal to G D P at market prices minus (indirect taxes minus subsidies) (. *ro&7%t A55roa%h Ìn Ìndia, for all these years we have been getting GDP Product-wise i.e. we have 8 sectors, we calculate how much has been produced (value added that is) in each sector and aggregate it to get G D P figure. We also get G D P based on state levels. Real ! " # or GDP at constant price: Ìs simply the value of today's output at yesterday price (meaning some base year price). Real G D P is calculated by tracking the volume or quantity of production after removing the influence of changing prices or inflation. Ìt reflects the real growth. &ominal ! " # or G D P at current prices: represents the total money value of final goods and services produced in a given year, where the values are expressed in terms of the market prices of each year. Simply it is the value of today's output at today's price. F.( UTIDIT) 1. G D P is an `aggregate' measure. Ìt does not speak any thing about how the GDP is distributed among the population of the country. Per capita income, another derivative of G D P, also does not indicate the pattern of income distribution. Thus, a country may have high GDP but much skewed distribution of income. Such inequality in income distribution often leads to social tensions. 2. Like the inequality of income distribution among population, there could be regional disparity in G D P with a few developed states contributing the most to the country's G D P and a majority of less developed state economies contributing a meagre. This is very true of Ìndia where regional strife due to disproportionate distribution of income region- wise is a common feature. 3. Higher G D P does not necessarily imply higher welfare. Welfare is a wider concept which encompasses development in all aspects of the society, e.g., health, education, sanitation, etc., Ìndia has over time grown from a low G D P nation to high G D P nation, yet its social development indicators are not commensurately favourable. Therefore, interpretation of G D P should always be supplemented by some kind of Human Development Ìndex (H D Ì) as developed by the World Bank. 4. G D P does not reflect the total income of a country if the country is an export- oriented economy like one of those South-East Asian economies. Gross National Product (G N P) is a more accurate measure in this context, as it factors in earnings from the external sector. 5. Concepts like G D P does not throw light on how much of the population is financially excluded or included. Lower level of financial inclusion is today a global malady and therefore G D P measures should be evaluated accordingly. 6. One of the newest concepts in G D P today is the 'green' G D P. A country may be achieving high G D P but at the cost of its environmental degradation. Environmental issues in growth are quite pertinent and sensitive matters today. Statisticians all over the world are busy with developing models which can measure 'green' G D P. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion1.*ersonal Cons7'5tion e65en&it7re on ho7sehol&s &i=i&e& into< The %hoi%es are: (1) Durable goods (2) Non-durable goods (3) Services (4) All of the above Ri,ht Ans8er: #.$ All of the a"o=e 97estion !. +a%tors of *ro&7%tion are: The %hoi%es are: (1) Land, Labour and Capital (2) Assets, Machineries and Money (3) Land, Labour, Capital and Entrepreneur (4) None of the above. Ri,ht Ans8er: #($ Dan&0 Da"o7r0 Ca5ital an& Entre5rene7r 97estion (. Mar2et *ri%e is the 6 6 6 5ri%e for 8hi%h ,oo&s or ser=i%e is offere& at the 'ar2et 5la%e. The %hoi%es are: (1) Nominal Price, (2) Economic Price (3) Marginal Price, (4) Deficit Price. Ri,ht Ans8er: #!$ E%ono'i% *ri%e Det Us S7' U5 Ì. GDP is the total market value of all the final goods and services produced within the domestic economy, using domestic resources, during a given period of time, usually one year. 2. G D P at market prices measures the value of output at market prices after adjusting for the effect of indirect taxes and subsidies on the prices. 3. G D P at factor cost measures the value of output in terms of the price of factors used in its production. 4. G D P is an 'aggregate' measure. Ìt does not speak any thing about how the G D P is distributed among the population of the country. 5. Higher G D P does not necessarily imply higher welfare. Welfare is a wider concept which encompasses development in all aspects of the society, e.g. health, education, sanitation, etc. /e38or&s G D P; Consumption; Gross Ìnvestment; Government; (Exports-imports); Measures of G D P; 'green' G D P; Output; Aggregate demand; External Economy; Monetary Conditions; Financial Markets; Ìnflation Situation; Growth and Ìnflation Outlook. END O+ CGA*TER F H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ERE 1 ADVANCED BANK MANAGEMENT UNÌT 10- Union Budget STRUCTURE 10.0 Objectives 10.1 Receipts 10.2 Expenditure 10.3 Plan Expenditure 10.4 Deficit Concepts Let Us Sum Up eywords 10.0 OBJECTIVES This chapter will be helpful in understanding: 1. Revenue Concepts 2. Expenditure Concepts 3. Deficit Concepts 10.1 RECEI*TS Re=en7e Re%ei5ts 1. Ta6 Re=en7e Iross Ta6 Re=en7e 1. Corporation tax 2. Ìncome Tax 3. Other Taxes and Duties 4. Customs 5. Union Excise Duties 6. Service Tax 7. Taxes of the Union Territories. Net Ta6 Re=en7e: Gross tax revenue (Minus) N C C D transferred to the National Calamity Contingency Fund Minus States' Share !. Total NonETa6 Re=en7e Ì. Ìnterest Receipts 2. Dividend and Profits 3. External Grants 4. Other Non-Tax Revenue 5. Receipts of Union Territories. Total Revenue Receipts: Net Tax Revenue plus Total Non-Tax Revenue Capital Receipts*: Non-debt Receipts plus Debt Receipts NonE&e"t Re%ei5ts: 1. Recoveries of Loans & Advances (excludes recoveries of short-term loans and advances from States and loans to Government servants, etc.) 2. Miscellaneous Capital receipts De"t Re%ei5ts. 1. Market Loans 2. Short Term Borrowings 3. External Assistance (Net) 4. Securities Ìssued against Small Savings 5. State Provident Funds (Net) 6. Other Receipts (Net) The receipts are net of repayments. Total Receipts: Total Revenue Receipts plus Capital Receipts plus Drawdown of Cash Balance. 0inancing of 0iscal "eficit: Debt Receipts + Draw-Down of Cash Balance 10.! E1*ENDITURE NonE*lan E65en&it7re Re=en7e E65en&it7re 1. Ìnterest Payments and Prepayment Premium 2. Defence 3. Subsidies 4. Grants to State and U.T. Governments 5. Pensions 6. Police 7. Assistance to States from National Calamity Contingency Fund 8. Economic Services (Agriculture, Ìndustry, Power, Transport, Communications, Science & Technology etc.) 9. Other General Services (Organs of State, Tax Collection. External Affairs etc.) 10. Social Services (Education, Health, Broadcasting, etc) 11. Postal Deficit 12. Expenditure of Union Territories without Legislature 13. Amount met from National Calamity Contingency Fund 14. Grants to Foreign Governments Ca5ital E65en&it7re. 1. Defence 2. Other Non- Non-plan Capital Outlay 3. Loans to Public Enterprises 4. Loans to State and U.T. Governments 5. Loans to Foreign Governments 6. Others &on-plan *+penditure: Revenue Non-Plan Expenditure plus Capital Non-Plan Expenditure 10.( *DAN E1*ENDITURE Re=en7e E65en&it7re 1. Central Plan 2. Central Assistance for State & Union Territory Plans Ca5ital E65en&it7re 1. Central Plan 2. Central Assistance for State & Union Territory Plans #lan *+penditure: Revenue Expenditure plus Capital Expenditure Total *+penditure: Total Non-Plan Expenditure plus Total Plan Expenditure 10.. DE+ICIT CONCE*TS 1. Revenue deficit is the excess of revenue expenditure over revenue receipts. !. !ross fiscal deficit is the excess of total expenditure including loans, net of recoveries over revenue receipts (including external grants) and non-debt receipts. (. &et fiscal deficit is the difference between gross fiscal deficit and net lending. .. !ross primary deficit is the difference between the gross fiscal deficit and interest payments. ?. &et primary deficit denotes net fiscal deficit minus net interest payments. @. The net R B Ì credit to the Central Government is the sum of increase in the Reserve Bank's holding of 1) Treasury Bills, 2) Government of Ìndia dated securities 3) rupee coins and 4) Loans and Advances from the Reserve Bank to centre since April 1, 1997 adjusted for changes in Center's cash balances with the Reserve Bank. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion1. E65an& N C C D The %hoi%es are: (1) National Council on Crime and Delinquency (2) National council on Credit and Debentures (3) National council on Commerce and deregulation (4) None of the above Ri,ht Ans8er: 1$ National Co7n%il on Cri'e an& DelinJ7en%3 97estion!. *i%2 o&& 'an o7t The %hoi%es are: (1) Customs (2) Service Tax (3) Ìnterest Receipts (4) Ìncome Tax Ri,ht Ans8er: #($ Interest Re%ei5ts 97estion(. *i%2 o&& 'an o7t The %hoi%es are: (1) Securities issued against Small Savings (2) Recoveries of Loans & Advances (3) State Provident Funds (4) Other Receipts Ri,ht Ans8er: #!$ Re%o=eries of Doans M A&=an%es 97estion.. *i%2 o&& 'an o7t. The %hoi%es are: (1) Loans to Public Enterprises (2) Pensions (3) Subsidies (4) Police Ri,ht Ans8er: #1$ Doans to *7"li% Enter5rises 97estion ?. Net fis%al &efi%it is the &ifferen%e "et8een The %hoi%es are: (1) gross fiscal deficit and net interest payments (2) gross fiscal deficit and interest payments (3) gross fiscal deficit and net lending (4) None of the above Ri,ht Ans8er: #($ ,ross fis%al &efi%it an& net len&in, Det Us S7' U5 () &et Ta+ Revenue: Gross tax revenue (Minus) N C C D transferred to the National Calamity Contingency Fund Minus States' Share. -) Total Revenue Receipts: Net Tax Revenue plus Total Non-Tax Revenue; .) Total Receipts: Total Revenue Receipts plus Capital Receipts plus Draw-Down of Cash Balance. 1) Total *+penditure: Total Non-Plan Expenditure plus Total Plan Expenditure /e38or&s Growth-oriented budget; Revenue Receipts; Capital Receipts; Total Receipts; Non-plan Expenditure; Plan Expenditure; Total Expenditure; Revenue Deficit; Fiscal Deficit; Primary Deficit. END O+ CGA*TER 10E ADVANCED BAN/ MANAIEMENTE C A I I B *A*ERE1 ADVANCED BANK MANAGEMENT UNÌT-11 Challenges Facing Ìndian Economy STRUCTURE 11.0 Objectives 11.1 Ìntroduction 11.2 Unique Features of the Ìndian Economy 11.3 Concerns Let Us Sum Up eywords 11.0 OBJECTIVES This chapter will be helpful in understanding: 1. Features of Ìndian Economy 2. Challenges facing Ìndian Economy 11.1 INTRODUCTION From the perspective of Emerging Market Economies (EMEs) and particularly for that of Ìndia, there are five concerns. These are: first, timing of exit from the accommodative monetary policy in the context of rising food price-led inflation but still weak growth; second, the possibility of another surge in capital flows, especially if we turn out to be an outlier in withdrawal of monetary stimulus; third, monetary transmission mechanism as it is evolving from the crisis period; fourth, return to fiscal consolidation and quality of fiscal adjustment; and finally, the implications of the efforts towards financial stability on financial inclusion and growth. 11.! UNI9UE +EATURES O+ TGE INDIAN ECONOM) There are a few unique features to the Ìndian economy. What are the unique features of the Ìndian economy that distinguish it from other EMEs? First, our growth is driven by domestic demand ÷ both consumption and investment. Consumption and saving are well balanced. Ìn Ìndia, the share of private final consumption expenditure in GDP is around 55 per cent. Our savings rate is 37.7 per cent and investment rate is 39.1 per cent. Second, twin deficits÷fiscal as well as current account deficit. Ìndia was on a path of fiscal consolidation before the crisis, but got off track because of the counter cyclical spending necessitated by the crisis. Unlike major EMEs, which are running current account surpluses, we have recorded deficits on the current account. Although current account deficits have been modest, the deficit reached a high of 2.6 per cent of GDP in 2008-09 but is expected to moderate during 2009-10. Third, given the right balance between domestic consumption and saving on the one hand, and infrastructural bottlenecks in major areas (such as power, roads, urban infrastructure as also social infrastructure) on the other, Ìndia is essentially a supply- constrained economy. Just before the crisis, such supply concerns led to a view that there might be overheating in the economy. Generally, weak external demand has led to some externally induced cyclical slowdown. However, as the global economy recovers, supply constraints are again expected to be binding. 11.( CONCERNS +irst Con%ern: *+it from 2ccommodative Monetary #olicy: !rowth vs) 'nflation While there is broad agreement that we need to exit from the present excessively accommodative monetary and fiscal policies, there is less agreement on when and how we should exit. There are incipient signs of recovery. Ìndustrial production has picked up in the past couple of months, but export growth remains negative. Business confidence surveys suggest recovery from the troughs touched a year ago although the confidence levels remain below the earlier peaks. Even as recovery remains weak, consumer price inflation (CPÌ) is running in double digits on the back of high food prices. Both Headline inflation (WPÌ) and Core inflation (CPÌ) are on the increase. The food inflation is a matter of concern. Higher food prices in our case are partly a result of the structural demand-supply imbalances. At present, cyclical factors are also at play. Monsoon in the current season, which ended on September 30, has been the weakest since 1972. Agricultural output is expected to suffer and this could keep upward pressure on food prices in the coming months. High food prices are, therefore, a mix of structural and cyclical factors. While the buffer stock of food grains and better supply management could mitigate the adverse effects to an extent, imports are not an easy solution given the requirement. Although inflation pressures emanating from higher food prices may limit the scope for monetary policy action, there are implications for inflation expectations. Furthermore, unlike the major advanced economies, growth remains positive. Real GDP growth was 6.7 per cent in 2008-09 and is expected to be 6.0 per cent (with an upward bias) as per the Reserve Bank's growth projections. Ìn view of the country specific features, we may need to exit from accommodative monetary policy earlier than advanced economies. This calls for careful management of trade-offs: growth concerns warrant a delayed exit, but inflation concerns call for an earlier exit. An early exit on inflation concerns runs the risk of derailing the fragile growth, while a delayed exit may engender inflation expectations. Se%on& Con%ern: Mana,e'ent of Dar,e an& Volatile Ca5ital +lo8s Ma3or central banks ÷ such as the US Fed, the ECB, and the BoE ÷ have flushed their financial systems with unprecedented amount of liquidity. Till the first quarter of 2009, this liquidity was finding its way back to the central banks as excess reserves because of risk aversion. Risk appetite is now returning. There are signs of recovery in portfolio investments to the EMEs. For instance, portfolio investments by FlÌs in the Ìndian equity market amounted to US$ 13.6 billion in the period April 1 ÷ September 18, 2009 as against outflows of US$ 5.2 billion in the corresponding period of 2008 reflecting a turnaround of almost US$ 19 billion. Moreover, as noted above, in view of incipient inflationary pressures, policy rates in our case may have to be tightened ahead of those in advanced economies. The resultant larger interest differential may attract larger capital inflows. Will capital inflows be modest or turn into a flood as in 2007? The latter concern is particularly relevant in view of abundant liquidity in the major advanced economies. What will the implications be for exchange rates? Ìn Ìndia, the current account is in modest deficit; hence large and volatile capital flows can impose macroeconomic costs. Emerging market central banks have three options in managing capital flows. The first option is for the central bank not to intervene in the forex market and let the exchange rate bear the burden of adjustment. Will undue exchange rate appreciation not further widen the current account and what will the implications be for future sustainability? Will exchange rate appreciation help to contain inflation? These are the questions to address if this option is adopted. Second, the central bank can intervene in the forex market, but refrain from sterilization. Such an approach runs the risk of excessive growth in monetary and credit aggregates which can lead to higher inflation as well as credit and investment booms and create financial fragility. The third option is to sterilize the interventions. Ìrrespective of the method of sterilization, the financial cost of sterilization in terms of national balance sheet is obviously ultimately borne by the government even though direct costs may be borne by separate agencies. Sterilized intervention can exacerbate fiscal pressures, but this needs to be assessed against the benefits of macro-financial stability. Thir& Con%ern: DeE%lo,,in, Monetar3 Trans'ission Me%hanis' Following the collapse of Lehman Brothers, the global economic outlook deteriorated sharply, and the Ìndian economy got impacted by the contagion through all the channels ÷ the financial channel, the real channel and the confidence channel. The Reserve Bank's crisis response included, like in the case of other central banks, both conventional and unconventional measures. Ìn response to the easing of policy interest rates and abundant liquidity made available, market rates eased significantly. Yields on 10-year central government securities fell from 8.6 per cent at end-September 2008 to 5.3 per cent by end-December 2008. This trend has since reversed with yields hardening since the beginning of the current calendar year on the back of large and abrupt increase in the government borrowing programme. Ìn contrast, interest rates on bank deposits and loans have exhibited stickiness. While the Reserve Bank cut the effective policy rate by 575 basis points, banks' Benchmark Prime Lending Rates (BPLRs) have seen a reduction of only 100-275 basis points. This stickiness has impeded monetary transmission and blunted the intended impact of policy actions- What is the explanation for the stickiness in the interest rate structure of banks? There are several factors that cause this stickiness ÷ the higher rates of interest offered by the small savings instruments which discourage banks from reducing deposit rates, the high cost of deposits raised by banks during earlier tighter monetary policy regime which raised their weighted average costs, and the large government borrowing programme which pushed up yields on government securities. These factors, which impeded monetary transmission, were in play even before the crisis. A definite task going forward will be to address the impediments to monetary transmission. +o7rth Con%ern: +is%al Sti'7l7s H ;ith&ra8al an& 97alit3 of A&A7st'ent Like in other economies, fiscal stimulus measures and weakening of economic activity have led to substantial increase in our fiscal deficits. The Central Government's fiscal deficit is budgeted to jump from 2.7 per cent of GDP in 2007-08 to 6.8 per cent in 2009- 10; the combined fiscal deficit of the Centre and the states is expected to increase from 4.2 per cent of GDP to 10.2 per cent over the same period. These deficits are large and need to be rolled back. What is the scope for adjustment? What lesson does our past experience offer? As a result of the discipline imposed by the Fiscal Responsibility and Budget Management (FRBM) Act, the Centre's fiscal deficit came down from 6.2 per cent of GDP in 2001-02 to 2.7 per cent in 2007-08. Over the same period, the deficit of the state governments declined from 4.1 per cent of GDP to 1.5 per cent. Thus, we saw a large adjustment over a relatively small period. This past experience with fiscal adjustment may raise hopes that we will be able to roll back the recent fiscal deficits. Such a simplistic approach may be misleading. A large part of our fiscal deficit is structural and not cyclical. Also, at least a part of fiscal consolidation resulted from high growth, not the other way round. Ìt is important to acknowledge this in order to define the problem and assess the enormity of the challenge. Three issues are important in this context. First, this concept of 'fiscal adjustment over a cycle' is inadvisable for us. Adjustment over a cycle is for mature and advanced economies. Even there it does not work ÷ the UK, for instance, was running its highest fiscal deficit at the peak of the economic cycle. We will be safest sticking to a single formula and tying ourselves down to annual, inflexible targets. This is a blunt but safe way of de-linking fiscal adjustment from democratic pressures. Second, we must focus on the quality of fiscal adjustment, not just chase a numerical target. The ratio of capital outlay to GDP for the Central Government has stagnated between 1 and 2 per cent of GDP since the early 1990s from around 2-3 per cent in the preceding decade. Third, we cannot sit back and hope that tax increase will deliver fiscal consolidation on a platter. Revenue expenditure has increased from around 12 per cent of GDP during the period 2000-08 to over 15 per cent now. We need to work seriously on expenditure compression. This is going to be politically challenging both at the Centre and in the States, but it needs to be done regardless. +ifth Con%ern: +inan%ial Sta"ilit3. +inan%ial In%l7sion an& Iro8th Given the enormity of the crisis, financial sector regulation is being tightened under the aegis of international bodies such as the Basel Committee on Banking Supervision and Financial Stability Board. There are proposals that would raise the reserve requirement of banks. New regulations for liquidity requirements are also going to be in place. There are also proposals to require banks to hold government securities. Many of these measures are necessary. But we need to recognize that all such proposals will have the impact of increasing the banks' funding costs which will translate into higher lending rates. How will banks react to such higher costs? Will this lead to an erosion of banks' social responsibility towards the poorer and other needy segments of the society? Ìn economies such as Ìndia, a large part of population remains financially excluded. We will need to ensure that efforts at financial inclusion do not get negated by the ongoing tightening of the regulatory regime. Ìn order to safeguard financial stability, we have traditionally used a variety of prudential measures such as specifying exposure norms and pre-emptive tightening of risk weights and provisioning requirements. But these measures are not always costless. For instance, tightening of risk weights arguably tempers the flow of credit to certain sectors, but excessive, premature or unnecessary tightening could blunt growth. Similarly, exposure norms offer protection against concentration risks; however, such limits could restrict the availability of credit for important growth sectors. This is a live issue in our country in the context of the immense needs of infrastructure financing. Thus, as in the case of price stability, central banks face the challenge of managing the trade-off between financial stability and growth. Ìt needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgment rather than analytical skill. This judgment skill is the one that central banks, especially in developing countries such as Ìndia, need to hone as they simultaneously pursue the objectives of growth and financial stability. Che%2 )o7r *ro,ress Ti%2 the Corre%t Ans8er 97estion 1. *i%2 o&& 'an o7t The %hoi%es are: (1) Brazil (2) France (3) Ìndia (4) Russia Ri,ht Ans8er: #!$ +ran%e 9estion!. E65an& EMEs The %hoi%es are: (1) External Marketing Economics (2) Environmental Efficiency (3) Emerging Market Economies (4) None of the above Ri,ht Ans8er: #($ E'er,in, Mar2et E%ono'ies 97estion (. E65an& B*DRs The %hoi%es are: (1) Benchmark Prime Lending Rates (2) Benchmark Prime Loan Rates (3) Benchmark Process Lending Rates (4)None of the above Ri,ht Ans8er: #1$ Ben%h'ar2 *ri'e Den&in, Rates Det Us S7' U5 1. UniJ7e feat7res of the In&ian e%ono'3 a. Growth is driven by domestic demand b. Twin deficits ÷ fiscal as well as current account deficit. c. Supply-constrained economy. !. +i=e %on%ern areas. (a) Timing of exit from the accommodative monetary policy in the context of rising food price-led inflation but still weak growth. (b) The possibility of another surge in capital flows, especially if we turn out to be an outlier in withdrawal of monetary stimulus. (c) Monetary transmission mechanism as it is evolving from the crisis period. (d) Return to fiscal consolidation and quality of fiscal adjustment. (e) The implications of the efforts towards financial stability on financial inclusion and growth. /e38or&s Emerging Market Economies; Domestic demand; Twin deficits; Supply-constrained economy; Financial, Stability; Fiscal Stimulus: De-clogging Monetary Transmission Mechanism; Management of Large and Volatile Capital Flows. END O+ CGA*TER 11E ADVANCED BAN/ MANAIEMENTE CAAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 12- Time Value of Money STRUCTURE 12.0 Objectives 12.1 Ìntroduction 12.2 Common Sense Approach to Present Value 12.3 Calculation of Present Value 12.4 Relation of Risk to Present Value 12. 5 Discounting/Compounding a Cash Flow 12.6 Annuity 12.7 Growing Annuities 12.8 Perpetuity 'eywords)Glossary *uestions Appendi+ , -resent .alue Ta%le 1!.0 OBJECTIVES The objective is to understand the concept that money has a time value. The notion that, a rupee today is preferable to the rupee in the future is intuitive enough for most people to grasp. This can be grasped without the use of models and mathematics. The concept of present value enables us to calculate exactly how much a rupee in the future is worth today. Ìn this chapter we shall examine the following questions: 1. What do we mean by time value of money? 2. What is the basis for present value? What factors affect the timing of cash flows and how does this affect the time value? 1!.1 INTRODUCTION The principles of present value are used in Corporate Finance by evaluating projects and valuation of company shares and also in personal finance and investment. Present value is a concept which shows that money has a time value. Ìt is an intuitive and simple concept, simple to calculate and can be applied in a wide range of situations in corporate finance. We can use this concept in buying a house, saving for a child's education, picking a project. That money has time value stems from the concept that the value of money gets eroded by the concept of inflation. How often have we heard our elders say that a kilo of rice was so cheap or that a house was so cheap? How often are clothes cheaper, education cheaper and all the common essentials becoming dearer year after year? Ìn the following section you will understand the concept and learn to apply it in real-life examples. 1!.! COMMON SENSE A**ROACG TO *RESENT VADUE A cash flow in the future is worth less than a similar cash flow today because: 1. People prefer present consumption to future consumption. People would have to be offered more in the future to give up present consumption. 2. Due to inflation, the value of money/currency depreciates or erodes over a period of time. This happens due to inflation. The greater the inflation, the greater is the erosion in the value of the rupee in the future. 3. Due to the uncertainty of receiving the cash flow in the future the value of the cash flow in the future reduces further. This means there is a risk associated with receiving the cash flow in future and this reduces the value associated with the cash flow. Higher the risk more is the erosion in value. The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the dis#ount rate. ;hat is Dis%o7nt Rate> The discount rate is a rate at which present and future cash flows are traded off. Ìt incorporates the following: 1. The preference for current consumption (greater preference ÷ higher discount rate). 2. Expected inflation (higher inflation ÷ higher discount rate). 3. The uncertainty in the future cash flows (higher risk ÷ higher discount rate). A higher discount rate will lead to a lower present value for future cash flows. Tra&e off in Cons7'5tion o=er Ti'e Although individuals prefer present consumption to future consumption, the degree of this preference varies across individuals/ across time, across different places. This trade-off between present consumption (C0) and future consumption (C1) can be explained as follows. People may get the same amount of money in each period and they may either consume it or save it or lend it. A may choose to consume the whole amount. B may consume more money by borrowing. C may consume less, save and lend the remaining portion. Ìf the preference for current consumption is strong, then we have to offer more in terms of future consumption to give up current consumption. Thus there is always a trade off which is reflected by the high-real rate of return or discount rate. Ìf the preference for current consumption is weak then a person can settle for a lower real rate of return or discount rate. The assumption here is that any money saved will always be lent out, because it can earn a return for the saver. The story of the grasshopper and the ant reflects this. The grasshopper may make merry and use all of his money whereas the ant may save to enjoy during winter. Many old couples enjoy their retirement because they have intuitively used the concept of time value of money properly and when their earning capacity goes down they can enjoy the fruits of their savings and investment decisions. 1!.( CADCUDATION O+ *RESENT VADUE The process of discounting future cash flows converts them into present cash flows. Conversely, the process of compounding converts present cash flows into future cash flows. Cash flows at different points of time cannot be compared and aggregated unless they are all brought to the same point in time before we can compare or aggregate them. There are different types of cash flows such as simple cash flows, annuities, perpetuities, etc. Si'5le Cash +lo8 A simple cash flow is a single cash flow in a specified future time period. On a time line, 0 to time t, it occurs at time t. This cash flow can be discounted back to the present, using a discount rate that reflects the uncertainty of the cash flow. Conversely, cash flows in the present can be compounded to arrive at an expected future cash flow. "iscounting is the process by which a cash flow, which is expected to occur in the future, is converted to its present value. /ompounding is the process by which a cash flow today is converted into its expected future value. Cal%7latin, *resent Val7e The present value of Rupees 100,000 a year from now must be less than Rupees 100,000 today. Thus, the present value of the future payment can be found out by multiplying the payment amount with the discount factor which is less than 1. Ìf the discount factor is more than 1, a rupee today would be less worthy than a rupee tomorrow. Ìf C1 denotes the expected payment at period 1, one year hence then *resent Val7e #*V$ is e4ual to Dis%o7nt fa%tor '7lti5lie& "3 C1 Let us now see as to how to work out the discount factor. Let us say that rate of return at which present value PV will become C1 at the end of period 1 is Ì per cent per period. Ìnterest for 1 period, ÌNT1 is equal to PV multiplied by i divided by 100 Ìf we denote i divided by 100 by r, then ÌNT1 is equal to PV multiplied by r Cash flow at the end of period 1 will be C1 is equal to P V plus PV multiplied by r equal to P multiplied by (Ì plus r) Suppose, now we have 2 periods (say 2 quarters) at the end of which value becomes C2. Ìnterest rate is i per cent for one period, and r is equal to i divided by100. We have seen above, at the end of period 1, cash flow C1 will be C1 is equal to PV multiplied by (1 -lus r) Now interest at the end of second period will be ÌNT 2 is equal to C1 multiplied %y r is equal to PV multiplied by, (1 plus r), multiplied %y r And total cash flow C2 will be C2 is equal to C1 plus ÌNT 2 Is equal to PV multiplied %y (Ì plus r) plus PV multiplied %y (Ì plus r/ multiplied %y r C ₂is equal to -. multiplied %y( (1 plus r) multiplied by (1 plus r) Is equal to PV multiplied by (1 Plus r) whole square Similarly at the end of 'nth' period, amount Cn will work out to be Cn is eJ7al to *V multiplied by #( plus r$ to the 5o8er of n0 8here r is eJ7al to i &i=i&e& "3 100. E6a'5le 1 Present value is Rs.10, 000 Ìnterest rate is 12 per cent per annum. Ìnterest is compounded on quarterly basis. What will be the cash flow at the end of first year? Now there are 4 quarters (as compounding is quarterly) Ìnterest rate per quarter is 3 per cent Thus, C ₄is equal to PV multiplied %y [1plus Ì divided by 100]⁴ is equal to 10,000 multiplied %y (1.03)⁴ is equal to 10000 multiplied %y (1.0609)² is equal to 10000 multiplied %y (1.12550881)² is equal to 12550.88 Cash flow at the end of the first year will be Rupees 12,550.88. Therefore, present value of Rupees. 12,550.88 due at the end of one year would be Rupees. 10,000. E6a'5le ! Cash flow at the end of one year is Rupees.10, 000. Discount rate is 8 per cent at quarterly rests. What is the present value? C ₄is equal to PV multiplied by 1plus 2divided by 100 10,000 is equal to PV multi plied by (1 .024)² PV is equal to 10,000 di$ided %y (1.02)⁴ Is equal to 10,000 di$ided %y 11.02/3 multiplied %y 11.02/3 Is equal to 10,000 di$ided %y 11.0404/3 Is equal to 9611.6880 divided by 1.0404 Is equal to 5267.48 E6a'5le ( You are considering investing in a house or property worth Rupees 4,00,000 today and your real estate advisor has estimated that the cost would go up to Rupees 5,00,000 in a year. That is not the only way you can earn money as you have various investment options. You can invest in Public Provident Fund with an interest rate of 8 per cent p.a. How much would you have to invest in PPF to receive Rupees 5, 00,000 after a year? That is easy as the interest rate is 8 per cent, you would have to invest Rupees 5, 00,000 divided by 1.08, which is Rupees 462963. Thus the building investment is a better option as you get a higher rate of return. However you must bear in mind that the real estate investment has a higher risk in terms of variability of return. Thus risk is related to return whereas the PPF option has a lower risk and lower return. To calculate present value, we discount the expected cash flow by the rate of return offered by equivalent investment alternatives in the capital or financial markets. This rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of capital. Ìt is called opportunity cost because it is the return forgone by investing in the project rather than investing in securities. Ìn our example the opportunity cost was 8 per cent. Present value was obtained by dividing Rupees 5, 00,000 by 1.08. PV is equal to Discount factor multiplied %y C is equal to 1 ₁ di$ided %y1 (1 plus r) multiplied by C₁ is equal to 5, 00,000 divided by1.08 is equal to 4, 62,963 Net *resent Val7e When we deal with number of cash flows that could be payouts and pay ins, we work out present value of each cash flow. Pay ins are assigned positive signs and pay outs have negative signs. Total of all the present values with respective signs is called Net Present Value. For example, we have following cash flows Today ÷ pay out of Rupees. 10,000 After one year ÷ pay in of Rupees.6, 500 After two years - pay in of Rupees. 9,000 After two years pay out of Rupees. 1,000 Now, assuming discount rate of 10 per cent and compounding is on annual basis, present value of these 4 cash flows will be as follows: PV ₁is equal to Minus 10,000 as it is payout PV ₂is equal to 6,500 di$ided %y (1 plus10 di$ided %y 100) is equal to Plus 5,909 PV3 is equal to Plus 9,000 di$ided 1.1² is equal to Plus 9,000 di$ided %y 1.21 is equal to Plus 7,438 PV ₄is equal to Minus 1,000 di$ided %y1.21 is equal to Minus 729.48 Now net present value NPV is equal to PV plus PV plus PV plus PV ₁ ₂ ₃ ₄ Is equal to (Minus10, 000) Plus (5,909) Plus (7,438) Plus (Minus826) is equal to 13,347 Minus 10,826 is equal to Plus 2, 521 Net Present Value or Net Present Worth is defined as algebraic total of present value (PV) of a time series of cash flows. Ìt is a standard method for using the time value of money to appraise long-term project. Ìt is used for capital budgeting and widely used throughout economics. Ìt measures excess or shortfall of cash flows, in present value terms. Ìt enables comparisons of cash flows over different time horizons. Dis%o7nt Rate The rate used to discount future cash flows to their present values is a key variable in the process. A firm's cost of capital or weighted average cost of capital is often used for this purpose. Another approach to choosing the discount rate factor would he to take into account return in alternative scenario, say, return on risk free investments. Ìt is also appropriate to use variable discount rates for cash flows at different time periods. This would reflect yield curve premium for long-term debt. For some investoRs, they may have targeted rate of return. This desired rate of return, if used as discount rate, would provide direct comparison with profitability of the project. When desired rate is used as discount rate and NPV > 0, it gives signal that the project may be accepted. Ìf NPV < 0, the project should be rejected. The situation of NPV is equal to 0 indicates neutral or indifferent decision. O55ort7nit3 Cost Ìt is not wise to keep money idle and not earn any return on that. Normally, a person would keep his surplus in a bank's fixed deposit, which is considered as a risk-free investment. Return in risk free investment such as bank's fixed deposit or government securities is the opportunity cost. When you invest in some business project or real estate or commodities/stock market, you forgo your return in such risk-free avenues. Returns from such ventures, projects are expected to be more than the returns on risk- free investments i.e. opportunity cost. Thus, opportunity cost is an important benchmark while making any investment decision. Opportunity cost is defined as return or income forgone in investing in a particular project instead of investing the same in risk-free securities. 1!.. REDATION O+ RIS/ TO *RESENT VADUE Ìn many of our calculations, we feel that it is enough to compare the present values and aggregates. However, we make the unrealistic assumption of assigning the same level of risk and taking decisions based on the comparative returns of alternative means of investments. The real estate advisor or property advisor cannot be sure about the return in the market. Ìf the future value of this property is risky, our calculation is wrong. Public Provident Fund is certainly less risky, as it is akin to government security. Thus, if you were asking someone else to invest in this property along with you, they may not agree to give you the present value amount but something less than that. Thus, we invoke another financial principle that a safe rupee is worth more than a risky one. Thus, we do not use the same discount factor while comparing alternative investment avenues. The discount rate for PPF may be 8 per cent or 0.08 but the discount rate for the building property may be 11 per cent or 0.11. Only after the present values are calculated using these two different discount rates, the best investment avenue or project is decided. Most investors avoid risk when they can do so without sacrificing return. However, the concepts of present value and the opportunity cost of capital still make sense for risky investments. Ìt is still proper to discount the payoff by the rate of return offered by an equivalent investment. But we have to think of expected payoffs and the expected rates of returns on other investments. Effe%t of Inflation on Dis%o7nt Rate: The effect of inflation on present value is evident. Ìt reduces the purchasing power of future cash flows. This adjustment reduces the value of future cash flows. These real cash flows will have to be reduced further to reflect real returns (i.e. the tradeoffs between current and future consumption) and any uncertainty associated with the cash flows to arrive at the present value. Thus, an investor who expects to make Rupees 11 lakhs a year from now will have to reduce this expected cash flow to reflect inflation rate and arrive at the present value. Ìf the inflation rate is 10 per cent, the present value would be Rupees 10 lakhs in this case. The general formula for converting nominal cash flows at a future period't' to real cash flows is Real Cash Flow is equal to (Nominal cash flow) divided by (1 + Ìnflation rate) Effect on Risk on Discount Rate: Although both the preference for current consumption, and expected inflation affect the present value of all cash flows, not all cash flows are equally predictable. Promised cash might not be delivered for a number of reasons: the promisor might default on the payment (Ìnterest and investment not received as company winds up); the promisee might not be around to receive payment ÷ (might have died) or some other contingency or happening may intervene to prevent the promised payment or to reduce it. The greater the uncertainty associated with a cash flow in the future, the higher the discount rate used to calculate the present value. Resultantly, the present value of that cash flow will consequently be lower. E6a'5le You have decided to invest in a construction of an office building. The project's future value is equal to its future income discounted at the rate of return offered by say, government securities. We can say this in another way. Our building venture is worth undertaking because its rate of return exceeds its cost of capital. The rate of return is simply the profit as a proportion of the initial outlay. Return is equal to Profit divided by investment is equal to (5, 00,000 minus 4, 30,000) divided by4, 30,000 is equal to (70,000) - (4,30,000) is equal to 0.163 about 16per cent The cost of capital is the return foregone by not investing in securities. Ìf the investment is made in government securities, it would give return of 8 per cent p.a. Return of 16 per cent on building far exceeds 8 per cent opportunity cost. Ìt is therefore worthwhile to invest in building project. We have two equivalent decision rules for capital investment. 1. Net Present Value Rule: Accept investments that have positive net present values. Rate of Return Rule: Accept investments that offer rates of return in excess of their opportunity costs of capital. 1!.? DISCOUNTINI4COM*OUNDINI A CASG +DO; Discounting a cash flow converts it into present value rupees and enables the user to do several things. First, once cash flows are converted into present value, they can be aggregated and compared. Second, if present values are estimated correctly the user should be indifferent between the future cash flow and the present value of the cash flow. Other things remaining equal, the present value of a cash flow will decrease as the discount rate increases. Thus present value is a decreasing function of the discount rate. Present value of a cash flow also decreases as the period of future flow increases. Thus present value is also a decreasing function of the time period. Co'5o7n&in, a Cash +lo8 Current cash flows can be moved into the future by compounding the cash flow at the appropriate discount rate. The future value of a simple cash flow is FV is equal to CF ₀ multiplied %y (Ì + r) º Where CF0 is equal to Cash Flow Now r is equal to Discount Rate n is equal to number of time periods The compounding effect increases with both the discount rate and the compounding period. Co'5o7n&in, is the process by which cash flows are converted from present value to future value. I""otson an& SinJ7efiel&Ls St7&3 As the length of the holding period is extended, small differences in discount rates can lead to large differences in future value. Ìn a study of returns on stocks and bonds between 1926 and 1992, Ìbbotson and Sinquefield found that stocks on the average made 12.4 per cent, Treasury Bonds made 5.2 per cent, and Treasury Bills made 3.6 per cent. Assuming that these returns continue into the future, the table below provides the future value of USD 100 invested in each category at the end of a number of holding periods ÷ Ì year, 5 years, 10 years, 20 years, 30 years and 40 years. The differences in future value from investing at these different rates of return are small for short compounding periods (such as one year) but become larger as the compounding period is extended. For instance, with a 40 year time horizon, the future value of investing in stocks, at an average return of 12.4 per cent, is more than 12 times larger than the future value of investing in Treasury bonds at an average return of 5.2 per cent and more than 25 times the future value of investing in Treasury Bills at an average return of 3.6 per cent. TABLE 12.1 1 112.40 108.20 106.90 8 1:5.40 127.78 115.64 10 621.79 199.02 142.46 20 1068.52 2:8.92 202.79 60 6664.17 48:.85 277.56 40 10:61.60 :85.97 411.82 The R7le of B!E A short%7t to esti'atin, the Co'5o7n&in, effe%t Ìn a pinch, the rule of 72 provides an approximate answer to the question 'How quickly will this amount double in value? Dividing 72 by the discount or interest rate used in the analysis. Thus, a cash flow growing at 6 per cent per annum will double in value in approximately 12 years, while a cash flow growing at 9 per cent per annum will double in value in approximately 8 years. Effe%ti=e Interest fate This is the true rate of interest, taking into account the compounding effects of more frequent interest payments. +reJ7en%3 of Dis%o7ntin, an& Co'5o7n&in, Frequency of compounding affects both the future and present values of cash flows. Ìn the preceding examples, the cash flows were assumed to be discounted and compounded annually ÷ that is, interest payments and income were computed at the end of each year, based on the balance at the beginning of each year. Ìn some cases, however, the interest may be computed more frequently, such as on a monthly or quarterly basis. Ìn these cases, the present and future values may be very different from those computed on annual basis. The stated interest rate on an annual basis can deviate significantly from the effective or true interest rate. The effective interest rate can be computed as follows. Effective Ìnterest Rate is equal to (1plus r divided n) º ÷1 where n is equal to number of compounding periods (quarterly - 4; monthly - 12) and r is annual rate. For Ìnstance, 10 per cent annual interest rate, if there is semi-annual compounding, works out to an effective interest rate of Effective Ìnterest Rate is equal to (1.05² ÷ 1) is equal to (1.1025 ÷ 1.0) is equal to 10.25 per cent. As compounding becomes continuous, the effective interest rate can be computed as follows: Effective Ìnterest Rate is equal to e r ÷ Ì where e is equal to exponential number r is equal to stated annual interest rate Table 1.2 provides the effective rates as a function of the compounding frequency. TABLE 12.2 provides the effective rates as a function of the compounding frequency. Annual 10 1 .10 10 Semi-Annual 10 2 (1plus10di$iidedby2) 2 minus1 10.25 Monthly 10 12 (1plus.10divided by12) 12 minus1 10.47 Daily 10 365 (1plus.10divided by365) 365 minus1 10.5156 Continuous 10 continuous e. 10 _1 10.5171 As compounding becomes more frequent, the effective rate increases, and the present value of future cash flows decreases. For example, a home loan may have monthly repayments and monthly compounding. The interest rate quoted may seem to be low, but that could be deceptive. To get the effective Annual rate, you should use the formula above and see what the actual effective interest rate works out. 1!.@ ANNUIT) An annuity is constant cash flow that occurs at regular intervals at fixed period of time. Defining A to be the fixed amount payable at regular intervals, the time line for an annuity may be drawn as follows: A 0 1 2 3 4 An annuity can occur at the end of each period, as in this time line, or at the beginning of each period. #resent 5alue of an *nd-of-the-#eriod 2nnuity The present value of an annuity can be calculated by taking each cash flow and discounting it back to the present and then adding up the present values. Alternatively, a formula can be used in the calculation. Ìn the case of annuities that occur at the end of each period, this formula can be written as *V of an Ann7it3 is eJ7al to *V '7lti5lie& "3 #A0r0n$is eJ7al to A &i=i&e& "3 rN1 'in7s 1 &i=i&e& "3#1 5l7srO n Where A is equal to Annuity r is equal to Discount Rate per period N is equal to Number of periods The notation used internationally for the present value of an annuity is PV (A, r, n). Suppose you start a rent-a-car business and want to buy an automobile. You have choice of buying the car cash down for Rupees 400,000 or paying Rupees 90,000 a year for five years for the same car. What would you do, if the opportunity cost is 10 per cent? PV of Rupees 90,000 each year for the next 5 years PV (90, 000,10,5 is equal to 90,000 multiplied %y (1.10 5 -1) di$ided %y 0.10 multiplied by 1.1 5 Is equal to 90,000 multiplied %y (1.61051-1) Is equal to 341171 ;%$iously it is %etter to ta"e the auto loan rather than pay #ash down. -erhaps( no auto loan #ompany or %an" will #ome up with su#h a s#heme. The present values of your installments versus cash down will always be higher. Ìf you do not have the money right now or you can get a higher return by using this loan then it is worthwhile taking the loan. Thus you will also have to look into your inflows by hiring out the car/s in your rent- a-car business. When the present values of your installment payments exceed the cash down price, it is better to pay cash down and acquire the asset. Alternatively, in above example, you could have discounted each installment separately and added up the present values for all five and arrived at the same figure. Nowadays, spreadsheets like excel are used to calculate the values of different annuities or using advanced program calculators. Thus using the formulas programmed in the spreadsheet and changing the variables like amount, time and rate of interest/discount factor, you can calculate the present value of different annuities and take financial decisions both, personal and commercial. 0uture value of *nd6of-the-period 2nnuities Ìn some cases, an individual may plan to set aside a fixed annuity each period for a number of periods and will want to know how much he or she will have at the end of the period. The future value of an end of-the-period annuity can be calculated as follows: +V of an Ann7it3 +V #A0r0n$ is eJ7al to A &i=i&e& "3 r '7lti5lie& "3 N#1 5l7s r$ n H 1$O The standard notation commonly practised for Future Value of an annuity is FV (A, r, n). Knowing the future value formula, can you calculate the future value of Rupees 5000 tax exempted PPF you deposit every year for twenty years? Assume you start at age 25 years. Ìf it is taxed, obviously you have a lower return. Juggling the above formula, if you know the future value of what you have to repay and you need to set aside a fixed sum every year for repayment, you can use annuity formula. Thus Annuity given Future Value ÷ which means you are given the future value and are looking for the annuity A (FV, r, n), can be calculated as follows: Annuity given the future value is equal to A (FV, r, n) is equal to FV multiplied by r divided by [(1 plus r) n -1] 7alloon Repayment Loan: A balloon Repayment loan refers to a loan on which only in crest is paid for the life of the loan, and the entire principal is paid at the end of the loan's life. Companies that borrow money using balloon repayment loans like bonds or debentures often set aside money in sinking funds during the life of the loan to ensure they have enough at maturity to pay the principal on the loan or the face value of the bonds. Thus any company will have to set aside a fixed amount each year till the date of redeeming of bonds/debentures for repayment to bond holders or debenture holders. The size of the sinking fund will vary with the change in interest rates. Sinking 0und: A sinking fund is a fund to which firms make annual contributions in order to have enough funds to meet a large financial liability in the future. Annuity at the beginning of Period .1 1 The annuities we talked about till now are end of the period cash flows. Both the present and future values are affected if the cash flow occurs at the beginning of each period instead of the end. To illustrate this effect, consider an annuity of Rupees 100 at the end of each year for the next four years, with a discount rate of 10 per cent; and we also consider similar annuity at the beginning of each year. Rupees 100 Rupees 100 Rupees 100 Rupees 100 Er,: of 1',,r,)d 2 Begin Penn( Rupees 100 Rupees 100 Rupees 100 Rupees 100 Ìn case "beginning of period' (BOP) annuity , the first of cash flow occurs right now, and the remaining cash flows take the form of an end-of-the-period annuity over three years, the present value of this annuity can be written as follows: PV of Rupees.100 at beginning of each year for four years is equal to 100 plus 100 divided by0.10 multiplied by [1minus1 divided by1.1 3 Ìs equal to 100 plus100O multiplied by [1 minus Ì divided by Ì 1.331] Ìs equal to 100+1,000 multiplied by (1-0.7513) Ìs equal to 100 + 248.70 Ìs equal to 348.70 PV of Rupees.100 at end of each year for four years is equal to 100divided by 0.10 multiplied by [1÷ 1 divided by 1.1 4 Ìs equal to 1000 multiplied by ( Ì ÷ 0.6830) Ìs equal to 1000 multiplied by 0.3170 is equal to 317 Thus you would observe, present value of BOP annuity is more than PV of end of period annuity. Present Value of Beginning-of-Period Annuities Ìn general, the present value of a beginning-of-a-period annuity over n yeaRupees can be written as follows: PV BOP is equal to A+ ÷Ax1, (Ì+r') Ì This present value will be higher than the present value of an equivalent annuity at the end of each period. +7t7re Val7e of Be,innin,EofE*erio& Ann7ities The future value of a beginning-of-a-period annuity typically can be estimated by allowing for one additional period of compounding for each cash flow: Ìf annuity of Rupees A is paid at the beginning of period, for n periods, the future value at the end of n periods can be calculated as following: +V of BO* Ann7it3 is eJ7al to +V 'in7s BO* #A0 r0 n$ is eJ7al to A &i=i&e& "3 r '7lti5lie& "3 #I 5l7s r$ '7lti5lie& "3 N#I 5l7s r$ n E1O This future value will be higher than the future value of an equivalent annuity at the end of each period. Thus if you invest your annuity at the beginning of each year instead of the end of each year, your future value will be higher. E6a'5le Suppose you put Rupees 1,000 in Recurring deposit account for 3 years with annual payments. The first payment is made today; the last and third payment is made at the beginning of the third year. Ìnterest rate is 10 per cent pa and compounding is done on annual basis. We now want to calculate the maturity value at the end of three years. FV (A, r, n) is equal to A multiplied by (Ì + r) multiplied by [(Ì+ r)' ÷Ì] divided by r FV (1,000, 0. 1. 3) is equal to 1,000 multiplied by 1. 1 multiplied by(1.1 3 -1) divided by0.1 Ìs equal to 1,000 multiplied1.1multiplied by Ì. multiplied by(1.331-1) divided by 0.1 Ìs equal to Ì, 000multiplied by0.33l multiplied by 1.1divided by 0.1 Ìs equal to 331 multiplied by 11 Ìs equal to 3641 Thus the maturity value in this case would be Rupees 3641 1!.B IRO;INI ANNUITIES A growing annuity is a cash flow that grows at a constant rate for a specified period of time. Ìf A is the current cash flow and g is the expected growth rate, the time line for a growing annuity is as follows: A(1 +g)' A(1 +g)is equal to All +g)3 A(1 +g)4 0 1 2 3 4 Note that to qualify as a growing annuity; the growth rate in each period has to be the same as the growth rate in the prior period. Dis%o7ntin, a Iro8in, Ann7it3 The present value of a growing annuity can be estimated by using the following formula: PV of a Growing Annuity is equal to A multiplied %y (1 plus g) di$ided %y(r minus g) multiplied %y [1 minus (1 plus g) n di$ided %y (1 plus r) n ] The present value of a growing annuity can be estimated in all cases but one ÷ if the growth rate is equal to the discount rate, the present value is equal to the nominal sums of the annuities over the period, without the growth effect. PV of a Growing Annuity for n years (when r is equal to g) is equal to n A Ìt is important to note that the expanded formulation works even when the growth rate is greater than the discount rate. 1!.C *ER*ETUIT) Perpetuity is a constant cash flow paid (or received) at regular time intervals forever. Thus a lifetime pension can be considered as a perpetuity or rentals received from exploitation of land which is passed on from generation to generation. The present value of perpetuity can be written as *V of 5er5et7it3 is e4ual to 2 divided by r A Console Bond is a bond that has no maturity and pays a fixed coupon (rate of interest). Assume that you have a 6 per cent coupon console bond. The original face value is equal to Rupees 1000. The current value of this bond if the interest rate is 9 per cent is as follows. Current Value of Console Bond is equal to Rupees 60 divided by 0.09 is equal to Rupees 667. The value of a Console bond will be equal to its face value only if the coupon rate is equal to the interest rate. Ìn this case Rupees 1,000, i.e. 60/0.06 !rowing #erpetuities A growing perpetuity is a cash flow that is expected to grow at a constant rate forever. The present value of a growing perpetuity can be written as *V of Iro8in, *er5et7it3 is eJ7al to C1 &i=i&e& "3#r 'in7s ,$ Where C, is equal to A (Ì plus g) i.e. payment at the end of the first period. A growing perpetuity is a constant cash flow, growing at a constant rate, and paid at regular time intervals forever. Although a growing annuity and a growing perpetuity share several features, the fact that a growing perpetuity lasts forever puts constraints on the growth rate. It has to "e Iess than the &is%o7nt rate for the for'7la to 8or2. /e38or&s4Ilossar3 &otations: Common Notations used in calculations are as follows and we have used them throughout the Unit.: Notation Meanin, *V *resent Val7e +V +7t7re Val7e Ct Cash flo8 at the en& of 5erio& t A Ann7it3 —Constant Cash +lo8s o=er se=eral 5erio&s r Dis%o7nt rate F E65e%te& ,ro8th rate in %ash flo8s n N7'"er of 5erio&s o=er 8hi%h %ash flo8s are re%ei=e& or 5ai& Time value of money: A rupee today is more valuable than a rupee a year later. 8pportunity /ost of /apital: When money is invested, what it earns should be compared with the earning from risk free investment. We should be able to earn at least the same amount or more. The interest rates on bonds/ securities, etc., will be the opportunity cost of capital. "iscount Rate: The process of discounting is simply the inverse of compounding. The rate at which the future cash flows are discounted is called the Discount rate. Annuity: A series of periodic cash flows of equal amounts, e.g. Sinking Fund, Pension Fund, Ìnsurance premia. #resent value of Money: The present value is calculated by discounting the future payments at the discount rate ( a) PV of a single cash flow C, after n years at r per cent interest rate: *V is eJ7al toC '7lti5lie& "3 N1 &i=i&e& "3 #1 5l7s r$ to the 5o8er of n (b) PV of an Annuity: A '7lti5lie& "3 N#1 5l7s r$ to the 5o8er of n E1O &i=i&e& "3 r '7lti5lie& "3 #1 5l7s r$ to the 5o8er of n 'nflation *ffect: Ìn an inflationary period, a rupee today represents greater real purchasing power than a rupee a year hence. 0uture 5alue of Money: Ìf you deposit your money in the bank, compound it annually at the given interest rate, then the deposit would grow to a bigger amount. FV of single cash flow: P (1 + r)to the power of n FV of an annuity: equal payment made every year for n years at r per cent A N#1 5l7s r$ to the 5o8er of n E1O &i=i&e& "3 r 0re4uency: When compounding (or discounting) is done more frequently than annually, the effective discounting rate of interest is greater than the nominal rate of interest. #erpetuity: Perpetuity is an annuity of infinite duration. The present value of perpetuity is expressed as is equal to A divided by r &et #resent 5alue $%: This value is the difference between the cash outflows and cash inflows at the base period. That is, calculate the present values of inflows and outflows and find the difference. Only when the NPV is positive, we should go ahead with the investments. 97estions 1. What will be future value of money invested at a given interest rate after a given period of time? 2. What is the present value of a cash flow to be received in the future? 3. How can we calculate present and future values of streams of cash payments? 4. What is the difference between ral and nominal cash flows and real and nominal interest rates? 5. Why does money have time value? 6. Explain the rule of 72. 7. Can we compare cash flows occurring at different times? What should we do to bring them to a common base? 8. Ì am 50 years old, retire at the age of 60 and expect to live 10 years more. Ìf Ì want to spend Rupees 10,000 per month, how much should Ì save by the age of 60 to support this plan? Assume an interest rate of 8 per cent. What is the required savings if the interest rate is only 5 per cent? Comment on the results. 9. How long will it take for Rupees 500 to grow to Rupees 2,000 at the following interest rates? (a) 4per cent; (b) 10per cent; (c) 12per cent 10. What is the effective annual interest rate in the following cases? (a) 12per cent compounded monthly (b) 8per cent compounded every 4 months Ì 1. Ìf Ì invest Rupees 5,000 today and expect to sell at Rupees 10,000 in 8 years. Ìf the interest rate is 5 per cent, is this a good deal? What if the interest rate is 12 per cent? 12. What is Net Present Value? When there is no profit or loss in an investment, what is the NPV? 13. How much should be deposited at the beginning of each year for 10 years, in order to provide a sum of Rupees 5 lakhs at the end of 10 years? 14. Ravi receives an amount of Rupees 10 lakhs from the Provident Fund. He deposits this amount in his bank and earns 10 per cent interest. Ìf he withdraws every year Rupees 2 lakhs; what will be the amount left in his account at the end of 5 years. 15. Ram is saving to buy a car after 5 years. The car costs Rupees 6 lakhs and he earns 8 per cent a year on savings. He wants to save an equal amount each year. (a) How much does he need to put aside at the end of years 1 to 5? (b) Suppose the interest rate decreases by 2 per cent from year 3.He still wants to go ahead with the purchase of the car, at the end of year 5. By how much should he increase the savings? (c) Ìf he follows earlier pattern of savings, when will he be able to buy the car? 16. ABC company has three projects to choose from. The Finance Manager and the Operations Manager discuss the matter. They are not able to come to a decision. Then they meet a consultant to get advice. As a consultant, what advice you will give? The cash flows are as follows. All amounts are in lakhs of Rupees. *roAe%t 1: Duration 15 years Beginning Cash Outflow is equal to Rupees 100 Cash inflows (at the end of the year) Year 1-Ruees 30; year 2- Rupees 30; Year 3- Rupees 30; Year4- Rupees10; Year 5- Rupees 10. *roAe%t !: Duration 5 years Beginning cash outflow Rupees 100 Cash inflows (at the end of the year) Year 1- 5; year2-15; year 3-25; year4-35; year5-50 *roAe%t (: Duration 15 years Beginning Cash Outflow ÷ Rupees 100. Cash inflows (at the end of the year) Year 1-Rupees 30 ÷ Year 2- Rupees 20 (for 10 continuous years) Years 11 to 15 ÷ Rupees 10 (for the next 5 years). Ìf the cost of capital is 8per cent, which of the 3 projects should the ABC Company accept? Answer the following questions (a) Ìf A invests Rupees 100 at 7per cent interest rate for 3 years, what will be the value at the end of 3 years? Ans8er: 1!!.?0 (b) My grandfather, starts giving me gifts of Rupees 1 lakh for the next 4 years. Ìf the interest rate is 10per cent pa, how much will Ì get at the end of 4 years? Ans8er: R75ees
[email protected] (c) A quarterly repayments of a loan carry an interest rate of 8per cent per annum. What is the effective annual interest rate? Ans8er: C.! 5er %ent (d) Find the interest rate. Present Value is Rupees 100. Future Value becomes 115.76 in 3 years. Ans8er: C 5er %ent. (e) A receives a contract for Rupees 15 lakh, providing Rupees 3 lakh for 5 years. B receives a contract for the same work, Rupees 14 lakh, for the same 5 Yr. period, giving him Rupees 4 lakh upfront and Rupees 2 lakh at the end of each year for 5 years. Who is better off? Ans8er: B (f) Ìf Ì take a loan of Rupees 8,000 and repay Rupees 225 per month, for 4 years, what is the effective annual rate on the loan? Ans8er: 1?.?C 5er %ent. (g) Ì buy a property for Rupees 3 lakh, and plan to sell it in 5 years for Rupees 4 lakh; (a) What is the PV of selling price if the interest rate is 8per cent? (b) Ìs the investment attractive? Ans8er: a$ R75ees !0 B!0!((. "$ No (h) Under the rule of 72, how long will it take for an investment to quadruple in value, if the interest rate is 12per cent? Ans8er: 1! 3ears (Ì) if the interest rate changes, from 8per cent this year to 10per cent next year. What is the Future value of Rupees 100 in 2 years? What is the Present Value of Rupees 100 to be received after 2 years? Ans8er: #1$ R75ees 11C.C< R75ees F..1C APPENDÌX - A PRESENT VALUE TABLES Appendix Table 1 Dis%o7nt +a%tors: *resent =al7e of R75ees 1 to "e re%ei=e& after t 3ears is eJ7al to 1 &i=i&e& "3#1 5l7s r$ t 1 . 9 . 98 .971 .962 .952.943 .935 .926 .917 .909 .901 .893 .885 .877 .870 2 . 9 . 96 .943 .925 .907.890 .873 .857 .842 .826 .812 .797 .783 .769 .756 3 . 9 . 94 .915 .889 .864.840 .816 .794 .772 .751 .731 .712 .693 .675 .658 4 . 9 . 92 .888 .855 .823.792 .763 .735 .708 .683 .659 .636 .613 .592 .572 5 . 9 . 90 .822 .784.747 .713 .681 650 .621 .593 .567 .543 .519 .497 6 .. .837 .790 .746.705 .666 .630 .596 .564 .535 .507 .480 .456 .432 7 .. .813 .760 .711.665 .623 .583 .547 .513 .482 .452 .425 .400 .376 8 . 9 . 85 .769 .731 .677.627 .582 .540 .502 .467 .434 .404 .376 .351 .327 9 . 9 . 83 .766 .703 .645.532 .544 .500 .460 .424 .391 .361 .333 .308 .284 10 . 9 . 82 .744 .676 .614.558 .508 .463 .422 .386 .352 .322 .295 .270 .247 11 . 8 . 80 .722 .650 .585.527 .475 .429 .388 .350 .317 .287 .261 .237 .215 12 . 8 . 78 .625 .557.497 .444 .397 .356 .319 .286 .257 .231 .208 .187 13 . 8 . 77 .681 .601 .530.469 .415 .368 .326 .290 .258 .229 .204 .182 .163 14 . 8 . 75 .661 .577 .505.442 .388 .340 .299 .263 .232 .205 .181 .160 .141 15 . 8 . 74 .642 .555 .481.417 .362 .315 .275 .239 .209 .183 .160 .140 .123 16 .. .623 .534 .458.394 .339 .292 .252 .218 .188 .163 .141 .123 .107 17 . 8 . 71 .605 .513 .436.371 .317 .270 .231 .198 .170 .146 .125 .108 .093 18 . 8 . 70 .587 .494 .416.350 .296 .250 .212 .180 .153 .130 .111 .095 .081 19 . 8 . 68 .570 .475 .396.331 .277 .232 .194 .164 .138 .116 .098 .083 .070 20 . 8 . 67 .554 .456 .377.312 .258 .215 .178 .149 .124 .104 .087 .073 .061 25 . 7 8 . 61 0 .478 .375 .295.233 .184 .146 .116 .092 .074 .059 .047 .038 .030 30 . 7 4 . 55 2 .412 .308 .231.174 .131 .099 .075 .057 .044 .033 .026 .020 .015 For example, if the interest rate is 10per cent per year, the present value of Re 1 received at year 5 is Rupees 0.621. 122 1 - Ì- tD BAN'~' Appendix Table 2 +7t7re =al7e of Re 1 after t 3ears is eJ7al to 1'7lti5lie& "3#1P r$ 1 1 1.010 1.02 0 1.03 0 1.04 0 1.05 0 1.06 0 1.07 0 1.08 0 1.09 0 1.10 0 1.110 1.120 1.130 1.14 0 1.150 2 1.020 1.04 0 1.06 1 1.08 2 1.10 2 1.12 4 1.14 5 1.16 6 1.18 8 1.21 0 1.232 1.254 1.277 1.30 0 1.323 3 1.030 1.06 1 1.09 3 1.12 5 1.15 8 1.19 1 1.22 5 1.26 0 1.29 5 1.33 1 1.368 1.405 1.443 1.48 2 1.521 4 1.041 1.08 2 1.12 6 1.17 0 1.21 6 1.26 2 1.31 1 1.36 0 1.41 2 1.46 4 1.518 1.574 1.630 1.68 9 1.749 5 1.051 1.10 4 1.15 9 1.21 7 1.27 6 1.33 8 1.40 3 1.46 9 1.53 9 1.61 1 1.685 1.762 1.842 1.92 5 2.011 6 1.062 1.12 6 1.19 4 1.26 5 1.34 0 1.41 9 1.50 1 1.58 7 1.67 7 1.77 2 1.870 1.974 2.082 2.19 5 2.313 7 1.072 1.14 9 1.23 0 1.31 6 1.40 7 1.50 4 1.60 6 1.71 4 1.82 8 1.94 9 2.076 2.211 2.353 2.50 2 2.660 8 1.083 1.17 2 1.26 7 1.36 9 1.47 7 1.59 4 1.71 8 1.85 1 1.99 3 2.14 4 2.305 2.476 2.658 2.85 3 3.059 9 1.094 1.19 5 1.30 5 1.42 3 1.55 1 1.68 9 1.83 8 1.99 9 2.17 2 2.35 8 2.558 2.773 3.004 3.25 2 3.518 10 1.105 1.21 9 1.34 4 1.48 0 1.62 9 1.79 1 1.96 7 2.15 9 2.36 7 2.59 4 2.839 3.106 3.395 3.70 7 4.046 11 1.116 1.24 3 1.38 4 1.53 9 1.71 0 1.89 8 2.10 5 2.33 2 2.58 0 2.85 3 3.152 3.479 3.836 4.22 6 4.652 12 1.127 1.26 8 1.42 6 1.60 1 1.79 6 2.01 2 2.25 2 2.51 8 2.81 3 3.13 8 3.498 3.896 4.335 4.81 8 5.350 13 1.138 1.29 4 1.46 9 1.66 5 1.88 6 2.13 3 2.41 0 2.72 0 3.06 6 3.45 2 3.883 4.363 4.898 5.49 2 6.153 14 1.149 1.31 9 1.51 3 1.73 2 1.98 0 2.26 1 2.57 9 2.93 7 3.34 2 3.79 7 4.310 4.887 5.535 6.26 1 7.076 15 1.161 1.34 6 1.55 8 1.80 1 2.07 9 2.39 7 2.75 9 3.17 2 3.64 2 4.17 7 4.785 5.474 6.254 7.13 8 8.137 16 1.173 1.37 3 1.60 5 1.87 3 2.18 3 2.54 0 2.95 2 3.42 6 3.97 0 4.59 5 5.311 6.130 7.067 8.13 7 9.358 17 1.184 1.40 0 1.65 3 1.94 8 2.29 2 2.69 3 3.15 9 3.70 0 4.32 8 5.05 4 5.895 6.866 7.986 9.27 6 40.76 18 1.196 1.42 8 1.70 2 2.02 6 2.40 7 2.85 4 3.38 0 3.99 6 4.71 7 5.56 0 6.544 7.690 9.024 10.5 8 12.38 19 1.208 1.45 7 1.75 4 2.10 7 2.52 7 3.02 6 3.61 7 4.31 6 5.14 2 6.11 6 7.263 8.613 10.20 12.0 6 14.23 20 1.220 1.48 6 1.80 6 2.19 1 2.65 3 3.20 7 3.87 0 4.66 1 5.60 4 6.72 7 8.062 9.646 11.52 13.7 4 16.37 25 1.282 1.64 1 2.09 4 2.66 6 3.38 6 4.29 2 5.42 7 6.84 8 8.62 3 10.8 3 13.59 17.00 21.23 26.4 6 32.92 30 1.348 1.81 1 2.42 7 3.24 3 4.32 2 5.74 3 7.61 2 10.0 6 13.2 7 17.4 5 22.89 29.96 39.12 50.9 5 66.21 For example, if the interest rate is 10per cent per year, the investment of Re 1 today will be worth Rupees 1.611 at year 5. Appendix Table 3 1 0.990 0.9 80 0.97 1 0.96 2 0.95 2 0.94 3 0.93 5 0.92 6 0.91 7 0.90 9 0.901 0.893 0.885 0.877 0 . 2 1.970 1.9 42 1.91 3 1.88 6 1.85 9 1.83 3 1.80 8 1.78 3 1.75 9 1.73 6 1.713 1.690 1.668 1.647 1 . 3 2.941 2.8 84 2.82 9 2.77 5 2.72 3 2.67 3 2.62 4 2.57 7 2.53 1 2.48 7 2.444 2.402 2.361 2.322 2 . 4 3.902 3.8 08 3.71 7 3.63 0 3.54 6 3.46 5 3.38 7 3.31 2 3.24 0 3.17 0 3.102 3.037 2.974 2.914 2 . 5 4.853 4.7 13 4.58 0 4.45 2 4.32 9 4.21 2 4.10 0 3.99 3 3.89 0 3.79 1 3.696 3.605 3.517 3.433 3 . 6 5.795 5.6 01 5.41 7 5.24 2 5.07 6 4.91 7 4.76 7 4.62 3 4.48 6 4.35 5 4.231 4.111 3.998 3.889 3 . 7 6.728 6.4 72 6.23 0 6.00 2 5.78 6 5.58 2 5.38 9 5.20 6 5.03 3 4.86 8 4.712 4.564 4.423 4.288 4 . 8 7.652 7.3 25 7.02 0 6.73 3 6.46 3 6.21 0 5.97 1 5.74 7 5.53 5 5.33 5 5.146 4.968 4.799 4.639 4 . 9 8.566 8.1 7.78 7.43 7.10 6.80 6.51 6.24 5.99 5.75 5.537 5.132 4.946 4 10 9.471 8.9 83 8.53 0 8.11 1 7.72 2 7.36 0 7.02 4 6.71 0 6.41 8 6.14 5 5.889 5.650 5.426 5.216 5 . 11 10.37 9.7 87 9.25 3 8.76 0 8.30 6 7.88 7 7.49 9 7.13 9 6.80 5 8.49 5 6.207 5.938 5.687 5.453 5 . 12 11.26 10. 58 9.95 4 9.38 5 8.86 3 8.38 4 7.94 3 7.53 6 7.16 1 6.81 4 6.492 6.194 5.918 5.660 5 . 13 12.13 11. 35 10.6 3 9.98 6 9.39 4 8.85 3 8.35 8 7.90 4 7.48 7 7.10 3 6.750 6.424 6.122 5.842 5 . 14 13.00 12. 11 11.3 0 10.5 6 9.89 9 9.29 5 8.74 5 8.24 4 7.78 6 7.36 7 6.982 6.628 6.302 6.002 5 . 15 13.87 12. 85 11.9 4 11.1 2 10.3 8 9.71 2 9.10 8 8.55 9 8.06 1 7.6G 6 7.191 6.811 8.462 6.142 5 . 16 14.72 13. 58 12.5 6 11.6 5 10.8 4 10.1 1 9.44 7 8.85 1 8.31 3 7.82 4 7.379 6.974 6.604 6.265 5 . 17 15.56 14. 29 13.1 7 12.1 7 11.2 7 10.4 8 9.76 3 9.12 2 8.54 4 8.02 2 7.549 7.120 6.729 6.373 6 . 18 16.40 14. 99 13.7 5 12.6 6 11.6 9 10.8 3 10.0 6 9.37 2 8.75 6 8.20 1 7.702 7.250 6.840 6.467 6 . 19 17.23 15. 68 14.3 2 13.1 3 12.0 9 11.1 6 10.3 4 9.60 4 8.95 0 8.36 5 7.839 7.366 6.938 6.550 6 . 20 18.05 16. 35 14.8 8 13.5 9 12.4 6 11.4 7 10.5 9 9.81 8 9.12 9 8.51 4 7.963 7.469 7.025 6.623 6 . 25 22.02 19. 52 17.4 1 15.6 2 14.0 9 12.7 8 11.6 5 10.6 7 9.82 3 9.07 7 8.422 7.843 7.330 6.783 6 . 30 25.81 22. 40 19.6 0 17.2 9 15.3 7 13.7 6 12.4 1 11.2 6 10.2 7 9.42 7 8.694 8.055 7.496 7.003 6 . For example, if the interest rate is 10per cent per year, the present value of Re 1 received in each of the next 5 years is Rupees 3.791. END O+ CGA*TER 1!E ADVANCED BAN/ MANAIEMENTECAIIB *A*ERE1 ADVANCED BANK MANAGEMENT UNÌT 13 ÷ Sampling Methods STRUCTURE 13.0 Objective 13.1 Ìntroduction 13.2 Random Sampling 13.3 Sampling Distributions 13.4 Sampling from Normal Populations 13.5 Sampling from Non-normal Populations 13.6 Central Limit Theorem 13.7 Finite Population Multiplies eywords 9uestions 2nne+ure- #robability Table 1(.0 OBJECTIVES The objectives of this unit are as follow: 1. Learn to take a sample from an entire population and use it to describe the population 2. Make sure the samples represent the population. 3. Ìntroduce the concepts of sampling distributions 4. Understand the trade off between costs of larger samples and accuracy 5. Ìntroduce experimental design ÷ sampling procedures. 6. Estimation ÷ data analysis and interpretation of sample data 7. Testing of hypotheses ÷ one-sample data 8. Testing of hypotheses ÷ two-sample data 1(.1 INTRODUCTION As you know, statistics is a tool used in business and finance. Statistics is an appreciated as well as maligned tool depending on how it is used. Ìn the last Lok Sabha elections in Ìndia the exit polls based on statistical forecasting were proved wrong. We need statistical methods to reduce risk, uncertainty and improve our decision making skills. Decision making in a situation involves collecting information and then using this data for the future strategy. Usually we cannot use the complete data because of the sheer size or numbers involved. Therefore, we take a sample and test it. For example if a milk plant processes 1 lakh litres of milk every day, one cannot break open each packet and test the milk for quality. Here we take samples from each batch. Ìf we want to do a market survey we cannot interview each and every household, we take a representative sample. Thus sampling becomes an integral tool of the quantitative methods we use. We take a sample, collect data from the sample and attempt to generalize the results for the whole data. Tea tasters at tea auctions are very highly paid employees of tea companies. They sample a small portion of the tea produced from the plantation before the auction. Food products are often tasted before being sold. Before you buy Diwali sweets, you may take a small bite, before deciding to buy it. Obviously everything cannot be opened and tasted or tested as there would be nothing left to sell. We have to select a sample and test that only. Ìf you want to write a report on why many people are migrating from Ìndia to Canada or Australia, contacting each and every Ìndian who migrated would be time consuming and expensive. So you would choose a sample and make a report accordingly. Thus time and size are decisive factors which make it necessary to take business decisions on sample. Ìf your sample is properly chosen, your report would truly reflect reasons of the entire population for migration. Of course in any situation, the best results would be available, if we collect data from the entire population. Such complete enumeration or census is used in the population census carried out in our country every ten years. Statisticians use the word population to refer not only to people but to all items that are to be studied. The word sa'5le is used to describe a portion chosen from the population. We can describe samples and populations by using measures such as mean, median, mode and standard deviation. When these terms describe a sample, they are called statistic and are not from the population but estimated from the sample. When these terms describe a population they are called parameters. A statistic is a characteristic of a sample; a parameter is a characteristic of a population. Conventionally, statisticians use lower case Roman letters to denote sample statistics and Greek or Capital letters to denote population parameters. Table 13.1 lists these symbols. TABLE 13.1 Ìmportant Statistics Notations and Symbol Population Ì Sample Definition Collection of all items Part of the population Characteristics Parameters Statistics Symbols Size ÷ N Size ÷ n Mean÷la Mean ÷ x Standard Standard Deviation ÷ a Deviation ÷ s Types of Sampling There are two methods of selecting samples from populations: non-random or judgement sampling and random or probability sampling. Ìn probability sampling all the items in the population have a chance of being chosen in the sample. Ìn judgement sampling, personal knowledge or opinions are used to identify the items from the population that are to be included in the sample. A sample selected by judgement sampling is based on someone's experience with the population. An oil drilling company would ask an experienced geologist to test different terrains or land beneath the sea before deciding where to explore for oil. Sometimes a judgement sample is used as a pilot or trial sample to decide how to take a random sample later. Ìf we want to launch a new city newspaper, a pilot test of the paper can be launched at a judgement sample to see the response. But the rigorous statistical analysis which can be done with random probability samples cannot be done with judgement samples. On the other hand, they are more convenient and can be used successfully even if we cannot test their validity. But if a study uses judgement sampling and loses a significant degree of representative ness, it will have purchased convenience at a high price. 7iased samples Suppose the Parliament is debating on the women's bill. You are asked to conduct an opinion survey. Because women are the most affected by women's bill, you go and interview a lot of women in different cities, towns and rural areas of Ìndia. Then you report that an overwhelming 95 per cent are in favour of reservation for women in Parliament. Sometime later the government has to take up the issue of Foreign Direct Ìnvestment (FDÌ) in print media. Since newspaper publishers are the most affected you contact all of them both national and regional in Ìndia and report that the majority is not in favour of FDÌ in print media. Ìn both these cases you picked a biased sample by choosing people who would have strong feelings on this issue. You have to have proper samples. A report based on the data collected from such biased sample then would not truly reflect public opinion. To avoid such errors, if we follow random sampling, it is possible to statistically determine the reliability of the estimates obtained from the sample. 1(.! RANDOM SAM*DINI There are four main types of random sampling. 1. Simple Random Sampling 2. Systematic Sampling 3. Stratified Sampling 4. Cluster Sampling 1. Si'5le Ran&o' Sa'5lin, Simple Random Sampling selects samples by methods that allow each possible sample to have an equal probability of being picked and each item in the entire population to have an equal chance of being included in the sample. Suppose we have 4 teenagers participating in a talk show. We want a sample of two teenagers at a time for participating with the chat show host. The following table illustrates the possible combinations of samples of teenagers, the probability of each sample being picked and the probability that each teenager will be in a sample. Teenagers A, B, C, D Possible samples of two teenagers: AB, AC. AD, BC, BD, CD. Probability of drawing these samples of two people is the same as below: P (AB) is equal to 1 divided by 6 P (AC) is equal to 1divided by6 P (AD) is equal to 1divided by6 P (BC) is equal to 1divided by6 P (BD) is equal to 1divided by6 P (CD) is equal to 1divided by6 You would observe that any one student appears in 3 of the 6 possible samples. Therefore, probability of a particular student in the sample is P (A) is equal to 1divided by2 P (B) is equal to 1divided by2 P(C) is equal to 1divided by2 P (D) is equal to 1divided by2 The example illustrates a finite population of four teenagers. Ìf we write A, B, C, D on 4 identical slips of paper, fold the papers, and randomly pick any two of them-, we get a sample. While picking up 2 paper slips, we may pick up one, keep it away, and then pick another from the remaining three. This type is called sampling without replacement There is another way of doing it. Suppose after picking the first slip, we note the name on it and put the slip back in the lot, i.e. replace the paper slip. Then we draw the second slip. There is a chance that we may draw the same student again. This is called sampling with replacement) Theoretically, it is possible to have an infinite population. For example, the population of all prime numbers is infinite. Although many populations seem exceedingly large, no truly infinite population of physical objects actually exists. After all, given unlimited resources and time, one can enumerate any finite population. As a practical matter, we will use the term infinite population when we are talking about a population that could not be enumerated in a reasonable period of time. Thus we use a theoretical concept of infinite population as an approximation of a large finite population. :ow to do Random Sampling; Suppose there are 100 employees in a company, and we wish to interview a randomly chosen sample of 10. We write the name of each employee on a slip of paper and deposit the slips in a box. After mixing them thoroughly, we draw 10 slips at random. The employees whose names are on these 10 slips are our random sample. This method of drawing a sample works well with small groups of people, but presents problems with large populations. Also, add to this the problem of the slips of paper not being mixed well. We can also select a random sample by using random numbers. These numbers can be generated either by a computer programmed to scramble numbers, or by a table of random digits. The table is a part like random digits. These numbers have been generated by a completely random process. The probability that any one digit from 0 through 9 will appear is the same for each digit, and the probability of one sequence of digits occurring is the same as for any other sequence of the same length. 15,819 20,685 82,621 83,748 69,662 09,281 72,950 85,961 48,980 06,840 41,120 48,326 18,824 54,466 94,470 74,574 63,491 00,923 04,142 51,336 00,995 02,727 96,703 12,671 31,976 59,987 93,247 72,301 34,290 69,051 69,787 72,950 56,709 54,709 70,945 71,642 54,358 40,316 88,897 99,907 35,939 34,406 11,987 23,691 70,582 67,494 30,909 20,395 50,973 74,338 96,974 22,756 34,574 81,235 60,089 i , METHODS 1 129 20,079 07,000 50,890 37,689 39,622 45,847 76,661 55,448 14,318 74,840 38,401 64,88B 08,409 90,352 56,923 63,151 91,208 72,286 78,612 98,120 01,904 02,727 18,928 53,446 01,778 55,700 48,000 38,595 60,089 26,117 26,926 36,478 33,822 45,786 36,984 31,406 67,652 15,134 53,872 87,520 70,645 65,145 96,286 59,837 79,304 83,832 97,712 31,209 83,209 09,007 11,865 68,401 98,654 43,211 11,559 16,264 19,856 40,972 75,623 09,406 52,203 64,287 05,963 23,673 32,329 49,420 22,936 42,003 32,367 15,130 02,875 33,739 27,092 29,805 75,614 88,094 92,125 72,709 42,514 40,618 31,196 26,299 50,839 67,173 82,465 Let us see how to use this table. We assign each employee a number from 00 to 99, consult the table above and pick a systematic method of selecting two digit numbers. Like the first two digits. So we have 15, 09, and so on till we get our 10 numbers. Systematic Sampling Ìn systematic sampling, elements are selected from the population at a uniform level that is measured in time, order, or space. Ìf we wanted to interview every twentieth student on a college campus, we would choose a random starting point in the first twenty names in the student directory and then pick every twentieth name thereafter. Systematic sampling differs from simple random sampling in that each element has an equal chance of being selected but each sample does not have an equal chance of being selected. This would have been the case if, in our earlier example we had assigned numbers between 00 and 99 to our employees and then began to choose our sample of 10 by picking every tenth number beginning 1, 11, 21, 31, and so forth. Employees numbered 2, 3, 4 and 5 would have no chance of being selected together. Ìn systematic sampling there is a probability of introducing an error into the sampling process. The system chosen may cause a problem. Ìf we want to check the chances of people eating out on different days of the week and choose Friday. There is higher likelihood of Friday as it is the beginning of the weekend and we get a higher result. Systematic sampling has some advantages. Even though systematic sampling may be inappropriate when the elements lie in a sequential pattern, this method may require less time and sometimes results in lower costs than the simple random sample method. Stratifie& Sa'5lin, To use stratified sampling, we divide the population into relatively homogenous groups, called strata. Then we use one of two approaches. Either we select at random from each stratum a specified number of elements corresponding to the proportion of that stratum in the population as a whole or we draw an equal number of elements from each stratum and give weight to the results according to the stratum's proportion of total population. With either approach, stratified sampling guarantees that every element in the population has a chance of being selected. ,hen to use< Stratified Sampling; Stratified sampling is appropriate when the population is already divided into groups of different sizes and we wish to acknowledge this fact. Example ÷ middle class, upper class, lower middle class, etc. or according to age, race, sex or any other stratification. A jeans company may want to study which age group prefers to wear jeans the maximum. Thus the age groups may be 13 to 20, 20 to 30, 30 to 40, 40 plus. The advantages of stratified samples are that when they are properly designed, they more accurately reflect the characteristics of the population from which they are chosen than do other kinds of samples. Cl7ster Sa'5lin, Ìn cluster sampling, we divide the population into groups or clusters and then select a random sample of these clusters. We assume that these individual clusters are representative of the population as a whole. Ìf a market Research team is attempting to determine by sampling the average number of television sets per household in a large city, they could use a city map and divide the territory into blocks and then choose a certain number of blocks (clusters) for interviewing. Every household in each of these blocks would be interviewed. A well designed cluster sampling procedure can produce a more precise sample at considerably less cost than that of simple random sampling. /omparison of Stratified and /luster Sampling With both stratified and cluster sampling, the population is divided into well-defined groups- We use stratified sampling when each group has small variation within itself but there is wide variation between the groups. We use cluster sampling in the opposite case ÷ when there is considerable variation within each group but the groups are essentially similar to each other. 7asis of Statistical 'nterference: Simple Random Sampling Systematic sampling, stratified sampling and cluster sampling attempt to approximate simple random sampling. All are methods that have been developed for their precision, economy or physical ease. However as we do problems, we shall assume that the entire sample we are talking about, are data based on simple random sampling. The process of making statistical inferences is based on the principles of random sampling. Once you understand the basics for random sampling, the same can be extended to other types of samples with some amendments which are best left to professional statisticians. Ìt is important that you get a grasp of the concepts concerned. 1(.( SAM*DINI DISTRIBUTIONS Ìn this section, we presume you would have learnt in your high school mathematics concepts such as mean, mode, median, standard deviation, etc. Each sample you draw from a population would have its own mean or measure of central tendency, and standard deviation. Thus the statistics we compute for each sample would vary and be different for each random sample taken. Let us take an example: We take a finite population of 5 young boys; A, B, C, D, E and collect data about their heights in centimeters. The data is shown in Table 13.2. TABLE 13.2 Sampling Distribution Table Boy A B C D E HEÌGHT (cm) 160 162 164 170 156 Now, if we take samples of size 3 that is, select 3 boys in each sample, we will get 10 different samples. We list these samples, the corresponding data and their mean in Table 13.3. T A S a es,th eieir N o12 4 5 6 7' a 9 10 S a A B A B ABE BCD BCE ACD ACE AÌDE BDE CDE D A T A 1 6 0 , 1 6 1 6 0 , 1 6 160, 162, 164 162, 164, 170 162, 164, 156 160, 164, 170 160, 164, 156 160, 170, 156 162, 170, 156 164, 170 156 M e a n 1 6 2 1 6 4 159.33 165.33 160.66 164.66 160 162 162.66 163.33 From Table 13.3, you can see that sample mean for each sample is different. This collection of different values of sample mean for samples of size 3 forms a distribution of sample means. This distribution has a mean. Ìf we add all sample means in Table 2, and divide the sum by the number of samples, i.e. 10, we get 162.397 Normally, we will be dealing with large populations. Hence the number of samples of a particular size is also very large. We could also have a sampling distribution of proportion. Suppose we have to determine the proportion of sugar plants in a plantation affected by pest disease in samples of 100 plants taken from a very large plantation. We have taken a large number of these 100 item samples. Ìf we plot a probability distribution of the proportions of infested plants in all these samples, we would see a distribution of the sample proportion. (The term proportion here refers to the proportion that is infected.) Sa'5lin, &istri"7tion is the distribution of all possible values of a statistic from all possible samples of a particular size drawn from the population. Des%ri"in, Sa'5lin, Distri"7tion Any probability distribution (and, therefore, any sampling distribution) can be partially described by its mean and standard deviation. Table 13.4 describes how different sampling distributions can be S.No. Population Sample Sample Statistic 1. Water in a River 10-one litre containers of water Mean number of parts of mercury per million parts S.No. Population Sample Sample Statistic 2. All professional basketball teams Groups of 5 players Median height 3. All parts produced in a manufacturing 50 of each part Proportion defective Sampling Distribution Sampling distribution of the mean Sampling Distribution Sampling distribution of the median Sampling distribution of the proportion Each of the above sampling distributions can be partially described by its mean and standard deviation. Con%e5t of Stan&ar& Error Standard deviation of the distribution of the sample means is called the standard error of the mean. Similarly standard error of the proportion is the standard deviation of the distribution of the sample proportions. The term standard error is used because it has a very specific meaning. For example, we take the average heights of college girls in Ìndia across various samples. We would calculate the mean height for each sample. Obviously, there would be some variability in our observed mean. This variability in sampling statistics results from the sampling error due to chance. Thus the difference between the sample and population means is due to the choice of samples. Thus the standard deviation of the sampling distribution of means measures the extent to which the means vary because of a chance error in the sampling process. Thus, the standard deviation of the distribution of a sample statistic is known as the standard error of the statistic. Thus a standard error indicates not only the size of the chance error but also the accuracy we are likely to get if we use the sample statistic to estimate a population statistic. Thus a mean with a smaller standard deviation is a better estimator than one with a higher standard deviation. Understanding sampling distributions allows statisticians to take samples that are both meaningful and cost effective. Because large samples are more expensive, decision makers should always aim for the smallest sample which will give the most reliable results. Sa'5lin, Distri"7tions Figures 13.1 (a) and (b) will help you to understand sampling distributions. There are three parts to this illustration. Figure 13.1(a) illustrates a population distribution. Assume that this population is all the non-performing assets of a large bank and this distribution is the number of years the assets have been classified as nonperforming in the balance sheet. This distribution of number of years has a mean mu and a standard deviation of Sigma. Suppose we are able to take all possible samples of 10 non-performing assets (NPA s) from the population distribution. There would be too many so we possibly cannot take all. Next we would calculate the mean and standard deviation for each one of these samples, as represented in Fig. 13-1(6). As a result each sample would have its own mean T, and its own standard deviation's'. All the individual sample means would not be the same as the population mean. They would tend to be near the population mean, but only rarely would they be exactly that value. As a last step, we would produce a distribution of all the means from every sample that could be taken. This distribution, called the sampling distribution of the mean, is illustrated in Fig 13.1(c). This distribution of the sample means (the sampling distribution) would have its own mean- µ-x, and its own standard deviation or standard error ó-x. Ìn statistical terminology, the sampling distribution is obtained by taking all the possible samples of a given size is the theoretical sampling distribution. Figure 13.1(c) shows an example of such a distribution. Ìn practice, the size and character of most real life populations prohibit 'us from taking all the possible samples from a population distribution. Fortunately, formulas are developed for estimating the characteristics of these theoretical sampling distributions, making it unnecessary for collecting large numbers of samples. Ìn most cases decision makers take only one sample from the population, calculate some statistics from the sample, and from those statistics estimate something about the parameters of the entire population. We shall show this shortly. Now, we shall be discussing the sampling distribution of the mean in the examples that follow. Once you understand the formulae and concepts here, the same can be applied to other sampling distributions as well. 1(.. SAM*DINI +ROM NORMAD *O*UDATIONS Let us go back to the example of taking samples of size 3 from a population of size 5. From Table 13.4, we find mean mu of the population '7 is eJ7al to 1@!..0 Ìn Table 13.5, we have the sample means, x bar for the 10 samples. The mean of these sample means mu, is equal to 162.40; which is the same as population mean. This is not a coincidence. The mean of the sample means is the same as the population mean, whenever we use simple random sampling. Now from Table 13. 1, we see that the values range from 156 to 170. From Table 13.2, we see that the sample means range from 159.33 to 165. Thus sample means have smaller spread than the population. Thus, if our population is normally distributed, the sampling distribution is also normal. Further (1) the mean of the sampling distribution is same as the population mean. Mu multiplied xbar is equal to and (2) the standard deviation of the sampling distribution is equal to the population standard deviation divided by the square root of the sample size. Sigma multiplied by x bar is equal to sigma divided by square root of n. Now suppose we increase our sample size from 5 to 20. This would not change the standard deviation of the items in the original population. But with samples of 20, we have increased the sample means. Figure 2.3 illustrates this point. The properties are also explained below. Properties of Sampling Distribution of Mean, when Population is normally Distributed Sampling Distribution has Mean equal to Population Mean. EJ7ation: '7 '7lti5lie& "3 6 "ar is eJ7al to '7 Sampling distribution has Standard Deviation equal to Population Standard Deviation divided by Square root of Sample size. EJ7ation: si,'a '7lti5lie& "3 6"ar is eJ7al to si,'a &i=i&e& "3 SJ7are root of n An example will further illustrate these properties. A bank calculates that its individual savings accounts are normally distributed with a mean of Rupees 2,000 and a standard deviation of Rupeess600. Ìf the bank takes a random sample of 100 accounts, what is the probability that the sample mean will lie between Rupees 1,900 and Rupees 2,050? This is a question about the sampling distribution of the mean; therefore, we must first calculate the standard error of the mean. Ìn this case, we shall use the equation for the standard error of the mean designed for situation in which the population is infinite (later, we shall introduce an equation for finite populations): Since the sampling distribution is a normal distribution, let us first see how to find the probabilities associated with a normal distribution. The probabilities associated with a standard normal variable, that is, a normal variable with mean 0, and standard deviation 1, are available in the form of a Table. See ANNEXURE at the end of this unit. We first convert a value in our sample to a standard normal value by using the equation Z is equal to is divided by sigma multiplied by xbar [X bar minus mu]. The ANNEXURE gives us the probability that the variable z is between 0 and the given value. For example, if we want to know the probability that the variable z is between 0 and 1.54, we get the answer from the Table 13.4 as 0.4382. The probability that the variable is between minus 0.96 and 0 is given as 0.3315. (Note that we ignore the minus sign.) The probability that the variable is between minus minus0.96 and 1.54 is then 0.4382 plus 0.3315 is equal to 0.7697 The probability that the variable is between minus 0.96 and minus 1.54 is 0.4382 minus 0.3315 is equal to 0.1067. The probability that the variable is between 0.96 and 1.54 is also 0.4382 minus 0.3315 is equal to 0.1067. So if the values have the same sign (plus or minus), we subtract the smaller value in the Table from the bigger one. On the other hand, if the values have opposite signs, we add the values obtained from the Table. Stan&ar& Error of the Mean for Infinite *o57lations Standard error of the mean is equal to sigma divided by square root of n Where ó is equal to population standard deviation n is equal to sample size. Applying this to our example, we get Standard error of the mean is equal to 600 divided by60 is equal to 10 Using this equation z is equal to (x bar minus Mu) divided by sigma multiplied by Mu. We get 2 z values For x bar is equal to Rupees 1, 900, z is equal to (1900-2000) divided by 60is eual to Minus 1.67 For xbar is equal to Rupees 2050, z is equal to (2050 minus 2000) divided by 60 is equal to 0.85 Annexure table gives us an area or probability of 0.4525 corresponding to a z value of ÷ 1.67, and it gives probability of 0.2967 for a z value of 0.83. Ìf we add these two together, we get 0.7492 as the total probability that the sample mean will lie between Rupees and Rupees 2,050. The probabilities are also shown by the areas under the probability curve shown in Fig. 13.2. 1(.? SAM*DINI +ROM NONENOMRAD *O*UDATIONS Ìn the preceding section, we stated that when the population is normally distributed, the sampling distribution of the mean is also normal. But we come across many populations that are not normally distributed. How does the sampling distribution of the mean behave when the population from which the samples are drawn is not normal? An illustration will help us answer this question. Consider the data in Table 13.5, concerning five motorcycle owners and the lives of their tyres. Because only five people are involved, the population is too small to be approximated by a normal distribution. Let us take all of the possible samples of the owners in groups of three, compute the sample means (30 1 list them, and compute the mean of the sampling distribution (µjE). We have done this in Table 2.5. These calculations show that even in a case in which the population is not normally distributed, (l-LX, the mean of the sampling distribution is still equal to the population mean. Now look at Fig. 13.3(a) which shows the population distribution of tyre lives for the five motorcycles owners, a distribution that is anything but normal in shape. Ìn Fig. 13.3(b) we show the sampling distribution of the mean for a sample size of three, taking the information from Table 13.1. Notice the difference between the probability distributions in Figs. 13.3(a) and 13.3(b). Ìn Figure 13.3(b), the distribution looks a little more like the bell shape of the normal distribution. Simulated effect of increases in the sample size on the appearance of the sampling distributions.1see Figs. 13.3 (a-b)]. We repeat this exercise, and enlarge the population size to 40; we could take samples of different sizes. Then plot the sampling distributions of the mean that would occur for the different sizes. This will show quite dramatically how quickly the sampling distribution of the mean approaches normality, regardless of the shape of the population distribution. 1(.@ CENTRAD DIMIT TGEOREM The example in Table 2.2 and the probability distribution in the above graphs, tell us many things. First, the mean of the sampling distribution of the mean will equal the population mean regardless of the sample size, even if the population is not normal. As the sample size increases, the sampling distribution of the mean will approach normality, regardless of the shape of the population distribution. This relationship between the shape of the population distribution and the shape of the sampling distribution of the mean is called The Central Limit Theorem. The central limit theorem is perhaps the most important theorem in all of statistical inference. Ìt assures us that the sampling distribution of the mean approaches normal as the sample size increases. 1. Actually, a sample does not have to be very large for the sampling distribution of the mean to approach normal. 2. Statisticians use the normal distribution as an approximation to the sampling distribution whenever the sample size is at least 30, but the sampling distribution of the mean can be nearly normal with samples of even half the size. 3. The significance of the central limit theorem is that it permits us to use sample statistics to make inferences about population parameters without knowing anything about the shape of the frequency distribution of that population Let's illustrate the use of the central limit theorem. The distribution of annual earnings of all bank tellers with five years' experience is as shown below in Fig. 13.4. This distribution has a mean of Rupees19, 000 and a standard deviation of Rupees 2,000. Ìf we draw a random sample of 30 tellers, what is the probability that their earnings will average more than Rupees19, 750 annually? Ìn Fig. 13.4 we show the sampling distribution of the means that would result, and highlighting the area representing 'earnings over Rupees19, 750. Our first task is to calculate the standard error of the mean from the population standard deviation, as follows: Standard error of the mean ÷ sigma multiplied by xbar is equal to sigma divided by square root of n. Ìs equal to 2000 divided by square root of 30 Ìs equal to 2000 divided by 5477 is equal to Rupees 365.16 Because we are dealing with a sampling distribution, we must now use the equation for z value and the Standard Normal Probability Distribution (App. Table z is equal to (xbar minus mu) divided by sigma multiplied by xbar. For xbar is equal to Rupees 19750 Z is equal to (19750 minus19000 divided by 365.16 Ìs equal to 750 divided by 365.16 Ìs equal to 2.05 Annexure Table gives us probability of 0.4798 for a z value of 2.05. We show the corresponding area in Fig. 13.4 as the area between the mean and Rupees l9,750. Since half or 0.5000 of the area under the curve lies between the mean and the right- hand tail, the shaded area must be 0.5000 (Area between the mean and the right-hand tail) ÷0.4798 (Area between the mean and 19,750) 0.0202 (Area between the right-hand tail and 19,750) Thus, we have determined that there is slightly more than a 2 per cent chance of average earnings being more than Rupees 19,750 annually in a group of 30 tellers. The central limit theorem is one of the most powerful concepts in statistics. What it really says is that the distribution of sample means tends to be a normal distribution. This is true regardless of the shape of the population distribution from which the samples were taken. E6a'5les 1. Ìn a sample of 25 observations from a normal distribution with mean 98.6 and standard deviation 17.2 (a) What is P (92 below xbar below102)? i b) Find the corresponding probability given a sample of 36. (a) N is equal to25, mu is equalto98.6 and sigma is equal to 17.2 Sigma multiplied by xbar is equal to sigma divided by square root of n Ìs equal to 17.s divided by square root of 25 is equal to 3.44 P (92below xbar below 102) is equal to P [(92 minus98.6) divided by 3.44is below (xbar minus mu) divided by sigma multiplied by xbar is below (100 minus98.6) divided by 3.44] Ìs equal to P multiplied by (-19.2 is below z is below 0.99) is equal to 0.4726 plus 0.3389 is equal to0.8115. (b) n is equal to 36 sigma multiplied by xbar is equal to sigma divided by square root of n is equal to 17.2divided by square root of 36is equal to2.87 P (92 is below xbar is below 102) is equal to P [(92 Minus 98.6) divided by2.87] below (x bar minus mu) divided by sigma multiplied by xbar is below (100 Minus 98.6) divided by2.87] Ìs equal to P (-2.30 below z below 1. 18) is equal to.4893 Plus 0.3 8 10 is equal to 0. 8703 2. Kamala, an auditor for a large credit card company knows that than on average, the monthly balance of any given customer is Rs112, and the standard deviation is Rupees 56. Ìf Mary audits 50 randomly selected accounts, what is the probability that the sample average monthly balance is (a) Below Rupees 100? (b) Between Rupees 100 and Rupees 130 The sample size of 50 is large enough to use the central limit theorem mu is equal to 112, sigma equal to 56, n is equal to 50, and sigma xbar is equal to 56 divided by square root of 50 is equal to 7.920 (a)P( xbar below100)is equal to P multiplied by [(xbar minus mu)divided by sigma multiplied by xbar below (100 - 112) divided by7.9201] Ìs equal to P(z below minus 1.52) is equal to 0.5 minus 0.4357 is equal to 0.0643 b) P(100belowxbelow130)is equal to P[(100 minus 112)divided by7.920below(xbar minus mu)divided by sigma multiplied by xbar below(130-112)divided by,7.920] is equal to P (Minus 1.52 below z below 2.27) is equal to 0.4357 plus 0.4884 is equal to 0.9241 2n important consideration in Sampling: The Relationship between Sample Si=e and Standard *rror We saw earlier in this chapter that the standard error, sigma multiplied by xbar (sigma xbar) is a measure of dispersion of the sample means around the population mean. Ìf the dispersion decreases (if (sigma xbar becomes smaller), then the values taken by the sample mean tend to cluster more closely around mu. Conversely, if the dispersion increases (if (sigma xbar becomes larger), the values taken by the sample mean tend to cluster less closely around Ìt. We can think of this relationship this way: As the standard error de#reases( the $alue of any sample mean will pro%a%ly %e #loser to the $alue of the population mean. As the standard error de#reases the pre#ision with whi#h the sample mean #an %e used to estimate the population mean in#reases. Ìf we refer to Equation, we can see that as n increases, sigma xbar decreases. This happens because in an Equation a larger denominator on the right side would produce smaller sigma xbar on the left side. Two examples will show this relationship; both assume the same population standard deviation sigma of 100. When n is equal to 10, sigma xbar is equal to sigma divided by square root of n 100divided by3.162 is equal to 31.63, standard error of the mean. And when n is equal to 100: Standard error of the mean; sigma xbar is equal to100divided by square root of 100 is equal to10 What have we shown? As we increased our sample size from 10 to 100 (a ten fold increase), the standard error dropped from 31.63 to 10, which is only about one-third of its former value. Our examples show that, because sigma xbar varies inversely with the square root of n, there is diminishing return in sampling. Ìt is true that sampling more items will decrease the standard error, but this benefit may not be worth the cost. Ìt seldom pays to take excessively large samples. Managers should always assess both the worth and the cost of the additional precision they will obtain from a larger sample before they commit resources to take it. 1(.B +INITE *O*UDATION MUDTI*DIER Ìn our discussion of sampling distributions, we have used the following equation to calculate the standard error of the mean: Si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n This equation is designed for situations in which the population is infinite, or in which we sample from a finite population with replacement (that is, after each item is sampled, it is put back into the population before the next item is chosen, so that the same item can possibly be chosen more than once). Ìn fact, many of the populations studied are finite; that is, of stated or limited size. Examples of these include the employees in a given company, the clients of a city social-services agency, the students in a specific class, and a day's production in a given manufacturing plant. So we need to modify the equation to deal with finite populations. The formula designed to find the standard error of the mean when the population is finite, and we sample without replacement, is Stan&ar& Error of the Mean for +inite *o57lations Si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n '7lti5lie& "3 Q8hole root of N 'in7s n &i=i&e& "3 NE1R where N is equal to size of the population n is equal to size of the sample The new term on the right-hand side, which we multiply by our original standard error, is called the finite population multiplier) +inite *o57lation M7lti5lier Finite population multiplier is equal to the whole root of N-1 divided by N-n A few examples will help us become familiar with interpreting and using the above equation. Suppose we are interested in a population of 20 textile companies of the same size, all of which are experiencing excessive labour turnover. Our study indicates that the standard deviation of the distribution of annual turnover is 75 employees. Ìf we sample five of these textile companies, without replacement, and wish to compute the standard error of the mean, we would use the equation as follows: Sigma xbar is equal to sigma divided by square root of n{whole root of N Minus n divided by N minus 1 is equal to 75 divided by square root of 5 multiplied by whole root of 20 minus 5 divided by 20 minus 1. is equal to (33.54) multiplied by(0.888) is equal to 29.8 Standard error of the mean of a finite population Ìn this example, a finite population multiplier of 0.888 reduced the standard error from 33.54 to 29.8. Ìn cases in which the population is very large in relation to the size of the sample, this finite population multiplier is close to 1 and has little effect on the calculation of the standard error. Say, that we have a population of 1.000 items and that we have taken a sample of 20 items. Ìf we use the Equation to calculate the finite population multiplier, the result would be N÷n Finite population multiplier is equal to whole root of N minus n divided by N minus 1 Ìs equal to whole root of 1000inus 20 divided by1000 Minus 1 Ìs equal to whole root of 1980 divided by 999 0.99 Using this multiplier of 0.99 would have little effect on the calculation of the standard error of the mean. This last example shows that when we sample a small fraction of the entire population (that is, when the population size N is very large relative to the sample size n), the finite population multiplier takes on a value close to Ì.C. Statisticians refer to the fraction n divided by N as the sampling fraction, because it is the fraction of the population N that is contained in the sample. When the sampling fraction is small, the standard error of the mean for finite populations is so close to the standard error of the mean for infinite populations that we might as well use the same formula for both, namely, Equation xbar is equal to sigma divided by square root of n The generally accepted rule is: When the sampling fraction is less than >)>?< the finite population multiplier need not be used) When we use above equation sigma is constant, and so the measure of sampling precision sigma xbar depends only on the sample size n and not on the proportion of the population sampled. That is, to make sigma smaller, it is necessary only to make n larger. Thus, it turns out that it is the absolute size of the sample that determines sampling precision, not the fraction of the population sampled. Although the law of diminishing return comes from economics, it has a definite place in statistics too. Ìt says that there is diminishing return in sampling. Although sampling more items will decrease the standard error, (the standard deviation of the distribution of sample means) the increased precision may not be worth the cost. Because n is in the denominator, when we increase it (take larger samples) the standard error (5T decreases. Ìn our example, when we increased the sample size from 10 to 100 (a tenfold increase) the standard error fell only from 31.63 to 10 (about a two-thirds decrease). Maybe it wasn't smart to spend so much money increasing the sample size to get this result. That's exactly why statisticians (and smart managers) focus on the concept of the "right" sample size. Some finite populations are so large that they are treated as if they were infinite. An example of this would be the number of TV households in our country. /e38or&s 4Ilossar3 /ensus: The measurement or examination of every element in the population. .Sample< A portion of the elements in a population chosen for direct examination or measurement. Strata: Groups within a population formed in such a way that each group is relatively homogeneous, but wider variability exists among the separate groups /lusters: Groups, in population, those are similar to each other, although the groups themselves have wide internal variation. Random or probability sampling: A method of selecting a sample from a population in which all the items in the population have an equal chance of being chosen in the sample. Stratified Sample: A method of random sampling. The population is divided into homogeneous groups or strata. Elements within each stratum are selected at random according to one of two rules. 1. A specified number of elements is drawn from each stratum corresponding to the proportion of that stratum in the population. 2. Equal numbers of elements are drawn from each stratum, and the results are weighted according to the stratum's proportion of the total population. Systematic sampling: A method of sampling in which elements to be sampled are selected from the population at a uniform interval that is measured in time, order or space. /luster sampling: A method of random sampling. The population is divided into groups, or clusters of elements, and then a random sample of these clusters is selected. @udgement Sampling: A method of selecting a sample from a population in which personal knowledge or expertise is used to identify the items from the population those are to be included in the sample. Statistic: Measures describing the characteristics of a sample. #arameters: 5alues that describe the characteristics of a population. Statistic: Measures describing the characteristics of a sample. Sampling distribution of the mean:: A probability distribution of all the possible means of samples of a given size, n, from a population. Sampling distribution of a statistic: For a given population, a probability distribution of all the possible values a statistic may take on for a given sample size. Sampling error: Error or variation among sample statistic. Differences between each sample and the population, and among several samples, which are due to the elements we happen to choose for the sample. Standard error: The standard deviation of the sampling distribution of a statistic. Standard error of the mean: The standard deviation of the sampling distribution of the mean, a measurement the extent to which we expect the means from different samples to vary from the population mean, owing to the chance error in the sampling process. Statistical inference: The process of making inferences about populations from information contained in samples. /entral Limit: theorem states that the sampling distribution of the mean approaches normality as the sample size increases, regardless of the shape of the population distribution from which the sample is selected. 0inite population: A population having a stated or limited size. 0inite population multiplier: A factor used to correct the standard error of the mean for studying a population of finite size that is small in relation to the size of the sample. 'nfinite population: A population in which it is theoretically impossible to observe all the elements. Sa'5lin, 8ith re5la%e'ent: sampling procedure in which sampled items are returned to the population after being picked, so that some members of the population can appear in the sample more than once. Sampling without replacement: A sampling procedure in which sampled items are not returned to the population after being picked, so that no members of the population can appear in the sample more than once. EJ7ations intro&7%e& in the Unit EJ7ation 1 si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n Use this formula to derive the standard error of the mean when the population is infinite, that is, when the elements of the population cannot be enumerated in a reasonable period of time, or when we sample with replacement. This equation states that the sampling distribution has a standard deviation, which we also call a standard error, equal to the population standard deviation divided by the square root of the sample size. EJ7ation ! - is eJ7al to #6 "ar Min7s '7 &i=i&e& "3 si,'a 6"ar. A modified version of the equation allows us to determine the distance of the sample mean x bar from the population mean mu, when we divide the difference by the standard error of the mean sigma xbar. Once we have derived a z value, we can use the Standard Normal Probability Distribution Table and compute the probability that the sample mean will be that distance from the population mean. Because of the central limit theorem, we can use this formula for non-normal distributions if the sample size is at least 30. EJ7ation ( si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n '7lti5lie& "3 8hole root of N 'in7s n &i=i&e& "3 N 'in7s 1 where N is equal to size of the population; n is equal to size of the sample This is the formula for finding the standard error of the mean when the population is finite, that is, of stated or limited size, and the sampling is done without replacement. EJ7ation . Finite population multiplier is equal to Whole root of N minus n divided by N minus 1. Ìn Equation 3, the term is equal to N Minus Ì , which we multiply by the standard error from Equation (1), is called the finite population multiplier. When the population is small in relation to the size of the sample, the finite population multiplier reduces the size of the standard error. Any decrease in the standard error increases the precision with which the sample mean can be used to estimate the population mean. 97estions Ì. Explain Random Numbers. 2. What is a Sampling distribution? 3. What is sample mean? 4. Explain Distribution of all sample means. 5. Define Standard Error. 6. Ìf we have a population of 10,000 and we wish to sample 20 randomly. Use random number table to choose the sample. 7. A population is made up of groups that have wide variations within the group and less variation from group to group. Which is the appropriate type of sampling method? 8. Explain: Sampling allows us to be cost-effective. We have to be careful choosing representative samples. 9. Suppose you are sampling from a population with a mean of 5.3. What sample size will guarantee that (a) The sample mean is 5.2? (b) The standard error of the mean is zero? 10. Ìn a sample of 16 observations from a normal distribution with a mean of 150 and a variance of 256, what is (a) P multiplied by xbar below 160)? P multiplied by (xbar greater than 142)? Ìf, instead of 16 observations, 9 observations are taken, find (c)P multiplied by(xbar below 160) P(xbar greater than 142) 11. Ìn a sample of 19 observations from a normal distribution with mean 18 and standard deviation 4.8 (a) What is P(16 below xbar below 20)?- (b) What is P multiplied by(Ì 6 less or equal to xbar is less than or equal to 20 )? (c) Suppose the sample size is 48. What is the new probability in part(a)? 12. Ìn a normal distribution with mean 56 and standard deviation 21, how large a sample must be taken so that there will be at least a 90 per cent chance that its mean is greater than 52? 13. Ìn a normal distribution with mean 375 and standard deviation 48, how large a sample must be taken so that there will be at least a 0.95 that the sample mean falls between 370 and 380? (b) Ìf the astronomer watches for an additional hour, will this probability rise or fall? Why? 14. The average cost of a flat at Powai Lake is Rupees 62 lakh and the standard deviation is Rupees 4.2 lakh. What is the probability that a flat at this location will cost at least Rupees 65 lakh 15. State whether following statements are true or false. (a) When the items included in a sample are based on the judgement of the individual conducting the sample, the sample is said to be non-random. True or False Ans8er: Tr7e (b) A statistic is a characteristic of a population. True or False Ans8er: +alse (c) A sampling plan that selects members from a population at uniform intervals in time order or space is called stratified sampling. True or False Ans8er: Tr7e (d) As a general rule, it is not necessary to include a finite population multiplier in a computation for standard error of the mean when the size of the sample is greater than 50. True or False Ans8er: +alse (e) The probability distribution of all the possible means of samples is known as the sample distribution of the mean. True or False Ans8er: Tr7e (f)The principles of simple random sampling are the theoretical foundation for statistical inference. True or False Ans8er: Tr7e (g) The standard error of the mean is the standard deviation of the distribution of sample means. True or False Ans8er: Tr7e (h) A sampling plan that divides the population into well-defined groups from which random samples are drawn is known as cluster sampling. True or False Ans8er: Tr7e (Ì) With increasing sample size, the sampling distribution of the mean approaches normality, regardless of the distribution of the population. True or False Ans8er: Tr7e (j) The standard error of the mean decreases in direct proportion to sample size. True or False Ans8er: Tr7e (k) To perform a complete enumeration, one would need to examine every item in a population. Trueor False Ans8er: Tr7e (l) Ìn everyday life, we see many examples of infinite populations of physical objects. True or False Ans8er: +alse (m) To obtain a theoretical sampling distribution, we consider all the samples of a given size. TrueorFalse Ans8er: Tr7e (n) Large samples are always a good idea because they decrease the standard error. TrueorFalse Ans8er: Tr7e (o) Ìf the mean for a certain population were 15, it is likely that most of the samples we could take from that population would have means of 15. True or False Ans8er: +alse (p) The standard error of a sample statistic is the standard deviation of its sampling distribution. True or False Ans8er: Tr7e (q) Judgement sampling has the disadvantage that it may lose some representative ness of a sample. True or False Ans8er: Tr7e (r) The sampling fraction compares the size of a sample to the size of the population. True or False Ans8er: Tr7e (s) Any sampling distribution can be totally described by its mean and standard deviation. TrueorFalse Ans8er: Tr7e (t) The precision with which the sample mean can be used to estimate the population mean decreases as the standard error increases. TrueorFalse Ans8er: Tr7e 1@. *lease sele%t the %orre%t ans8er fro' the %hoi%es 5ro=i&e&E 1. Which of the following is a method of selecting samples from a population? (a) Judgement sampling (b) Random sampling (c) Probability sampling (d) All of these (e) (a) and (b) but not (c) Ans8er: #e$ #a$ an& #"$ "7t not #%$ 2. Choose the pair of symbols that best completes this sentence: ÷is a parameter, whereas ÷ is a statistic. (a) N, g (b) (y, s (c) N, n (d) All of these (e) (b) and (c) but not (a) Ans8er: #e$ #"$ an& #%$ "7t not #a$ 3. Ìn random sampling, we can describe mathematically how objective our estimates are. Why is this? (a) We always know the chance that any population element will be included in the sample (b) Every sample always has an equal chance of being selected (c) All the samples are exactly the same size and can be counted (d)None of these (e) (a) and (b) but not (c) Ans8er: #e$ #a$ an& #"$ "7t not #%$ 4. Suppose you are performing stratified sampling on a particular population and have divided it into strata of different sizes. How can you now make your sample selection? (a) Select at random an equal number of elements from each stratum (b) Draw equal numbers of elements from each stratum and weigh the results (c) Draw numbers of elements from each stratum proportional to their weights in the population. (d) (a) and (b) only (e) (b) and (c) only Ans8er: #e$ #"$ an& #%$ onl3 5. Ìn which of the following situations would (7,, is equal to (For,rn be the correct formula to use for computing (a) Sampling is from an infinite population (b) Sampling is from a finite population with replacement (c) Sampling is from a finite population without replacement (d) (a) and (b) only (e) (b) and (c) only Ans8er: #&$ #a$ an& #"$ onl3 6. The dispersion among sample means is , the dispersion among the sampled items themselves because (a) Each sample is smaller than the population from which it is drawn (b) Very large values are averaged down and very small values are averaged up (c) The sampled items are all drawn from the same population (d) None of these (e) (b) and (c) but not (a) Ans8er: #"$ Ver3 lar,e =al7es are a=era,e& &o8n an& =er3 s'all =al7es are a=era,e& 75 7. Suppose that a population with N is equal to 144 has p is equal to 24. What is the mean of the sampling distribution of the mean for samples of size 25? (a) 24 (b) 2 (c)4.8 (d) Cannot be determined from the information given Ans8er: #a$ !. 8. The central limit theorem assures us that the sampling distribution of the mean (a) Ìs always normal (b) Ìs always normal for large sample sizes (c) Approaches normality as sample size increases (d) Appears normal only when N is greater than 1,000 Ans8er: #"$ Is al8a3s nor'al for lar,e sa'5le si-es 9. Suppose that, for a certain population, sigma xbar is calculated as 20 when samples of size 25 are taken and as 10 when samples of size 100 are taken. A quadrupling of sample size, then, only halved sigma xbar. We can conclude that increasing sample size is (a) Always cost-effective (b) Sometimes cost-effective (c) Never Cost-effective Ans8er: #%$ Ne=er CostEeffe%ti=e 10. For the previous questions, what must be the value of (Y for this infinite population? (a) 1,000 (b) 500 (c) 377.5 (d) 100 Ans8er: #&$ 100 11. The finite population multiplier does not have to be used when the sampling fraction is (a) Greater than 0.05 (b) Greater than 0.50 (c) , 0.50 (d) Greater than 0.90 (e) None of these Ans8er: #e$ None of these 12. The standard error of the mean for a sample size of two or more is (a) Always greater than the standard deviation of the population (b) Generally greater than the standard deviation of the population (c) Usually , the standard deviation of the population (d) None of these Ans8er: #%$ Us7all3 0 the stan&ar& &e=iation of the 5o57lation 13. A border patrol checkpoint that stops every passenger van is using (a) Simple random sampling (b) Systematic sampling (c) Stratified sampling (d) Complete enumeration Ans8er: #&$ Co'5lete en7'eration 14. Ìn a normally distributed population, the sampling distribution of the mean (a) Ìs normally distributed (b) Has a mean equal to the population mean (c) Has a standard deviation equal to the population standard deviation divided by the square root of the sample size (d) All of the above (e) Both (a) and (b) Ans8er: #&$ All of the a"o=e 15. The central limit theorem (a) Requires some knowledge of the frequency distribution (b) Permits us to use sample statistics to make inferences about population parameters (c) Relates the shape of a sampling distribution of the mean to the man of the sample (d) Requires a sample to contain fewer than 30 observations Ans8er: #"$ *er'its 7s to 7se sa'5le statisti%s to 'a2e inferen%es a"o7t 5o57lation 5ara'eters 17. A portion of the elements in a population chosen for direct examination or measurement is a ___________________ Ans8er: Sa'5le Ì8. The proportion of the population contained in a sample is the___________________ Ans8er: Sa'5lin, fra%tion. 19. _______________ is the process by which inferences about a population are made from information about a sample. Ans8er: Statisti%al inferen%e. 20._____________ sampling should be used when each group considered has small variation within itself but there is wide variation between different groups. Ans8er: Stratifie&. 2L A method of random sampling in which elements are selected from the population at uniform intervals is called________________ sampling. Ans8er: S3ste'ati% 2 2. ___________ is the degree of accuracy with which the sample mean can estimate the population mean. Ans8er: Stan&ar& error of the 'ean. 23. Within a population, groups that are similar to each other (although the groups themselves have wide internal variation) are called ____________ Ans8er: Cl7ster. 24. A sampling distribution of the proportion is a probability distribution of the __________ Ans8er: Sa'5le 5ro5ortion. ANNE1URE: *ROBABIDIT) TABDE END O+ CGA*TER 1(E ADVANCED BAN/ MANAIEMENT H CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 14 Correlation and Regression STRUCTURE 14.0 Objectives 14. 1 Ìntroduction 14.2 Scatter Diagrams 14.3 Correlation 14.4 Regression 14.5 Standard Error of Estimate 'eywords *uestions 1..0 OBJECTIVES 1. To understand relationship between two variables and its impact on decision making. 2. To draw scatter diagram from available data to visualize the relationship. 3. To use regression analysis to estimate one variable when a value of the other is given. 4. To learn how co-relation analysis describes the degrees to which 2 variables are linearly related to each other 5. To recognize the limitations of the coefficient of correlation. 1..1 INTRODUCTION `A good education is essential to achieve success in life.' We often hear this. We often say this too. But is it true? Suppose we decide to test it. We take a sample of 50 individuals and from each we collect data about two things: the number of years of education and annual income. These two variables are taken to quantify 'a good education' and 'success in life'. Our aim is to find if the two are %orrelate&. Further, we would also like to see if we can predict the annual income of a person if we know how many years' education he or she has had. This is called re,ression. There are situations where more than two variables come into play. The study in that case is called multiple correlation or regression. But here we shall limit ourselves to the study of the relationship between two variables. 1..! SCATTER DIAIRAM Visual representation of data can give us a good idea about the relationship between two variables. Let us start with an example. Suppose, the Principal of a college wants to find out whether there is a relationship between the entrance examination score and the final graduation GPA score of a student. Then, we take a random sample of students' data from college records, and plot the graph. The Principal wants to use the score in the entrance examination to predict final outcome. (see Fig. 14.1). The graph in Fig. 14.1 is called a scatter diagram. Ìn a scatter diagram we just plot the points whose coordinates are the data pairs. Ìn this example we have the data pairs, (6, 6), (7, 10), (10, 16), (14, 22), (14, 30), (12, 25), (13, 25). (17, 31), (10, 20), (11, 12), (15, 25). This diagram gives us a rough idea that if the entrance exam score is higher, the GPA score also is higher. Such a relationship is called a direct relationship. There are situations when the data indicate an inverse relationship. This is what you expect between the time spent on exercising and weight gain in a given period. There could be situations where there is no relationship between two variables. For example, the marks obtained by a student in English and those in Mathematics. We now give a few scatter diagrams to show you how easy it is to identify the relationship from them. (See Fig. 14.2). Ìn Fig. 14.2(a) you see that as one variable increases, the other decreases which indicating an inverse relationship. From Fig. 14.2(b), we can not infer anything about the variables. From Fig. 14.2(c) we see that the relationship is inverse in the beginning but becomes direct later on. Ìn Figs. 14.1 and 14.2 (a), we can imagine a line drawn across the points (see Figs. 14.3a and b). This means there is a linear relationship between the variables. Ìn Fig. 14.3(c) we cannot draw a line to `fit' the data, but a curve can be drawn. Such a relationship is called a curvilinear relationship. Ìn this chapter we shall study only linear relationships. Both scatter diagrams indicate a direct relationship. But the points in (a) are very close to the line drawn across them, and those in (b) are more scattered. The line drawn across the data points are used to predict one variable if the other one is known. From the figure, it is clear that the line in (a) fits the data better than the line in (b). This means, the predictions based on the data in (a) would be more accurate than those based on (b). Comparing the scatter of the points in (a) and (b), we can say that the variables in (a) are more strongly related than those in (b). So, the stronger the relationship, the better will be our prediction. So how do we measure the strength of a relationship? The measure we use is called coefficient of correlation or correlation coefficient, and is denoted by r. 1..( CORREDATION Ìf X and Y are two variables, correlation coefficient 'r' is computed as below: r is equal to covarient of (X,Y) divided by standard deviations of variables x and y where covariant of (X, Y) = Ì divided by N multiplied by sum(x minus xbar) multiplied by(y minus y bar) Cov (X, Y) is called the covariance between X and Y. N is the total number of observations. X bar Y bar are the means and sigma x, sigma y are the standard deviations of the variables X and Y. Y x1N; Y, y1N 1(x÷.302 N J(Y ÷Y)2 Correlation Coefficient can also be calculated using the formula: NTxy ÷ (Er) (Ty) (VNEX2 ÷ (Y-X)2) (VNXy 2 ÷ (,Y)2 ) E6a'5le1..1 Calculate the correlation coefficient for the following data. This formula is easier to use when calculations are done with the help of a calculator. Let us take an example. (Rupees in crores) The value of r always lies between Minus1 and 1. A value of r = Minus 1 indicates perfect inverse relationship between the two variables. A scatter diagram in this case will have all points lying on a line of negative slope, i.e. sloping from left to right. A value of r = 1, on the other hand indicates a perfect direct relationship, with all the points in the scatter diagram lying on a line sloping up from left to right. A value of r = 0 indicates that there is no linear relationship between the variables. Ìt is important to note here, that some other kind of curvilinear relationship may exist between the variables. Thus, the correlation coefficient is a measure of linear relationship between two variables. A value of the coefficient near plus 1 or minus 1 indicates a strong relationship. A value closer to zero indicates a weak relationship. Here are some exercises for you. Draw scatter diagrams and calculate the correlation coefficient for the following data sets. 1... REIRESSION Once we get an idea of the kind and strength of the relationship between two variables from the scatter diagram and the value of the correlation coefficient, we try to draw a line which best represents the points. To fit the data, the line should pass close to all points and should have points on both sides. This is to ensure that the difference between the points in the scatter diagram and those on the line is minimal. The technique of least squares is used to arrive at the following: The equation of the line used to predict values of y, if values of x are known, is y = a plus bx, where b is called the slope of the line. Ìts sign (plus or minus) tells us whether the line slopes from left to right, or from right to left. a is called the y-intercept. Ìt is the point where the line crosses the y-axis. [see Fig. 14.5 (a and b)]. After calculating a and b, we write the equation ' y = a + b-v and whenever a value of x is given, we put it in this equation to get the value of y. This is our prediction, based on regression. Let us take an example. E6a'5le 1..! Given the data in example 13. 1, estimate the value of y, when x = 70. See if you can predict the values in the following exercise: Estimate y when x = 35, for data in exercise (i) 90, for data in exercise (ii) 1..? STANDARD ERROR O+ ESTIMATE We have seen how to measure the strength of a linear relationship between two variables. We have also seen how to predict the value of one variable when that of the other is given to us. Our prediction is based on the line of best fit. Ìt would be useful to know how good our prediction is. Standard error of the estimate is a measure which tells us exactly this. For this, we calculate the difference between observed and estimated values of y. Ìf y denotes the estimated value of they variable, then the standard error S, is worked out as Se (Y V (n ÷ 2) where n is the number of observations of each variable. y = a+ bx, and so we can also write ÷ a1y ÷ bYxy (n-2) A small value of Se indicates that our estimates are fairly accurate. We can be reasonably sure (65 per cent confident) that the actual value of y will lie between S, ) and (y + S,) . y ÷ Se, y + S, ) is called a 65 per cent confidence interval.). We can be 95 per cent confident that the actual value of y lies between 2S, y + 2S,) we shall study more about confidence intervals in Unit 5. Di'itation of the Coeffi%ient of Correlation When we judge the strength of a relationship between two variables by the value of the coefficient of correlation, we must remember that it measures only linear relationships. So even though two variables have a perfect curvilinear relationship, say all points in the scatter diagram are on a circle, the coefficient of correlation will be zero. So correlation analysis should be applied only to linear relationships. Secondly the data obtained should be homogeneous. Ìf the sample chosen is heterogeneous, it may give rise to a high value of correlation coefficient, even when no correlation actually exists. Thirdly, a value of r close to 1 indicates a strong direct linear relationship. This means that the two variables rise or fall together. Ìt does not indicate any cause effect relationship between the two. For example, over a period of 20 years from 1970 to 1990, the annual consumption of rice in Ìndia has increased. Ìn the same period the number of road accidents has also increased. These two variables will, therefore, show a correlation coefficient close to 1. But it is ridiculous to say that increased rice consumption is the cause of the increase in road accidents. /e38or&s4Ilossar3 Scattered diagram: observed and predicted values. Helps to get feel of the situation. 'ndependent variable: Variable that is the basis of prediction. "ependent variable: Variable that is predicted is called dependent variable. Trend 2nalysis: The type of relationships ÷ straight line, curvilinear, parabola, circle, etc. Regression 2nalysis Fitting the line of relationship. Standard error of the estimate: Measure which tells us how good the prediction is. /orrelation 2nalysis: The strength of relationship is measured. Coeffi%ient of %orrelation: Coefficient of determination; Covariance. Questions 1. Plot the scatter diagram for the given data. Develop the estimating equation. Predict for x = 6,13.4 and 20.5. 2. Ìn the college, a teacher collected the data about absenteeism of students. He wanted to find out whether there is any relationship between absence and temparature of the day. (a) State the dependent variable and the independent variable. (b) Draw the scatter graph. (c) Does the relationship between the variables appear to be linear or curvilinear? (d) What is the type of curve? (e) What is the logical explanation for observation? 3. (a) For the following data find the best fitting line. (b) Compute std. error of estimate. (c) Find an approx. prediction interval for the dependant variable y, when x = 44 (with 95% confidence interval). 4. Ìn new housing areas appliances sales (mixers, refrigerators. heaters, toaster etc.) are very good. The data has been collected fora new area development. The number of houses and appliances are in thousands. (a) Develop an equation for the relationship between the appliances sales and house sales. (b) Ìnterpret the slope of the regression line. (c) Compute and interpret the s. error of the estimate. (d) For the next year as high as 8.0 million houses are being predicted (may be beyond the recorded range). Compute an approx. 90% prediction interval for appliances sales, based on previous data and the new prediction of housing starts. 5. Ìn a factory, a consultant was studying the relationship between the workers and supervisors. The consultant talks about the dangers of over-supervising their workers. A worker in an assembly line is given a series of complicated tasks to perform. During the workers' performance, a supervisor constantly interrupts the worker to assist him. Then at the end of the tasks, the worker is given a psychological test to measure his hostility towards the supervisor. The score of 8 workers are given below. Note: higher the score lower the hostility. (a) Plot the data. Develop the equation with the best-fit. Give your comments. (b) Predict the expected test Score, when x = 18. (c) Calculate the sample coefficient of determination and the sample coefficient correlation for the given data. 6. We give data for employment and output for 10 companies: (a) Which is the dependent variable? (b) Draw 2 linear trends, one using employment as dependent variable and other using output as dependent variable. (Least squares method) (c) Find coefficient of determination, covariance and coefficient of correlation. 7. The airlines company is interested in decreasing waiting time spent by customers while buying air-tickets. So the relationship between waiting time y (in minutes), and number of counters x operating to sell tickets has been studied. Therefore, customers were randomly selected and data was collected. x 2 3 5 4 2 6 1 3 4 3 3 2 4 y 12.8 11.3 3.2 6.4 11.6 3.2 8.7 10.5 8.2 11.3 9.4 12.8 8.2 (a) Calculate the regression equation that best fits the data. (b) Calculate the coefficient of determination and coefficient of correlation. (c) Give your comments on the results. (d) Ìf you want to reduce the waiting time to 5 minutes, what should you do. 8. What is regression analysis? 9. What is an estimating equation? 111. What is a correlation analysis? H. Define direct and inverse relationships. 12. What types of correlation (positive, negative, or zero) should be expected from these variables: (a) Ability of supervisors and output of their subordinates. (b) Number of years of education and age at first job. (Assume job is got immediately after education) (c) Weight and blood pressure. (d) Student's height and his score in the H.Sc. examination. 13. Draw a plot of points, where the correlation is zero, and explain why. 14. The correlation coefficient will always lie between Minus 1 and Plus 1. True or false. 15. What is the relationship between covariance and coefficient of correlation? CASE STUDIES /ase Study - ( $/ity Traffic #olice% When the number of cars is increasing, accidents are also increasing. But in this city, there are many minor traffic violations happening during weekends with parades, and rallies. The data about weekend accidents is given below: X ÷ Parades rallies 20 30 10 12 15 25 34 Y ÷ Accidents 6 9 4 5 7 8 9 (a) Plot this data. Develop the equation which best fits the data. (b) The traffic chief wants to predict the number of accidents in the next week when he expects 33 rallies. (c) Calculate the standard error of estimate. ,(d) What precautions can he take? /ase Study A - $BCD 0actory$ The management has been wondering about the increase in overheads. While production increases, overheads have been increasing but not proportionately. They were not fixed costs. So the C.E.O., Mr. Ramesh, wanted a formula with which he can calculate the expected overhead. He called his cost accountants Balla and Dalbhir, and asked them to work out the expected overhead costs, when he increases production. Ramesh: oh Ì do not want to face a situation when Ì do not know the overhead costs. Ì have to allocate them to products and work out prices. Secondly, if the level of overheads is too much we should take action to cut costs. He asked them to come back with results soon. Dalbhir and Balla collected for 10 days, the actual data of production and overheads: Production-units 40 42 40 53 35 56 39 48 30 37 Overheads 191 170 178 272 155 280 173 234 116 153 "albhir: Ì am not able to find out anything. 7alla: Ì think we should take the help of Statistics Dept. Ì have heard of something about best-fitting equation. "albhir: Ìt is important that we predict the estimated cost more correctly, than giving a guess. 7alla: Ìf we use statistical methods our prediction will be with less error. We can have a good prediction interval. (a) Do you agree with Balla? (b) What method should be used? (c) Give the best fitting equation. (d) Predict the level of overhead when the production of units = 50. (e) Calculate the standard error of estimate. (f) Give the upper and lower level of prediction interval, for a confidence level of 95 per cent. END O+ CGA*TER 1.E ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 15 Time Series STRUCTURE 1?.0 15.0 Objectives 15. 1 Ìntroduction 15.2 Variations in Time Series 15.3 Trend Analysis Ì5.4 Cyclical Variation 15.5 Seasonal Variation 15.6 Ìrregular Variation eywords 9uestions 1?.0 OBJECTIVES Ìn this unit, we will deal with changes that occur with time. Projecting such time based changes is called time series. We will learn the four components of a time series. We will look at seasonal indices and see how to use them to de-seasonalise a time series. We will learn how to analyse cyclical component of the time series and use regression based techniques to estimate and forecast the trend in a time series. We will deal simultaneously with all four components of the time series and see how to use time series for forecasting. 1?.1 INTRODUCTION Nothing stays the same. With time everything changes. Ìt is always assumed that growth is good and the economy becomes better. 'Either grow or stagnate' used to be the slogan earlier. But growth is not necessarily always good. Ìn fact, we want to limit the growth of some cities/ regions to avoid pollution and environment problems. Ìn an environment like this, we have to define growth and change so as to help in planning. We will have to forecast changes over time, as they are an important part of decision making. Ìn this module, we will learn how to measure amounts and rates of change. For example, we need to be careful while predicting the changes in the level of inventory in a factory. Unless we predict correctly, we may either have excess or less. Secondly, this may lead to liquidity problems, if we have to arrange for sudden ordering of materials. Thirdly, this may lead to cost escalations, or delivery problems due to unavailability of raw materials. We will also see how to describe the long-term patterns of change or secular trend. Along with long term trends, we will study about short term fluctuations like seasonal trends, business cycles and irregular variations. Secular trend is caused by basic inherent factors. Business cycle trends are mostly upward. The quality of forecast depends on the information provided by past data and its validity. Data or statistical information accumulated at regular intervals is called TIME SERIES. 1?.! VARIATIONS IN TIME SERIES There are 4 types of variations in time series. See graphs a, b, c, d of Figure 4.1. 1. Secular Trend 2. Cyclical Fluctuation 3. Seasonal Variation 4. Ìrregular Variation. 1. Se%7lar Tren& Ìn this first type of variation the change comes over a long period of time. A steady increase in cost of living recorded by Consumer Price Ìndex is a good example. From year to year there is a fluctuation but there is a steady increase in the trend. Let us see the series given here. Let us try to detect patterns in the information over regular intervals of time. Then let us try to predict to cope with uncertainty. TABLE 15.1 Year 1997 1998 1999 20W 2001 2002 2003 Number 98 105 116 119 135 156 177 8bservations There is an increase over time of 7 years. But the increases are not equal. !. C3%li%al +l7%t7ation Most common example of a cyclical fluctuation is a business cycle. Over time, there are years when business cycle hits peak above the trend line. There are also times when business activity slumps, and hits a point below the trend line. Fluctuations in business activity occur many times, and they have irregular periods and vary widely in amplitude from cycle to cycle. The time between hitting peaks and lows are periods ÷ it can be one or many. The cyclical moves do not follow any regular pattern, they are irregular. (. Seasonal Variation There is a pattern of change within a year. A doctor can expect the number of flu cases to increase in winter. Hill resorts can expect more tourists during summer. These are regular patterns and can be used for forecasting the amount of flu vaccines required during winter, the doctor's income during winter, the hotel bookings in resorts and availability of air and train bookings. .. Irre,7lar Variation The value of the variable is unpredictable, changing in a random manner. The effects of earthquakes, floods, wars, etc., cannot be predicted. As a result of flood, the agriculture output suffers. Then the prices go up at an unprecedented rate. This could not be predicted by using time series. Even though we described time series as exhibiting one or another variation, in most instances real time series will contain several of these components. Then the question is how to measure them. 1?.( TREND ANAD)SIS Of the 4 variations, secular trend represents long-term direction (see Fig. 15. la). We can visually fit a line in the graph sheet. A study of the trend helps us to understand historical patterns and events (for sudden unusual change). Studying trend also helps us to project trends into the future (see Fig. 15.1). Even a sudden change in the past due to a situation (like war, etc.) can be used to predict the trend if a similar sudden change happens (see Fig. 15.2). Trends can be linear or curvilinear. Trend that can be described by a straight line is called a linear trend. Equation for estimating a straight line, ybar is equal to b multiplied by x Where ybar is estimated value of the dependent variable x is an independent variable a is equal to y minus intercept (the value of y, when x is equal to 0) b is equal to the slope of the trend line. Some trends like pollutants in the environment increase, but they need not be a straight line. Another example of curvilinear relationship is the life cycle of a business product. When introduced, a product has a low sales volume. As the product gains recognition and success, the sales go up. After the product is firmly established, there is a stable rate of growth. As the product reaches the end of its cycle (new products, more competition, etc.) the sales decrease (see graph Fig. 15.2b). There are three main reasons, why we should study the trends: (a) We will be able to describe historical patterns, which will help us to evaluate the success of previous policies ÷ long-term direction of the time series is given by secular trend. (b) Past trends will help us to project the future ÷ some growth rate of population, GDP. (c) We will be able to separate the trend component and eliminate it from the series, to get an accurate idea of other components like seasonal fluctuations. Ìn the last unit, we have seen how to draw scatter diagram and a regression line to the data on two variables. Ìn time series, the independent variable x is time. Applying the same method, we fit the line ybar is equal to a plus b multiplied by x b is equal to Sum x multiplied by x minus n multiplied by xbar multiplied by y bar divided by Sum x square minus n x square and a is equal to y bar minus b. xbar Here the independent variable time is measured in terms of years, weeks, months, etc. We use a process for coding to simplify computation. To use coding, we find the mean time and then subtract that value from each of the sample times. Suppose our time series consists of 2000, 2001, 2002, 2003 and 2004. Ìf we have to use them in equations and find squares, the calculation becomes tedious. So we use coding. The mean is 2002. The corresponding coded values are minus 2, minus 1, 0, plus 1, and plus2. When the time series is an odd number of data, there is no problem as you get whole numbers and the mean is equal to 0. Ìn the case of even number of data like, 1990, 1991, 1992, 1993, 1994 and 1995. When we code this, mean is 1992.5; then the codes are minus2.5, minus 1.5, minus 0.5, plus0.5, plus 1.5, plus 2.5. Now the fraction becomes part of the calculation. To avoid this complication, we multiply this by 2, and call it coded time. Mean of the coded time becomes 0. Then it is easier to use the equations. Odd Number of x Values Even Number of x Values x x-mean x c. time x x- mean time (c. time x2) 20002000-2002 minus2 1990 Minus 2.5 Minus 5.0 20012001-2002 minus1 1991 Minus 1.5 Minus 3.0 20022002-2002 0 1992 Minus 0.5 Minus 1.0 20032003-2002 1 1993 0.5 1.0 20042004-2002 2 1994 1.5 1.5 1995 2.5 5.0 Sum x is equal to 10010; mean is equal to 2002 Sum x is equal to 11,955; mean is equal to 1992.5 Code time mean is equal to 0 Code mean is equal to 0 Slope b is equal to Sum x multiplied by y (since coded mean of x divided by Sum x square is equal to 0, the second part of the equation becomes 0). Then a is equal to y bar. E6a'5le Let us take the problem of number of ships loaded in a harbor as in Table 15.2, which is reproduced below TABLE 15.2 Year 1997 1998 Ì999 2000 2001 2003 2004 Number 98 105 116 119 135 156 177 208 m is equal to Sum T divided by n is equal to 2000.5; Dry is equal to 1266; Sum x square is equal to 168; Sum y is equal to 1114; y bar is equal to 139.25; x bar is equal to 0 b is equal to 1266/168 is equal to 7.536; a is equal to 139.25 Then the general equation for loading ships is y bar, is equal to 139.25 plus 7.536x Here x is the coded time; so when we want to predict for a particular year, we must convert that to coded time. For example, year 2007, will be equal to x is equal to 2(2007 ÷ 2000.5) is equal to 13.0, then is equal to 139.25 plus (7.536 multiplied by 13) is equal to 139.25 plus 97.97 is equal to 237.22; that is 237 ships loaded. General equation for a parabolic curve: Y is equal to a + ox + cx2 FÌGURE 15.3 Using Second "egree trends in Time Series: Till now we have been talking about fitting straight lines for the data. But many series can be best described by curves. Ìn these cases, the linear model does not adequately describe the change in the variable as time changes. To overcome this, we use parabolic curves (Fig. 15.3).. The general form of the equation is: y bar is equal to a plus b multiplied by x plus cx2 square, where a, b, c are numerical constants. Here also, we first code the time variable. Then we use the following three equations to find out the numerical constants. Ì. Sum y is equal to a multiplied by n plus c Sum x square. 2 Sum x square y is equal to a Sum x square plus c sum x to the power of 4. 3. b is equal to Sum xx divided by Sum x square. We find these values simultaneously. *+ample We have given the annual sales data of quartz watches. (in lakh) TABLE 15.3 m is equal to Mean T is equal to 2003; Sum Y is equal to247 After coding Sum x square is equal to 10; Sum x to the power of 4 is equal to 34; Sum xy is equal to 227; Sum x square y is equal to 565 By substituting, we get 247 5a plus 10c; 565 is equal to l0a plus 34c; b is equal to 227/10 is equal to 22.7 By solving the equations we get, a 39.3 and c is equal to 5.07; Y bar is equal to a + bx plus c multiplied by x square is equal to 39.3 + 22.7 x plus 5.07 multiplied by x square. Let us draw the graph to check how well the parabola fits the time series (Fig. 15.4) Ìf we want to forecast for the year 2010, code x is equal to T minus m is equal to 7 Y bar is equal to 39.3 plus 22.7(7) plus 5.07(49) is equal to 446.6 So we conclude, watch sales will be 446, 60,000 by 2010. 1?.. C)CDICAD VARIATION Cyclical variation is a component of the time series, which tends to oscillate above and below the secular trend line for periods longer than a year. Seasonal variation makes a complete regular cycle within each year and does not affect one year any more than another. Once we identify the secular trend, we can isolate the remaining cyclical and irregular components of the trend. Let us assume cyclical component explains most of the variations left unexplained by the trend analysis. Resi&7al Metho& We will start with dividing the actual, observed data by the trend, predicted data. This will give the cyclical variation as a percentage of the trend, (y divided by y bar) multiplied 100 where y v is actual time series value and y bar is predicted value. Another measure of the variation is called Relative cycle residual. Ìn this we find the (Table 15.4) percentage of deviation from trend for each value. This is equal to [(y minus y bar divided by y bar multiplied by 100. Then we can attribute the variation to factors known and unknown. (see Fig. 15.5) The result shows during the years 1996, 2001 and 2002 the actual was less than the estimates by 1.3per cent, 1.2per cent and 1.1per cent. Ìn the years 1997, 1999 and 2000, the estimates were correct. Ìn the years 1998 and 2003, the estimates were more than the actual. Ìn the per cent of trend around the trend line data we try to isolate cyclical components. Ìt is necessary to note that this technique can be used only for analyzing past cyclical variation and not for predicting future cyclical variation. 1?.? SEASONAD VARIATION Time series also includes seasonal variation. Seasonal variation is repetitive and predictable. This can be defined as movements around the trend line in one year or less. Ìn order to measure seasonal variations, time intervals must be measured in small units, like days, weeks, etc. 1. We can establish the pattern of past changes. 2. Then we can predict the future. 3. Once we establish the seasonal patterns, we can eliminate its effects from the time series. This will help us to calculate the cyclical variation that takes place each year- Eliminating seasonal variation from time series is called 'deseasonalization'. Ratio to Moving 2verage Method To measure seasonal variation we use Ratio to Moving Average method. This technique provides an index. This index is based on a mean of 100. The degree of seasonality is measured by variations away from the base. We know that more boats are rented in a lake resort during summer and the number decreases in winter. Ìf in a year 20,000 boats are rented out, the average per quarter should be 5,000. Ìf the index for spring quarter is 142, then we estimate the number of boats rented out during summer will be 5,000 (142 divided by100) is equal to 7,100. E6a'5le The resort wants to establish the seasonal pattern of rooms demanded by tourist. This will help them to plan and improve customer service. They will employ more staff during peak period. TABLE 15.5 Year 1 2 3 4 1998 1861 2203 2415 1908 1999 1921 2343 2514 1986 2000 1834 2154 2098 1799 2001 1837 2025 2304 1965 2002 2073 2414 2339 1967 Step (: Compute seasonal index: (a) Add total values of all four quarters of the 1st year. Write it in the middle of the set of 4 values. (b) Then to get the moving total, start from second quarter of first year and go up to first quarter of 2nd year. (Drop the first value and add the fifth value ÷ This is called 'sliding'.) (c) Ìn this way, continue the process of sliding till the end. (see Table 15.5.) Step -: Find the four quarter Moving Average by dividing each value derived in Step 1 by 4. (col. 5). Step .: Since we have 4 quarters, the centering becomes necessary. Ìf we have odd number like a 7-day data for a week, then centering is not essential. Ìn order to centre the moving averages, we again find the moving average for the values in step 2 - add 2 values and average it. Follow the process of sliding. (Column 5). We can see that moving average has smoothed down the peaks and troughs of the original time series (see Fig. 15.7). Step 1: We will now calculate S1 the percentage of actual value to moving average values. Percentage 100 (actual value/average). For example, we see that for 1998, 3rd quarter is equal to 100 (2415/2104.25) 114.8 See column (6). TABLE 15.6 Year q. Occu Step 1Step 2Step 3Step 4 Column number (1) (2) (3) (4) (5) (6) Si 1998 1 1861 ÌV 1908 8447 2111.75 2129.25 89.6 1999 1 1921 8587 2146.75 2159.125 89.0 ÌV 1986 8677 2169.25 2145.625 92.6 2000 1 1834 8488 2122.00 2070.00 88.6 ÌV 1799 7888 1972.00 1955.875 92.0 2001 1 1837 7759 1939.75 1965.5 93.5 ÌV 1965 8367 2091.75 2140.375 91.8 2002 1 2073 8756 2189.00 2193.375 94.5 ÌV 1967 Step ?: Draw a new table from Step 4 to calculate the modified mean of the seasonal indices [S]. Calculate modified mean by discarding the highest and the lowest value for each quarter. Year 01 02 03 04 1998 114.8 89.6 2002 94.5 109.8 Modified means are: 91.25; 107.70; 113.25; 91.90 Total of indices is equal to 404.10 By discarding the highest and lowest values of each quarter, we try to eliminate the extreme cyclical and irregular components of variation in the time series. When we average the remaining values, we further smooth the cyclical and irregular components. Then modified mean is an index of the seasonality component. Step E: Adjusting the modified mean to base 100. Note that the modified mean sum is 404.1 in this case. The four quarterly indices should total 400. To correct this error, we use the adjusting constant, (400/404.1) is equal to 0.9899. We multiply the values of modified mean by this number. Q1 is equal to 91.25 multiplied by 0.9899 is equal to 90.3; Q2 is equal to 106.6; Q3 is equal to 112.1; Q4 is equal to 91.0. Use of Seasonal In&e6 Seasonal indices are used to find out the seasonal variation. Then we remove the seasonal variations, to get the residual cyclical and irregular variations. We deseasonalize the time series, by dividing each of the actual value in the series by the appropriate seasonal index (expressed as a fraction of 100). Working with our data, for the year 1998, we get the deseasonalised values as follows: Q1 1861 divided by90.3 divided by 100 is equal to 2061 Q2 22203 divided by 106.6 divided by100 is equal to 2067 Q3 2415divided by 112.1 divided by 100 is equal to 2154 Q4 1908divided by 91.0divided by 100 is equal to 2097 This deseasonalised value reflects only the trend, cyclical and irregular components of the time series. Now, we can compute the trend line and use it for prediction. Suppose, our resort manager estimates from the deseasonalised trend line, that the deseasonalised average occupancy for the fourth quarter of next year will be 2121. Then to get the correct picture, we must take seasonality into account. Therefore, multiply the deseasonalised predicted estimate by the fourth quarter seasonal index and obtain the estimate for the season. 2121 multiplied by (91.0divided by100) is equal to 1930. There will be an average occupancy of 1930 rooms in the fourth quarter of next year. (?)E 'RR*!UL2R 52R'2T'8& The final component is irregular variation. After we have eliminated trend, cyclical and seasonal variations from the time series, we may still have unpredictable factor left. Ìrregular variations occur over very short intervals and follow random patterns. We may not be able to isolate them mathematically, but we may isolate the causes for the same. For example, an unusually very cold winter in a region may increase electricity consumption significantly. Wars may increase air and train travel because of the movement of troops. We may not be able to identify all causes. But over time, these random variations tend to correct themselves. E6a'5le Ìnvolving all Four Components (TSCÌ) of the Time Series The data is given on a quarterly basis, and let us first deseasonalize the series. This is sales per quarter of dresses, in a fashion store. TABLE 15.7 Modified means: Q1 is equal to 94.45; Q2 is equal to 129.05; Q3 is equal to 60.80; Q4 is equal to 113.15 Sum of modified mean is equal to 397.45 Adjusting factor is equal to 400/397.45 is equal to 1.0064 Multiplying the adjusting factor and modified mean, find the seasonal indices. Seasonal indices are: Q Ì is equal to 95.1; Q2 is equal to 129.9; Q3 is equal to 61.2; Q4 is equal to 113.9 Then the deseasonalised sales value is equal to (actual multiplied by seasonal index) divided by 100 04 1 16.8 16.2 14.7 15.8 5 18.9 20 22.9 21.9 Now, the second step is to develop the trend line. Code the time series. We have 20 values, i.e. 20 time intervals. This is even number. Then to avoid fraction, multiply by 2. Mean is equal to 0. yr 1 ql is equal to minus 9.5, then minus 8.5, and so on. Then they become; minus19, minus 17, minus15... plus 17, plus19. Mean Y is equal to 1Sumydivided by n is equal to 360.9divided by 20 is equal to 18.0 Sum x is equal to 0; Sum xy is equal to 420.3; Sum x square is equal to 2660; b is equal to 420.3 divided by 2660 is equal to 0.16 a is equal to mean y is equal to 18 plus 0.16x Trend line is equal to a plus bx ; Trend line is equal to 18 plus 0.16x Now we have identified seasonal and trend components of the time series. Calculate the trend values. see Table 4.7 Column 4. Next we have to find cyclical variation around the trend line. Use the Residual method. Find the percent of trend. Per cent of trend is equal to (deseasonalized value divided by trend value) multiplied by 100 (Table 4.7, column 5) Ìf we assume irregular variation is generally short-term and relatively insignificant, then we have analyzed this time series fully. See the graph for the original time series, moving average containing both seasonal and cyclical components and the trend line (deseasonalized). Suppose the management wants to determine the sales value for the 3rd quarter of year 6, First code the time of third quarter of year 6. Code is equal to 19 plus (2 multiplied by 3) is equal to 25 Substituting this value, is equal to a plus bx is equal to 18 plus 0.16multiplied by (25) is equal to 22 Thus the deseasonalized estimate is equal to 22,000 units. Now, seasonalize this data by multiplying it by the third q. seasonal index. 22 multiplied by (61.2 divided by100) is equal to 13.5 is equal to 13,500 units. /e38or&s The four components of time series ÷ Trend, Seasonal, Cyclical and Ìrregular (TSCÌ); Time Coding; Moving Averages; Seasonal index calculation; Deseasonalization; Residual method for cyclical variation; Secular trend; Cyclical fluctuation; Seasonal variation; Ìrregular variation Questions 1. What is Time Series? What is the use of old data. 2. What are the four components of time series? 3. What is coding of time measures? Why is it done? 4. What are the four errors that can affect forecasting with a time series? 5. Define seasonal variation. What are the principal causes for seasonal variations? Name ten products, processes, or activities in business that exhibit strong seasonal variation. Specify two products that have no seasonal variation. 6. Define a business cycle. Ìs it different from seasonal fluctuations'? 7. What is deseasonalization? Why it is necessary to do these calculations on the time series data? 8. Ìllustrate 5 irregular variations with their effects. 9. A time series data for 9 years for the sale of tables by a furniture mart is given below from year 1993-2001, sequentially. 175,190,185,195,190,200,185,190,205. (a) Find the linear equation that describes the trend of sales. (b) Give a forecast for the year 2003. 10. The data for number of solar homes built in the region during the last 7 months is given (variable x is month) sequentially. Number of homes: 16, 17, 25, 28, 32, 43, 50 (a) Plot the data, develop a linear equation that best describes the data and draw the line. (b) Develop a second degree equation for this data that best describes this data. Plot this curve also on the same graph. 11. A gas company has supplied cooking gas to the city of Mumbai. Ìt has supplied, 18, 20, 21, 25, 26 lakh cubic feet of gas for the years 1996 to 2000, respectively. (a) Find the linear equation that best describes the data. (b) Calculate the per cent of trend for this data. (c) Calculate the Relative cyclical residual for this data. (d) Ìn which years does the largest fluctuation from trend occur? Ìs it the same for both methods? 12. A department store is expanding its market share during the past 7 years, the sales are as follows (Rupees in crore): Year 1996 1997 1998 1999 2000 2001 2002 Sales 14.8 20.7 24.6 32.9 37.8 47.6 51.7 Find the linear estimating equation that best fits the data. Calculate percent of trend for this data. Calculate the relative cyclical residual for this data. Ìn which years does the largest fluctuations from the trend occur? Ìs it same for both models. 13. We have given you the percentages of actual to moving average in the following table from a bank data describing the amount of cash circulation in a small branch. Year Spring Summer Fail Winter 1998 87 106 86 125 1999 85 110 83 127 2000 84 105 87 128 2001 88 104 88 124 Calculate the seasonal index for each quarter. 14. The record of sales data for the past 10 years is given below. The company knows there is a strong seasonal variation. (a) Find the index of seasonal variation using the method of Ratios to Moving Average. (b) Now, deseasonalize the original data. (c) Plot the deseasonalised data and give your observations. What is the trend? (d) Try to fit a geometric line of least squares and calculate the trend values. (e) Divide the deseasonalised data by the trend values and isolate business cycle and irregular components (take short-term moving averages). The sales forecast for the next year is Rupees 84 lakh. The seasonal indexes for the sales are QÌ. 35; Q2. 96; Q3. 150; and Q4. 119. Determine the sales quota for each quarter. The following table gives the marketing performance of a company. (sales in lakhs). 1998 19 24 38 25 1999 21 28 44 23 2000 23 31 41 23 2001 24 35 48 21 Calculate seasonal index for this data. (Use 4 - quarter centered moving average) Deseasonalize the data. Find the least squares line that best describes the trend in deseasonalised data. Ìdentify the cyclical component by computing the percent of trend. END O+ CGA*TER 1? ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 16 Estimation STRUCTURE 16.0 Objectives 16.1. Ì Ìntroduction 16.2 Estimates 16.3 Estimator and Estimates 16.4 Ìnterval Estimates 16.5 Ìnterval Estimates and Confidence Ìntervals 16.6 Ìnterval Estimates of the Mean from Large Samples 16.7 Ìnterval Estimates of the Proportion from Large Samples eywords 9uestions
[email protected] OBJECTIVES Ìn this unit, we will deal with estimates and estimators. We will learn the criteria for good estimators. We will discuss point estimates of mean, variance, and proportion, understand the concept of interval estimate and apply the same for mean, variance and proportion from large samples; how interval estimate is more meaningful than the point estimate. We will discuss standard error and probability of correctness of estimates.
[email protected] INTRODUCTION Everyone makes estimates. When you are ready to cross a street, you estimate the speed of any car that is approaching the distance between you and that car, and your own speed. Having made these quick estimates, you decide whether to wait, walk or run. Credit managers estimate whether a borrower will eventually pay his dues. Prospective home buyers make estimates concerning the behaviour of interest rates in the mortgage market. All these people make estimates based on their experiences, outlook for future, etc. Statistical inference is a branch of statistics concerned with using probability concepts to deal with uncertainty in decision-making. Ìt is based on estimation. We shall be making inferences about characteristics of population from information contained in samples. How do managers use sample statistics to estimate population parameters? The department head attempts to estimate enrollments next year from current enrollments in the same courses. The credit manager attempts to estimate the creditworthiness of prospective customers from a sample of their past payment habits. The home buyer attempts to estimate the future course of interest rates by observing the current behaviour of those rates. Ìn each case, somebody is trying to infer something about a population from information taken from a sample. We will discuss the methods that enable us to estimate with reasonable accuracy the population proportion (the proportion of the population that possesses a given characteristic) and the population mean. To calculate the exact proportion or the exact mean would be an impossible goal. Even so, we will be able to make an estimate, make a statement about the error that will probably accompany this estimate, and implement some controls to avoid as much of the error as possible. As decision makers, we will be forced at times to rely on blind hunches. Yet in other situations, in which information is available and we apply statistical concepts, we can do better than that. 1@.! ESTIMATES We can make two types of estimates about a population: a point estimate and an interval estimate. A point estimate is a sin&le num%er that is used to estimate an un"nown population parameter Ìf, while watching a cricket team on the field, you say. 'Why, Ì bet they will get 350 runs,' you have made a point estimate. A department head would make a point estimate if she said, 'Our current data indicate that this course will have 350 students next year.' A point estimate is often insufficient, because it is either right or wrong. Ìf you are told only that her point estimate of enrollment is wrong, you do not know how wrong it is, and you cannot be certain of the estimate's reliability. Ìf you learn that it is off by only 10 students, you would accept 350 students as a good estimate of future enrollment. But if the estimate is off by 90 students, you would reject it as an estimate of future enrollment. Therefore, a point estimate is much more useful if it is accompanied by an estimate of the error that might be involved. An inter$al estimate is a ran&e of $alues used to estimate a population parameter. Ìt indicates the error in two ways: by the extent of its range and by the probability of the true population parameter lying within that range. Ìn this case, the department head would say something like, 'Ì estimate that the enrollment in this course next year will be between 330 and 380 and that it is very likely that the exact enrollment will fall within this interval.' She has a better idea of the reliability of her estimate. Ìf the course is taught in sections of about 100 students each, and if she had tentatively scheduled five sections, then on the basis of her estimate, she can now cancel one of those sections and offer an elective instead. 1@.( ESTIMATOR AND ESTIMATES A sample statistic that is used to estimate a population parameter is called an estimator. The sample mean + %ar can be an estimator of the population mean mu, and the sample proportion can be used as an estimator of the population proportion. We can also use the sample range as an estimator of the population range. When we have observed a specific numerical value of our estimator, we call that value as estimate. Ìn other words, an estimate is a specific value of a statistic. We form an estimate by taking a sample and computing the value taken by our estimator in that sample. Suppose we calculate the mean odometer reading (mileage) from a sample of used taxis and find it to be 98,000 miles. Ìf we use this specific value to estimate the mileage for a whole fleet of used taxis, the value 98,000 miles would be an estimate. Criteria of a Ioo& Esti'ator Some statistics are better than others. Fortunately, we can evaluate the quality of a statistic as an estimator by using four criteria: () Unbiased: This is a desirable property for a good estimator to have. The term unbiased refers to the fact that a sample mean is an unbiased estimator of a population mean %e#ause the mean of the samplin& distri%ution of sample means ta"en from the same population is equal to the population mean itself. We can say that a statistic is an unbiased estimator if, on average it tends to assume values that are above the population parameter being estimated as frequently and to the same extent as it tends to assume values that are below the population parameter being estimated. -) *fficiency: Another desirable property of a good estimator is that it be efficient. Efficiency refers to the size of the standard error of the statistic. Ìf we compare two statistics from a sample of the same size and try to decide which one is the more efficient estimator, we would pick the statistic that has the smaller standard error, or standard deviation of the sampling distribution. Suppose we choose a sample of a given size and need to decide whether to use the sample mean or the sample median to estimate the population mean. Ìf we calculate the standard error of the sample mean and find it to be 1.05 and then calculate the standard error of the sample median and find it to be 1.6, we would say that the sample mean is a more efficient estimator of the population mean because its standard error is smaller. Ìt makes sense that an estimator with a smaller standard error (with less variation) will have more chance of producing an estimate nearer to the population parameter under consideration. .) /onsistency: A statistic is a consistent estimator of a population parameter if as the sample size increases, it becomes almost certain that the value of the statistic comes very close to the value of the population parameter. Ìf an estimator is consistent, it becomes more reliable with large samples. Thus, if you are wondering whether to increase the sample size to get more information about a population parameter, find out first whether your statistic is a consistent estimator. Ìf it is not, you will waste time and money by taking larger samples. 4. Sufficiency: An estimator is sufficient if it makes so much use of the information in the sample that no other estimator could extract from the sample additional information about the population parameter being estimated. *oint Esti'ates The sample mean + bar is the best estimator of the population mean mu. Ìt is unbiased, consistent, the most efficient estimator, and as long as the sample is sufficiently large, its sampling distribution can be approximated by the normal distribution. Ìf we know the sampling distribution of x, we can make statements about any estimate we may make from sampling information. Let's look at a medical supplies company that produces disposable hypodermic syringes. Each syringe is wrapped in a sterile package and then jumble-packed in a large corrugated carton. Jumble packing causes the cartons to contain differing numbers of syringes. Because the syringes are sold on a per unit basis, the company needs an estimate of the number of syringes per carton for billing purposes. We have taken a sample of 35 cartons at random and recorded the number of syringes in each carton. Table 16.1 illustrates our results. TABLE 16.1 (Syringes per Carton) 101 103 112 102 98 97 93 105 100 97 107 93 94 97 97 100 110 106 110 103 99 93 98 106 100 112 105 100 114 97 110 102 98 112 99 We can obtain the sample mean + bar by finding the sum of all our results, Sum x, and dividing this total by n, the number of cartons we have sampled 7 is equal to Erin Using this equation to solve our problem, we get x is equal to 3570/35 is equal to 102 syringes Thus, using sample mean x as our estimator, the point estimate of the population mean is 102 syringes per carton. The manufactured price of a disposable hypodermic syringe is quite small (about Re 1), so both the buyer and seller would accept the use of this point estimate as the basis for billing, and the manufacturer can save the time and expense of counting each syringe that goes into a carton. *oint Esti'ate of the *o57lation Varian%e an& Stan&ar& De=iation Suppose the management of the medical-supplies company wants to estimate the variance and/or standard deviation of the distribution of the number of packaged syringes per carton. The most frequently used estimator of the population standard deviation sigma is the sample standard deviation s. We can calculate the same e standard deviation, as given in Table 16.2, and discover that it is 6.01 syringes. Sum x is equal to3, 570 Sum x square is equal to 3, 65,368 Sum(x minus s bar) whole square is equal to 1, 228 Now, if we use the formula s square is equal to Sum(x minus x bar) whole square divided by n to calculate the sample variance- s, the result would have some bias as estimator of the population variance. Ìnstead, using the formula s square is equal to Sum(x minus x bar) whole square divided by n minus 1; makes s square an unbiased estimator. This observation has n-1 mathematical basis. But we need not discuss it here. So we get s square is equal to Sum(x minus x bar) whole square divided by n minus 1 as the estimate of the population variance. *oint Esti'ate of the *o57lation *ro5ortion The proportion of units that have a particular characteristic in a given population is denoted by p. Ìf we know the proportion of units in a sample that have the same characteristic (p bar) we can use this p bar as an estimator of p. Ìt can be shown that p bar has all the desirable properties we discussed earlier. Ìt is unbiased, consistent, efficient, and sufficient. Continuing our example of the manufacturer of medical supplies, we shall try to estimate the population proportion from the sample proportion. Suppose the management wishes to estimate the number of cartons that will arrive damaged, owing to poor handling in shipment after the cartons leave the factory. We can check a sample of 50 cartons from their shipping point to the arrival at their destination and then record the presence or absence of damage. Ìf, in this case, we find that four cartons were damaged; the proportion of damaged cartons in the sample is 0.08. We would say that p bar is equal to 0.08 <-- Sample proportion damaged Because the sample proportion p bar is a convenient estimator of the population proportion p, we can estimate that the proportion of damaged cartons in the population will also be 0.08. Putting all of the definitions aside, the reason we study estimators is that we can learn about populations by sampling, without counting every item in the population. Of course, there is no free lunch here either, and when we give up counting everything, we lose some accuracy. But we would like to know the accuracy that is achieved when we sample. Statisticians can tell how the standard error behaves as you increase or decrease the sample size, and market researchers can tell you what the cost of taking more or larger samples will be. But it's you who must use your judgement to combine these two inputs to make a sound managerial decision. 1@.. INTERVAD ESTIMATES The purpose of gathering samples is to team more about a population. We can compute this information from the sample data as either point estimates, which we have just discussed or as interval estimates, the subject of the rest of this chapter. An inter$al estimate des#ri%es a ran&e of $alues within whi#h a population parameter is li"ely to lie. Suppose the marketing research director needs an estimate of the average life in months of car batteries his company manufactures. We select a random sample of 200 batteries, record the car owners' names and addresses as listed in store records, and interview these owners about the battery life they have experienced. Our sample of 200 users has a mean battery life of 36 months. Ìf we use the point estimate of the sample mean x bar as the best estimator of the population mean x bar; we would report that the mean life of the company's batteries is 36 months. FÌGURE 16.1 Sampling Distribution of the Mean *f Samples of -200ba But the director also asks for information about the uncertainty tagged with this estimate. We need to know the range within which the population mean is likely to lie. We need to find the standard error of the mean for this purpose. We already saw, that if we select and plot a large number of sample means from a population, the distribution of these means will approximate a normal curve. Furthermore, the mean of sample means will be the same as the population mean. Our sample size of 200 is large enough that we can apply the central limit theorem, to measure the spread, or dispersion, in our distribution of sample means. We can use the following formula and calculate the standard error of the mean: Standard error of the mean for an infinite population sigma x bar is equal to sigma divided by root of n where sigma is standard deviation of the population. Suppose we have already estimated the standard deviation of the population of the batteries and reported that it is 10 months. Using this formula for standard error, we can calculate the standard error of the mean: Sigma x bar is equal to sigma divided by root of n is equal to 10 divided by root of200 Ìs equal to 10/14.14 is equal to 0.707 month. This is standard error of the mean. We could now report to the director that our estimate of the life of the company's batteries is 36 months, and the standard error that accompanies this estimate is 0.707. Ìn other words, the actual mean life for all the batteries may lie somewhere in the interval estimate of 35.293 to 36.707 months. This is helpful but we still need to know the chance that the actual life will fall within this interval. Ìf we take a larger interval, the chances would tend to improve. *ro"a"ilit3 of the Tr7e *o57lation *ara'eter +allin, 8ithin the Inter=al Esti'ate We know about normal probability distribution and learned that specific portions of the area under the normal curve are located between plus and minus any given number of standard deviations from the mean. We also saw how to relate these portions to specific probabilities. We can apply these properties to the standard error of the mean and make the following statement about the range of values used to make an interval estimate for our battery problem. The probability is 0.955 that the mean of a sample size of 200 will be within plus or minus 2 times the standard error of the population mean. Stated differently, 95.5 percent of all the sample means are within plus or minus 2 times the standard error from mu, and hence mu is within plus or minus 2 times the standard error of 58.8 per #ent of all the sample means. Theoretically, if we select 1,000 samples at random from a given population and then construct an interval of plus or minus 2 times the standard error around the mean of each of these samples, about 955 of these intervals will include the population mean. Similarly, the probability is 0.683 that the mean of the sample will be within plus or minus1 time the standard error of the population mean, and so forth. This theoretical concept is basic to our study of interval construction and statistical inference. We have illustrated the concept graphically in Fig. 16.2 showing five such intervals. Only the interval constructed around the sample mean T4 does not contain the population mean. As far as any particular interval in the given figure is concerned, it either contains the population mean or it does not, because the population mean is a fixed parameter. Ìn 95.5 per cent of all samples, the interval will contain the population mean. Therefore, we are 95.5 per cent confident that the interval contains the population mean. Applying this to the battery example, we can now report to the director. Our best estimate of the life of the company's batteries is 36 months, and we are 68.3 percent confident that the life lies in the interval from 35.293 to 36.707 months (36plus or minus Ì multiplied by sigma x bar). Similarly, we are 95.5 percent confident that the life falls within the interval of 34.586 to37.414 months (36plus or minus 2 multiplied by sigma x bar) , and we are 99.7 percent confident that battery life falls within the interval of 33.879 to 38.121 months (36plus or minus3 multiplied by x bar ) . Every time you make an estimate, there is an implied error in it. Ìt is impossible to watch and measure every set of data. Ìt's a lot less expensive and a lot faster to use sampling to find the answer. 1@.? INTERVAD ESTIMATES AND CON+IDENCE INTERVADS Ìn using interval estimates, we are not confined to plus or minus 1, 2, and 3 standard errors. According to Probability Table given in Annexure of Unit 2, plus or minus 1.64 standard errors include about 90 per cent of the area under the curve; it includes 0.4495 of the area on either side of the mean in a normal distribution. Similarly, plus or minus 2.58 standard errors cover about 99 per cent of the area, or 49.51 per cent on each side of the mean. The probability that we associate with an interval estimate is %alle& the %onfi&en%e le=el. This probability indicates how confident we are that the interval estimate will include the population parameter. A higher probability means more confidence. Ìn estimation, the most commonly used confidence levels are 90 per cent, 95 per cent and 99 per cent, but we are free to apply any confidence level. The #onfiden#e inter$al is the ran&e of the estimate we are ma"in&. Ìf we report that we are 90 per cent confident that the mean of the population of incomes of people in a certain community will lie between Rupees 8000 and Rupees 24,000, then the range Rupees 8,000 ÷ Rupees 24,000 is our confidence interval. Often, however, we will express the confidence interval in standard errors rather than in numerical values. Thus, we will often express confidence intervals like this: x plus or minus 1.64 multiplied by sigma x bar where x plus1.64 multiplied by sigma xbar is equal to upper limit of the confidence interval x minus1.64 multiplied by sigma x bar f is equal to lower limit of the confidence interval Thus confidence limits are the upper and lower limits of the confidence interval. Ìn this case, (x + 1.64 multiplied by sigma xbar is equal to the upper confidence limit (UCL) and (x minus 1.64 multiplied by sigma xbar is) is called the lower confidence limit (LCL). Relationshi5 "et8een Confi&en%e De=el an& Confi&en%e Inter=al You may think that we should use a high confidence level, such as 99 per cent, in all estimation problems. After all, a high confidence level seems to signify a high degree of accuracy in the estimate. Ìn practice, however, high confidence levels will produce large confidence intervals, and such large intervals are not precise; they give very fuzzy estimates. There is a direct relationship that exists between the confidence level and the confidence interval for any estimate. As you set a tighter and tighter confidence interval, you would get to a lower and lower confidence level. Usin, Sa'5lin, Confi&en%e Inter=al Esti'ation Ìn our discussion of the basic concepts of interval estimation, we described samples being drawn repeatedly from a given population in order to estimate a population parameter. We also mentioned selecting a large number of sample means from a population. Ìn practice, however, it is often difficult or expensive to take more than one sample from a population. Based on just one sample, we estimate the population parameter. We must be careful, then, about interpreting the results of such a process. Suppose we calculate from one sample in our battery example the following confidence interval and confidence level: 'We are 95 per cent confident that the mean battery life of the population lies within 30 and 42 months.' Ìt means that if we select many random samples of the same size and calculate a confidence interval for each of these samples, then in about 95 per cent of these cases, the population mean will lie within that interval. 1@.@ INTERVAD ESTIMATES O+ TGE MEAN +ROM DARIE SAM*DES A large automotive parts wholesaler needs an estimate of the mean life, it can expect from windshield wiper blades under typical driving conditions. Already, management has determined that the standard deviation of the population life is 6 months. Suppose we select a simple random sample of 100 wiper blades, collect data on their useful lives, and obtain these results. n is equal to100 ... Sample size x bar is equal to 21 months ... Sample mean Sigma is equal to 6 months.... Population Standard Deviation Because the wholesaler uses tens of thousands of these wiper blades annually, he requests that we find an interval estimate with a confidence level of 95 per cent. The sample size is greater than 30, so the central limit theorem allows us to use the normal distribution as our sampling distribution even if the population isn't normal. See unit 2. We calculate the standard error of the mean Sigma x bar is equal to sigma divided by square root of n is equal to 6 divided by10 is equal to 0.6 standard error of the mean for an infinite population. Now, we consider the confidence level with which we are working. Because a 95 per cent confidence level will include 47.5 percent of the area on either side of the mean of the sampling distribution, we can see Probability Table in Annexure to Unit 2 for the 0.475 value. We discover that 0.475 of the area under the normal curve is contained between the mean and a point 1.96 standard errors to the right of the mean. Therefore, we know that (2) (0.475) is equal to 0.95 of the area is located between plus or minus 1.96 standard errors from the mean and that our confidence limits are X bar plus 1.96 multiplied by sigma xbar ...Upper confidence limit Xbar minus1.96 multiplied by sigma xbar ...Lower confidence limit Thus we substitute numerical values into these two expressions: 7 plus 1.96 multiplied by sigma x bar is equal to 21 months plus1.96 multiplied by0.6 month is equal to 21 plus 1.18 months is equal to 22.18 months UCL. Xbar minus1.96 multiplied by sigma x bar is equal to 21 months minus 1.96 multiplied by 0.6 month is equal to 21 minus 1.18 months is equal to 19.82 month LCL. We can now say that we estimate the mean life of the population of wiper blades to be between 19.82 and 22.18 months with 95 per cent confidence. A more complex interval estimate problem comes from a social-service agency in a local government. Ìt is interested in estimating the mean annual income of 700 families living in a four square block section of a community. We take a simple random sample and find these results. n is equal to 50 ... Sample size x bar is equal to Rupees 11,800 ... Sample mean s is equal to Rupees 950 ... Sample standard deviation The agency asks us to calculate an interval estimate of the mean annual income of all 700 families so that it can be 90 per cent confident that the population mean falls within that interval. The sample size is over 30, so once again the central limit theorem enables us to use the normal distribution as the sampling distribution. Notice that one part of this problem differs from our previous examples: we do not know the population standard deviation, and so we will use the sample standard deviation to estimate the population standard deviation: Estimate of the population standard deviation sigma hat is equal to s is equal to whole root of Sum(x minus x bar) whole square divided by n minus 1 The value Rupees 950.00 is our estimate of the standard deviation of the population. We can also symbolize this estimate value by sigma hat) Now we can estimate the standard error of the mean. Because we have a finite population size of 700, and because our sample is more than 5 per cent of the population, we will use the formula for deriving the standard error of the mean of finite populations (see unit 2): Sigma xbar is equal to sigma divided y root of n multiplied by whole root of N minus n divided by N minus 1 But because we are calculating the standard error of the mean using an estimate of the standard deviation of the population, we must rewrite this equation so that it is correct symbolically: *stimate of the #opulation Standard "eviation Symbol that indicates an estimated value sigma hat equal to sigma hat divided by root of n multiplied by whole root of N minus n divided by N minus 1 We find sigma that is equal to Ìs equal to 950 divided by square root of 50 multiplied by whole root of 700 minus 50 divided by whole root of 700 minus1 (950divided by 7.07) multiplied by (650 divided by 699) is equal to 134.37 x multiplied by0.9643 Rupees 129.57 as an estimate of the standard error of the mean of a finite population (derived from an estimate of the population standard deviation) At 90 per cent confidence level, 45 per cent of the area on either side of the mean of the sampling distribution would be included. Looking in Probability Table in Annexure to Unit 2 for the 0.45 value, we find that about 0.45 of the area under the normal curve is located between the mean and point 1.64 standard errors away from the mean. Therefore, 90 per cent of the area is located between plus and minus 1.64 times standard error away from the mean, and our confidence limits are: xbar plus 1.64 sigma hat is equal to 11,800 plus 1.64 multiplied (129.57) is equal to 11,800 plus 212.50 is equal to Rupees 12,012.50 UCL x bar minus 1.64 sigma hat is equal to 11,800 minus1.64 multiplied by (129.57) is equal to 11,800 minus 212.50 is equal to Rupees 11,587.50 LCL With 90 per cent confidence, we estimate that the average annual income of all 700 families living in this four square block section falls between Rupees 11,587.50 and Rupees 12,012.50.
[email protected] INTERVAD ESTIMATES O+ TGE *RO*ORTION +ROM DARIE SAM*DES We can also use a sample to estimate a proportion of occurrences in a population. For example, the government estimates by a sampling procedure the unemployment rate, or the proportion of unemployed people, in the work force. Binomial distribution is a distribution of discrete variables. We do not have continuous data. The two formulas for deriving the mean and the standard deviation of the binomial distribution are mu is equal to in multiplied by p; and Sigma is equal to square root is equal to square root of n multiplied by p multiplied by q Where n is equal to number of trials p is equal to probability of success q is equal to 1 minus p is equal to probability of a failure Theoretically, the binomial distribution is the correct distribution to use in constructing confidence intervals to estimate a population proportion. The computation of binomial probabilities is tedious. Using the binomial distribution to form interval estimates of a population proportion is a complex proposition. Fortunately, as the sample size increases, the binomial can be approximated by an appropriate normal distribution, which we can use to approximate the sampling distribution. Ìn estimation, n should %e large enough for both n multiplied p and n multiplied by q to be at least 5. When you use normal distribution as a substitute; mu is equal to n multiplied by p shows that the mean of the binomial distribution is equal to the product of the number of trials ÷ n, and the probability of success ÷p; that is n multiplied byp equals the mean number of successes. To change this number of successes to the proportion of successes, we divide n multiplied p by n and get p alone. Hence, we have mean of the Sampling Distribution of the Proportion mu multiplied by p bar is equal to P. and Standard Error of the Population mu p bar is equal to whole root of p multiplied by q divided by n We now illustrate how to use these formulas. Suppose we want to estimate proportion of the employees of a very large organization who prefer to provide their own retirement benefits in lieu of a company sponsored plan. First, we select a simple random sample of 75 employees and find that a proportion of 0.4 of them are interested in providing their own retirement plans. Our results are n is equal to75; p is equal to0.4; q is equal to 0.6 Next, management requests that we use this sample to find an interval about which they can be 99 per cent confident that it contains the true population proportion. But what are p and q for the population? We can estimate the population parameters by substituting the corresponding sample statistics p bar and q bar in the formula, for Estimated Standard Error of the Population sigma p bar is equal to whole root of p bar multiplied by q bar Ìs equal to whole root of 0.4+0.6 divided by 75 Ìs equal to square root of.0.0032 is equal to 0.057 Estimated standard error is equal to 0.057 Now we can provide the Now we can provide the etimate by using the same normal curve is located between the mean and a point 2.58 times standard error from the mean. Thus, 99 percent of the area is contained between plus and minus 2.58 times standard error from the mean. Our confidence limits then become p plus 2.58 sigma p bar is equal to 0.4 plus2.58 multiplied by 0.057 is equal to 0.4 plus 0.147 is equal to 0.547 UCL p bar minus 2.58 sigma p bar , is equal to 0.4 minus 2.58 multiplied by 0.057 is equal to 0.4-0.147 is equal to 0.253 LCL Thus, we estimate from our sample of 75 employees that with 99 per cent confidence we believe that the proportion of the total population of employees who wish to establish their own retirement plan lies between 0.253 and 0.547. /e38or&s4Ilossar3 *stimates: Numbers that represent parameters of population. They are derived from the samples. #oint *stimate: A single number that is used to estimate an unknown population parameter. 'nterval estimate: Describes a range of values within which a population parameter is likely to lie. /onfidence level: The probability associated with an interval estimate. This indicates how confident we are that interval estimate will include the population parameter. 97estions 1. Which are the two basic tools that are used in making statistical inferences? 2. Why do decision-makers often measure samples rather than entire populations? What is the disadvantage? 3. Explain the advantages of an interval estimate over a point estimate. 4. What is an estimator? How does an estimate differ from an estimator? 5. List and describe briefly the criteria of a good estimator. 6. What role does consistency play in determining sample size? 7. The CCÌ Stadium is considering expanding its seating capacity and needs to know both the average number of people who attend events there and the variability in this number. The following are the attendances (in thousands) at nine randomly selected sporting events. Find point estimates of the mean and the variance of the population from which the sample was drawn. 8.8 14.0 21.3 7.9 12.5 20.6 16.3 14.1 13.0 8. The Pizza Shop has developed business by delivering pizza orders promptly. The shop guarantees that Pizzas will be delivered in 30 minutes or less from the time the order was placed, and if the delivery is late, the pizza is free. The time that it takes to deliver each pizza order that is on time is recorded and the delivery time for those pizzas that are delivered late is recorded as 30 minutes. Twelve random entries from the register are listed. 15.3 29.5 30.0 10.1 30.0 19.6 10.8 12.2 14.8 30.0 22.1 18.3 (a) Find the mean for the sample. (b) Can this sample be used to estimate the average time that it takes for the shop to deliver a pizza? Explain. 9. A meteorologist for a television station would like to report the average rainfall for today on this evening's newscast. The following are the rainfall measurements (in inches) for today's date for 16 randomly chosen past years. Determine the sample mean rainfall. 0.47 0.27 0.13 0.54 0.00 0.08 0.75 0.06 0.00 1.05 0.34 0.26 0.17 0.42 0.50 0.86 10. A bank is trying to determine the number of tellers available during the lunch rush on Fridays. The bank has collected data on the number of people who entered the bank during the last three months on Fridays from 11 a.m. to 1.00p.m. Using the data below, find point estimates of the mean and standard deviation of the population from which the sample was drawn. 242 275 289 306 342 385 279 245 269 305 294 328 11. A Company was considering national distribution of its regionally successful product and was compiling proforma sales data. The average monthly sales figures (in thousands of Rupees) from its 30 current distributors are listed. Treating them; as (a) a sample and (b) a population, compute the standard deviation. 7.3 5.8 4.5 8.5 5.2 4.1 2.8 3.8 6.5 3.4 9.8 6.5 6.7 7.7 5.8 6.8 8.0 3.9 6.9 3.7 6.6 7.5 8.7 6.9 2.1 5.0 7.5 5.8 6.4 5.2 12. For a population with a known variance of 185, a sample of 64 individuals leads to 217 as an estimate of the mean. (a) Find the standard error of the mean. (b) Establish an interval estimate that should include the population mean 68.3 per cent of the time. 13. An undergraduate is interested in purchasing a used TV. She randomly selected 125 advertisements and found that the average price of a TV in this sample was Rupees 3,250. She knows that the standard deviation of used TV prices in this city is Rupees 615. (a) Establish an interval estimate for the average price of a TV so that she can be 68.3 per cent certain that the population mean lies within this interval. (b) Establish an interval estimate for the average price of a TV so that she can be 95.5 per cent certain that the population mean lies within this interval. 14. From a population known to have a standard deviation of 1.4, a sample of 60 individuals is taken. The mean for this sample is found to be 6.2. Find the standard error of the mean. Establish an interval estimate around the sample mean, using one standard error of the mean. 15. From a population with known standard deviation of 1.65, a sample of 32 items resulted in 34.8 as an estimate of the mean. Find the standard error of the mean. Compute an interval estimate that should include the population mean 99.7 percent of the time. 16. A company managing the flyover is concerned about the number of cars 'running' the toll gates and is considering altering the toll-collection procedure to make it more be cost-effective. Ìt randomly sampled 75 hours to determine the rate of violation. The resulting average violations per hour were 7. Ìf the population standard deviation is known to be 0.9, estimate an interval that has 95.5 per cent chance of containing the true mean. 17. A CHS manager wants to inform potential renters about how much electricity they can expect to use during each month. She randomly selects 61 residents and discovers their average electricity usage in August to be 894 kilowatt hours (kWh). She believes the variance in usage is about 131 (kWh)2. Establish an interval estimate for the average August electricity usage so he can be 68.3 per cent certain the true population mean lies within this interval. Repeat part (a) with a 99.7 per cent certainty. 18. Given the following confidence levels, express the lower and upper limit of the confidence interval for these levels in terms of x and (a) 54% (b) 75% (c) 94% (d) 98% 19. Define the confidence level for an interval estimate. 20. Suppose you wish to use a confidence level of 80 per cent. Give the upper limit of the confidence interval in terms of the sample mean y, and the standard, ay . 21. As each customer enters his barbershop, Shyam yells out the number of minutes that the customer can expect to wait before getting his haircut. The only statistician in town, after being frustrated by Shyam's inaccurate point estimates, has determined that the actual waiting time for any customer is normally distributed with mean equal to Shyam's estimate in minutes and standard deviation equal to 5 minutes divided by the customer's position in the waiting line. Help Shyam's customers to develop 95 per cent probability intervals for the following situations: (a) the customer is second in line and Shyam's estimate is 25 minutes. (b) the customer is third in line and Shyam's estimate is 15 minutes. (c) the customer is fifth in line and Shyam's estimate is 38 minutes. (d) the customer is first in line and Shyam's estimate is 20 minutes. (e) How are these intervals different from confidence intervals? 22. A social psychologist, surveyed 150 top graduate students and found that 42 per cent of them were unable to add fractions correctly. (a) Estimate the standard error of the proportion. (b) Construct a 99 per cent confidence interval for the true proportion of graduate students who cannot correctly add fractions. 23. A computer store that buys wholesale, untested computer chips, is considering switching to another supplier who would provide tested and guaranteed chips for a higher price. Ìn order to determine whether this is a cost-effective plan, Pascal must determine the proportion of faulty chips that the current supplier provides. A sample of 200 chips was tested and of these, 5 per cent were found to be defective. (a) Estimate the standard error of the proportion of defective chips. (b) Construct a 98 per cent confidence interval for the proportion of defective chips supplied. 24. The owner of the Home Loan Company randomly surveyed 150 of the company's 3,000 accounts and determined that 60 percent were in excellent standing. Find a 95 per cent confidence interval for the proportion in excellent standing. Based on part (a), what kind of interval estimate might you give for the absolute number of accounts that meet the requirement of excellence, keeping the same 95 per cent confidence level? END O+ CGA*TER 1@E ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 17 Bond Ìnvestment STRUCTURE 17.0 Objectives 17.1 Ìntroduction 17.2 Government Bonds 17.3 How do Bonds Work? 17.4 Bond Prices and Yields 17.5 Bond Prices and Ìnterest Rates Yield to Maturity 17.6 Rate of Return 17.7 Risks in Bond Ìnvestments 'eywords *uestions 1B.0 o"Ae%ti=es Ìn this chapter you will learn the basics of bond valuation. You will be able to: 1. distinguish among the bond's coupon rate, current yield and yield to maturity. 2. find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields may vary inversely. 3. appreciate why bonds exhibit interest rate risk. 4. understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. 1B.1 INTRODUCTION Ìnvestment in new plant and machinery requires money ÷ often a lot of money. Sometimes firms may be able to save enough out of previous earnings to cover cost of investments, but often they need to raise cash from investors. Ìn broad terms, we can think of two ways to raise new money from investors, either through debt or equity. Ìf companies need cash for a short while they may borrow from a bank. Ìf they require funds for medium/long term, they generally issue bonds which are essentially long-term loans. When companies issue bonds, they promise to make a series of fixed interest payments and then repay the debt. As long as the company generates sufficient cash, the payments on the bonds are certain. Ìn this case, bond valuation involves straightforward time-value-of-money computations. But there is some chance that the company may not repay its debts. Ìnvestors take this default risk into account when they price the bonds and demand a higher interest rate to compensate it. Governments also may need to raise funds. They issue bonds in a similar fashion. 1B.!IOVERNMENT BONDS Governments and corporates borrow money by selling bonds to investors. The money they collect when the bond is issued, or sold to the public, is the amount of the loan. Ìn return, they agree to make specified payments to the bondholders, who are the lenders. When you own a bond, you generally receive a fixed interest payment each year until the bond matures. This payment is known as the coupon because most bonds used to have coupons that the investors clipped off and mailed to the bond issuer to claim the interest payment. At maturity, the debt is repaid: the borrower pays the bondholder the bond's face value (or par value). Thus, a bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company. A government bond is a bond issued by a national government denominated in the country's own currency. They are normally issued for tenure of five to thirty years. Bonds issued by Ìndian Government in Ìndian Rupees are government bonds. However, bonds issued by Pone Municipal Corporation will not be considered as government bonds. Bonds issued by a national government in foreign currencies are referred to as sovereign bonds. Bonds issued by Ìndian government in US Dollars or Japanese Yen are therefore sovereign bonds. Ìncidentally, these would be also euro-bonds, as they are not in home currencies.( Please note that name euro-bonds has nothing to do with currency Euro). The first ever government bond was issued by the English Government in 1693, to fund its war against France. Government bonds are normally considered as risk-free bonds. Here risk-free means free of credit risk. The government bonds still have market risk. Bonds issued by different countries/governments have come to be known by some generic names. For example, US Government bonds are referred to as US Treasuries, bonds issued by France in Euro are called as OATS, German bonds are called as Bands, and UK bonds are known as Gilts. These bonds are quoted and traded on major exchanges. 1B.( GO; DO BONDS ;OR/> Consider a government bond as an example. Suppose the Ìndian Government raised money by selling 6 per cent coupon, 2012 maturity, and Treasury bonds. Each bond has a face value of Rupees 1,000/-. Because the coupon rate is 6 per cent, the government makes coupon payments of 6 per cent of Rupees 1,000 or Rupees 60 each year. When the bond matures in July 2012, the government must pay the face value of the bond, Rupees 1000, in addition to the final coupon payment. Suppose you have purchased this bond in the year 2009. Ìf you plan to hold this bond till maturity, then the cash flow is shown on the time line below. The initial cash flow is negative and equal to the price you have to pay for the bond. Thereafter the cash flows equal the annual coupon payment, until the maturity date. On maturity you receive the face value of the bond, Rupees 1,000, in addition to the final coupon payment. Dealers and brokers quote the figures or the prices which prevail in the bond market. This is essentially part of the debt market and you can see the prices quoted on the National Stock Exchange or NSE in the papers. Details such as the rate of interest, the year of maturity, price are reported in NSE website/ financial papers. A sample of some such trades is given as follows: Bond details Coupon Price YTM (%) GS-CG-2011 6.57 101.40 5.3274 GS-CG-2012 7.40 101.9690 6.4881 GS-CC-2020 6.35 91.28 7.6069 1B.. BOND *RICES AND )IEDDS Ìn this example we examined the cash flows for a 6 per cent treasury bond. How much would you be willing to pay for this stream of cash flows? To find out we have to compare with the interest rate on similar securities prevailing at that point in time. Let us presume the interest rate on three year maturities offer a return of 5.6 per cent. Thus we use this rate as the discount rate to value the cash flows from the bond. PV is equal to Rupees 60divided by 1 plus r plus Rupees 60divided by 1 plus whole square Rupees 1060 divided by 1 plus r whole cube. Ìs equal 60 divided by 1.056 plus 60divided by 1.056 square plus 60 divided by 1.056 cube. 56.82 plus 53.80 plus 900.15 Ìs equal to 1,010.77 Bond Prices are usually quoted as a percentage of their face value. Thus we can say that our 6 per cent treasury bonds are worth 101.077 per cent of face value, and its price would usually be quoted as 101.077. As you can notice that the coupon or interest payments on bonds and debentures are an annuity. Ìn other words, the holder of our 6 per cent treasury bond receives a regular stream of Rupees 60 for three years. Thus we can also use the annuity formula to value the coupon payments and then add on the present value of the final payment or final face value. PV is equal to PV (Coupons) plus PV (face value) is equal to PV (A, r, n) plus PV (face value) is equal to PV (60, 0.056,3) plus PV(1000) is equal to 60*0.177584/0.056*1.177584 plus 1000divided by1.177584 is equal to 10.65504divided by 0.0659447 plus 849.19 is equal to 161.58 plus 849.19 is equal to 1010.77 Ìf we need to value a bond of many years to run before maturity, it is usually better to use the annuity formula and separate the coupon or interest payments from the face value. Bon& *ri%es an& GalfE)earl3 Co75on4Interest *a3'ents We have assumed that interest payments occur annually but there are many countries where interest payments occur semi-annually. Thus if an interest rate is a semiannually compounded a rate of 5.6 per cent means that the 6 month rate is 5.6/2 is equal to 2.8 per cent. Thus the present value of such bonds is higher because half the interest is received six months earlier. The actual cash flow for the example given earlier of 6 per cent coupon bond maturing in 2007 is given here for semiannual coupon payments by a semiannual rate of interest. PV is equal to 30 divided by1.028 plus30 divided by 1.028 square plus30 divided by 1.028 cube plus30 divided by1.028 to the power of 4 plus 30 divided by 1.028 to the power of 5 plus 30 divided by 1.028 to the power of 6 is equal to 1,010.91 which is slightly more than the value of Rupees 1,010.77 that we obtained when we treated the coupon payments as annual rather than semi-annual. However we will assume annual interest payments here. 1B.? BOND *RICES AND INTEREST RATES As interest rates change, so do bond prices. For example, suppose that investors demanded an interest rate of 6 per cent on 3 year Treasury bonds. What would be the price of the Treasury bond valued earlier? Just repeat the last calculation with a discount rate of r is equal to 0.06 PV at 6 per cent is equal to 60 divided by 1.06 plus 60divided by1.06 square plus 1060 divided by1.06 cube is equal to 56.60 plus 53.40 plus 890 is equal to 1000 Thus when the interest rate is the same as the coupon rate (6% in our example), the bond sells for its face value. Now if, we discount the cash flows at a rate higher than the bond's coupon rate, the bond is worth less than its face value. Let us see the following example. Ìnvestors will pay Rupees 1,000 for a six per cent 3 year Treasury bond, when the interest rate is 6 per cent. Suppose that the interest rate is 10% when coupon is 6%. Now what is the value of the bond? We just repeat our initial calculation but with r is equal to 0.10 PV at 15% is equal to 60 divided by1.10 plus 60 divided by 1.10 square plus 60 divided by 1.10 cube is equal to 54.55plus 49.60plus 796.40 is equal to 900.55 The bond sells for 90.055 per cent of face value. We conclude that 1. when the market interest rate exceeds the coupon rate, bonds sell for less than face value; 2. when the market interest rate is below the coupon rate, bonds sell for more than face value. 1B.@ )IEDD TO MATURIT) Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10 per cent. Your investment advisor quotes a price for the bond. How do you calculate the rate of return the bond offers? For bonds priced at face value the answer is easy. The rate of return is the coupon rate. We can check this by setting out the cash flows on your investment. Cash Paid to You in Year You pay 1 2 3 Rate of Return Rupees 1,000 100 100 1,100 10% Notice that in each year you earn ten per cent on your money (100divided by1, 000). Ìn the final year you also get back your original investment of Rupees 1,000. Therefore, your total return is 10 per cent, the same as the coupon rate. Now, suppose the market price of the three year bond is Rupees 1136.16. Your cash flows are as follows: Cash Paid to You in Year You pay 1 2 3 Rupees 1,136 100 100 1,100 What is the Rate of Return now? Notice that you are paying out Rupees 1,136.16 and receiving an annual income of Rupees 100. So your income as a proportion of the initial outlay is 100divided by1136.16 is equal to 0.088 or 8.8 per cent. This is sometimes called bond's current yield. However, total return depends on both interest income and any capital gains or losses. A current yield of 8.8 per cent may sound attractive only until you realize that the bond's price must fall. The price today is Rupees 1136.16, but when the bond matures 3 years from now, the bond will sell for its face value or Rupees 1,000. A price decline (i.e. capital loss) of Rupees 136.16 is guaranteed, so the overall return over the next 3 years must be less than the 8.8 per cent current yield. Let us generalize. A bond that is priced above its face value is said to sell at a premium. Ìnvestors who buy a bond at a premium face a capital loss over the life of the bond. Hence the return on these bonds is always less than the bond's current value. A bond priced below face value sells at a discount. Ìnvestors in discount bonds face a capital gain over the life of the bond. The return on these bonds is greater than the current yield. Because it focuses only on current income and ignores prospective price increases or decreases, the current yield mis-measures the bond's total rate of return. Ìt overstates the return of premium bond and understates that of discount bonds, We need a measure of return that takes account of both current yield and the change in a bond's value over its life. The standard measure is called yield to maturity. The yield to maturity is the answer to the following question: At what interest rate would the bond be correctly priced? The yield to maturity is defined as the discount rate that makes the present value of the bond's payments equal to its price. Ìf you can buy the 3-year bond at face value, the yield to maturity is the coupon rate, 10 per cent. We can confirm this by noting that when we discount the cash flows at 10%, the present value of the bond is equal to its Rupees 1000 face value. PV at 10% is equal to 100 divided by 1.1. plus100 divided by 1.1 square plus 100 divided by1.1cube. is equal to 90.90 plus 82.65 plus 826.45 is equal to 1,000 But if you have to buy the 3 year bond for Rupees 1136, the yield to maturity is only 5 per cent. At that discount rate, the bond's present value equals its actual market price, Rupee.1136.16 PVat5% is equal to 100 divided by1.05 plus 100 divided by 1.05 square plus 100 divided by 1.05 cube is equal to 95.24 plus 90.70 plus 950.22 is equal to 1136.16. Cal%7latin, )iel& to Mat7rit3 for the Treas7r3 Bon& We have found the value of the 6 per cent coupon treasury bond by discounting at a 5.6 interest rate. We could have phrased the question the other way around: Ìf the price of the bond is Rupees 10 10.77, what return do investors expect? We need to find the yield to maturity, in other words, the discount rater that solves the following equation: PV at 10 per cent is equal to 100 divided by 1.1 plus 100 divided by1.1 square plus 100 divided by 1.1. cube. Ìs equal to 90.90 plus 82.65 plus 826.45 Ìs equal to 1000 But if you have to buy the 3 year bond for Rupees 1136, the yield to maturity is only 5 per cent. At that discount rate, the bond's present value equals its actual market price, Rupees 1136.16 PV at 5 percent is equal to 100 divided by 1.05 plus 100 divided by 1.05 square plus 100 divided by 1.05 cube. Ìs equal to 95.24 plus 90.70 plus 950.22 Ìs equal to1135.15 Cal%7latin, 3iel& for the Treas7r3 Bon& We have found the value of the 6 percent coupon treasury bond by discounting at 5.6 percent interest rate. We could have phrased the question the other way around: if the price of the bond is Rupees 1010.77, what return do investors expect? We need to find the yield to maturity in other words the discount rate r that solved the following equation: Price is equal to 100 divided by (1 plus r) plus 100 divided (1 plus r) square plus 100 divided by (1 plus r) cube. To find the yield to maturity most people use a financial calculator. For example Periodic Payment is PMT, Final payment is FV, number of periods is n and interest rates as the yield to maturity of the bond. From this, present value can be calculated. You can also feed in PV and get the Yield to maturity-YTM of the bond. The calculator will display the answer. The earlier example illustrates that the yield to maturity depends on the coupon payments that you receive each year (Rupees 60), the price of the bond - (Rupees 1010.77), and the final repayment of face value (Rupees 1000). Thus it is a measure of the total return on this bond, accounting for both coupon income and price change, for someone who buys the bond today and holds it until maturity. Bond investors often refer loosely to a bond's 'yield'. They are usually talking about its yield to maturity rather than its current yield. The only manual procedure for calculating yield to maturity is trial and error. You guess an interest rate and calculate the present value of the bond's payments. Ìf the present value is greater than the actual price, your discount rate must have been too low, so you try a higher interest rate (since a higher rate results in a lower PV). Conversely, if PV is less than price, you must reduce the interest rate. Ìn fact, when you use a financial calculator to compute the yield to maturity, you will notice that it takes the calculator a few moments to compute the interest rate. This is because it must perform a series of trial and-error calculations. Figure 17.3 is a graphical view of yield to maturity. Ìt shows the present value of the 6 per cent Treasury bond for different interest rates. The actual bond price, Rupees 1,010.77, is marked on the vertical axis. The figure illustrates relationship between interest rates and bond prices. When the interest rate rises, the present value of the payments to be received by the bondholder falls, and bond prices fall. Conversely, declines in the interest rate increase the present value of those payments and result in higher prices. FÌGURE 17.3 At times there is some confusion about the interest rate ÷ the return that investors currently require ÷with the interest, or coupon, payment on the bond. Although interest rates change from day to day, the Rupees 60 coupon payments on our treasury bonds are fixed when the bond is issued. Changes in interest rate affect the present value of the coupon payments but not the amount paid/payable. 1B.B RATE O+ RETURN When you invest in a bond, you receive a regular coupon payment. As bond prices change, you may also make a capital gain or loss. For example, suppose you buy the 6 per cent Treasury bond today for a price of Rupees 1010.77 and sell it the next year at a price of Rupees 1,020. The return on your investment is Rupees 60 coupon payment plus the price change of Rupees 1,020 minus 1,010.77 Rupees 9.33. The rate of return on your investment of Rupees 1,010.77p is Rate of Return is equal to (Coupon income plus Price change) divided by Ìnvestment (60+9.33)is equal to 60 plus 9.33 divided by 1010.77 is equal to69.33 divided by 1,010.77 is equal to 0.686 i.e. 6.86 percent Bond prices fall when market interest rates rise and bond prices rise when market rates fall. Resultantly, the rate of return that you earn on a bond will fluctuate with market interest rates. This is why we say bonds are subject to interest rate risk. Do not confuse the bond's rate of return over a particular investment period with its yield to maturity. The yield to maturity is defined as the discount rate that equates the bond's price to the present value of all its promised cash flows. Ìt i s a measure of the average rate of return you will earn over the bond's life if you hold it to maturity. Ìn contrast, the rate of return is calculated for any particular holding period and is based on the coupon income and the capital gain or loss on the bond over that period. The difference between yield to maturity and rate of return for a particular period is explained in the following example. Rate of Ret7rn Vers7s )iel& A six year coupon bond with maturity 2012 has 3 years left until maturity and sells today for Rupees 1010.77. Ìts yield to maturity is 5.6 per cent. Suppose that by the end of the year, interest rates have fallen and the bond's yield to maturity is now only 4 per cent. What will be the bond's rate of return? At the end of the year, the bond will have only two years to maturity. Ìf investors then demand an interest of 4 per cent, the value of the bond will be PV at 4% is equal to 60 divided by 1.04 plus 1060 divided by 1.04 square 1.04 1.042 is equal to 57.69 + 980.03 is equal to 1,037.72 You invested Rupees 1,010.77p. At the end of the year, you receive a coupon payment of Rupees 60 and have a bond worth Rupees 1,037.72. Your rate of return is therefore is worked out as follows: Rate of return is equal to (60+1037.72-1010.77) divided by 1010.77 Ìs equal to86.95 divided by 1010.77. Ìs equal to 0.860 i.e. 8.6 percent The yield to maturity at the start of the year was 5.6 per cent. However, because interest rates fell during the year, the bond price rose and this increased the rate of return. Ìs there any connection between yield to maturity and the rate of return during a particular period? Yes: Ìf the bond's yield to maturity remains unchanged during an investment period, its rate of return will equal that yield. When interest rates do not change, the bond prices change with time so that the total return on the bond is equal to the yield to maturity. Ìf the bond's yield to maturity increases, the rate of return during the period will be less than that yield. Ìf the yield decreases, the rate of return will be greater than the yield. Figure 6.4 plots the price of a 30 year maturity, 6 per cent Treasury bond over time assuming the yield to maturity per centage remains at ?)E per cent) The price declines gradually until the maturity date, when it finally reaches face value. Ìn each period, the price decline offsets the coupon income by just enough to reduce total return to 5.6 per cent. The dashed curve in the figure shows the corresponding price path for a low coupon bond currently selling at a discount to face value. Ìn this case, the coupon income would provide less than the rate of return. Ìts price gradually approaches face value, however, and the price gain each year brings its total return up to the market interest rate. FÌGURE 17.4 1B.C RIS/S IN BOND INVESTMENTS Interest Rate Ris2 We have seen that bond prices fluctuate as interest rates change. Ìn other words, bonds exhibit interest rate risk. Bond investors cross their fingers that market interest rates will fall, so that the price of their bond will rise. Ìf the market interest rate rises, the value of their investment falls. But all bonds are not equally affected by the changing interest rates. Compare the two curves in the Fig. 6.5. The black dark line shows how the value of the three year, 6 per cent coupon bond varies with the level of the interest rate. The thinner line shows how the price a 30 year, 6 per cent coupon bond varies with the level of interest rate. You can see that a 30 year bond is more sensitive to interest rate fluctuations than the 3 year bond. This should not surprise you. Ìf you buy a three year bond when the interest rate is 5.6 per cent and the rates then rise, you will be stuck with a bad deal ÷ you have just loaned your money at a lower interest rate than if you had waited. However, think how much worse it would be if the loan had been for 30 years rather than three years. The longer the loan, the more the income you have lost by accepting what turns out to be a low coupon rate. This illustrates a bigger decline in prices of a long-term bond. Of course there is a flip side too. When interest rates fall, the longer- term bonds respond with a greater increase in price. Defa7lt Ris2 Our focus has so far been on Government bonds. But Governments are not the only issuers of bonds. State Governments and local bodies as well as corporations issue bonds. Bonds can be issued in different currencies also. Normally governments do not go bankrupt ÷so we do not perceive a default risk. However bonds issued by corporations have a default risk in case the company is not able to repay the money. The risk that the bond issuer may default on his obligations is called default risk (or credit risk). Thus companies have to offer a higher interest rate in order to compensate for the higher risk of non-payment. The difference in the yield of a government bond and the corporate bond is called default premium or risk premium. Usually bonds are rated for safety by a ratio-, agency. Rating agencies, like CRÌSÌL and ÌCRA perform this task, in Ìndia. Variations in Cor5orate Bon&s There are varieties of bonds to suit various investors. Some of these are Zero Coupon Bonds: These are bonds which are redeemed at their face value and priced at a nominal value below their face value. The investor gets a return from the difference in purchase price and face value. 0loating rates bonds: Sometimes the coupon rate/interest rate can change over time. Thus the coupon payment is linked to some interest rate. The rate is reset according to the changes in the interest rate. Thus the return on the bond always approximates current market returns. /onvertible bonds: These bonds can be converted into a share at a later specified date. Thus they give an opportunity to a bond investor to participate in equity if the company is doing well. /allable bonds The issuer reserves the right to call back the bond, and pay a fixed price (generally at a premium over par value). This is less attractive to investors. As interest rate goes down, when the bond prices increase, the bonds are likely to be called back. /e38or&s4Ilossar3 7onds: Bonds have fixed maturity period, fixed value at maturity and interest rate specified. They are generally redeemed at par. &egotiable bonds are traded in the market, and their market value changes, depending upon the current interest rates. /oupon rare: This is the interest rate specified in the bond and the yearly fixed income depends on this rate. Cield to maturity is defined as that discount rate, which makes the present value of bond's payment equal to its price. /urrent yield focuses only on current payments. This ignores fluctuations in prices. Actually, it overstates the return on premium bonds and under states the return on discounted bonds. This is not a correct measure of return. #rice risk: The price of the bond changes, while the investor is holding it. Another important point to note is, the longer the period for maturity, greater the risk. Ìf there is an increase of 1 per cent in interest rate, (say from 10 to 11), the price of a 3 month maturity bond of face value Rupees 10,00,000 will decrease by Rupees 2,500 where as the corresponding price drop on a 9 month bond would be Rupees 7,600. Long-term bonds that pay no interest are referred to as zero coupon bonds. These bonds sell at a discount from its value of maturity, since any market interest rate will be more than 0 per cent /onvertible bonds: These bonds can be converted into equities of the firm. 97estions 1. What is a bond? How it is different from equity? 2. Why there is a interest rate risk, when interest amounts (nominal) are fixed? 3. Why do prices and yield to maturity vary inversely? 4. A 6 year bond with par value Rupees 1,000 has a current yield of 7.5 per cent and a coupon rate of 8 per cent. What is the bond's price? (Rupees.1066.7) 5. A 6 year bond pays interest Rupees 80 annually, and sells at Rupees 950. What is its coupon rate, current yield and yield to maturity? (Coupon rate is equal to 8 per cent; current yield is equal to 8.42; yield to maturity is equal to 9.12) 6. There are 2 bonds, and A wants to decide in which one he should invest. Bond 1:10 year maturity, coupon rate 8 per cent, yield to maturity is 10 per cent. Bond 2: 10 year maturity, coupon rate 12 per cent, yield to maturity is 10 per cent Next year also yield to maturity is same 10 per cent for both. 7. A bank sells bonds of face value Rupees. 1000, carry a coupon rate of 8 per cent, with a maturity period of 3 years. The bond sells at a yield to maturity of 9 per cent. (a) What is the interest payment a bond holder receives each year? (Rupees 80) (b) What is the selling price of the bond?(Rupees.974.13). (c) What will happen to the bond price, if the yield to maturity falls to 7 per cent? (The bond will sell at Rupees 1001.98) 8. Discuss the current Yield calculation and the calculation of yield to maturity, in terms of their usefulness to investors in decision-making. 9. RBÌ issues a 30 year bond at 8 per cent par value Rupees 1000. Ìf the market yield increases shortly afterwards, what happens to the following parameters? (a) coupon rate; (b) price; (c) current yield; and (d) yield to maturity. (no change) (decreases) (increases) (increases) 10. A corporation has a 14 per cent bond, which matures in 20 years. The bond is callable in 5 years at Rupees 114. This bond currently sells for Rupees 105. (a) What is the current yield? (13.33 per cent) (b) Yield to call? 11. What is the present worth of the bond where final payment at the end of 3 years is equal to Rupees 1000; n is equal to 3 years, coupon rate 6 per cent. Ìnterest paid twice a year? (Hint: use Present Value. Rupees 948) 12. Ì buy a bond of 10 year maturity and 8 per cent coupon rate, for Rupees 980. A year later the bond price is Rupees 1050. (a) What is the new yield to maturity on the bond? (7.23 per cent) (b) What is the rate of return over the year'? (15.31 per cent) 13. Calculate the present value of 6 year bond with 9 per cent coupon rate. Current interest rate is 12 per cent. (Rupees 876.66). 14. The interest rate increases from 5.6 to 10 per cent suddenly. Find the present values of the two bonds given below, both before and after the change. (a) Both the bonds have same coupon rate of 6 per cent, (b) Bond 1 has a maturity of 3 years and bond 2 has a maturity of 30 years. (3 year bond sells at Rupees 1010.77 before the increase in interest rate. Now the bond price falls to Rupees 900.53. Decrease is 10.9 per cent. The 30 year bond sells at Rupees 1,057.50 and the price falls to Rupees 622.92. There is a larger percentage decrease of 41.1 per cent) END O+ CGA*TER 1B H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 18 Linear Programming STRUCTURE 18.1 Ìntroduction 18.2 Graphic Approach 18.3 Simplex Method eywords 9uestions 1C.1 INTRODUCTION Linear Programming refers to several related mathematical techniques that are used to allocate limited resources among competing demands in an optimal way. For obtaining the optimal solution the problems should be structured into a particular format. Ìt has been found that linear programming has many useful applications to financial decisions. The type of problems should have linear constraints and the decision maker must be trying to maximize some linear objective function. Ìn this chapter we will discuss graphical and 'simplex' methods. Mo&el Let us assume that the selling prices, production and marketing costs are known for each of the 'n' products. The firm also has to operate under certain economic, financial and physical constraints. Some examples of resource and marketing constraints: (a) Bank may stipulate certain working capital requirements. (b) Market may not absorb the whole output (c) Capacity constraints (d) Labour availability (e) Raw materials, availability These constraints can be used to formulate the problem. The question is how to attain maximum profit, in the given circumstances? Under what conditions a Linear Programming problem can be formulated? 1) As the name implies all equations are linear- This implies proportionality. For example, if it takes 4 persons to produce one unit, then we require 12 persons to produce 3 units. 2) The constraints are known and deterministic. That is, the probabilities of occurrence are presumed to be 1.0. (3) Most important rule is that all these variables should have non-negative values. (4) Finally, decision variables are also divisible. 1C.! IRA*GIC A**ROACG Let us illustrate the graphic approach with simple numerical two-decision variables. (3 variables require 3-D graphing). This gives a quick insight into the nature of L.P. Let firm A produce radios and television sets. Each radio costs Rupees 500 in wages and Rupees 500 in materials. Each television set costs Rupees 2,500 in wages and Rupees 1,500 in materials. The firm pays the labour and material expenses in cash. The price of a radio is Rupees 2,000 and the price of a television is Rupees 6,000. As there is a strong consumer demand, the firm is able to sell as many units as it produces at prevailing prices. The firm also gives one period credit to consumers. The firm has 10 hours of machine time and 4 hours of assembly time per day. The production of radio requires 3 hours of machine time and 1 hour of assembly time. The production of television requires Ì hour of machine time and 1 hour of assembly time. The firm has Rupees 12,000 as cash balance (liquidity to pay for labour and materials). Now, given the financial and capacity constraints, how many radios and televisions should the firm produce in period 1, to maximize its profits? Let x and y be respectively, the units of radios and television sets produced in period 1. Then the constraints are: (a) (capacity constraint machine time) 3x plus y is less than or equal to 10 (b) (capacity constraint assembly time) x plus y is less than or equal to 4 (c) (financial constraint) 1000x plus 4000y is less than or equal to12, 000 ~ same as x plus 4Y <is less than or equal to12 (d) 1 (non-negativity) x is greater than or equal to0; (e) Objective function Maximize Profit is equal to1, 000x plus 2,000y Now, let us draw the graph. FÌGURE 18.1 Line 1 x plus Y is equal to 4 Data 0 2 4 V 4 2 0 218 'A' Line 2 3x plusY is equal to 10 Data X 3 2 1 0 y Line 3 X plus 4 yis equal to 12 1 4 7 10 Data X 0 4 8 12 Y 3 2 1 0 We have plotted the above three constraints in the graph. Find all the combinations of x and y, which satisfy the constraint and plot the points for all 3 lines. The graph is in the First quadrant. This satisfies the non-negativity condition. 1. All points on or below (inside) the line satisfy, x plus y is less than 4. 2. All points on or below the line 3x plus v <_ 10, satisfy the machine time constraint. 3. All points on or below the lines plus 4v < 12,satisfy financial constraint. Even though all constraints are listed separately, they should be satisfied simultaneously. When these restrictions are placed one on top of the other, we obtain a common area, which in this case is shaped like a pentagon. (say ÷ ABCDE). Every point in this pentagon satisfies the constraints. This area is referred to as a set of feasible solutions. Now, our objective is not to pick any feasible solution. Although x is equal to y is equal to 0 is also a feasible solution, the profit will be zero. This means no. production, S. So, our objective is to pick that feasible solution (that particular combination of x and y), from the set of feasible solutions which maximizes profit. FÌGURE 18.2 We already know that each radio contributes Rupees 1000 and each television contributes Rupees 2000. The optimal solution is obtained by drawing the 'Ìso-profit' line. The term 'Ìso-Profit' refers to the fact that any point on that line, (any combination of x and y) produces the same profit as any other combination on the same line. That is, in this case, the contribution of 2 radios is equal to the contribution of one television. This gives the concept that any point on a line with a slope of (-1 /2) is the 'iso-profit' line in this case. Starting from the origin, we move this line parallel to itself in the north-eastern direction as far as possible without removing it completely from the region of solutions Ìn the adjacent figure, this movement depicted by the continuous upward shift in the objective function T. The optimal solution is given by the final point of contact 'D' (the meeting of the pentagon vertex and iso-profit line). The firm can earn a maximum profit of Rupees 6,670 by producing 4/3 radios and 8/3 television sets. Ìf we have integer constraints, we should settle for the next best. But for the present, we find that assembly centre is fully utilized, and cash is fully exhausted. Machine centre has a surplus capacity. Hence the bottlenecks for greater profits arise from lack of assembly centre capacity, and liquidity crunch. We see that if an optimal solution exists, at least one such solution is an extreme point of the polygonal region representing the feasible solutions. This is also intuitively clear. As there is only finite number of vertices, we can straight away calculate the maximum profit. Only exception to this rule will be, that when the iso-profit line and the boundary coincide (i.e. the slope of the objective function is the same as the boundary line). Then we will have many optimal solutions with the same maximum profits, along that line. The main drawback of this approach is that in problems with large number of constraint equations, there will be more possible points to evaluate and this becomes inefficient. 1C.( SIM*DE1 METGOD Another method of linear programming is Simplex Method. The method is complex. With computer programmes, spread sheets available, it is possible to use this method effectively and solve equations with as many as 10-12 variables. Let us take the following problem to use Simplex Method. *ro"le' A company manufactures cricket bats and chess sets. Each cricket bat gives a profit of Rupees. 2 and chess set give a profit of Rupees 4. Ìf the company wants to maximize the profit, how many cricket bats and chess sets should be produced per day? Step Ì Formulate the problem. Let the production be 'B' bats and 'C' chess sets. (a) Objective function: Maximize Z is equal to 2B plus 4C (b) 4B plus 6C is less than or equal to 120 (Workshop 1) (c) 2B plus 6C is less than or equal to 72 (Workshop 2) (d) 1C less than or equal to10 (e) B, C greater than or equal to 0 We now change this to standard LP format. Ìn the standard LP form, all the constraints are converted into equations with the help of slack variables. Also make sure that these equations have non-negative right hand side. For example, 4B plus 6C less than or equal to 120 is changed to 4B plus 6C plus m is equal to 120 Here m is called a slack variable. Ìt takes non-negative values. Ìn fact all the variables in these equations take non-negative values. The standard LP format is as follows: (a) Objective function Maximize Z is equal to 2B plus 4C plus 0 m plus 0 n plus 0 p (b) 4B plusplis6C plus Ìm is equal to 120 (Workshop 1) (c) 2B plus 6C plus Ìn is equal to 72 (Workshop 2) (d) 1C plus 1pis equal to 10 (e) B, C greater than or equal to 0 m, n, p z 0 where m, n, p are the slack variables. Z equation is also written as Z minus 2B minus 4C minus 0 m ÷ 0 n ÷ 0 p is equal to 0. Now, make a tableau as follows This tableau gives the coefficients of the variables Z, B, C, m, n, p in the four equations written in the standard LP format, starting with the Z-equation. This tableau is a convenient way of setting up the information. This gives, Ì. The variables which are in the solution at that point.(Z, m, n, p) 2. Profit associated with the solution.(0 when B is equal to 0, C is equal to 0) 3. The variable that will add most to profit, if brought into the solution. This is indicated by the variable which has most negative coefficient in the Z-row. Here the most negative coefficient is minus4 for C. So C is called the entering variable. Next, we need to rewrite the tableau by replacing one of the basic slack variables by C. To decide which current basic variable is to be replaced by C, we concentrate on the C- column and the solutions column. Take the ratio of the corresponding entries in these columns. Look at the following table: Solution Ratio -4 0 6 120 120/6 is equal to 20 6 72 72/6 is equal to12 1 10 10/1 is equal to 10 Then we choose the smallest positive value in the ratio column, which is 10. The slack variable corresponding to this is p. Thus we decide to replace p by C. Look at the tableau below which is a reproduction of the previous one. We have highlighted the column under C, and the p-row, which is called the pivot row. The intersection of the highlighted row and column is called the pivot entry, which is Ì here. Now we forma new tableau where (1) new pivot row is equal to (current pivot row) divided by(pivot entry) (2) all other rows is equal to current row minus (pivot entry) multiplied by(new pivot entry) So we have completed one iteration of the problem. Second 'teration Basic variables Z m n P 1 0 0 0 ÷2 4 2 0 -4 6 0 1 0 0 0 0 1 0 0 0 0 1 0 120 72 10 Z B C Ìn n . P Solution 222 ( )<, o tid Ìt ( Ì alia it Now, the entering variable is B, which has the most negative entry in the Z-row. The variable to be replaced is n which corresponds to the smallest positive ratio 60/4, 12/2, 10/0 is n. The new tableau then becomes Look at the highlighted row and column. Since p has the only negative coefficient in the Z-row, it should be the entering variable. Then p should replace m, as the ratio corresponding tom (36/6is equal to6) is the smallest positive one. The next tableau is as follows Since there are no negative numbers in the Z-row, we stop here. The value in the solutions column against B is 24 and that against C is 4. Thus 24 bats and 4 chessboards should be made to get the maximum profit of Rs 64 under the given constraints. Let us now look at various steps of Simplex Method. 1. Formulate problem in terms of an objective function and a set of constraints. 2. Write it in the standard LP format. 3. Set up initial tableau. 4. Determine which variable to bring into solution (largest negative number in the Z- row). 5. Determine which variable to replace (smallest ratio of solution column to its comparable value in the optimum column). 6. Divide the identified row by the pivot entry to arrive at the new pivot row.. 7. Update remaining row values. 8. Ìf there is no negative number in the Z-row, you have reached the optimum solution. Otherwise repeat steps 4 to 7. Mini'i-ation *ro"le's The steps are identical for solving minimization problems. The objective is to minimize, rather than maximize. Therefore, a positive Z-row value now indicates potential improvement. The variable associated with the largest positive value in the Z-row would be the entering variable. The variable to be replaced is decided as before, by choosing the smallest positive ratio. The last tableau, which is called the optimum tableau, gives us a lot more information than just the values of the main variables. The values of the slack variables help us understand the status of resources. For instance, in the above example, mis equal to 6 in the optimum tableau. This positive value of m means that particular resource is not fully used up. Such a resource is called abundant resource. Here it means that workshop Ì is not fully utilized in producing the optimal quantity of bats and chess boards. So the management may decide to put it some other use. The other two slack variables n and p do not appear to be basic variables in the optimal tableau, This means their value is zero .This suggests that the resources corresponding to n and p i.e. workshops 2 and 3 are working to their full capacity in producing 24 bats and 4 chess boards. When the value of slack variable is zero, the corresponding resource is called scarce. Further analysis of this method can help us in decision-making: 1. L.P. can be used to find the sensitivity of results to changes in costs, availability of raw materials, labour, etc. For a Ì% change in cost, the % change in profit can be analyzed. 2. We can analyse the marginal effects of financial and other constraints on the liquidity and profitability of the company. When there are uncertainties in demand, we can use the probabilities while formulating the problem. 3. We can use L.P. in Profit planning also. We have a special type of L.P. called Goal Programming. The goals which are desired are incorporated into the objective function. Ìn goal programming, all goals, one or many are incorporated into the objective function. This helps us to do break-even analysis and take financial decisions. 4. Ìn the same way, we can use L.P. for Financial Budgeting. We should represent accounts in a matrix form in a spreadsheet. We can use this method to make multi- period budgeting also. /e38or&s Linear Programming; Maximize; Constraints; Objective Function; Non-negativity Conditions; Graphical Method; Basic Feasible Solution; Extreme Point; Optimum Utilization; Slack Variables; Ìteration; Entering Variable; Replacement Variable; Substitution Rate; Shadow Prices; Artificial Variable; Sensitivity Analysis. 97estions 1. What structural requirements of a problem are needed in order to solve by L.P.? 2, 2. 2. What type of information is provided by final Simplex Tableau'? 3. What are shadow prices? How are they useful in business decision-making? 4. What are slack variables? Why are they necessary'? Ìn a graphical solution, it is said the corner point will give the result. When do you have more than one solution (many solutions) along a constraint line? 6. Attempt the problem which was done by simplex method as example, by graphical method. (a) Plot the constraint equations. (b) Determine the area of Feasibility. (c) Plot the objective function. (d) Find the optimum point. 7. Solve the problem by simplex method. 5x plus 2y plus 3z less or equal to 100; x, y, z greater or equal to 0 4x plus y plus 2z is less than or equal to 60 Maximize f is equal to 3x is equal to 2y plus z. 8. Solve by graphical method: 3x plus y less than 15; 2x plus 5y less than or equal to 24; x plus y less than or equal to 7 x, y greater or equal to 0. Maximize f is equal to x divided by2 plus y 9. Case Study 1: MODEL TRANSPORT LTD. The fuel company wants to mix 2 fuels (A & B) for its trucks in order to minimize costs. Ìt needs no less than 3000 litres in order to run its fleet during the next month. Ìt has a maximum storage capacity of 4000 litres. There are 2,000 litres of fuel A and 4,000 litres of fuel B available. Mixed fuel must have an octane rating of no less than 80. When mixing the fuels, the amount of fuel obtained is just equal to the sum of parts put in. Octane rating is the weighted average of individual octanes, weighted in proportion to the respective volumes. Fuel A has an octane of 90 and costs Rupees 20 per litre and fuel B has an octane of 75 and costs Rupees 13.33 per litre. Ì. Write the required equations and the objective function. State any assumption to solve the problem. Solve the problem graphically. Give the quantity of each fuel to be used. 10. Case Study 2: DÌET ARRANGEMENT ÌN A HOSPÌTAL The dietician of the hospital is asked to prepare food which will have low cost, but at the same time provide the required nourishments. The diet should have between 1,800 to 3,600 calories. No more than 1,400 calories can be starch. No less than 400 calories of protein. The varied diet will be made of 2 foods A and B. Food A has 200 calories of starch and 400 calories of protein; it costs Rupees 150 per kg Food B has 700 calories of starch, 100 calories of protein and 100 calories of fat. Ìt costs Rupees 30 per kg We should not give more than 1 kg of A to any one. Write the equations representing the information. Solve the problem both graphically and through Simplex Method. END O+ CGA*TER 1C ADVANCED BAN/ MANAIEMENT CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 19 SÌMULATÌON 1F.0 STRUCTURE 19.1 Ìntroduction 19.2 Simulation Exercise 19.3 Simulation Methodology Keywords Questions 1F.1 INTRODUCTION Simulation is a way of studying effects of changes in the real system through models. Ìt is the imitation of some real thing or process. Ìn simulation, we try to imitate a system or environment in order to predict actual behaviour. Simulation can be defined as ÷ acting out or mimicking an actual or probable real life condition, event or situation to find cause of a past occurrence or to forecast future effects of assumed circumstances or factors. A simulation may be performed through solving a set of equations (mathematical model), constructing a physical model, stage rehearsal, a computer graphics or game. Simulations can be useful tools that allow experiments without actual exposure or risk, but they may be gross simplification of reality. They are as good as underlying assumptions. In financial world, it generally refers to using a computer system to perform experiments on a model of a real system. Such experiments can be undertaken before the real system is operational so as to aid in its design. We can see how the system might react to changes in its operating rules. We can evaluate how system's response to changes in its structure. 1F.! SIMUDATION E1ERCISE Simulation is appropriate to situations where size and/or complexity of the problem make the use of other techniques difficult or impossible. For example, queuing problems have been extensively studied through simulation. Some types of inventory problems, layout and maintenance problems also can be studied through simulation. Simulation can be used with traditional statistical and management techniques. Simulation is useful in training managers and workers in how the real system operates, in demonstrating the effects of changes in system variables and real-time control. Simulation is extensively used in driving lessons. The person who learns driving is made to face the real road situations (traffic jams and other problems) during learning, so that serious accidents can be avoided. Simulation is commonly used in financial world such forex, investment and risk management areas. A55li%ation of si'7lation 'etho&s: 1. Air Traffic control queuing 2. Aircraft maintenance scheduling 3. Assembly line scheduling 4. Ìnventory reorder design 5. Railroad operations 6. Facility layout 7. Risk modeling in finance area. 9. Foreign exchange market 10. Stock market The best way to learn about simulation is to simulate. So, let us take an example. The owner of an outlet wishes to evaluate his daily ordering policy. His current rule is order the demand of the previous day. But he has started thinking recently that he should follow better methods to decide the quantum of order. Ge purchases milk at Rs 12 and sells at Rs 16. He orders his requirement at the end of the day and gets the milk in the morning. From past experience, the vendor assessed that his demand is between 30 and 80 liters per day. Ge also kept a record of relative frequency of the quantity demanded during the last 10 days. Now he thinks of a new ordering rule ÷ mean of quantity sold in the last 10 days. Ge maintained the sales in a tabular form. The table has two columns. The first column shows the Demand and the second one shows the Relative frequency, that is, in the selected period of 10 days, how many times such demand occurred. Demand per day in Litres Relative Frequency 35 1 by 10, that is, only one day, out of ten days, demand of 35 litres occured 45 3 by 10, that is, only three days, out of ten days, demand of 45 litres occured 55 2 by 10, that is, only two days, out of ten days, demand of 55 litres occured 65 3 by 10, that is, only three days, out of ten days, demand of 65 litres occured 75 1 by 10, that is, only one day, out of ten days, demand of 75 litres occured He settles for the ordering rule [(35 into 0.1) plus (45 into 0.3) plus (55 into 0.2) plus (65 into 0.3) plus (75 into 0.1)] is equal to 55 litres. So we have 2 rules: Old rule and New rule. Representing mathematically, Old rule is equal to quantity demanded on previous day is equal to D(n minus 1). New rule is equal to Mean of the past 10 days is equal to 55 Now let us compare these orders in terms of profits. Profit 'P' is equal to (Sold Quantity into selling price) minus (Ordered quantity into cost price). Assume that the unsold milk packets are thrown away as they are perishable. Now to prepare for simulation, we have to develop a method for demand generation. Let us use the probability distribution of demand and random numbers to generate a demand for the next 20 days. Now arrange the chance process to generate occurrences in the system. Demand Per Day Relative Frequency Probability Random Number Ìnterval 35 1 by 10 0.1 00 to 09 45 3 by 10 0.3 10 to 39 55 2 by 10 0.2 40 to 59 65 3 by 10 0.3 60 to 89 75 1 by 10 0.1 90 to 99 With the above table and random numbers, we develop the demand for 20 days. Step 1: Choose a random number. Step 2: Find the random number interval associated with the random number. Step 3: Read the daily demand corresponding to the random number interval. Step 4: Assume D = 55 litres for day 0 Step 5: Calculate the quantity sold. Quantity sold will be lesser of the demand D or Quantity ordered Q1 (or Q2) Step 6: Profit = (Sold quantity into selling price) minus (Ordered quantity into cost price). Selling Price is Rs 16 per litre and cost price is Rs 12 per litre Step 7: Do all steps for 20 days to simulate. Day RN (rando m number D (demand related to respectiv e random number interval) Q1 (quantity ordered based on demand of previous day) S1 (quantity sold under old method) (lesser of D and Q1) PR-1 (rupees ) profit under old method (16 into S1) minus (12 into Q1) Q2 (quantity ordered) (mean of quantity sold in last ten days) S2 (quantity sold under new method) (lesser of D and Q2) PR-2 (rupees) profit under old method (16 into S1) minus (12 into Q1) 0 55 1 6 35 55 35 ÷100 55 35 ÷100 2 39 45 35 35 140 55 45 60 3 89 65 45 45 180 55 55 220 4 61 65 65 65 260 55 55 220 5 99 75 65 65 260 55 55 220 6 95 75 75 75 300 55 55 220 7 55 55 75 55 -20 55 55 220 8 35 45 55 45 60 55 45 60 9 57 55 45 45 180 55 55 220 10 59 55 55 55 220 55 55 220 11 30 45 55 45 60 55 45 60 12 81 65 45 45 180 55 55 220 13 2 35 65 35 -220 55 35 -100 14 18 45 35 35 140 55 45 60 15 87 65 45 45 180 55 55 220 16 68 65 65 65 260 55 55 220 17 28 45 65 45 -60 55 45 60 18 44 55 45 45 180 55 55 220 19 80 65 55 55 220 55 55 220 20 84 65 65 65 260 55 55 220 Total 1120 1110 1000 2680 1100 1010 2960 Averag e 56 55.5 50 134 55 50.5 148 ;e now see that the average demand according to simulation is 56 litres, Average sales is 50 litres, according to old method; and 50.5 litre according to new method. Average order is 55.50 litres under old method, whereas 55 hires under new method. Thus you would find that profitability improves under the new method. 1F.( SIMUDATION METGODODOI) Det us draw the flow chart for a simulation model. We will list the key factors or decisions on the right hand side. Det us define the problem. Problem definition for simulation differs a little from problem definition for any other tool of analysis. Essentially, it requires the specification of objectives and identification of the relevant controllable and uncontrollable variables of the system to be studied. The variables affect the performance and determine the extent to which the objectives are achieved. In our example, the objective is to maximize profits. The relevant controllable variable is the ordering Rule (under the control of the decision maker). The uncontrollable variable is the daily demand (amount sold). START Key factors DEFÌNE PROBLEMDefine objectives and variables CONSTRUCT THE SÌMULATÌON MODEL SPECÌFY VALUES OF PARAMETERS & VARÌABLES RUN THE SÌMULATÌON EVALUATE RESULTS PROPOSE NEW EXPERÌMENT STOP Specification of variables, parameters, decision rules, probability distribution and time incrementing procedure ÷ (fixed or variable) Determine starting conditions and run length Determine statistical tests Compare with other information I'5ortant +eat7res 1. A model has to be representative of the system. A simulation model is one in which, the system's elements are represented by arithmetic, analog or logical processes that can be executed, manually or otherwise, to predict the dynamic properties of the real system. !. Specification of time incrementing procedure: Ìn simulation models, time can be incremented by fixed time increments or variable time increments. Under both methods, a simulated clock is a must. The events occur at regular intervals ÷ we have fixed increments like hour, days, months, etc. The simulation proceeds from one time period to another. At each point in 'clock time' the system is scanned to determine if any event has happened. Then the events are simulated and time is advanced. Even if events do not occur, time is advanced by one unit. In the variable time incremental method, clock time is advanced by the amount required to initiate the next event. If we have a situation, where order is placed only if the inventory goes down to certain level, instead of daily (as in our example), we can follow this method. ;hen events occur with regularity, follow fixed time method. When events are infrequent, and happen in hop-jump fashion, follow variable time increments. You may have to simulate time increments also with probabilities. (. The ability to deal with the dynamic systems is one of the features that distinguishes these models from other models used for general problem solving. Even in the above example, an inventory formula along with cost of inventory could have been used to determine optimum ordering rule. Still a simulation run will be necessary to determine the effects of this inventory rule. .. Simulation models are custom built for the problem to be solved. On the other hand, a linear programming model can be used in a variety of situations with only a restatement of the values for the objective function and constraints. ?. Building and executing a model is only a guideline, and they are not rigid rules. @. Discrimination of run length: #a$ One approach is to run for a specified set period. #"$ Another approach is to set run length long enough to get large samples. ÷ this is no problem as we can run the model in computers. #%$ Third approach is to run the model till an equilibrium is achieved ÷ simulated data corresponds to historical data. Ìn our example, simulated demands correspond to their historical frequencies. A&=anta,es Simulation is desirable when experiments on the real system 1. would disrupt ongoing activities; !. would be too costly to undertake; (. require many observations over an extended period of time; .. do not permit exact replication of events; and ?. do not permit control over key variables. Simulation is preferable when a mathematical model 1. is not available to handle the problem; !. is too complex and arduous to solve; (. is beyond the capability of available personnel; and .. is not robust enough to provide information on all factors of interest. Disa&=anta,es 1. Time consuming. !. Requires computer experience and expertise on the part of the user. (. Ìmpossibility of quantifying and difficulty of casting complex problems in a format may cause difficulties; but simulations can be made to run under any type of assumption and these flaws can be overlooked. .. Ìn spite of widespread applications, there are very few principles to guide the user in making decisions on what to include in the model and the length and number of simulation runs. This will be more like an art than science. The user has to use his intuitive judgments. /e38or&s Simulation methodology; Problem definition; Real system/dynamic system; Specification of parameters; Controllable and uncontrollable variables; Set run length of simulation; Fixed time increments and variable time increments. 97estions 1. Case St7&3 Shrimps Galore is a firm in Cochin. With the blue revolution of the 1990's the firm became famous. They started exporting fresh shrimp to European countries. Ìt places orders for cases of shrimp from fleet representatives at the beginning of each week to meet the demand from its customers at the middle of the week. The shrimp is delivered to Shrimps Galore and then, at the end of the week, to its customers. Both the supply of shrimp and demand for shrimp are uncertain. The supply may vary as much as 10% from the amount ordered, and by contract Shrimps galore must purchase this supply. The probability associated with this variation in supply is ÷ 10%, 30 % of the time; 0%, 50% of the time and +10 %. 20% of the time. The weekly demand for shrimp is normally distributed with a mean of 800 cases and a S.D. of 100 cases. A case of shrimp costs Rs 300, and it sells at Rs 500. Any shrimp not sold at the end of the week are sold to a cat-food company at Rs 40 per case. Shrimps Galore may, if it chooses, order the shrimp 'Flash-Frozen'by the supplier at dockside. This raises the cost of a case by Rs 40 and the cost will become Rs 340. +lash freezing enables Shrimps Galore to maintain an inventory of shrimp. But it will cost Rs 20 per case per week to store the shrimp at the local ice-house. The customers are indifferent to regular or flash-frozen shrimp. Shrimps Galore has calculated that its shortage cost is equal to the mark-up ÷ that is, each case demanded but not available costs the company (500 ÷ 300) = Rs 200 Now, the game requires that each week a decision be made as to how many cases to order of regular shrimp and flash-frozen shrimp. The steps are as follows: #a$ Decide on the order amount of regular and/or flash-frozen shrimp and record the data. #"$ Assume that there is no opening inventory of flash-frozen shrimp. #%$ Determine the quantity that arrives and enter it in orders received in rows 4 and 5 respectively. (Accomplish through Random numbers & its associated level of random number intervals). 00-29=-10%; 30-79=0%; 80-99=10%. #&$ For example, if you decide to order 1000 cases of regular and 100 cases of flash-frozen, the quantity you will actually receive would be 1000 minus (0.10 into1000) is equal = 900 regular cases and flash-frozen is equal to 90 cases. Note that variation in supply in both cases is same. #e$ Add the flash-frozen in inventory (if any), to the quantity of regular and flash- frozen, just received ÷ enter in row 6. #f$ Determine the demand for shrimp. We know the demand is normally distributed with a mean of 800 and a S.D. of 100. Use random normal deviate value and calculate demand. Ìf the random deviate value is 1.76, the demand is [800 minus (1.76 into 100)] is equal to 624 cases. Enter demand in row 7. #,$ Determine the quantity sold (Row 8).This will be lesser of the amount demanded and amount available Le row 7 and row 8. Ìf the firm receives 990 and demand is 624, they can only sell 624. #h$ The remaining goes to excess. Always sell regular before flash÷frozen. Then regular is sold as cat-food. i$ Ìn the same way, determine shortages, quantity of unsatisfied demand - enter in row 11. 1. Week 1 2 3 4 5 6 7 8 9 10 2. Random number 3. Frozen Ìnventory 4. Order Regular 5. Order Frozen 6. Available catch-regular 7. Demand 8. Quantity sold 9. Cat food sold 10. Frozen extra 11. Deficit !. Cal%7late *rofit 1. (a)Revenue from sales is equal to 500 into column 7 (b) Revenue from excess is equal to 40 catfood into column 8 (c) Cost of regular purchases is equal 300 x col. 3 (d) Cost of flash-frozen 340 x col. 4 (e) Cost of holding flash-frozen 20 x col. 9 (f) Cost of shortages 200 x col. 10 (h) Profit is equal (a plus b) minus c is equal d plus e plus f). !. Enumerate with examples of areas wherein you can use simulation (. Ìf a box contains 100 balls, of which, 10 per cent are green balls, 40 per cent are red balls, and 50 per cent are spotted balls, develop a simulation model. Each time a ball is drawn, colour is noted and replaced. Use random numbers. .. The Supermarket Chain has hired a consultant to decide 'how many items per customer should be allowed in the fast checkout line'. You are expected to use simulation and you have one month and 2 assistants to gather data. Data Stores are located throughout the country is 10, Working hours are 12 hrs a day. Average size: 9 checkout lines per store including fast checkouts. Available checkers: 7 to 10; some engage in stocking activities, when not in checking stands. (a) How do you set up the study? (b) What additional data you will need? (c) How would you gather preliminary data? (d) How would you set up the problem for simulation? (e) The criteria you would use for making recommendations? (f) What factors will affect the application of your recommendations to all the stores? END O+ CGA*TER 1FE ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 20 Fundamentals of Human Resources Management STRUCTURE 20.0 Objectives 20.1 Ìntroduction 20.2 The Perspective 20.3 Relationship between H R M & H R D and their Structure and Functions Check Your Progress (A) 20.4 Role of H R Professionals Check Your Progress (B) 20.5 Development of H R Functions in Ìndia Check Your Progress (C) Let Us Sum Up Keywords Answers to Check Your Progress (A, B, C) Terminal Questions Suggested for Further Reading !0.0 OBJECTIVES After reading this unit, you should be able to: #a$ appreciate the fundamentals of Human Resource Management; #"$ understand the comprehensive perspective of H R M and the relationship with Human Resource Development; #%$ understand the role of H R professionals; and #&$ get to know the development of H R functions in Ìndia. !0.1 INTRODUCTION The effective utilization of people in any organized effort has always been a pressing problem in society. For a long time management theories have been characterized by a search of universal solution to provide practitioners with principles that can be applied to all kinds of organizations with universal success. This is mainly due to the fact that the organizations are primarily social systems. They combine people and science ÷ humanity and technology. Ìt is, therefore, not possible for every organization to have the same type of people and same level of technology. Thus, the human behavior in relation to an organization has assumed a great significance and forms the major subject matter of various studies conducted in the field of human resources management to provide the basis for the organizational development process and to improve the organizational effectiveness. Ìn his book THE LAND -MARKS OF TOMORROW, Peter Drucker the famous management guru observes: 'no matter how much we can quantify, the basic phenomena are qualitative one's: change and innovations, risk and judgments, growth and decay, dedication, vision, rewards and motivation, so on and so forth. The discipline we need cannot be a technical discipline though it will have many technical areas. Ìt must be a truly humanistic discipline'. *ractitioners and managers have come to recognize the complex world in which they must operate and have become increasingly willing to accept help from behavioral scientists in identifying and resolving organizational problems. An organization is a planned coordination of the activities of a number of people for the achievement of common organizational objectives through involvement of people to assigned functions and through a hierarchy of authority and responsibility using appropriate technology. The characteristics of an organization and its success are largely influenced by various managerial and organizational factors. Thus, the study of human behavior at work cannot be studied in isolation, ignoring various inter-dependent complexities. Ìndustrial work, originally, was organized around the technology available and rules of checks and balances. Organizations today have realized that they need to respond to changes occurring in the environment; be it technology, business dimension, strategies, customer expectations or the emerging markets. Their experience reveals that after due analysis, it is relatively easy to think and decide upon a response to business or technology dimension; but, the implementation is often a slow process or a difficult one to go through. This is because it involves convincing people, changing their habits and mindset, the established ways of thinking and perception. And even the 'best' strategy can fail if not implemented in the right spirit. The people component is thus becoming the key factor to success of the strategy; be it for survival or growth or achieving excellence. *eople management has been the most intriguing aspect of managing an organization all along. The organizations have recognized its contribution in the total framework but this aspect is so dynamic that it does not seem to reach a level of stability. The technology, the system and its subsystems or the infrastructural resources tend to get stabilized at least for a certain period in their evolution process, but people management tends to remain an 'alive* issue. One of the reasons for this lies in its being different in nature compared to any other resource the organization depends upon. The other resources are passive ÷ in the sense that they do not react or their reaction can be controlled or predicted. But human resource is not so. This resource is capable of responding to the treatment given to it and the response is not standard or uniform. Even a slight variation can create waves. Ultimately, organizations exist for producing products and services to meet human needs. Thus, manpower occupies the central place, looked at from any point or any organizational activity. Organizations have attempted to deal with people ÷ its employees ÷ according to the understanding prevalent about human behavior at any point in time. The variations have been characterized from a rather mechanistic approach to a philosophical one. The evolution of new approaches has been triggered by research in the field of management as well as social sciences. Human affairs in any organization are influenced by a wide variety of emotions like love and hate, human needs and expectations, human values, beliefs and perceptions, traditions and culture, and also by technical, social, economic, demographic and political changes and developments. This unit examines how these approaches have converged in the present perspective of H R Management. !0.! TGE *ERS*ECTIVE An appropriate beginning to understand the fundamentals of people management would be to appreciate the foundations of an organization. An organization is primarily a ramification of the fact that there is an interdependency implied in the satisfaction of needs of individuals alongside with the achievement of organizational objectives. An organization is coming together of individuals in order to attain a common goal/purpose. As defined by Edgar Schein, 'An organization is the rational coordination of the activities of a number of people for the achievement of some common explicit purpose or goal, through division of labour and function and through a hierarchy of authority and responsibility.' (Schein, 1979). Such a coming together can be formal or informal. Ìn a formal setup, there is a given goal, a structure, explicit roles and relationships in order to coordinate the activities whereas in an informal organization, these aspects evolve as an outcome of the group process. Drawing from this definition we can see that there are two interdependent aspects, i.e. one about people and the other about activities. Historically, two streams of thoughts have developed; one, on how to organize the activities most systematically and analytically so that specificity in the work processes and operations can be brought about, and the other, on how to understand an individual's relation to a given activity now recognized as 'work'. Obviously, enough thinking has developed in both these spheres over the years and the two perspectives have affected each other due to the high degree of their association and interdependence. The beginning of these two perspectives can be seen in the work of Robert Owen (1771-1858) and Charles Babbage (1792-1871). Owen, a manager by profession, claimed that a manager's best investment was in his workers ('vital machines' as he called them). He believed in providing better conditions for workers which he thought would result in higher productivity. Whereas Babbage, a professor of mathematics, was an early advocate of division of labour. He believed in applying scientific principles to work processes to increase productivity and reduce expenses. Whichever may be the focal point, cooperation of individuals to coordinate the activities in an organization is the beginning of people management. Organizations have attempted to explore the best way of achieving this and continue to do so. The genesis of people management lies in the evolution of management thoughts itself. Therefore, in order to trace the development of people management as a function, we have to study the various theories of management. During the flurry of the industrial revolution, the view of the coordination of activities taken by organizations was very simplistic. Ìt focused on the 'activities' that related to the work situation alone, i.e. doing the work. Ìt was assumed that people would do the work they have been employed for (paid for). This was also supported and subsequently highlighted by the 'scientific management' approach conceptualized and pioneered by Frederick Taylor (1850-1915) famous for his 'division of labour' concept and 'time and motion' studies and further substantiated by Gantt and Gilberths. Some of the major assumptions in this approach could be summarized as: #a$ the tasks can be broken down to simple units for people to understand and perform #"$ people will do a given activity in return for money #%$ people will have to do what is defined by the organization and in turn by technology. The simplicity of this approach ignored many important and vital aspects of human behavior which were later brought to the forefront. First of all, it concentrated only on the activities implied in the 'work' but certain other activities (behavior) which take place as a natural outcome were not considered. For instance, fatigue, boredom, the need to converse with others (not related to work), the relationships that may grow out of the interactions, etc., were not seen as relevant for managing. The perspective controlled and predicted the activities of people strictly related to work; and it chose to let go of the other aspects. Ìt was this simplistic mechanical approach that primarily was responsible for the rise of labor unions and labor unrest. Though certain factors like periodic economic depression, immigration of workers, aggressive stance of the management in combating the efforts of labor to unionize, delayed strengthening of the collective bargaining as a process, the genuineness of issues made it a permanent formal factor of organizations. The concept of unionism also for the first time made the organizations aware of the role of external socio-political pressures. In addition to this, certain developments in the internal environment of the organization gave rise to a few new issues. For instance, the tightly structured and planned work systems could not instill meaning/ pride in the work that individuals did and this had an adverse effect on productivity. This was the beginning of the awareness about the crucial role played by emotions in work situations. This realization led to the entire spectrum of research in the area of work motivation. The impact of 'Hawthorne Studies' carried out by Elton Mayo and others at Western Electric Company during 1924-33, is a landmark in the evolution of the management thought and human approach in management. These studies pointed out to various dimensions of human behavior that were not considered to be of any significance in the restricted approach taken earlier. The human relations movement that followed replaced the 'rational- economic man' by the 'social man' perspective. Ìt focused on the role played by the various relationships that develop at work as an outcome of the organizational interactions. Following the revelations, the people management systems were geared to take care of the relationships with supervisors, colleagues and groups. Later researchers like Chris Argyris, Abraham Maslow, Douglas McGregor and Fredrick Herzberg highlighted dimensions of motivation that are rooted in the growth need of an individual. The central theme of their arguments was that individuals are motivated by other than monetary factors too. They emphasised that individuals like to perceive meaning in the activities they do, they like to experience a sense of responsibility while performing a task, and have a sense of achievement when the task is complete. Ìf some of these elements are missing in the 'work' they do, the performance can be limited. Ìn other words, they need to feel proud about what they are doing. Their involvement in the process of deciding their activities may determine the level of their performance and satisfaction. Therefore, the perspective of people management should provide for these components. This was the beginning of the present developmental approach towards people management. The De=elo5'ent of *eo5le Mana,e'ent +7n%tions The history of management of people as a distinct managerial function goes back to the end of the nineteenth and the beginning of the twentieth century. With a significant increase in the number and size of organizational units as a sequel to the Ìndustrial Revolution, there was a need to have special departments like finance, accounting, production, etc. However, it was much later that the need for a department to manage people in the organizations was felt. Ìn Ìndia the experiment on group behavior in Ahmedabad mills by Prof. A. K. Rice in 1952 is a significant contribution. A +ew organizations had a post of welfare secretary to meet the needs of the workers and prevent workers from forming unions, (Werther and Davis, 1982). These social secretaries, as they were called, marked the birth of specialized human resource management as distinct from the day-to-day supervision of personnel by operating managers. The units dealing with such activities were mostly termed as Time Office in textile mills and factories and as establishment section in banks and commercial offices. They were, in fact, engaged almost entirely in promoting the organizational maintenance objective, although this was not widely recognized (Miner, 1969). Perhaps it was in the chemical and pharmaceutical industries, the term personnel officer was initially used in 1960s. Although the fundamental activities involved in people management, viz., acquiring, training, evaluating and compensating the employees continued, the broadened understanding of human behaviour contributed to the maturing of this function. As Fred Luthans observes, 'These examples offer ample evidence that the personnel function was very much in existence before the 1930s. However, the major change in the practice of management that included the personnel function, with its accompanying concern for the human element, did not occur until the socio- psychological upheavals in the late 1920s and early 1930s. (F. Luthans, 1985) In general, it appears that there have been two major traditions or trends within personnel management over the years. One of these, stemming largely from economics and accounting, emphasized a hardheaded, profit-minded approach to the utilization of human resources; the other, with its origins in social work and certain subfields within social psychology, took more of a social welfare viewpoint. This duality of approach appears to have hampered the development of the profession within certain segments of the American industry, and the signs of the split have still not entirely disappeared. The social welfare tradition has been viewed as antithetical to the 'real' organizational goal of productivity by many managers, both within and outside the personnel field. On the other hand, the feeling among those with a social welfare orientation has been that management generally paid more emphasize to productivity and profit and less to employee satisfaction. Only in relatively recent years there has been some lessening of this conflict as an increasing number of firms have come to accept the view that there are really two primary types of organizational goals ÷productivity and maintenance. Both appear to be essential, yet some policies and procedures which maximize one may well do so at the expense of the other (Miner, 1969). !0.( REDATIONSGI* BET;EEN G R M MG R D AND TGEIR STRUCTURE AND +UNCTIONS As can be observed, the changing perspective of HRM was triggered by greater and wider understanding of human behavior in relation to the formal organization. Therefore, the evolution of approaches is characterized by the addition of the dimensions rather than substitution. Ìn this framework of change, the H R M as a function in an organization matured to encompass the newer dimensions and deeper aspects of given dimensions. Ìn other words, none of the earlier aspects of people management were wiped out. They have become stabilized, reutilized and therefore become less crucial in comparison to the newer dimensions. The present perspective of H R M, to quote Sheth: => ? M assumes that the mana&ement of people is an inte&ral part of the resour#e mana&ement tas" within an enterprise for a#hie$ement of or&ani@ational o%Ae#ti$es. >uman %ein&s de$elop a sta"e in the enterprise as they wor" in it and hen#e their moti$ation( de$elopment and &rowth #onstitute a #riti#al fa#tor in the de$elopment and &rowth of the or&ani@ation. A #ru#ial mana&erial responsi%ility is to ma"e a #ontinuin& effort to harmoni@e the interest and &rowth of the or&ani@ation with those of the employees at all le$els. >uman sensiti$ity( trust in people and parti#ipati$e mana&ement are treated as a part of mana&erial #ulture and philosophyB 1!heth( 1552/. As implicit in the above quotation, H R M serves as an umbrella for all functions ÷ old and new. Ìt provides a guiding principle for developing new people related systems and also provides a yardstick to evaluate any existing subsystems in the area of people management. Ìn addition, it subtly emphasizes that managing people is a line-and-staff function both. Every manager has to implement/practice a component of this function through his day-to-day actions. Ìn other words, every system has a process requirement. Preparing the line manager to appreciate a system, its rationale and the linkage to the H R philosophy, forms a crucial component of the H R functionary today. The process of adopting the changing perspective of H R M by any organization is evident in the changing nomenclature of the function/department. Thus, at the first stage the labour and welfare department' being substituted or renamed as 'Personnel' and in the next stage brought under one HR functionary. A careful look reveals that the traditional activities still continue as sub-modules of the broad HRM function. Experts have put these either in the four traditional sub-modules of Acquisition, Development, Motivation and Maintenance (De'Cenzo, 1988) or Planning and Administration, H R D, Job and Salary, and Workers Affairs. (Pareek and Rao, 1981) The differences here are those of classifying. But by and large it can be observed that the conventional component of people management is categorized under (Personnel) Administration and Maintenance. The systems related to acquisition, (evaluation) promotion, administration, salary and long-term benefits are under administration and the traditional labour management, grievance and discipline management activities are covered under the maintenance systems. The developmental systems such as induction and socialization of the individuals, development and growth, performance appraisal and counselling, career planning are covered under the nomenclature of Human Resource Development (H R D). Another classification views two subsystems under HRM, viz. administrative, developmental and preventive (Mankidy, 1998). Looking at the comprehensive coverage one tends to agree that H R M function as the continuation and enlargement of the conventional areas of people management, certainly signifies 'maturation of the function of management of people as an integral part of enterprise management' (Sheth, 1992). Organizations increasingly compete with each other on the basis of effective people management and development by tapping into the ideas of workers and organizing their work in more effective manner and even by following the best practices of other organizations. This can be possible if the organizations procure right type of people with right type of skills and attitude for right jobs who can be developed to meet the present as well as future needs of manpower requirements. Besides the traditional role of maintenance and management of manpower, the H R M has to play a crucial role in human resource development, appraisal and utilization. Thus, H R D is sometimes considered as a significant subsystem of H R M. ;ide range of activities are included within the boundaries of H R M. The roots of people management and development reside in the welfare tradition with focus on improving organizational efficiency and effectiveness. Ìt should also emphasize the need for continuous professional development (C P D) to meet the organizational requirements. The development of professionals should be continuous because there is always scope for improvement of skills and performance. The individuals, however, have to own and manage their developmental needs. The development process should have clear learning objectives that aim to satisfy individual and organizational needs. There is no conflict between the structure and functions of H R M and H R D the difference is only in the approach and emphasis. While routine functions become a part of H R M, the H R D functions emphasize on organizational interventions for climate development, employee and organizational development linked with organizational goals/objectives and change management process. Ìt may involve some element of conducting surveys and research to seek employees' feedback and opinion, their aspirations, and suggestions to handle the present organizational issues. Ìt may also involve some element of innovations to formulate people related policies. Thus, the emphasis of H R D is on overall organizational development process which also includes development of people. Che%2 )o7r *ro,ress #A$ State 8hether the follo8in, state'ents are tr7e or false: 1. People component of an organization has always received due attention. ---- False. 2. Ìndustrial revolution led to the rise of unions. ---- False 3. Management theories and approach to people management are very closely related. ---- True. 4. Scientific Management approach is the foundation of today's concept of Human Resource Management. ---- False. 5. Labour Management to Human Resource Management is not just a quantitative expansion of the people management function but is qualitatively different. ---- True. 6. Personnel Management and H R D are synonymous terms. ---- False. 7. H R D and human relations movement are not the same. ---- True. 8. H R M and H R D are unrelated to each other. ---- False. 9. H R D is a subsystem of H R M. ---- True. 10. H R M is a subsystem of H R D. ---- False. 11. H R D and H R M are more or less same concepts. ---- False. !0.. RODE O+ GR *RO+ESIONADIA Corresponding to the evolution of the H R M, the role of the individuals handling this function (activities) has undergone change. This change is not only quantitative in terms of added activities or responsibilities but also qualitative. The shift has taken place from traditional people's management to modern people's development. Thus, the role of HRD professionals assumes a greater significance. Traditionally, this function was perceived merely in terms of the activities, and was a part of the duties of supervisors/managers. The focus as a specialized function came along with external, socio-legal influences needing awareness of the employment- related legislations and their implications. As the function further developed in terms of systems ÷ for recruitment, training, promotion, etc. ÷ this knowledge became essential. Slowly, individuals who acquired this knowledge were relied upon by the shop-floor managers. This led to the perception of personnel being a specialist job ÷ a staff function. Academics responded by designing courses with specific coverage of the required skills and techniques. Ìndividuals acquiring such qualifications joined the organizations as specialists-professionals and were mainly required to deal with people- related matters. Gowever, the maturing of this function from personnel to H R M and H R D, highlighted that it cannot be totally delinked from the line managers, and that the line managers are the delivery points of this function. Hence, line-managers have to develop the ability of people management including their development. On the second platform, the professionalization of this function raised the issue whether it should become a specialist function or could the line managers become H R functionaries. Ìmplied in the debate is the fact that the contents of the role of the functionaries include specialized skills and knowledge on one hand, and equally important and pivotal, the philosophical orientation. The knowledge and skills are helpful in developing systems but the ultimate success is decided by the human relation orientation. The H R philosophy makes the difference. Such philosophical orientation need not and is not the property of any profession per se. Ìn other words, can one with such orientation pick up the professional knowledge and skills? Experience of industries indicates both the patterns. The traditional function of people management existed in the narrow sense of the term in ensuring the attendance, ensuring output and quality, good working conditions, safety, hygiene, etc. Since these were to be ensured on the shop floor, the responsibilities were with the supervisors/managers. However, when some of these functions became a part of statutory obligations special personnel had to be appointed. Ìndividuals with knowledge of these laws, rules and regulations started getting preference in employment and the function was viewed as special. The bank unions became important power centers in the 1960s, 1970s and 1980s, and for dealing with unions, industrial relations functions emerged and occupied a special position in the banks. They also dealt with individual misconduct and disciplinary enquiries. The focus on administering the personnel activities like recruiting, training, promoting and compensating made the personnel functions all the more a specialized function. With further turn of events when the developmental perspective was recognized, the orientation of the functionaries became crucial. The emerging perspective highlighted 'along with the development of the whole man, an integration of the people with the organization so as to make cooperative action easier and more meaningful, improve understanding between people, reduce useless frustration, enabling (he individuals to serve the organizational objectives without losing personal identity' (Pandey, 1990). This perspective implies that the staff-line functionaries need to be partners in achieving the objectives of the H R D. Every activity / system has a component that needs to be dealt with by the personnel / H R M department and the line managers. ;hile viewing the functions of the developmental perspective as more dynamic than the traditional personnel function, Pareek and Rao (1981) have grouped the multiple functions under five headings as follows: 1. S755orti=e Role: This relates to the strengthening of the operating and executive levels and consolidating the strengths in an organization. !. Role of S3ste' De=elo5'ent an& Resear%h: This pertains to developing systems that deal with people, their problems and organizational dynamics. This was already present in the traditional role. (. Mana,erial role: This relates to performing managerial functions like planning future manpower, recruiting, utilizing by placement, returning, motivating-integrating people and their role, performance and potential assessment, planning the growth of individuals, etc. .. Role of De=elo5in, Co'5eten%e: This refers to developing technical, managerial, and processing competence among the human resource. The new perspective also includes helping and coping competence. ?. *ro%ess Role: An effective organization needs to respond to the changing environment for which it has to develop coping skills. Creating necessary culture and values in the organization, diagnosing the problem at organizational level and taking corrective steps are the related responsibilities of the HR functionaries. The above description reveals the qualitative orientation required in the HRD perspective. As Sheth (1992) has pointed out 'underlying H R M is a progressive reinforcement of values of democracy, liberalism, humanism and shared control over the workplace. Ìt implies social commitment to the need for widening the base of individual rights and corporate obligations.' *areek and Rao have identified the critical attributes for dispensing such a role. These include: Te%hni%al 1. Knowledge of performance appraisal systems and their functioning in various organizations !. Knowledge of potential appraisal and mechanism of developing a system (. Knowledge of various tests and measurements of behaviour .. Ability to design and coordinate training programmes at worker, supervisor and managerial levels. ?. Professional knowledge of personnel and management @. Knowledge of behavioural sciences B. Understanding of overall organizational culture C. Knowledge of career planning, processes and practices F. Knowledge and skills in counselling 10. Knowledge of techniques in behavioural research Mana,erial 1. Organizing ability 2. Systems development skills *ersonalit3 1. Ìnitiative !. Faith in human beings and their capabilities (. Positive attitude to others .. Ìmagination and creativity ?. Concern for excellence @. Concern for people and their development B. Friendly, sociable and affable C. Attitude for research and development work F. Ìnterest in learning new things 10. Ability to work as a team member In view of the objectives of H R M and the critical attributes listed above, it is apparent that certain personality characteristics like initiative, faith in human beings, concern for the development of employees, and ability to work as a team member are crucial. Ìn the absence of these the first two sets of attributes may not achieve much. G R functions in banks are generally not performed professionally, unlike other corporates, Banks still consider H R D as a generalist discipline and any one from the cadre occupies the position of H R head. The C H has developed a H R Competency Model (E T 26 February 2004) listing out 19 interlinked competencies for the H R heads in the organizations. These competencies include nine behavioral competencies viz. communication, initiative, drive, creativity, self-confidence, teamwork, influence, problem solving and inter-personal skills. These nine behavioral competencies have been embedded in ten functional competencies, viz. business knowledge, change management, diversity management, service orientation, execution excellence, financial perspective, building expertise, personal credibility, relationship management and strategic thinking and alignment. The H R functions in banks will have to undergo drastic changes keeping in view the challenges faced by the banks. H R D departments can no longer function in isolation. They have to play an important role in coordinating various organizational activities for improving overall effectiveness of banks. Strate,i% Role in the +7t7re Accepting the importance of HR in the 21st century, Ulrich (1998) opines that 'HR has never been more necessary (as it is today). The efforts to achieve excellence ÷ through a focus on learning, quality, teamwork and re-engineering, are driven by the way organizations get things done and how they treat their people. Those are fundamental HR issues.' He gives a new mandate for HR asking the professionals in this field: 1. To become a partner with senior and line managers in strategy execution, helping to move planning from the conference room to the marketplace. !. To become an expert in the way work is organized and executed, delivering administrative efficiency to ensure that costs are reduced while quality is maintained. (. To become a champion for employees, vigorously representing their concerns to senior management and at the same time, working to increase employee contribution, that is, employees' commitment to the organization and their ability to deliver results. .. And finally, to become an agent of continuous transformation, shaping processes and a culture that together improve an organization's capacity for change. This new agenda for H R is a radical departure from the status quo. Ìn most companies today, H R is sanctioned mainly to play policy police and regulatory watchdog. Ìt handles the paperwork involved in hiring and firing, manages the bureaucratic aspects of benefits, and administers compensation decisions made by others. When it is more empowered by senior management, it might oversee recruiting, manage training and development programmes, or design initiatives to increase workplace diversity. But the fact remains: the activities of H R appear to be ÷ and often are ÷ disconnected from the real work of the organization. The new agenda, however, would mean that everyone engaged in H R's activities would in some concrete way help the organization better serve its customers or otherwise increase shareholder value. To that extent they are termed as HR Relationship Managers in some banks. After conducting a study to find out the level of professionalism of H R M functionaries, Agrawal and others (1990) conclude that the individual, his organization, academic institutions and the professional bodies, all have played a role in improving capabilities of these professionals. Let us see what an individual, today, can do to enhance his role as an H R functionary. ;hat an GR *rofessional %an Do> 1. Acquiring additional professional qualifications relevant to their role requirements. !. Regular holding of study circle meetings amongst personnel officer/employees with a commitment for bringing improvements in HR professionals. The forum should be used for sharing of experiences and latest developments in the field. (. Exchange of ideas, views and sharing of experience amongst personnel fraternity from different companies. .. Association with and participation in the activities organized by various professional bodies such as National Ìnstitute of Personnel Management, Management Association, Ìndian Society for training and Development. ?. Regular interaction between HR professionals and technologists; HR professionals should he familiar with latest technological developments affecting the organization so that they can plan to disseminate new knowledge, skills and capabilities amongst employees. @. HR professionals should undertake problem-based project studies particularly as a part of various professional examinations. They should present their findings to the executives from the organization and should try to implement their project findings. Dastly. there is debate about who should become an H R functionary. Whether organizations should employ those with specific academic qualifications or could the line managers with the right perspective become H R functionaries? The academics guarantee knowledge but that can be acquired at any time. Ìf one accepts the criticality of values and beliefs in becoming effective H R Managers, then anybody with such values could be suitable. These values are not the prerogative of any particular discipline or knowledge base. Secondly, the future role of H R Manager is to become a partner in strategic planning in which case he needs to have technical knowledge about what the business activity of the organization is. Ìn this case a line manager with the right attitude could subsequently acquire the knowledge to become an H R functionary. The aim of the organization should he to place an individual with the required attributes and so both the options could be kept open. Che%2 )o7r *ro,ress #B$ State 8hether the follo8in, state'ents are tr7e or false: 1. The role of the H R Functionaries has undergone qualitative change. ---- True. !. H R functionaries have total responsibilities about the management of human resource in the organization. ---- False. (. H R functionaries arc responsible for development of H R-related systems. ---- True. .. H R professionals must have qualifications in H R M. ---- True. ?. Line Managers should not meddle with the management of H R. ---- False. @. Role of H R professionals is confined to H R activities of the organizations hence they should not be involved in strategic planning. ---- False. !0.? DEVEDO*MENT O+ GR +UNCTIONS IN INDIA Evolution of Human Resource as a function needing specific attention has gone through similar stages the world over. Primarily, whatever happened in the industrial era in the U S or U K was during the British-Raj and as such its ripples were felt in Ìndia. The communication was facilitated by the scientific advancement, and knowledge travelled faster compared to earlier times. The world wars too contributed by creating similar welfare issues across the nations. At the time of independence very few Ìndian industrialists were seen. Management and business perspective was not very obvious. However, in the area of people management, Ìndians were visible as Labour Welfare Officers under the provisions of the Factories Act. Their role was, initially, confined to being recruitment officers for the multitude of workers and badhlies, floating at the gates, keeping the muster rolls and leave records, running shabby canteens and toilet and change room facilities, and in wielding the security-cum-discipline stick. By the early 1950s the provisions of the Ìndustrial Disputes Act of 1947 were beginning to percolate down and to this list of unattractive duties were added all the legalistic aspects of labour management. Labour officers now had to become experts at drawing up charge sheets, evolving the intricacies of domestic enquiries, attending long drawn out conciliation proceedings, and briefing, the mushrooming breed of labour lawyers. By the 1960s the result of the focus on the activities required in the area of people management was reflected in the demand for personnel professionals with specific knowledge about people management systems and laws. Unlike other professions like medicine, law or engineering, there were no definite academic requirements for personnel executives (even today) but the personnel specialists expanded their sphere of influence by cashing on the inadequacies and trained incapabilities of engineers in line management. Most of the functions now performed by personnel were the forte of line managers. The growth of unionism, state interventions through a spate of legislation and code of practices, the stress on statutory welfare and need for broader and consistent policies made it easy for personnel specialists to expand their role and enhance their status. The need for equipping individuals with specific knowledge was satisfied by the forums like Ìndian Ìnstitute of Personnel Management (Ì Ì P M) and National Ìnstitute of Labour Management (N Ì L M) established in the early phase of personnel management. The National Commission on Labour has observed that ÌÌPM has the credit of making Personnel Management as a profession. Any area of knowledge to gain the status of a profession has to fulfill three main criteria, i.e. having a corpus of knowledge, a period of learning and apprenticeship and a code of conduct. Ìndian Ìnstitute of Personnel Management (Ì Ì P M) established in 1947 played a significant role in this movement. Another professional body created around the same time was the National Ìnstitute of Labour Management. Ìts main aim was to foster, encourage and promote the development of cordial relations between employers and employees. There is an overlap in the purpose of both the institutes though the latter focused more on the relation between the two forces, viz., employers and employees. Appropriately, subsequently in 1982 these two bodies merged to form the National Ìnstitute of Personnel Management. Thus, even though the subsequent era witnessed growth in the industry, the personnel function still remained something to be interpreted by the individuals rather than by the organization per se. So it mattered as to who is in charge and what he thinks about people management. The activities related to people management remained restricted to their perspective of the duties of labour and welfare officers. This is seen in the survey conducted by Monappa (1979) in which he has listed that personnel activities typically included employment, training, watch and ward, first-aid facilities, safety, housing, employee education, employee benefits, industrial relations, insurance programmes, etc. The multinational companies were. to some extent, influenced by the parent company and in many cases had well-established Personnel department and gave more attention to this due to their western experience; the large family controlled firms were slowly moving from the paternalistic to professional style and hence changed their outlook to personnel function. The public sector with an urge to demonstrate being 'model employers' paid more attention to strengthening this function. It is pertinent at this point to mention even during the early phases, Ìndia had visionaries like J.N.Tata who sowed the seeds of Tata Ìron and Steel Company at Jamshedpur, had long back emphasized human factors in an organization. His philosophy of building people in the organization was subsequently followed and crystallized by his successors, making TÌSCO a successful and proactive organization. The kind of perspective and actions taken by TÌSCO in an environment which was novice to H R M was highly progressive at that point of time. This is important for two reasons. First, the history of TÌSCO which is indicative of how the personnel function matures in an organization and secondly, it highlights what pro-activity means. There were a number of actions taken by TÌSCO which was unheard of at that point in time. The government has also enacted a few legislations related to employment and employee welfare. The first and fundamental of these is the Article 16(1) of Ìndian Constitution which ensures equal opportunity for employment. Drawing from this is the Employment Exchanges (Compulsory Notification of Vacancies) Act, 1959, which requires employers to notify the vacancies. The Apprentices Act of 1961 provides for training linked to employment. Certain other Acts like Child Labor Act, 1986, Bonded Labor System Act, 1976, Ìnterstate Migrant Workmen Act, 1979 aim at safeguarding interest and controlling exploitation of specific groups. The state and central level directive principles as guidelines, ensure attention to neglected sections of society like the S C/S T, Ex-servicemen, physically handicapped, etc. Through legislations, the government indirectly focused on eliminating any kind of exploitation by the employers. At times, such legislations are perceived as blocks to business growth by the organizations. To avoid such government interventions, the organization needs to adopt proactive, futuristic strategies to people management visualized through the H R M perspective. An organization which is sensitive to the emerging issues with an orientation to concern for people's welfare and growth in the organization can be said to have an H R M perspective. Ìt does not mean that there cannot be problems but the dynamism to face them is crucial. The next transformation came in the 1980s; this approach was introduced by Ìndian academicians around the same time when the western world started talking about H R D. The pioneering work done by Uday Pareek and T V Rao in the area of clarifying the H R D focus and developing H R D systems is a benchmark in the evolution of H R D in Ìndia. The focus of their work was on clarifying the developmental dimensions and its implication on other conventional systems. The government too introduced employee participation and allocating share holding to workers. The emerging hi-tech industries introduced 'knowledge workers' and in general an enlarged outlook for personnel was envisaged. The H R D as a subsystem of H R M emerged as a feature of this era. A few organizations from the banking sector who initiated processes during this period were State Bank of Ìndia, State Bank of Patiala. Bank of Baroda, and Canara Bank. The establishment of National H R D Network in 1985 brought under focus the experiences of organizations which had initiated H R D activities. As the name suggested, it aimed at networking between the H R D professionals. The Ìndian Society for Training and Development established in 1970 gained specific focus as it could give academic and developmental support to H R D functionaries through their training programmes. Annual conferences of forums created by institutes like N Ì P M, National H R D Network, Management Associations, Ì S T D, etc provided opportunities for organizations ÷ especially to H R functionaries ÷ to get exposed to the developments taking place in F Ì R M in organization across industries. Such networking can enhance the speed with which H R M perspective becomes a way of life for more and more Ìndian organizations. It can be observed that the Ìndian organizations are aware of the crucial role of management and development of human resource with respect and dignity and the integrative perspective of bringing the individual and the organization closer. Some of the organizations have already adopted the approach formally ÷ meaning that they have policies which state this perspective. A large number of organizations have the new approach on their anvil but are perhaps still debating on the pros and cons. To them, T V Rao has to say, 'We must understand that corporations are not in the business of human resource development. They are in their own business. But human resource development is an important tool which, unfortunately is being used in a limited sense. The corporate vision has not been attached to it. Actually, human resources must become the business of everyone in the organization.' (Business Today, January 1996) The principal mandate for the emerging people management is to develop and execute policy programmes and practices that align all human activity to corporate objectives. As Abhijit Gangopadhyay of Tata Ìnstitute of Social Sciences puts it, 'The major paradigm shift taking place in the management of human resources is the progressive integration of conceptual values with operational values.' (Business Today, January 1996). Since this includes a change in the mind set, conscious steps are required to be taken. Che%2 )o7r *ro,ress #C$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Ìndustrial Disputes Act was the beginning of management of people in Ìndia. ---- False. 2. At the time of independence, Ìndians were not among the industrialists but personnel and welfare officers were visible. ---- True. 3. Labour welfare, industrial relations, personnel administration were synonymous to Personnel Management. ---- False. 4. The Personnel Management was accepted as a profession by 1960s. ---- True. 5. Some Ìndian organizations had adopted H R M approach long time ago even when it was not talked about. ---- True Det Us S7' U5 In this unit, we examined how people management, a crucial element of any organization, developed over the years maturing in its coverage and philosophy. We briefly sketched how the research in social sciences and management sciences helped organizations to seek answers to the problems / situations created by the growing complexity of the organizations. We have examined the relationship between H R M, the traditional personnel function and the humanistic, growth-oriented H R D perspective. We have also traced the development of H R M as a function in the Ìndian context. When compared to the trend in the West, we observed similar orientations in H R M function in Ìndia. There has been a marked shift from labour welfare perspective to the emerging concern and the need to integrate individual and organizational needs through conducive processes encompassed in the H R M perspective. Besides identifying the landmarks we also observed the understanding of a few Ìndian organizations ÷ past and present. /e38or&s Organization; Management Thought; Unions; Collective Bargaining; Staff; Labour; Howthorne Studies; Scientific Management; Human Relations; Rational Man; Social Man; Ìndustrial Relations; Personnel Management; Human Resource Development; Human Resource Management: Royal Commission; Factories Act; Ìndustrial Disputes Act; National Ìnstitute of Labour Management (N Ì L M); Ìndian Ìnstitute of Personnel Management (Ì Ì P M); National Ìnstitute of Personnel Management (N Ì P M); Management Ethos; National H R D Network; Ìndian Society for Training and Development (Ì S T D) Ter'inal 97estions 1. Compare the situations in Ìndia and other part of the world which influenced the development of management of H R as a function? !. Would you say that development of H R M in Ìndia has been subjected to peculiar conditions ÷substantiate your argument. (. Describe the various stages of development of H R M. .. Why is it imperative to study the evolution of management theory and thought to understand the evolution of the function of managing people'? ?. What are the benchmark research findings which have contributed to the changes in the perspective of management A human resource? @. What is the relation between H R M, P M, Ì R and H R D? B. How modern H R D approach is different from traditional H R M? C. Critically examine the role of H R professionals in banks. How can the role be made more effective? F. Suggest the structure, role and functions of an ideal H R department in a medium- size bank. 10. Ìdentify the role of line manager vis-a-vis H R manager for the development of employees. Ìs there any role conflict or overlap? Examine critically. S7,,este& for +7rther Rea&in, Banerjee, R, 'FÌRM Profession ÷Past and Present' in HRM 2000: Ìndian Perspective, ed. K B Akhilesh, D R Nagaraj, NÌPM, Wiley Eastern Ltd., 1990. Business Today, 'Managing People', The Business Today Experiential Guide to Managing Workforce 2000, Fourth Anniversary Ìssue; January, 1996. De'Cenzo and Robbins; PersonneÌÌHRM, Prentice-Hall, 1988. Luthans, R Organisational Behaviour, McGraw-Hill, 1985. Miner, J B, Personnel and Ìndustrial Relations ÷ A Managerial Approach, Macmillan, 1969. Monappa, A, Personnel Management, Tata McGraw-Hill, 1979. Pandev. S N, Human Side of Tata Steel, Tata McGraw-Hill, 1989. Pareek, U and Rao T V, Designing and Managing Human Resource System, Oxford and ÌBH, 1981. Ramesha, K, 'Human Resources Management in Ìndia' in HRM 2000: Ìndian Perspective, EEd. K B, Akhilesh and D R Nagraj, Wiley Eastern. 1990. Schein. E; Or-ganisational Psvchologi-, Prentice-Hall. 1979. Sheth, N R; 'Some Thoughts on HRM' in Emerging Ìssues in HRM, Pramod Varna, Oxford and ÌBH Publishing Co, 1992. Tripathi, P C. Personnel Management, Sultan Chand & Sons, New Delhi. Venkata, Raman C S, and Srivastava B K: Personnel Managetnent and Human Resources. Tata McGraw-Hill Publishing Company Ltd.. New Delhi, 1991. Werther, W B, and Davis K, Personnel Management and Human Resources, McGraw-Hill, 1982 END O+ CGA*TER !0E ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 Advanced Bank Management UNÌT 21 Development of Human Resources STRUCTURE !1.0 Objectives !1.1 Ìntroduction !1.! HRD and its Subsystems Check Your Progress (A) !1.( Training and Development ÷ Role and Ìmpact of Training Check Your Progress (B) !1.. Attitude Development Check Your Progress (C) !1.? Career Path Planning Check Your Progress (D) !1.@ Self-Development Check Your Progress (E) Let Us Sum Up Keywords Answers to Check Your Progress (A, B, C, D & E) Terminal Questions Suggested for Further Readings !1.0 OBJECTIVES After reading this unit, you should be able to: #1$ understand how HRD philosophy is translated into the various systems #!$ appreciate how the HRD sub-systems are developed and how some of the existing systems #($ need to get modified in the process of aligning themselves with the developmental philosophy #.$ understand the importance of right attitude and issues in attitude development and change #?$ appreciate the importance and need for career path planning and self-development. !1.1 INTRODUCTION The perspective of managing people in the organization over a period of time has become matured to include the totality of human beings. As such, it now encompasses all aspects of dealing with people and is today termed as Human Resource Management (HRM). Originating as a mere set of activities, HRM today has acquired the status of a crucial function in the organization. This has happened as a result of the realization that people cannot be treated as just another factor of production but are an important resource in determining the overall success of the organization. Researchers and practicing managers have tried to evolve strategies to answer the human related issues. They certainly have accepted the linkage between the individual's satisfaction and the organization's growth. Time and again systems have been developed to attain this congruence. Ìn this context, new systems have been developed and a few traditional ones have been modified. Since this happened at different points in time, there is a need to view these systems and their linkages with a conscious and critical outlook, with a view to guarding against contradictions in their implementations. Ìn this unit, we will be focusing on the developmental subsystems of HRM. !1.! GRD AND ITS SUBS)STEMS The industrial revolution with its emphasis on quantity output and the prevalent understanding of how people could be made to produce more (work), had led to the de- humanization of the workplace. People were viewed as mere substitutes for machines, and the important components of human beings, namely, emotions, needs, aspirations, expectations, values, feelings, etc., had no place. This realization had given way to various optional human focused strategies. Primarily, they were related to motivation in the context of work. Ìn other words, efforts were directed to make the work more interesting, valuable, and meaningful to people so that they were involved in doing the activities beyond a mechanical perspective. For this, one approach was to recognize the emotions and needs of human beings, and the other was to change the 'content' of the activity so that the individual is motivated, and looks forward to doing this activity willingly. Both the aspects, that is, the feelings and the job content, are interlinked and therefore, organizations sometimes tinkered with the job content and sometimes paid attention to human feelings and needs. These approaches had roots in the earlier theories which either focused on how the jobs should be organized or how to make people do what they are supposed to do. At this juncture, it is pertinent to understand the linkage of individual development and organizational development/growth. Every organization sets certain goals towards which their entire efforts are directed. The goal may be in terms of productivity, better work culture and the like, with the ultimate objective of satisfying business goals besides the needs of the society at large. To achieve these goals, the organizations have systems for production, finance, sale, control and monitoring and the people employed fit in the entire gamut of systems to produce what is intended. The organization has a structure, a pattern ÷ to manage the entire process. There is differentiation in units, hierarchical and horizontal, with given sets of relationship and interdependence between these units. The success of the organization depends on effective performance of these units/levels which, in turn, is the performance of people occupying various roles in the organizational structure. Thus the structure can be viewed as the edifice around which processes are built. Each unit (job or role) of this edifice requires certain knowledge, skills and attitude in an individual, without which the individual may not be able to give the expected level of performance. Therefore, to make sure that the organizational goals are achieved, it is necessary to ensure performance of individuals at all levels in the organization and that the individuals have the required knowledge, skills, temperament and attitude. There can be various means by which this can be examined and achieved. For instance, whether the individuals have the required knowledge or skills could be checked prior to putting them on the tasks or even before recruiting them. When the jobs change (technology change), a new set of individuals, with new skills, could be recruited or the existing one could be retrained. There would be another scenario where individuals may be required to be shifted to another job in which case one has to search for a job that needs the skills the individual possesses. Ìn other words, assessment of employee is essential. The Performance/Potential appraisal is an essential component and the training can play an important role in ensuring performance. Primarily there are two ways the organization can ensure that people have the required skills, that is, either upgrade the skills of the existing people or get new people with the required skills. Historically, these questions have been dealt with by organizations in a different manner perhaps on the basis of the then situational context. Let us examine how this issue was tackled by organizations over the time. As Nadler (1984) puts it, Human Resource Development defined as the Cor&ani@ed learnin& e+perien#e in a definite time period to in#rease the possi%ility of impro$in& Ao% performan#e &rowthC. While tracing the history of HRD as 'organized learning' as defined by him, he notes that during the early twentieth century which was a period of industrial revolution, employers provided the necessary learning for employees ÷ new and old. During this period, learning programmes were also developed by unions: as they needed a specific group to become their members. Many unions were craft-oriented and to be able to become their member, individuals would have to attain a certain level of job skills. Ìt was the first realization of what training could contribute to the workplace. The period 1920-40 saw some development in this trend. For making production more profitable companies began tenting in outside people (researchers) to consider various ways in which the workplace could be manipulated to increase production. The famous Howthrone studies conducted at Western Electric Company in Chicago were a pointer to new directions. However, the impact of the Great Depression of 1930's that followed, left many experienced workers unemployed and as a result since the companies could now get skilled workforce, the need for training was not felt. They could get the skills they needed by hiring new employees and firing the old ones. The Second World War brought up new issues with respect to developing people. Ìn the private sector, there was need to expand but as young men were drafted for war, the only alternate source available was the women and the old men and a few ethnic groups. Women were so far not trained in this matter and the old were viewed as not suitable. However, ultimately this period revealed that 'most of the people in these groups could learn and could become productive members of the organization.' This realization culminated in the establishment of the American Society for Training and Development. The 1960s primarily witnessed enhancement in technology and application of behavioural science to workplace. This development was in a way a reaction to the earlier feeling that HRD training has not been showing the desired impact on organizations. Attention was then shifted to 'efforts to change the workplace as one way of improving performance. Ìt was accompanied by increased interest in people, as well as in the technical aspects of organization.' Several significant changes came through in the 1970s and 1980s and HRD went beyond mere training activity. Ìn the 1990s, there was a continued surge for industrial democracy. Workers demanded a larger, more autonomous role in decision-making, market selection, product identification, work planning and even supervisor selection. As a result of this 'managers needed continual training in participative leadership, conflict resolution, interpersonal communication and matrix/task force management. The 1990s focused on massive computerization of work place mainly to improve operational efficiency and cost reduction. The PC revolution during the period changed totally the work processes and required Computer literacy at all operating levels without any loss of time. This has put a lot of pressure on the training system. The seniors who could not pick up the computer skills started feeling powerless and developed fear and anxiety. This period also saw a massive outsourcing initiative by the organizations to Curtail costs. The present decade, that is, the first decade of the twenty first century saw extensive competition due to liberalization, privatization and globalization of Ìndian economy. The organizations mainly focused on improving customer service by meeting customers' expectations through customization of products and services in a highly competitive environment. The focus was again on training to equip the work force for inter-personal and customer relations skills. The customers are now dictating their terms as they have wider choice and their brand loyalties are diminishing. The traditional Ìndian banks both public sector and old private sector faced challenges in the form of competitive pressures and changing customer demands from foreign banks and new private sector banks. Most of the public sector and old private sector banks had their existence for more than a century with a number of legacy issues to tackle. While the new private sector banks could adopt the best practices, organizational culture: and could implement latest technology in their operations, the foreign hanks acquired the practices and technology akin to their host countries within the regulatory framework of Ìndia. Faced with the threat of competition from the foreign and new private sector banks the banks employed a number of measures like going for fully automated systems (Core Banking Solution based operations) preceded with business process reengineering (BPR), offering VRS to its employees, training and retraining, of staff, lateral recruitment of specialists, emphasis on marketing, advertising, customer relationship management and improving brand image, diversification of activities, introduction of electronic based multiple service delivery channels, setting up of back offices and data centres, business process outsourcing, etc, to improve the operational efficiency, meeting customer expectations and reduction in operating costs. Productivity is the real test of performance in any organization. Some of these banks have undergone restructuring exercise with the involvement of international consulting agencies to adopt best practices and remove bottlenecks in their operations. These changes needed well thought of HR policies to attune the existing staff to adapt to the changes and to train them to learn new skills. GRM is now being called upon to become a strategic initiative to make its efforts more effective and performance-oriented. Thus, strategic HRM is gaining its significance. While imparting new technology based training, the organizations have to focus on development of behavioural and inter-personal skills. HRM initiatives can be initiated through involvement of line managers. GRD today is a process by which the employees of an organization are helped in a continuous and planned way to: #1$ Acquire or sharpen capabilities required to perform various functions associated with their present or expected future jobs; #!$ Develop their general capabilities as individuals and discover and exploit their own inner potential for their own and/or organizational development purpose; and #($ Develop an organizational culture in which supervisor-subordinate relationships, teamwork and collaboration among subunits are strong and contribute to the professional well-being, motivation and pride of employees (Rao and Pereira, 1986). This definition highlights that HRD is not only a training for operational skills but also includes behavioural skills as it ultimately aims to create an enabling culture wherein the capabilities are 'acquired, sharpened and used'. In this context the specific goals of HRD (as pointed out by Rao and Pereira) are to develop: #1$ capabilities of each employee as an individual; #!$ capabilities of each individual in relation to his or her present role; #($ capabilities of each employee in relation to his or her expected future role(s); #.$ dyadic relationship between each employee and his or her supervisor; #?$ team spirit and functioning in every organizational unit (department, group, etc.); #@$ collaboration among different units of the organization; and #B$ organization's overall health and self-renewing capabilities, which, in turn, increase the enabling capabilities of individuals, dyads teams, and the entire organization. The typical systems developed to enhance achievement of these HRD goals include: #1$ Training and Development #!$ Performance Appraisal, Feedback and Counselling #($ Potential Appraisal, Career Planning and Counselling #.$ Organizational Development #?$ Human Resource Ìnformation System Det us now briefly examine the linkages between and amongst these sub-systems. The HRM broadly has three sub-systems, viz., administrative, developmental and maintenance. There are strong inter-linkages between these three. However, for the purpose of discussion and detailed study we are focusing only on developmental subsystems in this unit. It must be highlighted, in this context, that since work is the pivotal point for development of individuals, the job analysis is fundamental to any of the sub-systems mentioned above. We may therefore, understand various aspects of Job or Role analyses. Jo" or Role Anal3sis Job Analysis is a technique which facilitates the listing of what is required to perform a task or a job. A typical job analysis comprises three parts - job description, job specification and job evaluation. Jo" Des%ri5tion: This simply records each and every component of the job which an individual has to perform in a given set-up. For example: for a job of a stenographer or a private secretary, the job description may include taking dictation, typing the matter, keeping the record of boss's engagements, dealing with and taking care of visitors, record keeping of inward and outgoing cases, preparing travel plan of boss, filing letters, etc. Jo" S5e%ifi%ations: On the basis of the job description a list of requirements is prepared in terms of educational qualification, age, work experience, specific knowledge, skills, expertise, temperament, etc. Again in the example of a stenographer or a private secretary, a certain temperament and skills are required. For example, besides the shorthand and typing skills, the person need to have a good knowledge of language (English or Hindi or both), maturity, charming personality, sharp understanding, patience, etc. Jo" e=al7ation: This is primarily used to compare similarity between jobs within an organization or between organizations or even in an industry. Thus, this is often the base for wage settlements and is used for comparison of two or more jobs in terms of their complexities and competence. Ìf we compare a stenographer with a private secretary attached to a senior executive, we may observe that the technical skills required, viz., taking dictation, typing, etc., may be similar but the complexity of job of a private secretary to a senior executive will be much more hence he may deserve a higher compensation package compared to a stenographer who just takes dictation and types. It may be noticed that the first two aspects can provide the basic data for training, need identification as well as for performance appraisal in order to get the right man for the right job. Having listed out all specifications, a few crucial ones can be identified for decisions related to training and appraisal. It is relevant to note that there are various terms which are used to describe the work people do in an organization. Terms like task, job, position, role, and work are often used interchangeably but in academics these have a certain relationship with each other. Pareek and Rao (1986) have explained the relationship as follows: Tas2: This is a basic element of a job and as such requires a person to achieve a specific product. Ìn the process the individual is isolated from others. Jo": This is a complex system of tasks requiring an individual to achieve an overall product and still making the relationship irrelevant. *osition: Puts an individual in a hierarchical pattern, expecting those below to report or surrender to higher positions and conform to their expectations while those higher up may be led to exploit the relationship and demand conformity. Role: Emphasizes on the pattern of (mutual) expectations. ;or2: Ìnvolves a more complex pattern as it goes a step further to encompass socio- psychological relationship. The traditional concept of task and Job has the problem of treating individuals as the means to achieve the product as an isolated machine. Perhaps, it is such a perspective that alienates the individuals from what they do. The concept of position too, makes one person powerful in relation to others and is likely to have a de-humanizing effect like the earlier two. Ìt is the concept of role or work which takes an individual out of the traditional framework and puts in a complex relationship involving job-self others. Ìn the HRD perspective, role is a very relevant and imperative concept. Dike a job analysis technique, the roles can be analyzed by using the Role Analysis Technique (RAT) of which job analysis is a significant component. Ìn addition to merely listing the activities, expectations of the counterparts - all those related to the given role - (role set) are also considered. Ìn the framework of role, the Key Performance Areas (KPA) are identified and the critical attributes that an individual needs to perform effectively are listed. Che%2 )o7r *ro,ress #A$ State 8hether the follo8in, state'ents are Tr7e or +alse: #1$ Even though the focus on people management underwent change, the systems which were developed in the past could continue and need not change. ---- False. #!$ Performance Appraisal, Training and Development are critical elements (subsystems) in the entire Human Resource Development System of HRM. ---- True. #($ For HR functionaries, major challenge in training is to keep the workforce updated with current knowledge; what is not significant now can be forgotten. ---- False. #.$ New skills can be easily blended with the old ones. ---- False. #?$ Job Analysis is the basic framework for most of the HRD systems. ---- True. #@$ Performance Appraisal is one system which has qualitatively got modified. ---- True. #B$ Performance and Potential Appraisal systems have lot in common. ---- False. #C$ Career Planning is a motivational exercise. ---- True. #F$ When an organization develops in size and its business, it is called organizational development. ---- False. !1.( TRAININI AND DEVEDO*MENT E RODE AND IM*ACT O+ TRAININI In the earlier approaches related to employees and their utilization, an individual was hired for a specific job and he continued doing it all through his work-life, one was discarded when he was not able to do it due to his age or due to change in technology. Ìt has subsequently, been realized that the individual has also a basic need to grow. Ìndividuals are not static and they change by acquiring new knowledge, skills, attitudes and beliefs. They also tend to demonstrate certain capabilities which may not get adequate opportunity for expression in the normal course. Some critical event brings forth the capability. Ìt appears as if individuals have a lot more in store. Maslow's explanation of the need hierarchy highlighted the point that it is as natural a need for an individual to realize his potential, self-actualization, as satisfying the physical need. Ìt is recognition of the fact that 'Ìndividuals change over time'. They find new capacities within themselves and learn to interact with each other more productively. They learn to cope with stress, or to help others to do so. The problem of managing development within organizations is to understand how one may hasten and channelise this process of 'learning and discovery' (Handy, 1976). The rationale of training and development is to comprehend how this concept of learning could be applied in the organizational context. What aspect of this learning could be made a part of the formal system, what could be left to the specific individuals, and how the organization can enhance the process of individuals' becoming mature and effective in their environment, are its prime concern. We will examine the details of establishing Training and Development system as part of the HRD efforts and this involves: #1$ identification of training needs; #!$ conducting the training; #($ evaluation of training; and #.$ selection and development of trainers. These aspects have adequately been covered in Systematic Approach to training in a subsequent section. *7r5ose of Trainin, an& De=elo5'ent GRD as an approach to management of HR and as also a function, is based on the premise that employees should be provided with learning opportunities to enable the individual and the organizations to achieve their goals. The organizations on their part have to consciously analyze their requirements, define them, specify the time and level at which these are required so that the system can take care of them. This need of the organization can be linked to the career progress of individuals so that it may implicitly satisfy the growth need of individual. The activities which relate to this area are: #1$ improved performance of individual on his present job; #!$ his preparation for an identified job in a not-too-distant future; and #($ his general growth (development) not related to any specific job. According to Nadler (1984) if these activities are not identified or separated, the learning can be less effective. For the purpose of facilitating communication, a label can be applied to each of these levels: #1$ Training is for learning related to present job; #!$ Education is for learning to prepare the individual for a different but identified job; and #($ Development is learning for growth of the individual not related to a specific present or future job. There could be different categorization available for these three activities. Some experts may call futuristic learning as development and general (non-work-specific) learning as 'education'. Some authors classify training as specific to a given job whereas management development as 'attempts to instill sound reasoning processes - to enhance one's ability to understand and interpret knowledge - rather than imparting a body of serial facts or teaching a specific set of motor skills'. Development, in this perspective focuses more on the employee's personal growth and organizational development initiatives. Whether one uses Nadler's classification or any different categorization, it does not make a difference so long as it is understood uniformly in the organization but some kind of segregation is necessary. Such segregation helps in differentiating objectives for these three activities. The objectives are qualitatively different. First, when the goal is to improve performance, training should be conducted and evaluated to check on the improvements. Ìf the goal is futuristic, then one cannot evaluate performance until the individual moves to a new job. But if the objective is development then it has to be remembered that no direct impact may be seen on the performance. Secondly, the differentiation helps clarifying mental expectations. Both the parties - the individual and the organization (the superior) - are clear about what should be the outcome; the chances of misunderstanding are reduced. Thirdly, and most importantly, the differentiation helps in identifying who is responsible for what activity, for example, for training, the responsibility of identifying the need and ensuring that opportunity is given, has to be with the immediate superior but for education and development, it could be the central department or the overall HR functionary who decides when and how to conduct the activity. I'5erati=es of A&7lt Dearnin, It is interesting to note that though most of the people think that Adult Education is a recent phenomenon, but it is not so. Ìn ancient times great teachers like Confucius, Lao Tse, Hebrew Prophets, Jesus, Socrates, Plato, Aristotle - were 'teachers of adults'. To these teachers 'learning was a process of active inquiry on the part of the learners'; they invented 'techniques for involving the learners in active inquiry.' Ìn case of child learning the teacher has full responsibility for making all decisions about what should be learned, how it should be learned, when it should be learned and if it had been learned ... the student was left passive ... when adult education is organized with the model available for children known as Pedagogy it does not give the desired results. Ultimately, in and around the 1920s-30s, some thought was given to adult learning. Ìt was Lindeman's work which can be cited as the first instance of defining the perspective of adult learning. He explains his idea of adult education as, 'a cooperative venture in non-authoritarian, informal learning, the chief purpose of which is to discover the meaning of experience, a quest of mind which digs down to the roots of the preconceptions which formulate our conduct; a technique of learning for adults which makes education coterminous with life and hence elevates living itself to the level of adventurous experiment'. The special efforts to define and understand adult learning includes Thorndike's early explanation that ability to learn diminishes with age which subsequently was modified to that it is the speed to learn that diminishes and not the power to learn. These efforts were then substantiated by the experience of teachers involved in adult teaching, and most of the social sciences like sociology, social psychology, also contributed their bit. Thus, a new term Andragogy was coined to differentiate adult learning process from that of child learning. Today, what we understand commonly is that learning is concerned with bringing about relatively permanent change as a result of experiences. There are, indeed, a number of theories to explain 'how' we learn. Knowles (Nadler, 1984) categorizes them in three sets as follows: Me%hanisti% or Beha=io7rist Theories: These theories hold that the learner is passive in the process of learning. Ìf one introduces an input (stimulus) into a human being, you will get a predetermined response. Ìn other words, learning occurs only when a learner is conditioned to give the 'right' response to a given stimulus. Co,niti=e Theories: These theories equate man with his brain, based on the proposition that one thing that distinguishes human beings from other living things is that they possess brains that are capable of critical thinking and problem solving. The purpose of learning therefore is to teach the brain to engage in such critical thinking and problem solving. Or,anis'i% or G7'anisti% Theories: These theories hold that learning occurs only when learners have the 'freedom to learn' what is particularly relevant to their personal life situation. The purpose of learning is to encourage each individual to develop his or her full, unique potential. ;hen we examine the training and development function in the organizational context, it becomes apparent that all the three sets are relevant as all the three types of situations exist in the organization. Besides the specific framework of the theories, most of them have certain common assumptions, there are theories related to the variables associated with the actual Teaching-Learning situation. Decenzo and Robbins (1995) list some as: #1$ Dearnin, is enhan%e& 8hen the learner is 'oti=ate&: This means that the learning experience must be so organized that it should create desire to learn. #!$ Dearnin, reJ7ires fee&"a%2: Knowledge of results is necessary for learner to improve upon his mistakes. The feedback also tends to act as motivator when the learner knows that he is proceeding in the right direction. #($ Reinfor%e'ent in%reases the li2elihoo& that a learne& "eha=ior 8ill "e re5eate&: Behavior that is positively reinforced are encouraged and therefore sustained. (4) Practice increases a learner's performance: Learners need to practice what they learn. #?$ Dearnin, '7st "e transfera"le to the Ao": Learning a skill just for the sake of it will not work; it must be possible to apply what is learnt. ;hile establishing an effective training sub-system, all the aspects related to adult learning should be considered and kept as backdrop, namely, who needs training? The different groups could be: #1$ young recruits, #!$ Specialists, #($ middle level executive, #.$ senior and top executives, etc. The contents and nature of training for the groups will vary. For the young one's it may be modem management techniques, for those with experience, it may centre around to their being enabled to take up more responsible positions. For specialists, the training should keep them abreast with the latest developments in their field of specialization. For the senior and top management, it could relate to development of vision, entrepreneurship and business strategy. S3ste'ati% A55roa%h to Trainin, #SAT$ ;ith the developmental emphasis accepted by the organization, it becomes imperative that organizations establish training systems. There needs to be a systematic approach to manage training which has to answer a few basic queries like: #1$ Will the training to be done internally or externally? Does the organization have or intend to develop an in-house training centre? #!$ How much and what kind of training will be done externally and is this also an essential part? #($ Who are the functionaries responsible for administering the training system? It is a fact that majority of the organizations today have some kind of in-house establishment which primarily caters to the training of operational knowledge and skill requirements specific to the organization. This implies that the need for certain advanced, specialized training is met by sending people to other (external) institutions. The most common among these are specialized institutes which impart training in management, finance or behavioural skills. Whether the actual training is done internally or externally, organizations have to follow certain logical processes for enhancing knowledge, skills, and attitudes of their personnel. These are: Ste5 1: Training Need Analysis (TNA) and Ìdentification of Training Needs Ste5 !: Preparation of a Training Plan; Ste5 (: Conduct of the training which includes designing the programme in terms of the time, duration, target group, sequence of inputs and methodology; Ste5 .: Evaluation of the Training Programmes and the Plan; and Ste5 ?: Selection and Development of Trainers. Det us examine each one of these a bit more in detail. Ste5 1: Trainin, Nee& Anal3sis #TNA$ an& I&entifi%ation of Trainin, Nee&s Identification of training needs through the TNA (training need analysis) is the first step for successful implementation of any training initiative. One has to consider that the training needs are perceived in the present as well as future context. The present context refers to the level of skills the existing employees have and in what direction they need to be upgraded. The information for such gap can come from their performance appraisals done by their superiors, the productivity measure (norm) set by the organization, the larger rejects for the job done by an employee or a department, the number of accidents, the inspection reports, etc. Ìn other words, the level of an individual's performance and the errors that he/she makes can be indicative of the gap in his knowledge, skills and attitude which can be bridged through training. Ìt may however be noted that all performance problems cannot be tackled through training intervention. The poor performance on account of poor technology, outdated processes, poor working conditions, etcetera, cannot be solved by training. The future needs of an organization also indicate the gaps to be filled by training. The organization's future business plan may include expansion in new or old business domains. The organization needs to take a look at the skill levels of the existing workforce and compare it against the requirement, to determine the total training efforts required by the organization. Sometimes, organizations may have some specific focus in the training as an offshoot of change in technology or a business strategy adopted by the organization. The training needs can be identified in formal or informal ways. Formal processes are part of the administration of the training system. They are obvious, explicit links and processes. For example, the training needs identified as offshoot of the business consideration would be the result of conscious deliberations between the business plan and the HR functionaries. There should be an accepted mechanism or forum for this to happen at a given point in time. Another formal way for identifying present needs would be to gather data from the micro level from different stakeholders. Either the mechanism of performance appraisal or an independent exercise by an individual may spell out what, in his opinion, are his training needs to perform better on the job he is assigned. This statement is then qualified by his superior. Such data is collected from all levels and an analysis can be carried out to find out if there is any particular trend. Ìt may happen that a specific department or a particular geographical area is indicating specific needs. Thus, the analysis can highlight the major-minor specific groups of employees which can be considered while preparing the annual training plan. TNA requires collection of data systematically. Ìt should include data to: #a$ define the need; #"$ identify solution; #%$ specify those needing training; and #&$ provide the planning details of the delivery of training (Rao, 1995). TNA can stem from different objectives, that is, it can be for employee development concern, personnel and staffing concern, administrative and management concern or organization development concern. Ìt is possible to determine this with a set of questions to identify what concerns are being focused upon. Ste5 !: *re5aration of a Trainin, *lan The training need identification process provides the basic data for preparing the Annual Training Plan. The primary focus at this stage is to prioritize the various issues thrown up by the data and seek an appropriate balance between meeting the needs and resources required. The training plan is expected to specify: #1$ Number of training programmes to be conducted ÷ Ìnternal External. #!$ Level of employees ÷ what will be the coverage of employees through the plan? #($ What will be the subject areas that will be highlighted and what will be left out of the plan for future? #.$ What will be the plan for allocation of resources ÷ what are the contingencies worked out? #?$ What arrangements are made to accommodate something that emerges beyond the plan? Rao (1995) has suggested a framework to facilitate the process of deciding priorities. Of the factors mentioned by him, 'organizational policy and priorities' is a vital factor. Without a favourable and committed policy for training and development the entire exercise of collecting data, analyzing it and prioritizing will be a waste of effort. Another related aspect is to decide whether training should be given on the job or in a formal classroom set-up. There are situations where certain knowledge or skill based training can be given on the job. Apprenticeship programmes, Job instruction training, Understudy assignment (Mentor-prototype relationship), Programmed instruments (self- learning), Job rotation are commonly used on the job training methods. As may be observed, very often organizations use this channel to train employees in the routine, procedural, operational aspects. The advantages are to the extent that the individual is actually contributing to the events in the organization and secondly, the individual sees the relevance and gets the 'feel of things' of what is to be done. This has its own significance in the initial period of joining the organization. An individual is likely to be motivated as he is on the scene of the work and not in the classroom. Ste5 (: Con&7%t of the Trainin, *ro,ra''es In most cases the first two steps are handled by the training department of corporate office and this third step is specific to the actual delivery system, that is, training centre. When there is an in-house training setup available, this is their responsibility. But in cases where such an arrangement is not available and the organization out-sources this facility, the organization could specify their concern vis-a-vis the contents, emphasis, methodology and output expected from conducting the training programmes. The logical beginning for any training programme is to spell out the objectives of the programme. This facilitates the decision regarding the inputs in the training programme. For instance, if the objective is to impart a particular skill, then it is obvious that enough time should be allocated to practice the skill after the participants have been given the specifics of the skill. The objectives also indicate what methodology could be adopted to communicate the ideas. Of course, the profile of the participants/target group influences the methodology too. For instance, if the target group has no work experience then work related discussions may not serve any fruitful purpose as they may have nothing in particular to share. The teaching methodology may include: ?eadin&s( Le#turetts( E+perimental Le#tures( Dis#ussion( -arti#ipati$e Trainin&( Case !tudies( ?ole -lays( Instrumentations 1use of tests and instruments/( !imulation Games( !tru#tured E+perien#es( Intensi$e !mall Groups and Intensi$e Growth Groups( et#. As is apparent when the involvement is the lowest, the meaning of what the learner is exposed to is external to him - which means that the learning process is aimed at making him or her aware of it. While on the other extreme of involvement, the meaning of what the learner is exposed to is internal to him and the learning process is to facilitate the learner to be responsible for his learning. Ìt is his or her experience that he is analyzing and drawing conclusions about. The selection of the methodology from this continuum among other things is based on the objectives, subject matter to be covered, target group, profile, trainer's skills and capabilities. It must be observed that the more one moves towards interactive side of the continuum, the trainer's ability to deal with the data generated becomes crucial factors in facilitating learning. The trainer needs to have clarity of the concepts he is dealing with in the training sessions and should be able to draw and summarize learning points. Ste5 .: E=al7ation of Trainin, The primary purpose of evaluation is to improve training by discovering whether the training processes have been successful in achieving their objectives. Some experts choose to make a distinction between `validation' and 'evaluation'. Validation means assessment of whether the training has achieved its laid down objectives and evaluation means the measurement of the total effect of the training programme. However, in practice it is difficult to obtain information on the total effects of training. Most commonly evaluation is done at four levels as the processes that occur as a result of successful training, are at these levels. The levels are: #1$ Rea%tion De=el: Participants form opinions about the content, the method, the trainers, the usefulness, the relevance and their enjoyment, etcetera. Ìn other words, these are the reactions of the trainees. #!$ Dearnin, De=el: Trainees learn-knowledge, skills and attitudes about the subject matter which are acceptable for translating into behaviour ... what is learnt. This can be measure through some type of tests conducted before and after the training. #($ The "eha=ior De=el: Trainees apply the learning to actual situations, and this can be observed in terms of change in behaviour at work, that is, transfer of learning to workplace. This may reflect in the work performance after the training which can be assessed with the help of their superior. #.$ +7n%tionin, De=el: The changes in behaviour on the job affect the functioning of the organization. This can be measured by indices which generally are expressed in terms of financial benefits or return on training investment. The modern organizations view the raining expenditure as an investment so they look for the return on investment. Ìt is quite difficult to segregate the financial benefits on account of training alone. Ste5 ?: Sele%tion an& De=elo5'ent of Trainers ;hen there is an in-house training set-up, selection and development of the trainers is another important activity. Both the aspects need to be consciously looked at if the training has to be effective. The first question that arises is that: should the trainers be practicing managers/operational people or should they be recruited specially as 'core faculty' from academics? Both the options have their own merits. The advantage of having operational people lies in the fact that they can relate to the actual work situations while communicating in the classroom. They can speak the same language that trainees understand. The disadvantage can be the danger of adopting a narrow approach. Ìt is like in-breeding; new ideas may not emerge. The advantage of professional trainers is their ability to view matters from a different outlook and the professional knowledge about the concepts, teaching, methodology, etc. The disadvantage will be seen if the trainer is unable to relate to the work situations. He may remain an alien and be perceived as a mere theoretician. Ìn in-house training programmes, often a combination of the two has proved to be effective. Whichever mode of selecting trainers is adopted, development of their skill is imperative. In case of the operational personnel, the selection process should ensure their willingness, communication skills, and concern for others (trainees). The specific knowledge and skills that they may be required to teach can be checked or developed in the second stage. Having ensured this the first developmental step for them would be the exposure to a course on Teaching Methodology which, by and large, covers the issues discussed earlier about designing and delivering the training. Ìn case of the recruitment of professional trainers, the teaching skills are available but the trainers need to be oriented towards organizational issues. They could be placed in the actual work situations for a couple of months so that they are in a position to relate to the organizational scenario. S755ort S3ste's for Trainin, an& De=elo5'ent Since HRM is a commitment to philosophy, the linkages and congruence among the sub- systems is significant for its success, more so with training and development. Ìts most important link is to the 'Performance' and, therefore, how the performance appraisal system functions and how far there is information flow from it to the training and development system is a significant determinant. Ìn the absence of such information, the training system has a danger of becoming a mechanical process and not a developmental one. The Human Resource Ìnformation System (HRÌS) is another support system for effective training. Since the data regarding the on-the-job experience, placements, and skills acquired by way of professional qualifications or training attended is stored here, this serves as a useful database for training. A comprehensive updated HRÌS enhances the developmental efforts. The most critical support is in terms of the organizational culture. As we understand, it refers to the shared beliefs and values of the people at various levels. The superior who sends his subordinate for training, the HR functionary, the top management are the key players in emphasizing the importance of training. Ìf their actions give a contradictory message, the purpose of training for development will be wiped out. Ìf the superior hesitates to nominate or to relieve an employee for attending training or placement elsewhere, if the top management itself gives a passive treatment to the training subsystem by way of not sanctioning enough budget or flexibility, one can imagine what level of motivation can exist among those who deliver and those who receive the training. Ìn one of the Ìndian companies, in the case of a covenanted staff, at the time of the performance appraisal, the DGM (training) acts as the mentor and an undertaking from the appraiser is taken for training the appraises in certain agreed areas. This undertaking is incorporated in the key result area for the superior for the following year. Ìt is important, therefore, that certain positive notion or beliefs should exist in the organization culture about usefulness of training. Ìt is relevant to look at them consciously and make sure that these are again and again talked about explicitly within the organization. Top management's commitment to the following beliefs (Rao, 1988) and their reiterating them, is significant. #1$ Human resources are the most important assets in the organization. #!$ Unlike other resources, human resources can be developed and increased to an unlimited extent. #($ A healthy climate, characterized by the values of openness, enthusiasm, trust, mutuality, and collaboration, is essential for developing human resources. #.$ HRD can be planned and monitored in ways that are beneficial both to the individual and to the organization. #?$ Employees feel committed to their work and the organization if the organization generates a feeling of 'belonging'. #@$ Employees are likely to have this feeling if the organization provides for their basic needs and for their higher needs through appropriate management styles and systems. #B$ Employee commitment is increased with the opportunity to discover and use one's capabilities and potential in one's work. #C$ Ìt is every manager's responsibility to ensure the development and utilization of the capabilities of subordinates, to create a healthy and motivating work climate, and to set examples for subordinates to follow. #F$ Higher the level of manager, in the hierarchy, the more attention should be paid to the HRD function in order to ensure its effectiveness. #10$ The maintenance of a healthy working climate and development of its human resources are the responsibility of every organization. Che%2 )o7r *ro,ress #B$ State 8hether the follo8in, state'ents are Tr7e or +alse: #1$ Training should be given in the organization because people like to learn new things. ---- False. #!$ Employees can learn anything that they want for their development. ---- False. #($ Training, education and development have different meanings, they need to be differentiated. ---- True. #.$ Pedagogy and androgogy mean the same thing. ---- False. #?$ Learning will not take place if there is no motivation. ---- True. #@$ Ìt is better to do all the training in-house. ---- False. #B$ Training need analysis is a systematic process of looking into the gaps between what is there and what is desired. ---- True. #C$ Training plan is a summary of all training needs identified. ---- False. #F$ The methodologies adopted in training situations are decided by the trainer's skill. ---- False. #10$ Evaluation of training is an important step but it may not be possible to quantify all the aspects. ---- True. #11$ Operational personnel do not need training in teaching methodology. ---- False. #1!$ Primary purpose of training is learning related to present job. ---- True. #1($ The purpose of development is learning for growth and not related to any specific job. ---- True. !1.. ATTITUDE DEVEDO*MENT Definition The term 'attitude' is frequently used to describe people in terms of their behaviour and its impact on behaviour. More precisely, an attitude can be defined as a persistent tendency to feel and behave in a particular way towards some object. For example: Ram does not like a job involving touring. Attitude can be characterized in three ways. First, attitude tends to persist unless something is done to changes. Second, attitude can fall anywhere along a continuum from very favourable to very unfavourable or positive to negative. Third, the attitude is directed towards some object about which a person has perception, feelings and beliefs, which in many cases may result into emotionally charged opinion and prejudices. Co'5onents of Attit7&es Attitude can be broken down into three basic components, viz., emotional, informational and behavioural. The emotional component involves the person's feelings or their affect ÷positive, neutral or negative÷about an object. Emotions play a very important role in organizational behaviour of employees. The expression of emotions, either positive or negative, is also important to work behaviour. The information component consists of beliefs and the information that an individual has about that object. Generally, the beliefs or the information are founded on insufficient observations or opinions which may not be empirically correct. A manager may believe that 2 week's training is sufficient for an employee to effectively work as systems administrator. Ìn reality, minimum 4 weeks training may be required. The belief of the manager represents his attitude about the training. The behavioural component consists of a person's tendency to behave in a particular way towards the object. For example, the manager in the above example may assign only 2 weeks for the Systems Administration training to an employee which may not be sufficient for the employee to perform his job effectively. Thus, the attitudes have significant impact on workplace for achieving the organizational objectives. Si,nifi%an%e of Attit7&e at ;or25la%e An understanding of the role of attitudes is important to study and understand its impact on human behaviour at work for a number of reasons. Attitudes help predict work behaviour. For instance, if an attitude survey shows that workers are upset by a change in the work rules, it may have an impact on their work behaviour. Ìt may result large absenteeism. The management may conclude that the negative attitude towards work rule has resulted into absenteeism. Another reason why an understanding of attitude is important is that attitudes help people adapt to their work environment. Attitudes serve four important functions in the process. These are: #1$ The Adjustment Function, #!$ The Ego-Defensive Function, #($ The Value-Expression Function, and #.$ The Knowledge Function. The A&A7st'ent +7n%tion Attitudes often help people adjust to their work environment. When the employees are properly treated by their boss, they are likely to develop a positive attitude towards supervision and the organization. These attitudes therefore help employees to adjust to their environment and area basis for future behaviour. The E,oEDefensi=e +7n%tion Besides helping employees to adjust, attitudes also help them defend their self-image. For example, an older manager whose decisions are continually challenged by a younger subordinate may feel that the latter is brash, cocky, immature and inexperienced. May be the younger subordinate is right in challenging the decisions. The older manager may not be effective and may be taking poor decisions but he is not going to admit this and will try to protect his ego. As a result, the older manager will have a negative attitude towards the younger officers. The Val7eEE65ression +7n%tion Attitudes provide people with a basis for expressing their values. For example, a manager who believes strongly in the work ethic will tend to voice attitudes toward specific individuals or work practices as a means to reflect this value. A supervisor who wants a subordinate to work harder might put in this way: `You have to work harder. That has been the tradition of the company since it has been founded'. This also helps to subscribe the ethics. The /no8le&,e +7n%tion Attitudes help supply standards and frames of reference that allow people to organize and explain the world around them. For example, a union office bearer may have a negative attitude toward management. This attitude may not be based on facts, but it does help the individual to relate to management. As a result, everything that management says is regarded by the unions as a pack of lies, a distortion of truth, or an attempt to manipulate. Regardless of how accurate a person's view of reality is, attitudes toward people, event and objects impact the individual make sense out of what is going on. Chan,in, Attit7&es As we have seen the attitudes of employees have significant impact on their behaviour at workplace. Ìt is therefore necessary to develop the right attitude of the employees for the benefit of both, the organization as well as the employees. A positive attitude helps a person in all spheres of life including his organizational life. Though it may be difficult, it is possible to change the attitudes of people. The level of difficulty depends upon various factors including to what extent a particular attitude about a particular object is deep routed and emotionally charged. The major barriers for attitude change are prior commitment and lack of information. A prior commitment occurs when a person feels a commitment to a particular course of action and is unwilling to change. The insufficient information can distort the attitude about some object. For example, someone goes to meet his old friend. The friend could not devote much time to his old friend because of his other urgent commitments. Because of one incidence he may develop a negative attitude about the behaviour of his friend who otherwise was considered as a very good person. There are ways in which the barriers can be overcome and attitudes can be changed. One of these is by providing new information. Sometimes this information will change a person's beliefs and, in the process, can change his or her attitudes. The second way of changing the attitude is through the use of fear. Researchers have found that fear can cause some people to change their attitudes. However, the degree of fear seems to be important to the final outcome. Ìf low levels of fear arousal are used, people often ignore them. The warnings are not strong enough to warrant attention. Ìf moderate levels of fear arousal are used, people often become aware of the situation and are likely to change the attitudes. However, if high degrees of fear arousal are used, people often reject the message because it is too threatening and thus not believable. A good example is provided in the case of anticigarette smoking campaigns. When the department of health runs ads using patients who are dying of cancer, the message is so threatening to smokers that many of them shut it out. They refuse to listen. The third way of changing the attitude is by resolving the discrepancies between attitude and behaviour. For example, when a job seeker has more than one job offer and is forced to choose one, he often feels that his final choice may go wrong. However, once he has chosen a particular job he will start feeling that he has taken a right decision. He will start to have negative feeling toward the job that was not chosen and positive feeling toward the company that was chosen. Influence of friends, peers and opinion leaders also has a great role on attitude change. Thus, the role of leaders becomes very crucial for changing and developing right attitudes of the followers. The leaders have to develop interpersonal trust and present themselves as rational persons interested in other's wellbeing. Additionally, when a particular matter is of personal interest to people, they are likely to reject extreme discrepancies between their current behaviour and that of others. This is why unethical behaviour is so difficult to combat because of other motives. The managers are the formal leaders of an organization. Their attention is focused on organizational objectives and performance of employee. Ìf a person intends to improve the attitude of an individual employee he needs to be friendly with him. Then only, in due course, he will know the employee and what motivates him. He will also know the employee's potential and shortcomings. Ìn this process the manager can identify the learning needs of individual employees and can decide how to help the employee for acquiring deficient skills. For this to happen, the manager will have to know the employee and should be genuinely interested in the development of the employee. A final way in which attitude changes often take place is by co-opting, which means taking people who are dissatisfied with a situation and getting them involved in improving things. For example, John is not satisfied with the present welfare schemes, as a result the company appoints him as a member of the employee welfare committee. Once he begins realizing how these benefits are determined and how long and hard the committee works to ensure that the people are given the best benefits possible, he is likely to change his attitude. Che%2 )o7r *ro,ress #C$ State 8hether the follo8in, state'ents are Tr7e or +alse: #1$ Attitude is directed towards some object about which a person has feelings and beliefs. ---- True. #!$ Attitudes do not have any impact on the emotions of a person. ---- False. #($ Attitudes of employees have significant impact on their work performance. ---- True. #.$ Attitudes are formed based on facts and objective criteria. ---- False. #?$ Changing attitude is not possible for most of the people. ---- False. #@$ There are ways in which the barriers can be overcome and attitudes can be changed. ---- True. !1.? CAREER *ATG *DANNINI It is not uncommon to find that after the initial excitement in the job, individuals tend to lose interest or get 'disillusioned' and feel that they have no `career' in a particular organization or a profession. What is implied in such a feeling is that things have not happened as expected. Ìn other words, individuals expect certain changes/advancements to take place ÷ time-bound or as a result of certain behaviour. When these changes do not occur it leads to the feeling of frustration or alienation. The mismatch between expectations and actual events could be in terms of the time for results being too long, or the absence of result itself. Sometimes there may have been irrationality in expectations leading to wrong perceptions. Organizational experts have tried to identify the variables responsible for this and explained the process in the context of organizational realities and expectations about careers. Ìt is relevant therefore, to examine the underlying concepts in the generic observation that: #1$ individuals desire and expect change at certain stages in life: #!$ there is a (predictable) pattern in these changes; and #($ there is a feeling of frustration if things do not happen as desired or expected. There area number of explanations available about the career in general and the career in organizational context. They refer to different aspects of career like the stages, the movements, the perspectives at the stages, etc. We will take a look at the career in general and also elaborate the same in the organizational context. The most commonly used framework for understanding the Life Stages is the one given by Erik Erikson. He has divided the life into eight stages of which four are in the childhood and four in the adulthood. The adulthood stages are relevant to understand what individuals expect in organizational careers. According to Erikson the first stage in adulthood is: A&oles%en%e: Ìn this stage individual's development is to achieve an ego identity. Ìndividual is involved in reconciliation process of what he perceives himself to be, what he thinks others perceive him to be and make an adjusted assessment to form his identity. )o7n, A&7lthoo&: Ìt is the next stage where he/she starts developing relationships with individuals, group or occupation. This could be establishing a close relationship, developing an interest group or a work group. A&7lthoo&: The stage is that of guiding the next generation and during this stage one is passing on the knowledge, values or sponsoring the younger colleagues and in the Mat7rit3: A stage when person attempts to achieve ego integrity by examining whether life has been meaningful or satisfying. Devinson and his colleagues have offered explanation about /areer Transitions on the basis of the study of careers of a group of 40 individuals from different occupational groups. He maintains that every five to seven years the individuals have to pass through some kind of personal or career related crisis with apparently a fairly predictive sequence. The transitions are from early adulthood to late adulthood and as such are similar to Erikson's four stages. Devinson's age-specific transitions correspond to Erikson's four adult stages. Erikson's perspective is more generic and do not spell out specific age per se. Ìt is relevant to notice that similar stages are perceived in relation to the careers within the organizations in the concept of CAREER ROLES given by Dalton, Thompson and Price ( 1977). They have emphasized on the sequence of roles and relationships an individual may experience in the four career roles labelled as ÷ Apprentice, Colleague, Mentor and Sponsor. At each of these stages, the tasks are different; relationships are different requiring personal adjustments: A55renti%e: This is the beginning of the career. An individual does routine work under the supervision of the mentor, who helps to learn. At this stage the individual needs to accommodate himself to a certain degree of dependency. Collea,7e: This is the beginning of making an independent contribution though still in a subordinate role. There is less dependence on superiors for advice and direction. Mentors: This stage signifies the beginning of complex functions. The individual develops ideas, manages others, and must learn to assume responsibility for his subordinates' work. S5onsors: At this stage the individual needs to broaden his perspective and think long- term as he is now a part of the top management. He is required to define the direction in which the entire organization or at least a major segment of it would develop. He needs to develop the capability to choose the right people in the organization who can support the process of influencing. Career *atterns The expected changes emerge as the pattern of movements that occur in the life related to work. Driver (1985) has listed these patterns as Carver Concepts. He says there are some individuals who enter into an occupation and develop a plan for upward movement within the same profession using organizational hierarchy. This is Linear Career concept. Ìn another pattern, individuals choose a profession, acquire higher skills but do not choose to go higher up in the hierarchy. This is a Steady State Career. Ìn the Transitory pattern individuals shift from one job to another not necessarily related to the previous one without acquiring any excellence. Lastly, in Spiral Career individuals take on a new job, work hard, perform well, move up in status and rank, then move on to another type of work and follow the same pattern of development and performance. They tend to be geared up to take on new challenges at regular intervals and as such can be viewed as motivated by personal growth. Ìn addition to the four patterns described by Driver, one can observe a Plateau career which indicates reaching a level higher than where one started but then continuing on the same level ÷ a plateau. Schein has given another comprehensive framework of Three Dimensional Movement., viz., Vertical, Circumferential, and Radial. Vertical movement is along the hierarchy of the organization, Circumferential movement is along the different divisions and functions while Radial is towards the centre of the organization. He then explains the conical career movement which incorporates sequential movements in all the three dimensions. Schein has visualised all the three dimensional movements to occur in the career pattern aiming to reach the top level of the hierarchy. ;hen these movements are predetermined in a logical sequence to enable an individual to have knowledge of all activities of the organization (horizontal movement), different perspectives of management (field and controlling) and different levels of management (hierarchical) it could be said that the organization has developed a Career Path. In practice, this means that after an individual joins a bank, he/she will have to go through the assignments that are along the horizontal plane, i.e. branches with different business focus. This also being his apprentice stage, these assignments can be viewed as teaming opportunities. Only after he has passed through some testing grounds, he becomes eligible to try for higher levels. At this level he may enter in the colleague role and make his independent contribution to the organization. Ìt may be that as he moves up with promotion he is allowed to have exposure to the activities associated with the centre, that is, the controlling function and after a specified period he again moves along the peripheral assignment in the branch with more and complex business mix. The next level puts him in the mentor's role. As a regional manager he will be responsible for the development of the region, the business, and the people ÷ internal (employees) as well as external (the customers). The concept of career path thus, relates to the sequencing of movements, deciding the time period for each one, and so on. Ìt implies that there is a destination to reach either at the hierarchical level or at the level of expertise. Ìt denotes the distance one has to cover, the crossroads and the turns one has to encounter. Ìt requires the individual to take decisions and for that there has to be a signboard indicating direction and information. It is logical to realize that in an organization, the movement will be decided by its structure and the signboards are the criteria laid down for the eligibility to move on. Ìndividuals will have to travel through these, while acquiring knowledge and skills and learn to face issues of higher/different levels. This process is expected to enable the organization to have competent personnel at all levels and at all times enhancing simultaneously the growth and development of the individuals. Ìn the context of organizational career this implies that the organization can provide opportunities for individuals through a defined career path to develop, and individuals will have to live up to those challenges to satisfy the implicit need for growth. With an established Career Path Planning subsystem, the organization can have a continuous supply of individuals with required capabilities for future roles. A word of caution is needed here. Career Development does not take place merely by having a path and a desire to go in a direction. On this path there are benchmarks which the individuals must cross in terms of achievements, skills, attitudes, etcetera. Moreover, the organizational structures are pyramidcal in shape, that is, lesser and lesser positions are available at higher levels thus the career path does not ensure a smooth movement for everyone. The competitive environment in the organizations has adversely affected the smooth movements in the ladder of hierarchy. There are some more factors to remember. The employees including executives at every level are likely to face frustration. Circumstances may be created by the management to enable them to get over the frustration. Every one cannot reach the top, people should be made to realize and accept the ground realities. There may be supersession due to performance, appraisal system and bottlenecks. These may also create great degree of frustration. Career An%hors Schein's concept of Career Anchor provides one explanation why individuals try to follow a particular pattern. The concept of career anchor refers to a personal sense of type of work individual wants to pursue and what that work or career means to an individual. These anchors start developing early in the career as an individual goes through various types of assignments. Ìt is a mutual discovery of the individual and the organization with respect to developing occupational self-concept. This has three components: #1$ Self-perception of talents and abilities based on one's performance; #!$ Self-perceived motives and needs based on self-diagnosis and feedback; and #($ Self-perceived attitudes and values based on interactions with the norms and values implicit in the organization. Schein maintains that an individual needs to work in organizations for a considerable period to develop these meet anchors. On the basis of his research, he has found five such career anchors: 1. Te%hni%al or +7n%tional Co'5eten%e: Some individuals 'fall in love' with a particular field or function. They desire to be outstanding in the field; their self-concept is associated with their skills in that area. !. Mana,erial Co'5eten%e: Some individuals like to manage. Their early career experiences indicate to them that they will be able to rise in the management hierarchy. (. Se%7rit3: Some individuals seek a secure work environment and career by tying themselves to a particular organization or geographical location. .. Creati=it3: There are some individuals who want to create something new. They like to start something and make it a success. ?. A7tono'3: Another group of individuals finds organizational life unpleasant or difficult. They prefer to maintain their freedom. Schein has sought to explain the matching between the opportunities and the individual's inclination through the concept of external and internal careers. Ìn his perspective the opportunities are available externally in the education system, in society, in organizations. The internal career refers to the individual's career anchors, that is, an individual's self-concept about what he is good at and has proved to be so. Career *ath *lannin,: A S3ste' The Career Planning in an organization is primarily an HRD sub-system. Ìt establishes the linkages between and amongst other subsystems like manpower planning, job rotations, transfer, placement, training and performance appraisal. Ìt is essentially directed towards structuring employees' aspirations for upward movement through the organization and moderating these aspirations if they are found unrealistic (Pareek and Rao, 1986). As such, it need not mean any commitment on part of the management to promote an employee. Ìt only implies that the individual, after becoming aware of some of his capabilities and career advancement opportunities, chooses to develop himself in that direction. The prime responsibility of the organization for developing and implementing the career plan is to see that: 1. The policy of career planning is made explicit. Ìt lays down the benchmarks for performance at critical stages which the employees must attain. !. Ìt is made clear that career path is a facility for growth and not a right for advancement. (. The career path - a sequence of job assignments, training requirements and promotion to higher level - is made known to the employees from the time of entry. Performance feedback is a part of the career path. .. The career path is followed uniformly for all employees without any bias/ prejudices. ?. Ìt should be flexible to accommodate variations which may be needed to deal with the given circumstances. Besides working out the general policy guidelines, the HR functionaries will have to chalk out the career path. For this purpose knowledge of all the activities performed in the organization is a definite requirement. Ìt is only with such knowledge that sequencing of assignments is possible. The specific steps that follow then are: 1. For instance, if we take the concept of Career Roles then up to what level the 'apprentice' role would continue? At what level would it be considered as a colleague or mentor or sponsor? !. Ìdentify the Core Jobs at Each Level: At each level, the jobs that are comparable in terms of the knowledge, skill required can be identified and categorized as a group. These identified clusters are called 'Job Families'. Ìt is necessary to have such job families because all units may not have identical jobs or assignments. The rationale is that an individual must be assigned at least one job from such job family. (. Define and Spell out the Criteria for Each Successive level: The mechanism to move on to the next level (promotion) should be transparent in terms of the criteria, the weightages, and the measurements. Ìn a way, an open appraisal system makes it explicit as to what is expected and how it is to be measured. Ìt must be mentioned that sometimes promotions may take place within a career stage, that is, in the apprentice stage itself. .. Placement is the Next Career Role: Ìt is to be ensured that only those who clear these criteria can move on to next level. And when the career stage changes, the transition is facilitated by training and counselling. This is to highlight the change in orientation that is associated with changing career role. This is particularly significant when one moves from the role of colleague to mentor. The entire emphasis is on shifting to a developmental role. The transition from mentor to sponsor is crucial too as these calls for conceptual skills like visioning, planning, creative problem-solving, etcetera. The experiences and practices in the organizations speak of more than one career and a choice for individuals to opt. Conventionally, in any industry, the topmost position is looked as the ultimate of the career aspiration and, therefore, logically one thought of only one career. However, there are reasons to visualize multiple careers (discussed below) even within a given organization having single business focus. M7lti5le Careers 8ithin Or,ani-ation Traditionally, organizations were simple and smaller. They were engaged in single business and their activities were focused. The other activities like finance, personnel, marketing, planning, etcetera, were together clubbed in the administrative functions and these were perceived as not requiring much heterogeneity in skills. However, as organizations visualized the wider canvas and as management science grew, it was realized that many of the aforesaid activities need special attention and skills. Today, these are clearly understood as separate independent functions, which require expertise. Thus, in the manufacturing industry, one can see specialization at the top management level for finance, personnel, marketing, planning, and quality besides the traditional focus on production and maintenance. Ìn this scenario it is feasible to perceive and develop multiple careers within the organization. Individuals may join the organization with basic technical knowledge required for the given job but during his work life he could become expert in any, other than core, technical area. For instance, a few decades ago we did not have financial managers as experts as we have today. Financial Management has achieved a status of expert function which a technical person can strive for. That has emerged as a career within. Currently, Ìnformation Technology (ÌT) has emerged as an area of specialization. Since the potential of ÌT in any industry is tremendous; it is almost impossible to have a readymade expertise. An otherwise technical person like engineer, medical professional, artist, accountant can with a little bit of effort, develop expertise in ÌT within the boundary of the organizational activities. The same holds good in service organizations too. In fact, in the larger context, even the management profession is getting into specialization for different industrial sectors as well as industries. Therefore, we have specialization in poultry management, hotel management, hospital management and so on. Thus, a majority of the functions in the organizations are offering specific careers. Ìn view of this, career plans could be drawn up to ensure that attention is given in an organized way to develop specific competencies required for these functions. Ìn the traditional context, the practice was to recruit specialists but now one can think of creating experts within the organization by using the system of career planning. This implies that the general career path drawn up must ensure that the core assignments of these specialized functions are also incorporated in that path. HR professionals must be careful to find out whether the employee/executive has a detailed understanding of the new job, insight into the culture, technology and the social atmosphere in the new organization. Schein has talked about career counselling workshops at different stages of career wherein the individual is facilitated to understand his/her career anchors in the light of his/her performance and introspection. Counselling is seen as a process to facilitate the individual in realizing his strengths and weakness vis-a-vis the competencies listed for various career options. Career Workshops can be the forum for making the individual aware of his career anchors and giving him opportunity to express his desire to follow a particular direction. The concept of multiple careers is becoming more and more relevant as we are moving towards flatter organizations. The emphasis and the chances of aiming at the apex level position do not exist in such an organization. Ìn flatter organizations, hierarchy is neither desired nor available and what is needed is to develop expertise in different areas. Expertise building in one or more areas is crucial and challenging. Ìn a way, the spiral career concept given by Driver is becoming an ideal one for meeting the emerging situation. This makes the multiple-career concept more relevant for the future. Che%2 )o7r *ro,ress #D) State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Organizations cannot take responsibility of individual's career. ---- False. !. Career Planning is not one time exercise, plans have to change. ---- True. (. Career Planning is sequencing events for development. ---- True. .. Career Progression is the right of the individual. ---- False. ?. Career Planning is a new concept for Ìndian organizations. ---- False. @. Career Planning can become successful when the HR functionaries, the individual and the immediate supervisor perceive this as a joint responsibility. ---- True. !1.@ SED+EDEVEDO*MENT The Con%e5t of SelfE&e=elo5'ent: *ersonal Effi%a%3 Before discussing about the self-development and personal efficacy, it may be worthwhile to understand the concept of self. Self can be categorized into two parts, namely,. the 'patent self' and the 'inner self'. The patent self can also be called the external self which normally comprise individual's identity and physical features. On the other hand the 'inner self' signifies the behaviour patterns, values and other psychological factors including strengths and weaknesses. Before coming in close contact with someone, we normally identify a person from his patent self, that is, a tall man or a fair complexioned women, etcetera. Once we come into close contact with someone the identifying parameters change. Now, we start identifying a person as a very kind man or very helpful woman or very emotionally strong person or very sensitive person, etcetera. The self-development essentially refers to developing a mature personality who can handle different tasks and situations with comparative ease. And in this direction seeking self improvement becomes an ongoing process. Ìt is the process of discovering and utilizing the tremendous potential within one's individual personality. *resently organizations are experiencing much uncertainty vis-a-vis their human resource. They are forced to bring about strategic changes involving business diversification, expansion, and structural changes in response to the emerging demands in a liberalized and globalised environment. There are two challenges to be met viz. (1) keep and improve the existing things and (2) look for new opportunities in a changing world. This is where we find it difficult to change people, i.e. their mindset. Most of the organizations need to do that since their strategies can bring result only if the 'true spirit' behind those changes is understood and appreciated by the people involved in the tasks. As Pareek (1994) states, 'structures are modified and new reporting relationships are put down on paper but unless the individuals' mindsets are altered to this effect the change would be deceptive. While addressing issues one cannot avoid looking at 'what' is to be changed but must also address simultaneously 'how' individuals can be facilitated to change. Ìn other words, organizational renewal implies similar renewal at the level of the individual and organizations must address this.' As a part of the organizational development, the organizations need to make individuals understand this and accordingly initiate their development process in line with the organization's expectations and vision. ;ith a view to creating learning organizations, individuals in the organization should be perceived as the `focal' point. Unless they are sensitized to the need for self-renewal, the organizational efforts for change may remain only at the cosmetic level. To achieve a lasting effect, they now have to concentrate on how the Human Resource could be oriented towards such a self-renewal. The attempt could be specific to those having problems in adjusting but more generic effort would be to give an emphasis on 'being learning individuals' throughout the organization. This is related to the process dimension of change and can be achieved through an appropriate focus on 'Personal Efficacy'. The factors that contribute to personal efficiency are motivation, self-awareness, proactive behaviour and action-orientation (Pareek, 1997). This includes the perception of an individual with respect to his suitability to the activity he is doing presently, how much he values that activity, how much he thinks others value the activity, and how much scope for improvement he perceives in it. Thus, it includes awareness about one's capabilities the desire to do well, belief that improvements are possible and efforts made to enhance the capabilities and competencies. It is not merely for the benefit of the organization that the individual needs to develop, in his own interests he must do so. Ìndividuals need to be sensitized to the fact that unless they change and develop, they would not survive and grow. The change can come about if and when the individual senses the changes occurring, evaluates them and then decides to take corrective steps so that he does not become a misfit. `Of primary importance at the personal level is the process of self-awareness, i.e. to what extent the person is aware, of what is happening to him, of social reality, of his relationship with others and so on. This process also relates to his awareness of the various aspects of his personal life which are primarily concerned with self-actualization, that is, achieving those goals which are important to him in his life' (Pareek, [994). Thus personal efficacy is not only in relation to his job but in the process of exploring himself. This would include the motivational processes, such as how the individual copes with the problems he faces, and the creative processes which are important aspects of self actualization. Such processes are important for the integration of the individuals with the organization. The prerequisite for introspection and learning is to understand the fundamentals of human behaviour. There area number of aspects one needs to understand about oneself. However, in the context of our discussion on self- development in relation to the organization, the following aspects will be discussed. At Ìndividual level Motivational Pattern, Locus of Control, Power Bases At Ìnterpersonal level Ìnterpersonal Needs, Transactional Analysis At Group level Being effective member in the Work Group At In&i=i&7al De=el The needs and expectations of employees have drastically changed during recent years. They have a better exposure to the outside world; the environment has become quite competitive, and the opportunities have also increased. Technology has played a major role in influencing the needs and expectations. Organizational loyalties and long term association with a single organization are disappearing. Moti=ational *attern An individual has to make conscious efforts to be aware of what his life goals are. Awareness of one's own need bases can enhance an individual's acceptance of self- concept. How the individual attempts to balance self-concept with what he feels others think of him. Many a time, at a superficial level an individual may feel he is aware of what he wants but that may not be the reality. Ìndividuals have to be actively helped with some questionnaires and discussions to assess their orientation; to develop a more reliable and meaningful understanding. Ìndividuals could become aware about what motivates them, whether it is individual achievements or contribution to the group activities or in exerting influence. Such analysis can reveal that for job satisfaction one can look for those opportunities. Ìt would facilitate creating awareness about career anchor and then deciding what is the most suitable action for development and for increasing effectiveness. Ìt is important to realize that people work for a variety of reasons like money, status, appreciation, work satisfaction, self-growth etc. and the emphasis on a given goal keeps changing. HR Policy has to remain sensitive to the changing needs & enable people to give their best. Do%7s of Control *ersonal efficacy is also related to an individual's ability to take the initiative which closely relates to his belief that he can change things. The concept of locus of control given by Leftcourt (1969) and Levenson (1972) explains that individuals have beliefs about who is responsible for what happens in life. Some believe that events are determined by external forces like other influential persons in society, luck, destiny and so on. Whereas some others believe that the individuals can determine events. Thus, we have individuals with more external locus of control and some with more internal locus of control. These beliefs definitely have impact on the action orientation of individuals. For instance, it is logical to expect a person with internal Locus of Control to be generally geared up to look for resources around him, anticipate events and do not wait for things to happen. On the contrary, individuals who believe that there is not much they can do, will wait for external forces to push and exhibit a general dependency. Conscious examination of one's orientation about 'who controls', can reveal areas of development. Specific strategies could then be given or suggested to individuals to bring about change in the orientations in the desired direction. For instance, to reorient a person with more external locus of control to internality, he could be facilitated to realize that it was his efforts or his ideas which have contributed to his success in an assignment and not the ease of the task or the luck. A feedback of this type can enhance the process of his conscious thinking about his contribution to the outcome of his actions. Ìt is obvious that organizations would like to have managers who have belief in their capabilities. *o8er Bases Another important concept related to influencing others is Power, Kotter (1979) has defined power as 'a measure of person's potential to get others to do what he or she wants them to do, as well as avoid being forced to do what he or she does not want to do.' Distinction is also made in terms of fear or love being used as base of exercising this power. Flanders (1970), Hersey and Blanchard (1982) and Pareek ( 1997) have contributed to the present understanding that coercive bases include organizational position, punishment, charisma, personal relationship, (emotional power), closeness to a source of power and withholding information on resources. The persuasive bases include expertise, competence, and modelling (example set by behaviour). Ìn using the power bases concept, a person becomes aware of the power he/ she has and how much more is needed which is quite relevant. Perception of having and using power empowers a person. After all, the exercise of authority (power) is essential for the functioning of any organization. This is the power dimension of working. From this, one develops the power dimension of rewarding employees by deciding as to who should get what differential compensation. Inter5ersonal Intera%tions: D3a&i% Relationshi5 In organizations most of the situations imply interacting and influencing others. While certain roles it may be more specifically labeled, so the process is common to all transactions that take place in the organization. Ìt is therefore advantageous for individuals robe aware of the process of influence through interpersonal interaction and about the various influencing styles that lead to the desired effect. In the focus of influencing others we need to understand our interpersonal interaction pattern. Here we will discuss the concept of Interpersonal Needs and Interpersonal Intera#tions 1throu&h transa#tional analysis/. Inter5ersonal Nee&s Schutz (1958, 66) drew attention to three basic interpersonal needs implied in interaction among people; viz., inclusion, control and affection. As Schutz defined, 'The interpersonal need for inclusion is defined behaviourally as the need to establish and maintain a satisfactory relationship with people with respect to interaction and association. Satisfactory relationship includes: #a$ a psychologically comfortable relationship with people somewhere on a dimension of initiating interaction, and #"$ a psychologically comfortable relationship with people with respect to eliciting the behaviour from others. On the level of feeling, the need for inclusion means need to establish and maintain a feeling of mutual interest' (Pareek, 1996). The interpersonal need to control is to establish and maintain satisfactory relationship including: #a$ a psychological comfortable relationship in controlling all behaviour of other people, and #"$ eliciting behaviour from them which controls one's own behaviour. It may be understood that these concepts are to be examined in the framework of one- to-one relationship and not in a group situation. They facilitate the process of creating awareness about one's tendency to be wanted to be loved, acknowledged, belonged or controlled. Ìt is educative for individuals to learn about themselves as they can observe and analyse their own interactions with their colleagues, subordinates, superiors and other work related people external to the organization. Transa%tional Anal3sis Another framework available to understand interpersonal relationship and interaction is in terms of Transactional Analysis ÷ a concept developed by Eric Berne and in terms of existential positions conceptualized by Harries (1969). A transaction is a combination of a stimulus and its response in an interpersonal interaction. The personality of an individual comprises collection of behaviour patterns developed over a period of time. These behaviour patterns are evoked in different degrees from three ego states, namely, Parent, Adult and Child. As Berne states, 'although we cannot directly observe these ego states, we can observe behaviour while individuals are interacting or transacting and from this we can infer which of the three ego states is operating at that moment.' The three ego states are discussed below: An individual's personality has a combination of these three ego states which could be unique to an individual. Ìt would also not have a direct relation to the age or any other demographic parameter of an individual. Thus, we may have an individual who is proportionately more adult (orientation) at the age of sixteen and have another individual who is more child (orientation) at the age of sixty. This profile of the ego states of an individual determines his interaction with another individual. Thus one could behave in a more regulatory or analytical or a very casual orientation while dealing with others. Ìn the context of influencing others in the organization an appropriate behaviour suited to the situation is required. Eric Berne defined the ego states as 'consistent pattern of feeling and experience directly related to a corresponding consistent pattern of behaviour.' The terms parent, adult, child are related to orientations an individual has. For instance, 1. The parent ego state regulates behaviour and nurtures it, More of ethical, conscientious behaviour and influenced by preaching's from parents and elders !. The adult ego state collects information and processes it. More of a analytical, rational and practical orientation (. The child is concerned with creativity, curiosity, reactions to others and adjusting behaviour. More of instinctive behaviour with motive of enjoyment. The parent ego state is a result of the messages (conditioning) people receive from their parents, elders, teachers and others during their childhood. These messages are recorded in people's heads. These messages help in regulating one's behaviour by telling what is right, what is wrong, what is desirable and what is undesirable. There are two kinds of Parent ego: #1$ Nurturing parent and #!$ Critical parent. Nurturing parent is that part of a person which is understanding and caring about other people. Critical parent behaviour criticizes others for their undesirable behaviour. When a person is in critical parent ego state he is very much evaluative and judgmental and makes others to feel that they are not OK. The adult ego state evokes behaviour that could be described simply as logical, reasonable, rationale and unemotional. Behaviour from the adult ego state is characterized by problem solving, analytical and rationale decision making. These people examine alternatives based on facts and figures and probabilities prior to engaging in behaviour. The child ego state is associated with the behaviour that appears when a person is responding emotionally. A person's Child contains the 'natural' impulses and attitudes learned from experiences. The child ego state can be classified into Adopted child, Natural child and Little Professor. The part of child state which adapts to what must be done to others to get along. A natural child tries to enjoy every bit and take the things as they come. The little professor is the 'thinking' part of child. Ìt is creative, intuitive, imaginative and does experimentation. He dreams up new ideas. The compatibility of people largely depends on the ego states of interacting people. Ìf the transaction is complementary, namely, from Parent to Child and back from Child to Parent or Adult to Adult, situation is classified as desirable. But, if the transaction is crossed, i.e. Parent to Child and again from Parent to Child, it is not a desirable situation, the transaction is blocked. Ìn an organizational situation for improving the effectiveness through better interpersonal relations and interactions it is desirable to avoid any crossed transaction. *eople make basic assumptions about their own self-worth as well as about the significant people in their environment. Harris called these combinations as Life #ositions) These life positions are described in terms of 8kayness. Thus the individuals are either 8 or &8T 8. Four life positions can be described as: 1. Ì am 8 you are 8 (both have value) !. Ì am 8 you are &8T 8 (Ì have value but you don't have value) (. Ì am &8T 8 you are 8 (You have value but Ì don't have value) .. Ì am &8T 8 you are &8T 8 (neither person have value) Subsequently expanding on the work of Avary (1980), James (1975), Pareek (1984) has developed twelve influencing style, six of them in the O/ states and six in the NOT O/ states. Pareek's application of this to the organizational role in the form of Styles Profile of Ìnteraction Roles provides relevant framework. The purpose of understanding the Ego State (personality orientation) profile is to make necessary modifications in one's behaviour. Behaviour scientists have suggested certain behavioural patterns in the framework of Ego State Profile and Life Position ('OK' and 'NOT OK') as desired while certain others as undesirable and therefore to be avoided. Awareness of one's own pattern and intensity in these styles can be a step towards developing healthy influencing relationships. ;or2in, in Tea's Synergy is the highest activity of life, it creates new untapped alternatives; it values and exploits the mental, emotional and psychological differences between people. Ìn any situation requiring the real time combination of multiple skills, experiences, and judgments, a team inevitably gets better results than a collection of individuals operating within confined job roles and responsibilities. A group of people with high degree of interdependence geared towards the achievement of a goal or the completion of task is known as a team. 'Group' and 'team' are used interchangeably, though there are some differences. The term 'Group Dynamics' was coined in 1930s by Kurt Lewin Ìt refers to the: 1. internal nature of groups !. how they form (. their structure and processes .. how they function and affect individuals and organization An individual's interactions do not stop at one to one situation ÷ they exist in the context of work groups. How effectively one performs the role as a member, can be meaningful information for self-development. To this effect, understanding group dynamics and the roles in the group is a necessary input for increasing effectiveness. Ìndividuals must understand that the members have two major sets of roles to play. One set is geared towards the task of the group. The other one is to maintain the cohesiveness of the group. Ìt is the second set which is crucial and has a long-term perspective. The issues involved here are about listening to other members, respecting them and their views, contributing meaningfully to the group activities and understanding the appropriate meaning of consensus and group decision-making process. Consensus is often mistaken for compromise, or majority view. There is a kind of negative emotion implied for those who compromise or those who are in minority. Such feelings are not healthy for the group in the long-term. Ìt is necessary that members understand that consensus means debating over the pros and cons with full respect for each other. Ìt is useful to understand the stages in group formation and group behaviour namely: 1. Forming (Awareness): Members with varied experience get acquainted, Understand the Team's goal and its role !. Storming (Conflict): Conflict among the members, through this conflict team attempts to define itself (. Norming (Cooperation): Norms are laid as to how the task will be accomplished, the manner in which the team will behave, and the rules and regulations it will follow. .. Conforming (Adjustment): Adjusting one with the team expectations and norms ?. Performing (Productivity): Members behave in mature fashion and focus on accomplishing their goal. Members can devote full energy to work SelfEa8areness Understanding self helps in self-development and using one's potential better. Ìt is always useful to do the SWOT analysis of self to understand the Strength, Weaknesses, Opportunities and Threats. This may help in better use of strengths, overcoming weaknesses, capitalizing the opportunities and safeguarding against threats. Ìt is relevant to refer to the concept of Johari Window given by Loft and Ìngham (1973) which explains what is meant by self-awareness. The authors refer to the two dimensions, namely, #1$ how much of one's behaviour is known to him or her, and #!$ how much he feels others know him or her. These two dimensions give four windows called Arena, Blind, Closed, Dark. The diagram below explains the model. As can be seen the area which is known to self and others is the Arena (open) aspect of one's personality and one which is not known to both is the Dark aspect. The Blind section is known to others but not the self and the Closed section is closed to others so to say. The closed window is also referred as Private, being private to self. Known to self Not known to self Known to others ARENA is known to others and known to self too. BLÌND is known to others but not known to self. Not known to others CLOSED is not known to others but known to self only. DARK is neither known to others nor to self. In this, the size of arena or open space is critical for improving effectiveness. Ìt is implied that he more the person feels, the others know him or her; more and better conducive the environment becomes and the stronger the self-concept. As we deliberated, the more one knows about oneself, the better equipped he is to face the challenges. The strategy to increase the Arena (open-self) implies that the individual sensitizes himself to receive feedback from others and by making more and more disclosures. Thus, the receiving feedback and self disclosures help in increasing the Arena (open-self). Such persons are more trustworthy, open to other's ideas and suggestions, have better self awareness. E'otional Intelli,en%e The contemporary research by experts has revealed that for success in life the traditional concept of ÌQ is not enough as a predictor. Daniel Goleman has cited a number of recent researches indicating that `link between ÌQ test scores and the achievements in life is dwarfed by the totality of other characteristics that one brings to life' (Goleman. 1995). He has visualized these other characteristics as 'Emotional Ìntelligence: abilities such as being able to motivate oneself and persist in the face of frustration; to control impulse and delay gratification; to regulate one's moods and keep away distress from swamping the ability to think; to empathize and to hope'. Goleman has drawn on the understanding developed by Gardner in his 1983 work on "intelligence and success in life". Goleman states that unlike the ÌQ, which is stable from childhood, Emotional Ìntelligence grows throughout adulthood. Ìt can be learnt as one matures with proper awareness assessment and efforts to correct. The five components of Emotional Ìntelligence which relate to how we manage ourselves and manage others are: 1. Self A8areness: Ability to recognize, understand one's mood, emotions and drives, as well as their effects on others. !. Sell Re,7lation: Ability to control or redirect disruptive impulses and moods and propensity to suspend judgment ÷ to think before acting. (. Self Moti=ation: Passion to work for reasons that go beyond money or status and propensity to pursue goals with energy and persistence. .. E'5ath3: Ability to understand the emotional make-up of others and skill to treat people according to their emotional reactions. ?. So%ial s2ills: Proficiency in managing relationships and building networks and ability to find common ground and build rapport. Self 2wareness includes ability to recognizing one's emotions and their effects, Self Assessment i.e. knowing one's strengths and limits and Self Confidence, that is, A strong sense of one's self worth and capabilities Self Regulation includes self Control i.e. Keeping disruptive emotions and impulses in check, Trustworthiness i.e. Maintaining standards of honesty and integrity, Conscientiousness i.e. Taking responsibility for personal performance, Adaptability, i.e. Flexibility in handling changes and innovation, i.e. Being comfortable with novel ideas, approaches and new information Self Motivation includes achievement Drive i.e. striving to improve or meet a standard of excellence, Commitment, that is, aligning with the goals of the group or organization, Ìnitiative, that is, readiness to act on opportunities and Optimism, that is, persistence in pursuing goals despite obstacles and setbacks *mpathy signifies: understanding Others i.e. sensing others' feelings and perspectives and taking an active interest in their concerns, Developing Others i.e. sensing others' development needs and bolstering their abilities, Service Orientation i.e. anticipating, recognizing and meeting other's needs, Leveraging Diversity, i.e. Cultivating opportunities through different kinds of people and Political Awareness, i.e. reading a group's emotional currents and power relationships Social Skills $:andling Relationships% cover: influencing, that is, wielding effective tactics for persuasion, Communication, that is, listening openly and sending convincing messages, Conflict Management, that is, negotiating and resolving disagreements, Leadership, that is, inspiring and guiding individuals and groups, Change Catalyst, that is, Ìnitiating or managing change, Building Bonds, that is, nurturing relationships, Collaboration and Cooperation: working with others toward shared goals, Team Capabilities, that is, creating group synergy in pursuing collective goals. Ìn the arena of management of human relationships it is wise to remember that no single style of management is likely to hold good all the time. One, therefore, has to be adaptive to different types of style to suit the given situation. Che%2 )o7r *ro,ress #E$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Organizational changes are not effective unless the people also change their way of thinking accordingly. ---- True. !. Ìndividuals can accept only those changes that relate to the work. ---- False. (. Organizations need to make the individual change. ---- False. .. Self-perceptions are enough to bring about improvements. ---- False. ?. Personal efficacy is how efficiently one is doing his job. ---- False. @. 'Locus of Control' refers to one's belief about who is responsible for the events in one's life. ---- True. B. People have different motivational bases. Some receive satisfaction in achieving by themselves, some others by working in groups while some others by exerting influence. ---- True. C. With experience, age and hierarchy in the organization, the Child component of the personality should be eliminated. ---- False. F. The Adult ego state is mainly responsible for creativity, curiosity and reactions to others. ---- False. 10. The Parent ego state mainly regulates behaviour and nurtures it. ---- True. 11. ARENA refers to the part of personality known to 'self' but not known to others. ---- False. 1!. BLÌND refers to the part of personality known to self but not known to others. ---- False. 1(. CLOSED refers to the part of personality known to self but not known to others. ---- True. 1.. DARK refers to the part of personality not known to self or known to others. ---- True. 1?. Emotional Ìntelligence refers to being emotional. ---- False. 1@. Emotional Ìntelligence refers to being empathetic. ---- True. 1B. Emotional Ìntelligence refers to being self-motivated. ---- True. 1C. Emotional Ìntelligence refers to being self- regulated. ---- True. Morale Morale is an important mental state and the spirit of a person or group which is dependent on a number of intangible factors within the organization. High morale of an individual or a group contributes significantly to the achievement of organizational goals. Morale is generally exhibited by confidence, cheerfulness, discipline, and willingness to perform assigned tasks. The morale denotes a spirit, as of dedication to a common goal that unites a group: the high morale of the troops; the esprit of an orchestra; the esprit de corps of the swim team; the morale of the troops. Ìt also displays the emotional or mental condition with respect to cheerfulness, confidence, zeal, etc., especially in the face of opposition, hardship, etc. The spirit and the desire of a group that makes the members of the group succeed is influenced by the level of morale. *ositive employee morale is highly dependent on employee motivation; and also on rewards and recognition. Organizations want a workplace in which high morale translates into positive motivation, increased productivity, exceeding expectations for performance and happy employees. Like a disease, poor morale can infect every aspect of a business. Ìt can lead to reduced productivity, reduced revenue, high staff turnover and more. According to Sirota Consulting, the share price of low morale companies saw only a 3 per cent increase in price versus an industry average of 16per cent. E'5lo3ee Morale Booster ;el%o'e I&eas: Employee morale improves when staff feels they are valued. Share and implement their innovations and ideas. /ee5 S%ore: Mount a large score board in the office to recognize top performers and to motivate those on the bottom of the list. Ins5e%t: The old management adage, inspect what you expect is true. Companies with a lack of focus can confuse staff and lead to less morale. Than2 )o7 Note: Send a special 'thank you' letter to your staff's family or spouse, praising their good work and efforts. G7&&le: Have a daily morning huddle to highlight tasks for the day and to cheer yesterday's wins. O5en U5: Provide an open forum or one-on-one time to allow employees to express their concerns and feelings can be an easy means to boost morale. Ga=e +7n: Special events and outside work activities can take the pressure off the day- to-day grind in the office. Sho8 Charit3: Get your staff involved in a bigger cause to help them see there is more to life than work. A&& *er2s: Use low cost perks such as a Foosball table in the lunch room. +ire Staff: Sometimes the root cause of low employee morale can be a staff member whose negativity brings down the group. Even a top performer can bring down staff behind your back. Meas7re It: Keep tabs on the levels of morale in your business by regularly measuring employee satisfaction. The backbone of business success resides in the productivity and output of employees. Those companies who remain vigilant to the signs of low morale and who focus on improving morale can thwart off the impact of a low morale workplace. This is a best case scenario. You have received feedback about negative rumors and you know that the underlying cause of the negativity is based on faulty information, incorrect assumptions, or deliberate misinformation. You may receive feedback that a new policy or procedure is not understood correctly. People may be misinterpreting a corporate memo. An industry newsletter might have referenced an industry problem your company does not share. You may have fired an individual who is circulating false information about the company. Ìn each of these circumstances, you have some control over the information, the situation, and the communication. You can solve the problem and communicate well to overcome the negativity. ;hen you can control or influence the situation, use a systematic problem-solving process with the affected employees to improve the identified areas of negativity. Do this as quickly as you determine that negativity exists. (Many Human Resources offices launch a complete investigation, and by the time the facts are gathered, the negativity is out of control). Ìnclude the employees who are closest to the negative situation in the problem-solving process. Do a good cause analysis so that all possible causes of the negativity are identified. Ìt is not enough to say, 'We have low morale.' You need to identify exactly what is causing the low morale to have any chance of improving it. Solicit widespread input to each step of the action plan you develop so that solutions are 'owned' across your organization. Ìnvolve as many people as you can in its development and particularly in its implementation. Ìmplement the chosen solutions quickly. Then, periodically assess that the plan is working. At each step of the problem- solving process, communicate as much information as you have about the negativity and the solutions. When the solutions selected in the action plan are rolled out, people in the organization are not surprised. They have participated in the information exchange as each step or opportunity was discussed. Det Us S7' U5 In this unit we examined how the present HRD perspective aims at integration of individual needs and growth with the satisfaction of organizational needs and growth. This understanding being fundamental to developing human resource, we considered a few important subsystems that relate to the developmental aspect. These are training and development, attitude development, career path planning, and self-development. ;e also focused on the training and development as a specific subsystem of HRD. To appreciate the importance of the system per se, we initially examined the present understanding of 'Training', `Development' and 'Education'. We examined the concept of adult learning and why it is different from what we commonly understand by teaching. We, then, elaborated on the systemic issues of training and development. Specifically we studied the various steps involved in the introduction and maintenance of a formal training system in an organization. We also discussed the importance of attitudes at workplace and the need methods of attitudinal change. ;e examined the relevance of the concept of career with its implications in organizations. We reviewed the terms Career Stages, Career Transitions, Career Movements, Career Roles, and Career Anchors. Ìn the organizational context, Career planning as a system plays an enhancing role in the Human Resource Development. We discussed the steps in establishing this HR sub-system and the emerging need to develop multiple careers. ;e focused on the individual's role and responsibility vis-a-vis the developmental efforts initiated by the organization for self-development. As such we examined the concepts underlying human behaviour which can be appreciated by the individuals in the process of development. The 'Personal Efficacy' is the process intervention to substantiate some of the HRD systems that aim at individual's growth and development. Ìn the emerging profile of organizations, interpersonal styles, group behaviour, facilitating leadership and empowerment of subordinates are going to be behavioural benchmarks. Ìn this context we also discussed the concepts, role and application of Transactional Analysis as tool of inter-personal skills/behaviour. The concept and content of Johan window as a framework to improve personal efficacy though the mechanism of feedback and disclosure have also been discussed. The factors associated with improving emotional Ìntelligence viz. Self Awareness, Self Regulation, Self Motivation, Empathy and Social Skills for improving personal and inter-personal effectiveness have also been discussed. We also discussed the concept of employee and group morale and its impact on organizational productivity. The impact of motivation, reward and recognition on employee morale has been identified. The morale boosters are also discussed. Case St7&3 1 Mr. Mansorie has been working on the Pension Desk of Establishment Section in the Zonal Office of a Public Sector Bank for last eight years and is now due for inter departmental transfer. He has been very sincere, hardworking and knowledgeable worker. His boss Mr. Natrajan, Assistant Manager was having full confidence in his sincerity and ability, therefore, he was not worried about this aspect of work and was concentrating on other establishment matters like payment of salary in time, preparation of PF statement, payment of bills etc. Mr. Mansorie was rarely taking leave and was not considered for training for a long time. Mr. Natrajan received a communication from the training department nominating Mr. Mansorie for a week's training to the Staff Training Centre (STC) on 'Public Relation' in the last week of month. The communication was received from the training department in time. The STC is located in the same building. Three days before the commencement of training Mr. Natrajan approached the Chief Manager pleading for not relieving Mr. Mansorie for the training on the plea that the disbursement of the pension is a time-bound activity, if he is relieved for the training the work will suffer. The other clerks were not very much conversant with the work being performed by Shri Mansorie. Case St7&3 ! A large public sector bank having an apex training college and 10 Staff Training Centres (STCs) at different locations across the country runs regular courses on different aspects of banking, ÌT and HRM. While the apex training college caters to the needs of middle and senior management, the STCs are mainly training to award staff and junior management officers. The top management of the bank is not satisfied with the training system as a whole because it is not producing the right type of trained staff to meet the emerging challenges. Training initiatives are implemented as rituals. The syllabi of the courses are not periodically revised. The course coverage is decided by the trainers themselves based on their own knowledge and exposure, training infrastructure is inadequate, selection of trainees is based on adhocism resulting into uneven training opportunities to employees, there is also gap between the type of skills required and available and this gap is widening due to ageing profile of the employees, training opportunities are underutilized mainly because of lack of motivation and also non cooperation of line managers to spare the right staff for the training. The training department is playing a passive role. Ìt has become hard to increase the training budget, as there is wide feeling that training is a wasteful expenditure, people are not taking training seriously and the trainers are not competent. Training job was considered as risk free and comfortable. Training is considered as a cost centre and line managers perceive no visible benefits out of training. No evaluation is taking place except a reaction level at the time of conclusion of training. There is lack of coordination between different stakeholders of training system. /e38or&s Human Resource Development; Training and Development, Education; Job Analysis, Job Description, Job Specification, Job Evaluation Attitude and Attitudinal Change; Career Development, Career Path Planning, Career Counselling; Life Career Stages, Career Transitions, Career Concepts ÷ Liners, Spiral, Steady, Transitory; Career Anchors, Career Paths, External-Ìnternal Career Path; Career Roles: Apprentice, Colleague, Mentor, Sponsor; Personal Efficacy; Self-awareness; Johari Window; Motivational Base; Power Bases; Locus of Control; Ìnterpersonal Ìnteraction: Needs; Ìnterpersonal Ìnteraction: Styles; Transactional Analysis; Working in Teams; Consensus; Emotional Answers to Check Your Progress 1. False; 2. True; 3. False; 4. False; 5. True; 6. True; 7. False; 8. True; 9. False. 1. False; 2. False; 3. True; 4. False; 5. True; 6. False; 7. True; 8. False; 9. False; 10. True; 11. False; 12. True; 13. True 1. True; 2. False; 3. True; 4. False; 5. False, 6. True. D 1. False; 2. True; 3. True; 4. False; 5. False; 6. True. 1. True; 2. False; 3. False; 4. False; 5. False; 6. True; 7. True, 8 False; 9. False; 10. True; 11. False; 12. False; 13. True; 14. True; 15. False; 16. True; 17. True; 18. True. Ter'inal 97estions 1. What is HRD? How did the concept develop? !. Examine the rationale why special focus is needed to be given to Human Resource Development as a subsystem. (. What were the events that lead the organizations to learn that the existing workforce can be developed to do new things? .. Explain the linkage between the individual performance and organizational performance and HRD system. ?. What are the HRD subsystems? How do they connect with each others? Explain any one of them in detail with its linkages to others. @. Human Beings are learning beings - Discuss. B Organizations must provide learning opportunities because human beings have a desire to learn. Do you agree? C. Why is Pedagogy not suitable for adults? F. What is the difference between adult and child learning? 10. Describe the various stages in establishing Training and Development system. 11. State the reasons for having a systematic approach to organise training. 1!. What is Training Need Analysis? 1(. Discuss the various teaching methodologies. 1.. What is the purpose of training, development and education? How are they different? Should organizations have emphasis on all of them? 1?. What is the significance of having right attitudes? Discuss in the context of bank's efficiency and productivity. 1@. How can we change the attitude of dissatisfied staff? 1B. The organizational career is the responsibility of the organization and the individual - Discuss. 1C. All the concepts that have been developed around 'Life Stages and Transition' can be applied to organizational careers - Elaborate this statement. 1F. Write short notes on: Career Movements/Patterns Career Roles Career Path Career Anchors !0. What is meant by multiple careers? !1. Why is there a need for individuals to appreciate that they need to change? Explain. !!. What are the aspects that individuals need to understand about themselves? Explain any two aspects discussed in the unit on self-development. !(. What is the relevance of understanding interpersonal interactions in the organizational context? !.. Write short notes on: Personal Efficacy Locus of Control Working in Teams S7,,este& for +7rther Rea&in, 10 David, Decenzo A and Stephen Robbins P; -ersonnel)>uman ?esour#e Mana&ement( Prentice-Hall of Ìndia, 1995. !. Luthans, Fred, ;r&ani@ational Eeha$iour( McGraw-Hill Ìnternational Edition, 1995 (. Mankidy, J; >uman ?esour#e Mana&ement in Ean"s< Contemporary Issues( National Ìnstitute of Bank Management, 1998. .. Nadler, L; The >and%oo" of >uman ?esour#e De$elopment( A Wiley-Ìnterscience Publication, 1984. ?. Pareek, U and Rao, T V; Desi&nin& and Mana&in& >uman ?esour#es !ystems( Oxford & ÌBH, 1986. @. Rao, P L; >?D Throu&h InFhouse Trainin&( ÌSTD and Vikas Publishing House, 1995. B. Rao, T V; Pereira D F, ?e#ent E+perien#es in >uman ?esour#es De$elopment( Oxford & ÌBH Publishing, 1988. C. Sahani, A; CCareer -lannin& for >?D and tili@ationC( Ìndian Management, June 1984. F. Schein, E; CCareer De$elopment< Issues for ;r&ani@ationsC( B Taylore and G Lipitt (ed). Management Development and Training, Handbook, McGraw Hill Co., 1983. 10. Stoner, J; and Wankel, E; =;r&ani@ational Careers and Indi$idual De$elopmentB in Management, Prentice-Hall Ìndia, 1987. END O+ CGA*TER !1E ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 Advanced Bank Management UNÌT 22 Human Ìmplications of Organizations STRUCTURE 22.0 Objectives 22.1 Human Behaviour and Ìndividual Differences 22.2 Employees Behaviour at Work Check Your Progress (A, B and C) 22.3 Diversity and Gender Ìssues 2'.4 Theories of Motivation and their Practical Ìmplications Check Your Progress (D, E and F) 22.4 Role Concept and Analysis Check Your Progress (G) Let Us Sum Up Keywords Answers to Check Your Progress (A, B, C, D, E, F and G) Terminal Questions Suggested for Further Reading 1 29 !!.0 OBJECTIVES After rea&in, this 7nit0 3o7 sho7l& "e a"le to: 1. understand the various facets of human behaviour and individual differences, !. understand the various aspects of employees' behaviour at work and its significance in organizational performance, (. appreciate the diversity and gender issues at workplace, and .. appreciate the motivational aspects and their practical implications at work, ?. appreciate and analyze the significance of role in the context of organizations. !!.1 GUMAN BEGAVIOUR AND INDIVIDUAD DI++ERENCES Understanding and appreciating the importance of individual differences and its impact on human behaviour is a most crucial aspect of human resource management. As each individual is different from the other in his/her physical appearance, he or she is also different from other person in his/her behaviour and other psychological parameters, viz., feelings, perception, values, etc. One finds striking differences in intelligence, physical features and personality traits, etc., among people. From the day of birth, each person is unique; individual experiences after birth, make people even more different. Guman behaviour is a complex phenomenon. Ìt is most difficult to define in absolute terms. Ìt is primarily a combination of originating and responding behaviour. The behaviour reflects the psychological structure of a person. Ìt is also the result of biological, psychological and social processes. According to psychologist Kurt Lewin, behaviour is a function of the person and the environment around him. These two factors are linked with each other. Any one of these individually cannot explain fully the behavioural characteristics. Thus, different people behave differently in the same or similar environment. After explaining the foundations of human behaviour, the individual differences are examined in this Unit. Various personality theories have also been discussed in detail. The Unit also brings out the connection between the employee and the organization. The employees' motivation and its practical implications at work have also been brought out in this unit. The behaviour of an individual is influenced by several factors. These can be grouped under the following heads: 1. En=iron'ental +a%tors: #a$ Economic, #"$ Social (norms and cultural values), and #%$ Political; !. *ersonal +a%tors: #a$ Age, #"$ Sex, #%$ Education, #&$ Abilities, #e$ Marital Status, #f$ No. of dependants, etcetera; (. Or,ani-ational +a%tors: (a) Physical Facilities, (b) Organization Structure and Design, (c) Leadership, (d) Compensation and Reward System, etcetera.; and .. *s3%holo,i%al +a%tors: (a) Personality, (b) Perception, (c) Attitudes, (d) Values. (e) Learning, etcetera. En=iron'ental +a%tors: These factors are mainly external and they influence individual's behaviour. These, broadly include the social, cultural, political and economic environments. Among these, economic environment determines the behaviour of an individual to a great extent. Economic environment consists of the level of employment, wage rates, economic outlook, etcetera. Cultural factors such as work ethic, achievement needs, values, etcetera., form part of the environmental factors. The political climate also influences individual behaviour. The stability of the government can contribute to employment opportunities. The quality of the political system also has a bearing on individual behaviour. The social environment, which includes societal norms and the family atmosphere, also influences to some extent the individual behaviour. *ersonal +a%tors: Every individual brings to his workplace several personal characteristics such as age, sex, education, knowledge, intelligence, abilities, family dependents and similar other related factors. Performance of an individual depends on these factors to a great extent. Or,ani-ational +a%tors: The structure of the organization, the availability of physical facilities, the existence of reward and compensation system, the personnel policies, the organizational culture, etc influence the behaviour of an individual in an organization. The quality of leadership also influences individual behaviour. *s3%holo,i%al +a%tors: The individual behaviour is determined to a great extent by the physical and mental personalities of that individual. The values, perceptions and attitudes also contribute to the individual behaviour. Since each person is individually different implying that in order to motivate the employees they have to be treated differently keeping in view the needs and motives of the employees. Ìf the needs and motives of two persons are different they must be treated differently. Ìf it were not for individual differences, some standards could have been adopted for dealing with employees and minimum judgment would have been required thereafter. There might have not been any difference in dealing with men and machines. +rom the organizational angle, managers usually view their employees as rational human beings who are primarily motivated by money. Accordingly, they adopt 'economic man' and the 'rational man' approach to understand and predict human behaviour. However, it has also been realized that man is also a social being. He wants to belong to a group, and his behaviour at the workplace emanate from his social needs as well. One of the well-known studies (Hawthorne studies) has made it clear that economic motives alone do not explain human behaviour. Social interactions at workplace, especially how they are treated, and how their contributions are acknowledged, make a big difference in their attitude to perform. Thus the idea of 'social man' was developed. Gowever, as time passed by, the 'social man' approach was also considered somewhat simplistic. This approach does not pay adequate attention to work, its intrinsic nature and its organization. Nor does it concern itself with the economic functions and responsibilities of the enterprise. And at times, it is plainly manipulative. Organizational behaviour theorists such as Argris G C, Likert R, and McGregor D argued that people in organizations need opportunities to use their creativity and this growth need should be met to enable them to contribute effectively. At the same time, all employees may not want to develop and grow on their job; they may have their preference elsewhere. Hence, the current thinking is to accept man as a complex being and to recognize that personalities always differ. An understanding of the concept of personality and the influence of its components on the behaviour at work is necessary to provide a congenial environment in which employees can perform. Such an understanding may help managers to adjust their own behaviour also and contribute to organizational cohesiveness. Besides, this may enable them to predict employee- behaviour at work (absenteeism, turnover, work involvement, etc.) and take timely preventive measures. !!.! EM*DO)EES BEGAVIOUR AT ;OR/ The behaviour of people at workplace plays an important role in organizational success. The behaviour of an employee as an individual as well as his behaviour in a group makes a difference in achievement of organizational and group objectives. The technical competence of an individual is important but beyond that his behaviour and interpersonal skills are extremely important. The people in the organizations do not work in isolation, their role and performance is interdependent. They work in teams where contribution of each member is important and significant. The team-building skills which are founded on individual behaviour and interpersonal skills can help in getting synergy at workplace where the cooperation and collaboration can improve the group performance and output beyond the individual contributions. Synergy is the highest activity of life, it creates new untapped alternatives; it values and exploits the mental, emotional and psychological differences between people. There are some basic assumptions about human behaviour at work: 1. There are differences between individuals. !. Concept of a whole person. (. Behaviour of an individual is caused. .. An individual has dignity. ?. Organizations are social systems. @. There is mutuality of interest among organizational members. B. Organization behaviour is holistic. ;hile the first four concepts centred around people, the next two are concerned with organizations. The last one is a combination of the first six assumptions. *ersons differ and again, there are certain 'commonalities' in the persons. Every person is, in certain respects, 1. like all other persons, !. like some other persons, and (. like no other person. This position indicates that an individual possesses some common characteristics of most of the people. He may have some features of some other people. He may also have some characteristics which other persons do not have, i.e. the features unique to an individual. Human personality is thus a complex and multidimensional phenomenon. There is indeed no simple definition of what personality is. However, personality can be examined in terms of certain stable characteristics, tendencies and behaviour patterns. Salvotore Maddi defined personality as a stable set of characteristics and tendencies that determine those commonalities and differences in the psychological behaviour (thoughts, feelings, and actions) of people that have continuity in time and that may not be easily understood as the sole result of the social and biological pressures of the moment. This definition does not imply that people do not ever change. Ìt simply indicates that individuals do not change drastically overnight and their thoughts, feelings, values and actions remain relatively stable over time. Changes in personality behaviour pattern that take place in individuals occur slowly over an extended period of time. Thus by understanding certain dimensions of personality and behaviour, managers can, to a great extent, predict the likely behaviour in terms of actions and outcomes of actions in respect of employees. There are several theories to explain the concept of personality. One dimension of personality which is getting attention both from organizational as well as medical researchers is the Type A and Type B behaviour profiles. A person exhibiting Type A behaviour is generally restless, impatient with a desire for quick achievement and perfectionism. Type 'B' personality people are much more easy going, relaxed about time pressure, less competitive and more philosophical in nature. +riedman, Meyer and Ray Roseman have mentioned the following characteristics of Type W personality: 1. Restless by nature, so that he always moves, walks and eats rapidly. !. Ìs impatient with the pace of things, dislikes waiting and is impatient with those who are not impatient. (. Multitasker ÷ does several things at once. .. Tries to schedule more and more in less and less time, irrespective of whether everything is done or not. ?. Usually does not complete one thing before starting on another. @. Often displays nervous gestures such as clenched fist and banging on a table. B. Does not have time to relax and enjoy life. Type B personality exhibits just the opposite characteristics and is more relaxed, sociable and has a balanced outlook on life. ;e come across both Type A and Type B Managers in banks. Usually Type A Manager's cabin is untidy, and gives a Messy appearance. Further, his table is full of papers and many a time, it is difficult to trace important papers kept on his table. He has a tendency even to lose some papers and to blame others for such a loss. Type B personality, however, is systematic and methodical in his day-to-day work. He has full control over time and does not complain of lack of time even due to pressure of work. This is because he plans the work in such a way that urgent and important matters are disposed of in time. Although he is busy like many other managers, he appears to take things easy and normally does not get disturbed. A development model of personality described by E H Erikson also helps us to understand the concept of personality. Erikson has identified eight developmental stages in explaining the personality. These stages which are based on a person's state of mind at a given point of time are mentioned below: Sta,e 1: Tr7st =ers7s Mistr7st As children we depend on others for our various needs. Ìn the process we develop feelings of trust or mistrust towards others depending on our experience about the fulfillment of our needs. Similarly, in the workplace, we may not know everything about the job and therefore, we are dependent on others for guidance. Ìn the process we also develop feelings of trust or mistrust towards others in the organization depending upon how well they respond to our needs and help us to find our place in the system. Sta,e !: A7tono'3 =ers7s Sha'e an& Do7"t As children we experienced a great need to be on our own and whenever we succeeded, we felt we are independent and autonomous. When we failed in such attempts, we experienced a sense of shame and doubt. Similarly, in the workplace after induction and initial training, we feel happy when we can function independently. But when we commit mistakes we start doubting our own competence and experience a sense of shame for not doing things right. Sta,e (: Initiati=e =ers7s I7ilt This stage indicates the child's efforts at trying to do things on its own initiative and feeling guilty if mistakes are committed. Similarly as employees we take initiative and use our talents to settle down in the jobs; if things go wrong, we may experience a sense of guilt that we have wasted our energy and the resources of the organization. Stale .: ln&7str3 =ers7s Inferiorit3 As we grow up we become diligent and industrious. We want to pursue our goals and manage our life. Ìf we are successful in these efforts, we feel good about ourselves; if we fail, we develop a sense of inferiority. Similarly, in the workplace we try to work hard to find a place in the organization; if we are not successful, we tend to suffer from a feeling of low self-concept and low self-esteem. Sta,e ?: I&entit3 =ers7s Role Diff7sion As we grow, we experience conflict due to the socially imposed requirement of becoming an independent and effective adult. This, at times, becomes difficult. Ìn the workplace also, we are expected to prove ourselves as high, performing members. Obviously, this is not always easy for everybody. Ìn the process some may find their role identity diffused rather than identified and distinguished. Sta,e @: Inti'a%3 =ers7s Isolation As a youth, one feels the need to develop intimate relationship with others. However, there may be impediments to develop such relationship and hence some might feel isolated. Same is the experience in the workplace also. We may develop close contact with others and we may also feel a sense of isolation. Sta,e B: Iro8th =ers7s Sta,nation In middle adulthood, there are compulsions to forego one's immediate needs in favour of developing one's children. Ìf this is not effectively resolved within the individual, a sense of stagnation creeps in. Similarly, in an organization as one reaches mid-career, there is an expectation and need to develop others in the system and help them to grow. Ìf this is not done properly, the person senses a feeling of stagnation. Sta,e C: Inte,rit3 =ers7s Des5air During the later part of life, there is a natural decline of social and biological roles due to the ageing process. As a result one may experience a sense of uselessness. Ìf he is in a position to accept reality, he may resolve the conflict and feel happy about his lifelong achievements. Likewise, in an organization, as one approaches retirement age, he may experience either a high sense of self-worth due to his perceived accomplishments in the career or he may withdraw himself with a sense of purposelessness and despair. The two theories (Type A and B) and Erikson's model of personality bring out different aspects of the concept. While Type A and B focus on certain personality features, Erikson's model narrates different stages of an individual's growth and their effects on his mental personality. Che%2 )o7r *ro,ress #A$ Ans8er the follo8in, H Tr7e or +alse: 1. Type 'A' person feels a chronic of time urgency. ----,, True. 2. Type 'B' is an easy going individual. ----,, True. 3. Type 'A' person is not achievement oriented. ----,, True. 4. Type 'B' person does not experience any competitive drive in his activity. ----,, False. 5. Erikson's model of personality has eight stages. ----,, True. 6. During youth, according to Erikson, one develops a need for intimate relationship with others. ----,, True. 7. There is mutuality of interest among organizational members. ----,, True. 8. Type 'B' person does several things at a time. ----,, False. There are certain common patterns and variables which determine the personality of the people. The patterns of behaviour can be to some extent predicted if we can identify the type of personality. People with similar attributes can be classified in one category and their behaviour can be predicted. Accordingly, experts have developed certain personality theories. *s3%hoEanal3ti%al Theor3 #*T$ *T is based primarily on the Freudian concept of unconscious, subconscious and conscious nature of personality. Freud noted that his patient's behaviour could not always be explained. This led to him believe that the personality structure is primarily founded on unconscious framework and that human behaviour and motivation are the outcome of psychoanalytic elements, namely, id, the ego, and the super ego. Ìd is the foundation of the unconscious. Ìt strives for sexual pleasure and other biological pleasures and has animal instincts of aggression, power and domination. Ego is conscious in nature and relates our conscious urges to the outside world. Ìt keeps the id in check through the realities of the external environment. While id demands immediate pleasure, whatever the cost, ego controls it so that these pleasures are granted at an appropriate time and in an acceptable manner. Because of difficulty of keeping the id under control, ego is supported by super ego. The super ego is the higher level restraining force and can be described as the conscience of the person. The conscience creates standards of what is wrong and what is right and is generally subconsciously developed by the absorption of cultural and ethical values of the social environment. All these three Freudian elements are interrelated and each cannot exist in isolation from others. Ìn order to create a 'normal' personality, there must be a balance in the relationship among these three forces. For example, an overdeveloped super ego would make the person highly moral and make him feel guilty for every little thing that slightly deviates from the norm. This would not be considered practical or rational. Similarly, an underdeveloped super ego would let id urges loose and would characterize the person as one having weak morals and values. This psychoanalytical approach to personality structure analysis has made some impact on organizational behaviour. For example, stages of creative process are unconscious in nature and can be brought out by psychoanalysis. Similarly, such employee behaviour as daydreaming, forgetfulness, absenteeism, tardiness, sabotage, alcoholism and drug abuse, can be analysed through psychoanalytical studies and analysis. Trait Theor3 Trait theory believes that the traits of a person which determine his personality and behaviour are basically inherent to a person, that is, more of a heredity impact than the environment .Trait theory explains personality as a demonstration of certain traits of the individual. While there are many traits common to most people, there are many other traits that are unique to a person and are not shared by other individuals. On the basis of Trait theory, people can be described as aggressive, loyal, pleasant, flexible, humorous, sentimental, impulsive, cool and so on. Traits are the basic elements of personality and can be used to explain their behaviour. People behaving in a forceful manner in most situations could be described as aggressive. Similarly, if a person allows others to take the initiative, he is 'submissive'. SelfECon%e5t Theor3 This theory believes that personality and behaviour are to a great extent determined by the individual himself. We have an image of our own and our actions would be consistent with that image. Carl Rogers is closely associated with this theory. According to him, the best vantage point for understanding behaviour is from the internal frame of reference of the individual himself. An individual himself is the centre of experience. His self-image is an integral of how he views himself and his perception of how others view him. This self-concept is a result of a person's interaction with his environment. This interaction in the form of learning experience helps us to grow and mature, and we modify our self-concept as a result of these experiences. When we get positive feedback from others in response to our behaviour, our self-concept is positively reinforced. On the other hand, when we get negative feedback, our self-regard is lowered, resulting in tension and anxiety. Thus, an employee with a self-concept of high intelligence, independence, and confidence may not look for such reinforcement techniques as monetary rewards, job security or directive supervision. He may look for a challenging environment where he gets recognition, responsibility and achievement. On the other hand, the monetary rewards and job security may be more effective on employees who have a self-concept of dependence, insecurity and who lack confidence in themselves. So%ial Dearnin, Theor3 This theory believes that personality development is more a result of social variables than biological factors. Much of human behaviour is either learnt or modified by learning. Through learning, one acquires knowledge, attitudes, values skills, etcetera. Further motives can be traced to known and conscious needs of the individuals. Personality is the sum total of all that a person has learned. The social learning theory uses 'reinforcement and punishment' approach in understanding personality. For example, frustration caused by external environment, causes and reinforces aggression as a personality trait. Also, good behaviour is rewarded by the society in terms of praise which further reinforces good behaviour. Thus, behaviour and external environment have mutual interaction. Behaviour partly creates the person's environment and the environment affects the person's behaviour as well. Che%2 )o7r *ro,ress #B$ Ans8er the follo8in, — Tr7e or +alse: 1. Ìd is the foundation of the unconscious. .. True. !. Ìn order to create a normal personality there should be a balance in the relationship among the id, the ego and the super ego. .. True. (. People behaving in a forceful manner in most situations could be described as sentimental. .. False. .. We have an image of our own and our actions are consistent with that image. .. True. ?. Personality is a sum total of all that a person has learnt. .. True. *ersonalit3 an& Brain #Deft an& Ri,ht Brain$ An important biological factor which influences personality is the role of brain of an individual. Two types of contribution can be found in this area: Electrical stimulation of the brain (ESB) and split brain psychology. Human brain is believed to contain certain definite pleasurable and painful areas. Accordingly it may be possible physically to manipulate personality through ESB. Ìt may also be possible to use ESB as a method of reducing stress and tension and stimulate creative thinking. Split brain, right versus left, psychology is closely related to ESB and is probably more popular. The characteristics and dimensions attributed to the left and right hemispheres of the brain are indicated in the following table: Left Hemisphere Controls Right side of body Right Hemisphere Controls Left side of body 1. Speech and Verbal 1. Spatial and musical 2. Logical and Mathematical 2. Holistic 3. Linear and Detailed 3. Artistic and symbolic 4. Sequential 4. Simultaneous 5. Controlled 5. Emotional 6. Ìntellectual 6. Ìntuitive, creative 7. Dominant 7. Minor (quiet) 8. Active 8. Spiritual 9. Analytic 9. Synthetic, gesalt-oriented 10. Reading, writing, naming 10. Facial recognition 11. Sequential ordering 11. Simultaneous 12. Perception of significant order 12. perception of abstract 13. Complex motor sequence patterns 13. Recognition of complex figures Note: Adapted from Freed Luthans, Organizational Behaviour, 6th Ed. The Left and Right hemispheres of the brain are attributed with some specific dimensions and characteristics as shown in this table. These areas are, however, still open for further research. Mat%hin, *ersonalit3 8ith Jo"s John Holland's personality job fit theory is of late receiving increasing attention. The theory is based on the match of personalities with jobs. Holland presents six personality types and proposes that satisfaction and dissatisfaction with the job depends on how individuals successfully match their personality with their occupations. Table describes the six types, their personality characteristics, and gives examples of congruent occupations. TABDE !!.1 Gollan&s T35olo,3 of *ersonalit3 an& Con,r7ent O%%75ations Type Personality Characteristics Congruent Occupation 1. Realistic: Prefers physical activities that require skill, strength and coordination. 1. Shy, genuine, persistent, stable, conforming, practical. 1. Mechanic, drill press operator, assembly-line worker, farmer. 2. Ìnvestigative: Prefers activities that involve thinking, organizing and understanding. 2. Analytical, original, curious, independent. 2. Biologist, economist, mathematician, news reporter. 3. Social: Prefers activities that involve helping and developing others 3. Sociable, friendly, cooperative, understanding 3. Social worker, teacher, counseller, clinical psychologist. 4. Conventional: Prefers rule-regulated, orderly, and unambiguous activities, flexible file clerk 4. Conforming, efficient, practical, unimaginative, bank teller. 4. Accountant, corporate manager. 5. Enterprising: Prefers verbal activities where there are opportunities to 5. Self-confident, ambitious, energetic, domineering. 5. Lawyer, real-estate agent, public relations specialist, small business influence others and attain power. manager. 6. Artistic: Prefers ambiguous and unsystematic activities that allow creative expression. 6. Ìmaginative, disorderly, idealistic, emotional, impractical. 6. Painter, musician, writer, interior-decorator Che%2 )o7r *ro,ress #C$ Ans8er the follo8in, state'ents in Tr7e or +alse: 1. Human brain is believed to contain definite pleasurable and painful areas. .. True. !. Extroverts are quiet, reflective people. .. False. (. Successful people have high tolerance for ambiguity. .. True. .. Ìndividuals with low self-esteem take more risk in their career. .. False. ?. Personality job fit theory was developed by John Holland. .. True. @. Right brain controls intuitive and creative behaviour. .. True. B. Left brain controls analytical behaviour. .. True. C. Right brain controls Speech and Verbal ability. .. False. !!.( DIVERSIT) AND IENDER ISSUES Di=ersit3 an& Di=ersit3 Mana,e'ent Many organizations have acknowledged the importance of the increasing diversity in the workforce. They have begun to question the effectiveness of the human resource (HR) systems that are largely designed for a more homogeneous workforce. There is a need to consider the implications of diversity for the development and synthesis of specific HR policy areas. There is also need to study the degree to which the current theories and practice have incorporated issues of diversity management. While race/ ethnicity and gender are the most recognized forms of diversity, there are other types with important implications for HR systems and management. They include disability, family background, age, lifestyle and culture. Each of these identity group memberships can affect an employee's attitudes and behaviour at workplace as well as influence his or her ability to work well with other organizational members. Organizations have traditionally HR systems based on models of homogeneity. They promote similarity not diversity, provide a number of examples illustrating how traditional HR management models foster workforce homogenization, viz., recruiting practices emphasise people from sources that have historically been reliable or selecting candidates similar to those who have been successful. Similarly, decision-makers have tempted to hire, promote and evaluate people in terms of the degree to which they are like their own image. Such an approach has been coined 'homogeneous reproduction' referring to the tendency of selection and promotion systems to allow only those employees to pass through who fit with the characteristics of the dominant coalition. The aptitude tests used for mass selections and recruitment are also designed in such a way that it selects the candidates with similar abilities and competence. Once that ability or the competence becomes obsolete the entire work group becomes redundant. For example, in 1970s and 1980s the Ìndian banks had recruited a large workforce with numerical ability to meet the growing demand of employees in the banking services due to rapid branch expansion. With large scale computerization in banking sector in 1990s and current decade of this century the numerical ability became an obsolete skill as the reconciliation and all back office jobs have been taken over by the computers. With growing competition between the banks, the selling and marketing skills have become more in demand and banks are facing a problem of re-skilling the staff into the marketing skills. There is a drastic shift of orientation of people of back office work and front office jobs requiring inter-personal skills. Thus, having people with heterogeneous and complementary skills are always beneficial for the organizations. Too much similarity in the work force in an organization can be detrimental to long-term growth, renewal, and ability to respond to important environmental changes such as dynamic market conditions, new technologies and ideas, societal shifts, or the expectations. HR policies supporting diversity can help the culture to continually adapt in response to new environmental demands. Such systems are critical for attracting, selecting, motivating, developing and retaining highly skilled diverse workforce. Modern employers now encourage diversity at workplace. When workgroup diversity is managed effectively, groups develop processes that can enhance creativity, problem solving, workgroup cohesiveness and communication. At organizational level, performance, and the quality of product and service may improve. Diverse group of employees who possess the key success factors are needed to compete in today's changing marketplace. Despite these reported benefits, their realization has remained elusive for most of organizations. This is because traditional HR strategies manage diversity, which has largely been introduced in piece meal, without taking a holistic view, lacking integration with other systems. For example, in most of the countries, legislations have been enacted for equal pay for similar work irrespective of gender, race, etc. without changing the culture and human beliefs. The three predominant traditional HR approaches for managing diversity are: di$ersity enlar&ement( di$ersity sensiti$ity and #ultural audits. Diversity enlargement approach increases the representation of individuals of different ethnic and cultural backgrounds in an organization. The goal of this strategy is to create diversity by changing an organization's demographic composition. Employers seem to assume that increasing diversity and exposure to minority employees will result in improved individual and organizational performance. The employers have wider choice from diversified groups. Diversity sensitivity approach acknowledges the existence of cultural distance and attempts to teach individual members about cultural differences via training. Often training sessions are held to help sensitize employees to stereotyped differences of various employee racial, ethnic and gender groups. The purpose is to promote communication and understanding, and to build relationships among members of different backgrounds. A third strategy, the cultural audit, generally tries to determine what is blocking the progress of nontraditional employees. Data is collected through surveys to assess various demographic groups' identification of major obstacles they face in the current culture. This helps in bringing out their feelings about the predominant culture and the dominant ethnic groups. Conducting cultural assessment as an isolated strategy is likely to fail unless it is linked to HR systems. Managing diversity is a mutual process and the new culture and HR strategies must be designed to be inclusive to allow all members to contribute to their potential. Cultural audit not only needs to focus on the differences between groups but also identify the similarities between groups that the culture and supportive HR systems can reinforce to achieve organizational objectives. There are several issues and problems associated with achieving objectives in terms of hiring and managing diverse employees. One problem that emerges is the issue of 'critical mass'. Organizations planning for diversity often find themselves 'spinning their wheels' because of inability to bring enough diverse workers into the organization. The problem here is that it may need a critical mass of diverse workers in order for such employees to feel welcome and accepted. Entrance of few diverse workers into the organization may fall flat because of sense of isolation and/or overexposure in the role as 'token' (Kanter.1977). Another problem with achieving diversity objective is that it takes considerable time before the organization with best of intentions begins to show a complete demographic profile which reflects their objectives and efforts. Finally, the nature of underlying business conditions may limit achieving business objectives. When the organization is growing/expending and hiring with greater frequency, it allows faster achievement of diversity goals. However, when the expansion is slow or nonexistent or during downsizing, it becomes difficult to achieve the diversity objective. Ien&er Iss7es The major factors for diversity are gender and race differentiation. Many jobs have preference for a particular gender both from employer's and worker's points of views. This differentiation is basically on account of physical, social, psychological and emotional considerations. For jobs requiring greater physical strength, men are preferred, whereas for the jobs requiring hospitality and emotional aspects, women are preferred. Gradually the difference is getting blunted. Now, women are willing to accept all sorts of jobs and have proved themselves successful in the jobs which were predominantly being occupied by men. The jobs like aero plane pilot, police, etcetera are successfully being handled by women. The women, however, also have the responsibility of managing their household affairs in addition to their jobs. *owel (1987) conducted a major review of the empirical literature on gender as it relates to recruitment and selection decisions in the organizations. He found that gender did not significantly affect the selection decisions. The greater the amount and relevance of information (namely past performance) about the job and applicant received by the evaluator, the lesser gender biased the decisions. Research also suggests that attributes of success and failures may explain the relationship between gender and personnel decisions. There has been whole host of initiatives by the governments worldwide to remove the discriminations in employment and employment conditions based on gender. The initiatives have been generally in the nature of legislations. The employment opportunities for women have considerably improved in recent years in almost all sectors and areas of specializations. The employment rate of women has gone up considerably in recent times. Lots of opportunities for part-time employments for women have emerged. Women are disproportionately represented in secretarial occupations whereas the men are highly represented in machine operative works and craft related occupations. Ìn spite of government policies, there has been large number of instances of pay disparities to the disadvantage of women employees for similar jobs. Ìn a survey conducted in UK (Labour Market Trend ÷ 2001) women got 82 per cent of the average hourly earnings as compared to male counterparts in full time employment. The pay gap varies between sector to sector and job to job. In Ìndia, the representation of women in employment is still quite poor. The recent years have seen some significant improvement in the proportion of women representation. Women workers are visible almost in all sectors and all occupations. A large number of women workers are seen in manual work like construction activities. Banking, teaching and health care have traditionally been seen as the preferred occupations for women. As women are generally required to shoulder dual responsibility, they prefer a job with regulated working hours so that they can devote sufficient time to their family and household affairs. There are avenues for women in almost every job. Government policies and legislations also do not permit any gender discrimination in pay or any other service conditions. The Equal Remuneration Act, 1976 has provided for the payment of equal remuneration to men and women employees and for prevention of discrimination on the grounds of gender against women. The act also seeks to provide for more opportunities to women in specialized employments. However, keeping in view the vulnerability of women at workplace, jobs requiring odd hours of work require permission under the Factories Act, 1948: to allow women workers to work during odd hours and shift duties under special circumstances and proper protection. The preference for a male child is predominant in Ìndian society. Recent Census conducted by the Government of Ìndia indicated that there has been a significant sex imbalance in many of the states. There is also significant gap in the literacy level between male and female. To improve the literacy level of women and girl child for the purpose of making them self-reliant, government is encouraging literacy by providing various incentives, concessions and encouragements. To improve the status of women in society, the government has recently amended the Hindu Succession Act 1956 to give equal rights to female successors at par with their male counterparts in ancestral property. There has been significant representation of women in village panchayats, state legislations and the parliament but the number is disproportionately low compared to their ratio in the population. The proposed legislation giving 33 per cent representation to women in parliament is pending for a long period. Ìt could not be passed due to vested interests and lack of will on the part of male counterparts occupying power centres. The security of women at workplace has always been a major concern. A number of cases are being reported of exploitation, sexual harassment and discrimination at workplace. The Supreme Court of Ìndia has taken a serious view of the matter and issued a comprehensive directive to avoid such incidences. Ìt has defined what constitutes sexual harassment and the manner it should be dealt in the organizations. Ìn spite of Supreme Court's directive, a number of cases of sexual harassment still continue and there is under-reporting of such cases because of job insecurity and social stigma. !!.. TGEORIES O+ MOTIVATION AND TGEIR *RACTICAD IM*DICATIONS ;hat is Moti=ation> To begin with, we will define the term motivation. The word motivation is derived from Latin word 'movere' (to move). Accordingly, it attempts to account for the 'drives' and 'wants' of an individual rather than just focusing on the individual's actions. The term motivation is commonly used and understood by everyone but there is no uniform definition of the term. One can find as many definitions as number of books on the subject. Ìn its simplest form motivation in an organizational context is referred as 'the extent of willingness of an employee to respond to the organizational requirements'. Motivation is generally directed, consciously or unconsciously, towards satisfaction of needs (motives). Motivation has direct impact on the job performance of individuals. Motivation is a process beginning from inner state of a person and ending with need fulfillment. For example, when an employee works hard, his level of motivation may be considered as high and if he avoids work, his motivation level may be considered as low. The level of motivation of an employee can be judged by his actual work behaviour. The managers are, therefore, interested in knowing the factors which motivate employees to work hard and also the factors which contribute to 'de-motivation'. Every human being has a given level of satisfaction at a given point of time. Motivation as a behavioural concept is of great interest to the executives and managers in organizations today. One of the biggest problems a manager faces is how to motivate the people working under him. What is motivation and how can employees be motivated to work'? What is the relationship between motivation and performance? Whether a highly motivated employee is necessarily a good performer or an employee whose performance is not good can be considered as de-motivated? These are some of the issues which are drawing the attention of the organizations. Theories of Moti=ation The various theories of motivation are: 1. Scientific Management or Rational Economic View !. Human Relations Model (. Abraham Maslow's Need Hierarchy Theory .. Frederick Herzberg's Two-Factor Theory ?. Clayton Alderfer's ERG Theory 6. Achievement Motivation Theory 7. Victor H Vroom's Expectancy Model 8. James Stacy Adams' Equity Theory 9. Lyman W. Porter and Edward E Lawler - Performance Satisfaction Model. 10. Reinforcement Theory S%ientifi% Mana,e'ent or Rational E%ono'i% Vie8 + W Taylor, who is known as the Father of Scientific Management, has contributed much to the theory of motivation. Scientific Management is a set of methods and techniques applied to organization of work at the operational level for the purpose of increasing efficiency. He believed that the best way to increase output was to improve the techniques and methods used by workers. Workers had to adjust to the management and not the management to the people. Taylor's logical and rational approach to management explained that people are primarily motivated by economic considerations and will exert more if offered opportunity to improve their economic gains. Put simply, Taylor's theory stated that: 1. Physical work could be scientifically studied to determine the optimal method of performing a job. 2. Workers could thereafter be made more efficient by giving prescriptions for how they were to do their jobs. 3. Workers would be willing to adhere to these prescriptions if paid on a differential piece work basis. Scientific approach to motivation based on rational economic view has however been criticized severally. Ìn particular, behavioural scientists have argued that Taylor and his colleagues de-humanized workers by treating them as mere factors of production, who could be manipulated completely through economic incentives. The most fundamental problem with Taylor's approach from a motivational viewpoint is concerned with his rather simplistic assumption about human behaviour. Taylor believed that workers would be motivated more by the need for money (this assumption is called 'rabble hypothesis'). He thought that the primary interest of the worker is economic gain in the form of higher wages. Contrary to this rabble hypothesis, workers seek satisfaction of a variety of needs in the workplace like need for security, social fulfillment, and a challenging job, including pay. G7'an Relations Mo&el Elton Mayo in 1920s and early 1930s conducted Hawthorne Studies at Western Electric Company. He found that in addition to finding the best technological methods to improve output, management needs to look into human affairs. The real power centres within an organization were the interpersonal relations that developed within the working unit. The organizations were to be developed around the workers and had to take into consideration human feelings and attitudes. The leader was to facilitate co-operation for attainment of goals by followers. Leader was to provide opportunity for the personal growth and development of workers. The main focus was on individual needs rather than the organizational needs Eventually it became clear that the assumption that workers are primarily motivated by money, may not be correct. Elton Mayo and his team found that the social contacts which the workers have at workplaces are also important. Mayo and others also believed that the managers could motivate employees by acknowledging their social needs and by making them feel useful and important. As a result, employees were given some freedom to make their own decisions on their jobs. Greater attention was paid to the organization's informal work groups. More information was provided to employees about the manager's intentions and about the operations of the organization. In the Scientific Management Model the workers were expected to accept management's authority in return for higher wages. Ìn the Human Relations Model, workers were expected to accept management's authority because supervisors treated them with consideration and were attentive to their needs. The problem with the Human Relations Model is its undue reliance on social contacts at work situation for motivating employees. Social contacts, though desirable, by themselves do not always help motivate workers. Che%2 )o7r *ro,ress #D$ Ans8er the follo8in, state'ents in )es or No: 1. The term Motivation has been derived from the Latin word 'movere' (to move). .. Yes. !. Taylor's Scientific Management theory belongs to Content Theories of Motivation. .. No. (. Human Relations Model is one of the early theories of Motivation. .. Yes .. Elton Mayo contributed to a great extent to Human Relation Model. .. Yes Maslo8s Gierar%h3 of Nee&s Abraham Maslow, a clinical Psychologist from USA submitted (1954, 1968) that people have the following five basic levels of needs. He identified five needs in an order of hierarchy, namely, #hysiological &eeds< Safety and Security &eeds< Social &eeds< Self-esteem &eeds< Self-actuali=ation &eeds) The prominence of these needs generally follow a hierarchy i.e. when a need is satisfied then only the next need becomes prominent in that hierarchal order. But there have been found exceptions to this order for certain persons. They are prepared to sacrifice a lower order need for achieving a higher need. *h3siolo,i%al Nee&s This group of need includes the needs for food, drink, shelter, oxygen, sleep, sex, weather, etc. These physiological needs are required to maintain the physical entity of the individual. These are the basic needs in the sense that they satisfy the very livelihood of the individual for survival. *hysiological needs dominate human desires and only when these needs are reasonably satisfied, one's attention turns to other needs. Ìn the organizational context, physiological needs are represented by the employee's concern for salaries and good physical working conditions. The organization should therefore endeavour to satisfy the physiological needs of the employee. Only then they will be motivated to perform better. Safet3 an& Se%7rit3 Nee&s Safety needs become motivators after physiological needs are met. Maslow suggested that the safety needs are most readily observed in infants and young children because of their relative helplessness and dependence on adults. Safety and security needs in the organizational context relate to such factors as job security, salary increases, safe working conditions, unionization, and lobbying for protective legislation. Managerial practices to satisfy the safety needs of the employee include pension scheme, group insurance, provident fund, gratuity, safe working conditions, grievance procedure, etcetera. Arbitrary or unpredictable actions, which create a feeling of uncertainty (particularly regarding continued employment), favouritism, or discrimination on the part of the management do not create a feeling of security in the employee's mind. So%ial Nee&s This need is expressed through the desire to belonging and affection in a social context. Ìn the organizational context, social needs represent the need for a compatible work group, peer acceptance, professional friendship, and friendly supervision. These are the needs one acquires, learns or adopts through experience and these needs are mostly culturally determined. They are largely a manifestation of the desire to belong and be accepted by others. Managers would do well to encourage informal groups amongst the employees so that this need is adequately met. Care should be taken that the informal groups should not work contrary to the requirements of the organization. May be, if workers have the freedom to form their own work teams and decide upon the distribution of work within the teams and to that effect organize the team, one may be able to see a productive outcome. SelfEestee' Nee&s The esteem needs for self-respect and recognition and for respect of others are often referred to as ego or status needs. The satisfaction of this need generates a feeling of self-confidence and of being useful and necessary in the world. Ìn contrast, the thwarting of this need leads to a feeling of inferiority, ineptness, weakness, and helplessness. Maslow emphasized that the healthiest self-esteem is based on earned respect from others rather than on fame, status or adulation. In the context of workplace, self-esteem needs correspond to job title, merit, pay increase, peer and supervisory recognition, challenging work, responsibility, etcetera. Managerial practices to fulfill these needs include challenging work assignments, performance feedback, performance recognition, personal encouragement and involving employees in goal setting and decision-making. SelfEa%t7ali-ation Nee&s In an organization, self-actualization needs correlate to the desire for excelling in one's job, advancing an important idea, successfully managing the unit and the like. This level of needs encompasses the ability to accomplish and achieve something in life, i.e. to maximize one's potential and the desire to become what one is capable of becoming- By being aware of the self-actualization needs of subordinates, managers can use a variety of approaches to enable the former to achieve their personal as well as the organizational goals. The workers who operate at self-actualization need do prefer autonomy and do not require supervision. ;hile Maslow's needs classification theory makes good sense, problems arise with his contention that they are arranged in a hierarchical fashion and that the lower level needs must be first satisfied before the higher level needs in the pyramid will be activated. Take for instance the case of teachers, poets, artists and musicians all over the world who have tried to self-actualize themselves by their immortal work without ever having satisfied their lower level needs. Thus, it is possible for some at least, not to go through every step in the hierarchy. Another problem with Maslow's theory is the operationalisation of some of his concepts which make it difficult for researchers to test his theory. For instance, how does one measure self-actualization? Despite the problems the theory has useful practical implications for managers. Ìt is a fact that the vast majority of employees joining organization at lower levels, are by and large, seeking to satisfy their physiological needs first and then move up the levels step by step. Ìt thus offers a good conceptual scheme for managers to understand and deal with issues of employee motivation at the workplace. Ger-"er,s T8oE+a%tor or Moti=ationEG3,iene Theor3 +rederick Herzberg (1959) extended the work of Maslow and developed a specific content theory of work motivation. He conducted a widely reported study on about 200 accountants and engineers from eleven industries in Pittsburg, USA. He used the critical incident method of obtaining data for analysis. He asked them two questions: 1. When did you feel particularly good about your job ÷ what turned you on? !. When did you feel exceptionally bad about your job ÷ what turned you off? He then asked them to describe the conditions that led to these feelings. Gerzberg found that employees named different types of conditions for good and bad feelings. His study revealed that the factors responsible for job satisfaction are quite different from the factors that led to dissatisfaction. Reported good feelings were generally associated with job experiences and job content. Reported bad feelings, on the other hand, were generally associated with the surroundings, peripheral aspects of the job ÷ the job context. These two feelings were not adverse to each other. Ìf a person was satisfied with a job in a particular condition, the absence of such condition would not mean job dissatisfaction, but it might be called no job satisfaction. Similarly, opposite of job dissatisfaction is not job satisfaction but it might be no job dissatisfaction. Thus Herzberg suggested that the opposite of satisfaction is not dissatisfaction, as was traditionally believed. Removing dissatisfying characteristics from a job does not necessarily make the job satisfying. Gerzberg's theory is based on a two-factor hypothesis, that is, factors leading to job satisfaction and the factors leading to job dissatisfaction. The factors so identified were classified by him into two categories: 1. Motivational Factors; and 2. Hygiene or Maintenance Factors. Moti=ational +a%tors These factors are related directly to the job itself. The presence of such factors creates a highly motivating situation, but their absence does not cause dissatisfaction. People tend to respond positively to the presence of such factors. Herzberg mentioned six such factors: 1. Recognition !. Advancement (. Responsibility .. Achievement ?. Possibility of Growth @. Work itself Factors like achievement and responsibility are related to job itself and others emanate from it. This set of factors has been designated as motivators or satisfiers and are related to job contents. G3,iene or Maintenan%e +a%tors This set of factors is such that their presence does not significantly motivate the employees but their absence cause serious dissatisfaction. The non-availability of such factors is likely to affect motivation and bring down the level of performance. Maintenance factors mostly are related to environment, outside the job. Herzberg named ten such factors: 1. Company policy and administration !. Technical supervision (. Ìnterpersonal relations with subordinates .. Salary ?. Job security @. Personal life B. Working conditions C. Status F. Ìnterpersonal relations with supervisors 10. Ìnterpersonal relations with peers and colleagues Hygiene or maintenance factors are the context factors. They provide a background on which people work. They create an atmosphere for doing work, but there is nothing in them that motivates them. According to Herzberg, they can dissatisfy by their absence but cannot satisfy by their presence. Che%2 )o7r *ro,ress #E$ *lease 'ention 8hether the follo8in, state'ents are tr7e or false: 1. There are five types of needs according to Maslow's theory. .. True. !. Self-esteem needs is the highest need in Maslow's Need Hierarchy. .. False. (. Herzberg theory is prescriptive in nature. .. True. .. Herzberg's theory is based on two factors namely motivators and hygiene. .. True. ERI Theor3 This theory is based on existence, relatedness and growth. These are the three sets of needs in organization. ERG theory was advanced by Clayton Alderfer. Alderfer argued on the same lines of Maslow that people have needs in a hierarchy and that these needs are important determinants of human behaviour relating to work performance. These needs are related to survival and growth. However, the ERG theory differs from the Maslow's theory in following respects: +irst0 instead of five levels of needs, the ERG theory indicates only three. Se%on&0 Maslow's theory postulates a rigid step like progression. The ERG theory, instead, postulates that more than one need may be operative at the same time. Thir&0 Maslow argues that a person will stay at a certain level until that need is satisfied. The ERG counters by noting that when a higher level need is frustrated, the individual's desire to increase a lower level need takes place. A%hie=e'ent Moti=ation Theor3 This theory was developed by David C. McCelland and his associates. According to this theory, there are three needs, namely, need for achievement, need for power and need for affiliation. Nee& for A%hie=e'ent Employees with high achievement motivation derive satisfaction from achieving goals. Succeeding at a task is important to them. Although people with a high need for achievement are often wealthy, their wealth comes from their ability to achieve goals. However, high achievers are not motivated by money per se; money is their indicator of achievement. They prefer to work independently and dislike easy tasks which do not throw any challenge or a competitive situation. Nee& for *o8er The employees exhibiting the need for power derive satisfaction front the ability to control others and having control over resources. Actual achievement of goals is less important to them than the means by which goals are achieved. Ìndividuals with a high need for power derive satisfaction from being in positions of influence and control. Organizations that foster the power motive tend to attract individuals with a high need for power (for example, military, civil services and political organizations). Nee& for Affiliation Ìndividuals exhibiting this need as a dominant motive derive satisfaction from being social with interpersonal activities. They have a strong need for interpersonal ties and to 'get close' to people psychologically. Ìf asked to choose between working at a task with those who are technically competent and those who are their friends, individuals with high need for affiliation will choose their friends. Vroo'Ls E65e%tan%3 Mo&el This theory has several names such as instrumentality theory, path-goal theory and valence-instrumentality e+pectancy theory. The theory was developed by Victor H Vroom. The expectancy model is based on the belief that motivation is determined by the nature of the reward people expect to get as a result of their job performance. The underlying assumption is that a man is a rational being and will try to maximize his perceived value of such rewards. He will choose an alternative that would give him the maximum benefit. People are highly motivated if they believe that a certain type of behaviour will lead to a certain type of outcome and their extent of personal preference for that type of outcome. There are three important elements in the model. These are: E65e%tan%3 This is a person's perception of the likelihood that a particular outcome will result from a particular behaviour or action. This likelihood is probabilistic in nature and describes the relationship between an act and its outcome. For example, if a student works hard during the semester, he will expect to do well in the final examination though he cannot be hundred per cent certain. There is some probability attached to this outcome. Instr7'entation This factor relates to a person's belief and expectation that his performance will lead to a particular desired reward. Ìt is the degree of association of first level outcome of a particular effort to the second level outcome ÷ which is the ultimate reward. For example, working hard may lead to better performance ÷ which is the first-level outcome, and it may result in a reward such as salary increase or promotion or both ÷ which is the second-level outcome. Ìf a person believes that his high performance will not be recognized or lead to expected and desired rewards, he will not be motivated to work hard. The instrumentality is the performance-reward relationship. Valen%e Valence is the value a person assigns to his desired reward- He may not be willing to work hard to improve performance if the reward for such improved performance is not what he desires. Ìt is not the actual value of the reward but the perceptual value of the reward in the mind of the person that is important. An employee may be motivated to work hard not to get pay raise but to get recognition and status. Another employee may be more interested in job security than status. A&a's EJ7it3 Theor3 Although several authors have contributed to this theory, it was James Stacy Adams whose formulation became prominent. The following terms are relevant to this theory: 1. *erson: The individual for whom equity or inequity exists. !. Co'5arison: Any group or individual used by a person as a reference regarding inputs and outcomes. (. In57ts: Characteristics which individuals bring with them to the job, namely, education, knowledge, skills, attitudes, experience, etc. .. O7t%o'es: Salary, promotion, perquisites received from a job. The theory proposes that the motivation to act develops after the person compares inputs and outcomes with the identical ratio in comparison to the other person. Ìnequity is defined as the perception that person's job inputs and outcomes ratio is not equal to the inputs and outcomes ratio in comparison to the other. The basic equity proposal assumes that, upon feeling inequity, the person is motivated to reduce it. Further, the greater the felt inequity, the greater would be the motivation to reduce it. When attempting to reduce inequity, the person may try a number of alternatives. He may alter his inputs or, alter his outcomes or, distort his inputs and outcomes cognitively or, leave the field or try to alter or cognitively distort input and outcomes in comparison to the other, or force him to leave the field. *orters *erfor'an%e Satisfa%tion Mo&el This model starts with the premises that: #a$ motivation (effort or force) does not equal satisfaction and, or, performance. Motivation, satisfaction and performance are all separate variables and related in different ways; #"$ effort (force or motivation) does not directly lead to performance. Ìt is mediated by abilities/ traits and role perceptions; and #%$ the rewards that follow and how these are perceived will determine satisfaction. The model suggests that performance leads to satisfaction. Reinfor%e'ent Theor3 This theory assumes that the consequences of an individual's behaviour in one situation influence that individual's behaviour in a similar situation. Techniques based on this principle have been developed to change human behaviour. Such a technique, generally known as 'operant conditioning', has been advocated by B F Skinner. Ìts implication is that individual behaviour can be predicted, from a person's past experiences. The operant conditioning approach to behaviour is based on the law of effect, which states that behaviour which has a rewarding consequence is likely to be repeated. There is positive reinforcement. On the other hand behaviour that leads to negative or punishing consequence, tends not to be repeated. There is negative reinforcement. When operant conditioning is used to control behaviour of employees in an organization, it is called organizational behaviour modification or OB Mod in its acronym. Many of the negative traits and behaviour pattern are developed because the earlier similar behaviour was rewarding or encouraged. For example, a thief has not been caught several times earlier; he will have courage to repeat his act and behaviour again and again. Similarly a ticket-less traveler in a Mumbai local train repeats his act because he has not been caught. Che%2 )o7r *ro,ress #+$ State 8hether the follo8in, state'ents are Tr7e or +al8: 1. ERG theory was developed by Alderfer. !. There are four needs as per Achievement Motivation theory. (. Ìnstrumentality theory is another name for Expectancy Model. .. There are five items in Equity theory. ?. Reinforcement theory has positive and negative reinforcements. @. Ìndividual's behaviour in one situation does not influence that individual's behaviour in a similar situation. Moti=ation an& Beha=io7r Behaviour of an individual is generally motivated by a desire to achieve some goal. Sometimes goal may not always be known to the individual but still he may behave in a particular way. 'Why did Ì do that?' or 'Why did Ì not do that?' Answers to these questions will indicate the reason for a particular behaviour. Behaviour is either an 'activity' or, 'a series of activities'. Each activity is supported by motivation. To predict behaviour, managers must know which motives or needs of people evoke a certain action at a particular time. Moti=es Every individual carries a set of inner motivations and drives that influence the way he behaves much more radically than he realizes. Ìndividuals differ not only in their ability to do but also in their will to do, or motivation. Motives are sometimes defined as needs, wants, drives, or impulses within the individual. These are directed towards goals, which may be conscious or subconscious. Motives are the 'whys' of behaviour. They arouse and maintain activity and determine a general direction of the behaviour of an individual. Ìn essence, motives or needs are the mainsprings of action. When we use these two terms interchangeably ÷ motives and needs ÷ we refer to something within an individual that prompts that person to action. Ioals Goals are outside an individual. Goals are sometimes referred to as 'hoped for' rewards towards which motives are directed. Psychologists use the term 'incentives' for these goals. Ìncentives include tangible financial rewards such as increased pay and also the non-financial intangible rewards such as praise or power; and both tangible as well as intangible rewards are crucial in evoking behaviour. Moti=ation to ;or2 A mere knowledge of theories of motivation is not sufficient for the manager. He should also know specific ways and techniques to motivate employees in the work situation. Most of these techniques are practical in nature and can be adopted by him in the normal course. While there are several ways of motivating employees in the work situation, some of the common incentives like money, appreciation, job enlargement, job enrichment, job rotation, participative management, and quality of work are frequently used in organizations. Mone3 Most of the motivational theories have indicated that money is an important motivator for several reasons. Money is capable of purchasing several things which in turn meets several needs of a person. For example, Maslow's physiological needs like food, clothing and shelter can be met through money. So in organizations the wage/salary structure becomes an important and powerful motivator for the employees. The levels of salary should not only satisfy all the basic needs of the employee but should also meet his higher needs like entertainment, pleasure, etcetera. A55re%iation Money has limited impact as a motivator. Ìt has a diminishing return with regard to its utility. Employees look for something beyond salary and monetary benefits. The most effective non-monetary benefit is the recognition and appreciation for a good job. Ìt satisfies the self-esteem need and the employee feels important and tries to perform still better to be recognized as a distinct member of the work group. Ìt also has an impact on other group members. They also try to improve their performance to get recognition. The managers must use this incentive wherever possible to acknowledge the contribution of the employees. However, it should be done in an objective and impartial manner so that it does not have any adverse impact on the other members of the work group. Jo" Enlar,e'ent Job enlargement refers to assigning more and more jobs of same level to diversify the skills of a person. For example, in ÌBM a machine operator was waiting fora machine setter to come and set the machine. He started setting the machine himself. Later he became an expert in setting the machine. Job enlargement helps both the organization and the individual. The individual gets the satisfaction of working on a variety of jobs and learns more and more skills whereas the organization gets a person who can handle different jobs. Jo" Enri%h'ent A job is enriched when it is exciting, challenging and creative and involves higher responsibility. Ìt should give the employee more decision-making, planning and controlling powers. A few studies conducted in the United States demonstrated the usefulness of job enrichment. For example, employees at AT&T showed improvement in job performance after job enrichment. Another study with technicians, engineers, and sales representatives showed similar results. Job enrichment is generally effected either by promotion to a higher post or by delegation of authority. Jo" Rotation Job rotation means, shifting an employee from one job to another at a same level with different functionality. For example, somebody may be working in the dispatch seat. He maybe asked to do typing. Job rotations are quite common in banks. When employees are rotated in different jobs, the manager will know what type of job suits which employee. Further, it removes boredom of the employee as he is not required to do the same job for a long period. Ìn spite of the advantage of job rotation a large number of employees prefer to continue on the present job because of inertia and fear of unknown. The time duration required for job rotation depends upon the nature of job being carried out and the nature of the learning curve of a job in relation to one's capabilities. For example, a highly qualified employee is placed on a routine job; he will reach to highest level of efficiency in a shorter time and will start getting disinterested and over confident resulting in a lowering of his performance. Before reaching such a stage the person should be rotated to some other job. On the other hand there are certain jobs which will provide more and more challenges and will provide learning opportunities all the time. *arti%i5ation Employee participation in management is one of the tools available to increase the motivation levels of employees. Participative management refers to associating representatives of employees at every stage of decision-making. Starting at the shop, participation may extend right to the board level. Participation encourages employees' contributions to managerial decisions, goals and plans along with suggestions on how these can be implemented. Employees feel their importance in the organization, and their power need is satisfied to some extent. Such participation by the key employees reduces the resistance to change. Many times it is used as a strategy by the management before initiating any major change. Thus, participation fosters greater acceptance of change. The motivational basis of participation is that employees like to be asked their views about the problems affecting them and feel happy when they know that their ideas have some influence in the ultimate management action taken. The underlying assumptions are: people derive satisfaction from being a part of the decision-making process, from doing an effective job, and from having self-control rather than management control. Most people readily agree more to what, in part, they have created than what is alien to them. Besides, participation fosters the feeling of belonging and being wanted. Ìt inflates or at least recognizes a person's ego and provides a needed sense of importance. Ìn addition, it encourages better decision-making, gets people to accept responsibility, promotes teamwork, and emphasizes the use of creativity. Some feel that in the exercise of workers participation, the worker should be given some well-defined authority so that he can make his own decision independently. When one has to make a decision, he acts with responsibility. 97alit3 of ;or2 Dife The term 'quality of work life' means, different things to different persons. Ìt is a combination of physical and emotional comforts. For example, to a clerk in dispatch seat, it may just mean a fair day's pay. To a mine worker, it means safe working conditions. Shop floor workers want their supervisors to treat them with dignity. A probationary officer, who has just joined the bank, may look forward to opportunities for promotion, creative tasks and a successful career. The following factors contribute to the quality of work life: 1. Adequate and fair compensation. !. A safe and healthy environment. (. Jobs aimed at developing and using employee's skills and abilities. .. Growth and security; jobs aimed at expanding employees' capabilities rather than leading to their obsolescence. ?. An environment in which employees develop self-esteem and a sense of identity. @. Protection and respect for employee's rights to privacy, dissent, equity. etc. B. A sensible integration of job career and family life and leisure time. !!.? RODE CONCE*T AND ANAD)SIS Intro&7%tion Role means a set of expected behaviour patterns attributed to someone occupying a given position in a social unit. The idea of 'role' comes from Sociology. Ìt is the pattern of actions expected of a person in activities involving others. Ìt includes both rights and obligation. Ìt refers to the part that an individual is required to play as a result of occupying some position or status in life. Human beings, as a result of occupying various positions play such roles as father, mother, worker, manager, nurse, friend and soldier. All these are separate and well defined roles. But every human being plays many roles. Thus an individual may be a worker, a father, a son, a trade union leader, and so on. All these constitute what is called the role space of that person. At the centre of the role space is the self. Con%e5ts an& Anal3sis Role and position are two sides of the same coin. But they are different concepts. Role is a position one occupies in a social system. Ìt is defined by the functions one performs in response to the expectations of the significant members of the social system. Position is a relational and power-related concept, but role is an obligational concept. The concept of role is important for the integration of the individual with the organization. The organization has its own structure, systems and procedures and goals. Similarly the individual or a person connected with the organization, has his own personality and needs. All these aspects interact with each other and get integrated into a role. The concept of role is central to an organization. Similarly, the concept of self is central to the several roles of a person. A person performs various roles that are centred around the self and are at varying distances from the self (and from each other). These relationships define the role space, which is then a dynamic interrelationship between the self and the various roles an individual occupies. Similarly, role set is a pattern of interrelationships between one role (called a focal role) among many others. For example, all the different persons with whom a supervisor interacts have role expectations concerning the way in which the supervisor should act, and these expectations collectively make up the role set for the job. Ìn a role set map, the focal role is in the centre. The concept of role widens the meaning of work and the relationship of the employee with other significant persons in the system. The concept of job is more prescriptive in nature, while role includes more discretionary part of work. A job assumes relationship of the employee with his supervisor whereas the role emphasizes his relationship with all those who have expectations from him (as he has from them). Recently, much emphasis has been given to the development of roles and making them more effective in organizational context. Certain important aspects of role are discussed now: Role Sta,nation Most of the organizations have definite promotion policies. They promote persons based on the appraisal of their performance. When a person gets a promotion, he enters into a new role. The new role demands that an individual outgrow the previous one and take charge of the new role effectively. But the person may fail in his new role. This is bound to produce role stress and he may experience role stagnation even though he has occupied a new role in the organization. For example, a senior clerk, who has put fifteen years of service in a bank, may be promoted as a junior officer. Apart from the changes in the position, he is now occupying a new role. The role expectations from the position of a junior officer in the bank are different from that of a clerk. This person may not be able to take charge of this new role effectively, he may therefore, experience role stagnation which in turn causes role stress. InterERole Distan%e When an individual occupies more than one role, there are bound to be conflicts between them. For example, a bank manager quite often faces a conflict between his organizational role as a manager and his role as a husband and a father. His wife and children may place demands on his time. He may not be able to cope with their expectations, if he has to perform his organizational role effectively. He may therefore experience inter-role conflicts which in turn cause role stress. Role Set Confli%ts The role set consists of important persons who have different expectations from the role that an individual occupies. The conflicts arise due to incompatibility among the expectations of significant others and the individual himself. These role set conflicts take the following forms: 1. Role a'"i,7it3 Sometimes an individual may not be clear about the various expectations that people have from his role and this causes role ambiguity. Ìt may be due to lack of information available to a role occupant or may be due to lack of understanding of the cues available to him. Role ambiguity may be in relation to activities, responsibilities, priorities or general expectations. Generally role ambiguity is experienced by persons occupying roles that are newly created or roles that are undergoing change. For example, a bank has set up a branch computerization department. A new post of Deputy General Manager (DGM) has been created to head this department. Somebody who is already a DGM has been posted to this department. Many computer professionals who have been recruited to work in this department are reporting to him. A doubt may arise regarding the eligibility of the DGM to head the department. Perhaps this DGM has been selected on the basis of relatively better computer knowledge possessed by him than his contemporaries. !. Role E65e%tation Confli%t When there are conflicting expectations or demand from a role, the role occupant experiences conflict and stress. The conflicting expectations may come from the boss, subordinates, peers, customers, etc., and his role occupant is not sure how he should act in such situations. (. Role O=erloa& Sometimes a role occupant feels that there are too many expectations from the significant others in his role set. For example, a bank branch accountant may face different types of problems. When the branch is set to commence business, he may have to allocate duties to take care of vacant seats to his employees. At the same time, some customers may rush to him for certain clarifications. Simultaneously, the branch manager may call him for certain important discussions. Ìn such situations, this branch accountant may experience role overload. Role overload may also occur when the role occupant lacks power or where there are large variations in the expected output or when there is no proper delegation. .. Role Erosion Sometimes a role occupant feels that certain functions which he would like to perform are being done by some other person having a different role. Role erosion is the individual's subjective feeling that some important expectations that he has from a role are shared by other roles within the role set. Some organizations create new positions as a part of their reorganization exercise. Such new positions, which also create new roles, may take away certain functions of the existing roles. Ìn such situations, the existing role occupants may experience role erosion. Sometimes, the organizations may also redefine the existing roles and this may result in the present role occupants experiencing role erosion. For example, in one small sized bank, the sole general manager was looking after both planning and operations. As the business of the bank increased, it created another post of a general manager and the planning was assigned to the new general manager. The existing general manager felt that his role has been eroded as he was now not connected with planning. ?. Reso7r%e Ina&eJ7a%3 A role occupant may experience resource inadequacy when the resources required by him to perform his role effectively are not available. Resources may include information, people, material, finance, facilities. etc. For example, in these days of rapid communication facilities, a bank official may experience resource inadequacy if the branch is not provided with certain latest communication equipment like fax, Ìnternet, etc. @. *ersonal Ina&eJ7a%3 When a role occupant feels that he does not have enough knowledge, skills or experience to perform a role effectively, he may experience role stress. Sometimes persons who are given new roles without adequate training are likely to experience personal inadequacy. The difference between role ambiguity and personal inadequacy is that: in the former, the role occupant has certain amount of knowledge of his new role, but he experiences some ambiguity whereas in case of personal inadequacy the role occupant suffers from lack of knowledge or skills to perform his new role. B. Role Isolation Ìn a role set, the role occupant may feel that certain roles are closer to him, while other, are at a greater distance. The main criterion of distance is the frequency and ease with which he performs the role. When linkages are strong, the role isolation is low and vice versa. For example, when the branch accountant goes on leave in a bank, the branch field officer, (person in charge of advances), may be asked to perform the accountant's role as it is felt that the field officer's role can be kept in abeyance temporarily in small branches. Ìn such cases, the field officer may experience role isolation, if he is unable to perform the accountant's role effectively. Ìn organizations, generally roles are expected to be well-defined and set so that one can say that an employee has a given role. This is only partially true. Ìn course of time, he is likely to experience a variety of incidents and develops expertise to deal with similar situations even proactively. For example, a paying cashier may know the credential of the customer well and is likely to pay-out even before checking the balance available in the account. A personnel manager, because of his closeness with certain government authorities may take decisions without consulting the union, etc. Thus, apart from the given role, the role may be person driven as well. Hence, we find differences in the way a predecessor and a successor handle the same function. Now, in this background, the H.R. man has the role or duty to design the role of employees, especially in today's turbulent times where technology, markets and products are changing all the time, impacting the roles drastically. Hence, functions, the need to decentralize control and decision-making, systems that operate at any given time, clarity of individual's task and position, economy of effort, vision for attaining the objective of the company and enable the employee to become more competent in his field should be the criteria. For this purpose, knowledge must be built into products and services to get benefits of excellence. For example, a highly sophisticated computer and technology backed bank cannot have experts in manual systems managing branches. The technology will not be used to the possible extent, if the manpower using the technology is not competent and trained. Che%2 )o7r *ro,ress #I$ Mention 8hether the follo8in, state'ents are Tr7e or +alse: 1. The role integrates an individual with an organization. .. True. !. Role and position are one and the same concept. .. False. (. Each individual occupies and plays several roles. .. True. .. Role ambiguity is caused due to personal inadequacy. .. False. ?. Ìntra-role conflict leads to role isolation. .. True. @. Role set conflicts for a role occupant refers to erosion of role due to creation of new roles and positions. .. False. Det Us S7' U5 Organizations are social systems. They are composed of individuals. Each individual's behaviour in the organization is affected by several factors. These factors are personal, psychological, organizational and environmental. We have examined in this unit several theories of personality and human behaviour. We also discussed certain critical dimensions of personality that influence human behaviour at work. Personality and its interaction with the environment help us to understand why employees behave as they do. We also saw how managers can help employees by understanding the effects of personality on behaviour and coping mechanisms. The connection between personality and brain has been discussed with a view to examining the influence of biological factors on personality. The factors affecting employee behaviour have also been studied in detail. We have also studied the impact of diversity in the organizational context and the role of HR policies in diversity management. One of the major factors of diversity is the gender difference. We have studied the gender issues with reference to recruitment, service conditions and protection of interest of women at workplace. We have surveyed different theories of motivation and their practical implications on human behaviour. While each theory is unique and has several interesting features, no single theory brings out clearly all the complexities of motivation and its impact on performance. However, all the theories put together contribute to our understanding the concept of motivation and its applicability in organizational setting. Role is a position one occupies in a social system. Role and position are, however, separate concepts. They are two sides of the same coin. Concept of role is important for the integration of an individual within an organization. The organization has its own structure and its goals. Similarly, the individual has its personality and its needs. All these aspects interact with each other and get integrated into a role. /e38or&s Ego; Extroversion; Heredity; Ìntroversion; Locus of Control; Machiavellianism; Personality; Psychoanalysis; Self-Esteem; Behaviour Modification; Expectancy; Hygiene Factors; Ìnstrumentality; Job Enlargement; Job Enrichment; Motivation; Money; Need for Affiliation; Need for Achievement; Need Hierarchy; Need for Power; Quality of Work Life; Role Ambiguity; Role-Coping; Role Distance; Role Efficacy; Role Erosion; Role Ìsolation; Role-Making; Role Stress. Answers to Check Your Progress 1. True; 2. True; 3. True; 4. False; 5. True; 6. True; 7. True; 8. False R 1. True; 2. True; 3. False; 4. True; 5. True; 1. True; 2. False; 3. True; 4. False; 5. True; 6. True; 7. True; 8. False D, 1. Yes; 2. No; 3. Yes; 4. Yes; 1 1. True; 2. False; 3. True; 4. True; 1 1. True; 2. False; 3. True; 4. False; 5. True: 6. False (1: 1. True; 2. False; 3. True; 4. False; 5. True; 6. False Ter'inal 97estions 1. What are Erikson's stages of Personality Development? 2. What are the advantages of employing Type A personality in organizations? 3. Write a note on factors affecting human behaviour. 4. What are the factors of diversity and their impact at workplace? How to manage diversity through effective HR system? 5. What is motivation? Why is it a critical issue of interest to managers in organizations? 6. Compare and contrast Maslow's Need Hierarchy Theory with Herzberg's Two-Factor Theory of Motivation. 7. Write a brief note on the following: (1) ERG theory of motivation (2) Vroom's expectancy model of motivation (3) Equity theory (8) Write a note on Achievement Motivation theory advocated by David McCelland. (9) How the concepts of job enlargement, enrichment and rotation can be applied to motivate the employees? 10. Explain the following: (1) Role space conflicts (2) Role set conflicts Case 1 ABC Limited is a major manufacturer of refrigerators in Ìndia. While the main components of the refrigerator are manufactured by the company, other parts of the final product are produced by the subcontractors. The company employs around 300 hundred workers. Ìt does not have state-of-the-art manufacturing facilities and also suffers from low productivity of the employees. Due to secured working conditions productivity was low. The employees' morale also remained low due to less market share for its product. The company decides to introduce a profit sharing plan in terms of which they would be encouraged to improve upon productivity and quality of product. The company promised share in the extra cost saved or extra profit earned. Ìnitially the workers were skeptical about the programme. Ìn due course workers started getting monetary benefits as per the company's promise. While their programme was successful, some workers were unhappy due to sharing of gains by all workers equally. 1. Do you think gains-sharing programmes are considered to be motivators for workers as individuals? Explain how the programme has motivated the workers at ABC Limited. 2. Should the management continue with the current manufacturing facilities or should it invest capital in upgrading the technology of production? Which option would help the management more and why? 3. What can the management do about the unproductive workers who are getting the same benefits as the productive workers? Case ! Mr. Satwant Singh joined a bank as a specialized officer as economist. He got first promotion quite early alongwith his batch mates and his performance as well as motivation level was quite high. Being the youngest in his batch he was expecting to reach the level of DGM to head the Research Department of the bank. He used to have difference of opinion with his boss Mr. Mohanty, both on official and other issues. Mr. Mohanty was not happy with the behaviour of Mr. Singh and used to criticise him publicly. Mr. Singh was trying to ignore his comments and was concentrating on his job performance. Since both Mr. Mohanty and Mr. Singh belonged to the specialised department there was no chance of getting rid of each other. When the time for next promotion came, Mr. Singh was hopeful to get the promotion because of his performance. To his surprise, he was not selected. He came to know informally that his Performance Appraisal Report (PAR) was not up to the mark. He was thoroughly disappointed but continued to perform. He did not get the promotion next year also. Most of his batch mates have superceded him. He decided to leave the bank. He got an opportunity in another bank and decided to join at the same level losing all the benefits of his seniority. Discuss the above case with reference to different motivational theories. S7,,este& for +7rther Rea&in, De, N R; Alternative Design of Human Organizations, Sage Publications, New Delhi. Dwivedi, R S; Human Relations and Organizational Behaviour. Oxford & ÌBH, 1993. Ellen Ernst Kossek and Sharon A, Lobel, Human Resource Management ÷ Transforming the Workplace, A Maya Blackwell Ìmprint, New Delhi, 2001. Freidman, Meyer and Ray, Roseman; Type A behaviour and your heart, Alfred A Knopf, 1974. Holland, J L; Making Vocational Choices: A Theory of Vocational Personalities and Work. Keith, Davis; Human Behaviour at Work: Organizational Behaviour McGraw-Hill, NY, 1985. Lorsch, J W and Morse, J J; Organization and their Members: A Contingency Approach, Harper and Row, New York, 1974. Luthans, Fred; Organizational Behaviour, New York: McGraw-Hill, 1989. Pareek, Udai; Motivating Organizational Roles: Role Efficacy Approach, Rawat Publications, 1984. Rogers, C R; The Concept of Fully Functioning Person, Mimeograph Paper, 1955. Stephen, P Robbins; Organizational Behaviour ÷ Concepts, Controversies and Applications, Prentice-Hall of Ìndia, New Delhi, 1989. END O+ CGA*TER !!E ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT Unit 23 ÷ Employees' Feedback and Reward System STRUCTURE ..0 Objectives ..1 Employees' Feedback Check Your Progress (A) ..! Reward and Compensation System Check Your Progress (B) Let Us Sum Up Keywords Answers to Check Your Progress (A & B) Terminal Questions Suggested for Further Reading !(.0 OBJECTIVES After studying this Unit, you should be able to: 1. appreciate the use of employees feedback in formulating HR policies, 2. understand the process of getting employees feedback through surveys, 3. understand the process of reward and compensation, and 4. have an idea about the compensation system in the Ìndian Banking Ìndustry. !(.1 EM*DO)EES +EEDBAC/ Satisfaction of employees at workplace is considered an important parameter for achieving organizational objectives. Progressive organizations always try to get the regular feedback from the employees on various human resource management aspects, and new initiatives taken in this regard through some satisfaction or climate surveys. The information is gathered both formally and informally about the attitude and satisfaction of employees. This information is used for refining and fine tuning the policy initiatives from time to time. At formal level the information and feedback is gathered through well designed questionnaires, psychological instruments, suggestion schemes, etc. The informal information is also gathered through discussions with the representatives, observations of managers and superiors based on the behaviour pattern of the employees. Vital information can also be gathered while conducting appraisal interviews and also through exit interviews of employees particularly those who leave the organization unexpectedly. These interviews provide useful clues to the management to understand the expectations of the employees and to fine tune the personnel policies and human resource development initiatives. Many organizations are attempting to use climate survey data and performance data to measure and evaluate the quality of their management of human resources. Research conducted by Schuster (1982) based on a survey called Human Resource Ìndex (H R Ì) provides some insight into current H R M practices. When several thousand employees in a cross section of twenty-eight diverse organizations were surveyed for fifteen factors in their work situations, they strongly expressed that they were least satisfied with the opportunities they had to participate in the decision-making of the organization. They also voiced that they did not get enough information about business objectives, goals, and plans of the organization. The employees were also relatively dissatisfied with their reward systems and their relative distribution within their organization. Perhaps the most important conclusion that can be drawn from such surveys is that how effectively an organization is managing its people. Moreover, the survey data have proved helpful in diagnosing specific problems and in initiating organizational development initiatives by opening up two-way communication about matters of practical significance to the organization and its employees. +ee&"a%2 Thro7,h Cli'ate S7r=e3s< Climate surveys are most popular and prevalent means to gather feedback from the employees. Ìf designed properly, these surveys can provide very useful information and clues to the management for effective human resource management. Organizations used to measuring employees' perceptions of the prevailing climate in an organization are called climate surveys. Although climate is usually measured for the organization as a whole, scores are typically analyzed department/division wise so that the management can assess the climate in different units and compare them with other units. The Human Resources Development/Management department ordinarily coordinates the entire exercise, from designing the questionnaire to administering the questionnaire and tabulating and presenting the results. The assistance of line managers is also sought in administering the questionnaire. The results of the survey are presented to the top management by the HR Department and the view of the departmental heads/unit heads are obtained to analyze the position and finding out viable solutions for improvement. Although the content of the climate surveys may vary from organization to organization, the coverage of a typical survey can be as follows: 1. Str7%t7re: The feeling that employees have about the constraints on the groups, rules, regulations, procedures, communications channels (layers in decision making), delegation and authority, etc. !. Res5onsi"ilit3: The feeling of being your own boss, clarity of role and responsibility vis-a-vis superior, subordinates and peers, etc. (. Re8ar&: The feeling of being rewarded for a job done well, perception about reward and punishment system, perception about pay and promotion, etc. .. Ris2: The sense of riskiness and challenge in the job and in the organization, and any emphasis on taking calculated risk (risk taking is encouraged and bona fide errors are protected) or playing safe is encouraged and accepted. ?. ;ar'th: The general feeling of fellowship that prevails in the workgroup atmosphere, the prevalence of informal supporting culture and social groups. @. S755ort: The perception about helpfulness of managers and other employees in the group, emphasis on mutual support from above and below in the heirarchy. B. Stan&ar&s: The perceived importance of implicit and explicit goals and performance standards, the emphasis on doing a good job, the challenge represented in personal and group goals. C. Confli%t: The feeling that the managers and other workers want to hear different opinions, the process of conflict resolution, opportunity to express the views, etc. F. I&entit3: The feeling of belonging to the organization and perceived value in the organization and work group, etc. The survey should be conducted from time to time at reasonable intervals to analyze trends in the matters of attitude, expectations, satisfaction, and frustrations, if any. The survey may be completed utilizing variety of instruments, both standard (already available in published form) and/or custom-tailored to a particular organization. The consequences of unfavourable climate characteristics include using job time to confer with peers in order to cope, high stress, looking for another job, considering reporting sick, reduced communication with superiors and considerable job dissatisfaction. Ìn contrast, the likely advantages of favourable climate characteristics are open problem solving, loyalty, cooperation, among peers and across groups, enhanced motivation and satisfaction, and high quality customer service. We can also infer that the top management in the banks with the help of HRD department should formulate a conscious strategy to create and maintain the favourable climate. There are many pros and cons regarding employee survey, and if some bank decides to conduct such survey, help of some expert may be taken especially in designing the questionnaire, selection of sample respondents, interpretation of results and deciding strategy to overcome some genuine problems. Ìf the survey is not done scientifically and the employees are not prepared to voice their genuine opinion in a constructive way, employee survey can create more problems than they can solve. Ìt is always desirable to communicate the results of the survey to the employees ÷ may be in a summarized form otherwise it will create more confusion. Che%2 )o7r *ro,ress #A$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Employees' feedback is useful for the organization. .. True !. Conducting climate surveys does not serve much purpose as employees do not come out with their views freely. .. False. (. The surveys have to be designed well otherwise they can be counter productive. .. True .. The survey questionnaire should be customized for different organizations keeping in view the peculiarity of the organization. .. True ?. Ìt is beneficial to take the help of a consultant for organizing a climate survey. .. True @. There is no need to develop a questionnaire for the organization as they are available in the marked which can be used across the organizations. .. False. !(.! RE;ARD AND COM*ENSATION S)STEM The prime motive of a person to take up a job is to meet his basic needs first. The basic needs are adequately met by the wages he gets for his contribution to the organization. The wages in the form of compensation is viewed as the main attraction to join or change a job. The compensation should be reasonable and justifiable to keep the employee happy and committed to the organization. There should also be an inbuilt reward system for better performance. Thus, the basic goal of an individual in an organization is to earn satisfactory wages or compensation and perform well to be recognized for other financial and non-financial rewards. The salary and wage structure of any organization is an important part of its personnel policy. Ìt is necessary that the efforts of the employees are adequately compensated. Ìf the compensation is disproportionate to the type of work and the industry trend, either the company will attract only a poor quality of employee or there will be a very high turnover ratio. The compensation should not be so meagre that employees do not feel motivated to put in their best. Ìn such cases all good employees will leave and the organization will be left only with mediocre performers. Too high a level of compensation may also prove to be counter-productive. Ìdeally, the compensation should be such that it continually attracts talent, it is a major source of retention of the existing manpower and has an edge which motivates them to give their best. This is, however, a sort of over simplification of the situation. At this stage let us note that there are different motivating factors and compensation is one of them. We will see how the compensation gets decided, theories and philosophies behind it, and other related issues. T35es of Co'5ensations Let us first understand what 'compensation' means. Ìt may be defined as money m remuneration received for the performance of work plus the kinds of benefits provided by the organization. Ìf these benefits are quantifiable in terms of money they get added. Compensation is expressed in terms of money. Ìt would thus include: wages or salary, bonus, cash allowances and benefits such as accident, health insurance cover, employer's contribution to the retirement funds, provision of accommodation, etc. The jobs are broadly classified in four groups and the compensation for them is commonly referred to as shown below: 1. Managerial (top, middle, junior) ... remuneration !. Supervisory ... salary (. Clerical or Administrative ... salary .. Unskilled, semi-skilled, skilled and highly skilled ... wages The words remuneration, salary and wages are generally used interchangeably in different context and form part of compensation. The compensation can also be grouped by the method of payment. Compensation could be payable to an individual for his contribution, to a team of a group for certain measurable results, a certain fixed component every month and a variable portion related directly to the performance of an individual or of the team. Co'5ensation Base Compensation policy is an important element in personnel management. What is the basis or factors on which compensation gets decided? Ìt could be: 1. Company objectives !. Market situation or prevailing market rate (. Ìnternal and external pressures. Co'5an3 o"Ae%ti=e is the main basis on which the level of compensation gets determined. There are certain companies which aim to be the highest pay masters and try to attract people. The company philosophy in such cases could be to attract the best talent at a high salary but keep the size of the company very lean. Some companies recruit people only from the prestigious professional institutions to gain professional edge. To attract people from these sources will obviously take the compensation level quite high. The company objectives in turn will depend on its capacity to pay and its cost benefit analysis. Mar2et sit7ation is another factor which will decide the compensation level. Certain types of skilled people and certain kind of experienced candidates are very scarcely available. For example. in banking, exposure in the area of foreign exchange trade, treasury or risk management is available to a very few candidates. Naturally, their market demand and value is high. The market situation depends upon prevailing market rates for certain types of employees and expertise to be recruited and their demand and supply situation. The requirement goes up if the new companies come into existence. The organization's policy of 'overall growth' or 'the right man on the right job' also has an impact on market condition. Ìf the policy of overall growth is followed it may be possible to develop from internal source a hand, to man such a position and the company may not be totally at the mercy of the market situation. Internal an& e6ternal fa%tors determine the levels of compensation. Ìnternal factors could be: capacity of the company to pay, bargaining power of the unions, attraction and retention pressures, the motivational factor, etc. External factors include: labour laws governing the subject of wages, provisions of Companies Act in respect of remuneration of managers, different wage concepts, compensation surveys, recommendations of arbitrations, pay commissions, etc. Co'5ensation Theories Let us now consider conceptual and theoretical aspects of compensation. A good compensation package should cover factors like adequacy, societal considerations, supply and demand position, fairness, equal pay for equal work and job evaluation. These concepts are explained briefly: A&eJ7a%3 of ;a,es The Committee on Fair Wages pronounced certain wage concepts such as: 1. Minimum wages !. Living wages (. Fair wages .. Need-based minimum wages While the concept of minimum wages is wage level to sustain the worker, living wages considers the aspect of satisfaction of social needs and insurance coverage. Fair wages is the one between the minimum wages and the one which could be determined on the capacity of the organization to pay, but covering the aspects of productivity of worker, prevailing rates, economic scenario, etc. The need-based minimum wages are aimed at satisfying the minimum human needs of the worker. So%ietal Consi&eration an& De,al +ra'e8or2 The level of compensation in any industry, theoretically, gets decided by the socio-economic considerations. Skewed distribution of wages will make the flow of supply shift and with the application of basic principle of demand and supply the equilibrium will be attained. This means that the compensation levels will, more or less, tend to be at par for the comparable work. Ìn practice, however, this happens very rarely. Ìn the free economy the Government does not control the aspect of wage administration and normally the market forces determine the compensation level. However, the administration is bound to protect the workforce from irrationally low wages. Taking this as the prime objective the Ìndian Government has enacted: 1. The Payment of Wages Act, 1936, !. The Minimum Wages Act, 1948 (. The Payment of Bonus Act, 1965, and .. The Equal Remuneration Act, 1976. These Acts ensure payment of wages at regular intervals, prohibit unauthorised deductions from the wages, define a certain minimum level of wages for certain industries which ought to be paid, provide for payment of bonus, in the form of deferred wages every year irrespective of the profit or loss of the organization, decide the minimum and maximum rates for payment of bonus and propound the principle of equal remuneration for equal jobs to both men and women workers. Thus, the Government has ensured a bare minimum level of compensation to the workers and ensures through its administrative arms and law-enforcing authorities that there is no exploitation of workers at the hands of employers. Jo" E=al7ation This is one important measure to determine the level of compensation package. A scientific job evaluation will ensure parity of compensation levels for similar or equal jobs. Ìt also helps in distinguishing jobs in the level of complexity, skills required, the risk involved and link compensations accordingly. Job evaluation is a method of appraising the value or worth of one job in comparison to other jobs in the organization. The objectives are: 1. to determine the compensation rates !. to link pay with the requirement of the job (. to provide for pay differentials taking into account skills, efforts, hazards required in each job .. to establish a compensation structure. The process includes job analysis, job description and job specification. The job evaluation may also be useful for some other aspects in the organization, viz., manpower planning, performance appraisal, etc. The jobs are ranked according to the perceived difficulty and value addition they make. They are classified in groups based on skill intensity, difficulty, hazards, responsibility, experience required, etc. Once the jobs are ranked and classified it is easy to decide the level of pay for each job. The jobs which are considered more valuable to the organization than the one which are not so, will obviously carry more pay. Similarly the higher level of responsibility will command higher pay. Following this doctrine the supervisors draw more pay than the workers because the responsibility and experience required are of a higher order. However, in exceptional cases the supervisors may draw lower pay if the job to be performed by the workers is risky and requires higher skills or hard physical work. Re8ar&s Din2e& to *erfor'an%e We have so far seen the various types of compensation, compensation bases, theories and concepts and legal framework. Let us now consider another concept of compensation linked to performance. Compensation can be, from this point of view, three types: fixed, totally variable and mixed. However, let us see why there is a need to link compensation to performance. We have considered that job evaluation appraises the skills required in the job and higher the level of skills, higher the level of compensation. But it is an admitted fact that individuals differ in their performance on job. Although the job analysis defines the skills required, the degree of skills and the fineness with which the job is performed, is different for each individual. There is a growing feeling that this finesse needs to be recognized and compensated for. Ìt is argued that this not only motivates the high performer but also motivates others and their performance level will go up. Let us now examine how this is achieved. Fixed level of compensation means that based on job analysis, or market conditions or the collective bargaining power of the unions, the compensation is fixed for various jobs. Ìt assures payment at that agreed rate to all the employees irrespective of how they perform their jobs. This leads people to perform below their potential. Where quality control systems are not well established, as in the service industry, fixed compensation levels may prove to be counter-productive, with no inducement to high performers and no compulsion for low performers to improve their contribution. Fixed level of compensation thus suffers from creating a low level of motivation and converting high performers to mediocre performers. Variable level of compensation attempts to remove this drawback. Ìt decides the compensation solely on the performance level of the employee. Ìn the manufacturing unit it is a compatible system as the number of pieces produced and the quality can be measured against the benchmarks already decided. More the number of pieces of acceptable quality, higher could be the compensation rate. This theory induces a very high level of production but also puts undue pressure on employees to perform under all conditions. Their compensation level is directly linked to the level of their performance. But on many occasions the performance may come down because of reasons beyond the employee's control. The system has therefore to take care of such eventualities. The other drawback of the theory is that in a service industry where the measurement of performance is a difficult task, it may be subject to human error in judging the performance, which may lead to frustration. The mixed compensation level tries to remove the drawbacks of both the above systems and at the same time seeks to get the benefits of both of them. Ìt assures a fixed level of compensation and proposes additional compensation depending upon the level of performance. For example, a predetermined salary and reward linked to one's level of performance is one combination. The additional compensation may be in the form of bonus, or additional wages, etc. Both the variable and mixed compensation theories presuppose a well established performance appraisal system. This system is followed in most of private sector organizations including new private sector and foreign banks. However, the variable part of the compensation is kept secret and the employees are prohibited to disclose it to other employees. Co'5ensation Str7%t7re Ìn a traditional system, wage structure includes basic pay, dearness allowance linked to consumer price index, house rent allowance if no accommodation is provided, city compensatory allowance, conveyance allowance etc. But there has been a new trend in keeping the structure flexible. Many companies in the private sector offer, what is known as a 'cafeteria' or 'menu' option to their employees. The employee decides what he will draw as basic salary, what amount as house rent allowance, etc. This is of course within the overall package level decided for the employee beforehand. The idea to have a flexible structure is to allow the employee to plan his income under the various heads of salary depending on his requirement for the particular year and to offer him the permissible tax benefits to the maximum extent. There is a concept of cost to the company and the flexible pay and allowances will form part of total cost to the company. The cost to the company includes other costs, viz., Leave Fare Concession, Leave Encashment, Medical Benefits and other benefits offered by an organization. *ra%ti%e in the In&ian Ban2in, In&7str3 The determination of salary level in the banking industry has undergone a change during the last five decades. To trace the progress, in the initial days, salary was decided solely at the discretion of the banks, when all the banks were in the private sector. There was no union and association and as such there was no system of fixation of salary after discussion or negotiation. However, with the trade union movement taking shape in the banking industry, the first dispute was on the salary. The unions contended that the banks had the capacity to pay higher salary but they were denying the same and paying much lower salary, whereas banks argued that salaries cannot be determined on the only criterion of capacity to pay. The matter went finally for adjudication to the tribunals. The Sastry Award and the Desai Award are examples of how the arguments were articulated for and against by the parties, and the salaries were decided by the tribunals for the bank-men across the country. Thus, fixation of salary through settlements by a third party, i.e. the tribunal, became an acceptable thing. Since 1966, however, so far a "workman" staff is concerned, the wages are being settled through Bipartite Settlements between the Management of Banks (represented by Ìndian Banks' Association) on the one hand, and their Workmen (represented by various central trade unions in the industry) on the other. The settlement is binding on parties for the specified period of time. At present the settlement period is for 5 years. The settlement takes place for all the banks which are the members of ÌBA. Currently a debate is going on proposing that each bank should have freedom to decide its compensation package as the capacity to pay differs from bank to bank. This is on the grounds that many public sector banks are not performing up to the desired level, and revision of salary at a regular interval puts strain on weak banks. The other argument in favour is that the banks would also like to have freedom in designing certain policies which will recognize high performers and try to work out a reward system linked to performance so that good performers are motivated and the general efficiency level is raised. The Government has indicated that such freedom can be granted. However, the recent settlement has been done industry-wide under the pressure of trade unions. Che%2 )o7r *ro,ress #B$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. People do not give much importance to the compensation in the organizations. --- False. !. Wage, salary and remuneration all mean the same. --- False. (. The reward linked to the performance generally improves the motivation level of employees. ---- True. .. Ìt is not necessary to give market -linked wages to employees. They may otherwise continue because of job security. ---- False. ?. Uniform wage structure helps in improving the performance. ---- False. @. Job Evaluation is necessary as it helps in distinguishing jobs in the level of complexity, skills required and risk involved. ---- True. B. 'Cafeteria' or 'Menu' option of compensation refers to providing cafeteria or canteen facilities to the employees. ---- False. C. The compensation paid to the managerial position is generally referred to as salary. ---- False. Det 7s S7' 75 The feedback from employees about various organizational policies serves a great purpose in understanding the employees' perspectives about the personnel policies and their level of satisfaction, or, dissatisfaction. Well designed climate surveys provide useful data to the management for fine tuning organization's personnel policies. Ìt also gives opportunity to the employees to air their views and feelings which may be quite valuable for the organization. We studied different concepts, theories, legal aspects and the recent trend in compensation packages. We also studied the practice followed in the Ìndian Banking Ìndustry in this regard. Compensation is a vital factor in the personnel management. We have discussed various types of compensation packages with their merits and demerits. A carefully designed compensation package and rewards system is likely to help the organization to keep its people happy and satisfied which in turn may enable them to give their best to the organization. /e38or&s Climate survey; Employees' feedback; Designing questionnaire; Wage; Salary; Compensation; Reward; Remuneration; Performance linked compensation. Ter'inal 97estions 1. What is the purpose of obtaining employees' feedback on various organizational aspects? 2. How climate surveys can help organizations? How a systematic climate survey can be designed and conducted? What are the benefits to the management? 3. What should be the coverage of climate survey? 4. Explain the different compensation bases. 5. Describe compensation theories and how the legal framework addresses this issue. 6. Discuss the need of "rewards linked to performance". 7. Examine the present practice in the Ìndian banking industry in respect of determination of salaries. Do you think there is scope to introduce performance linked pay? S7,,este& for +7rther Rea&in, Edwin B. Flippo, Principles of Personnel Management, McGraw-Hill Book Company, 6th edition, 1984. Fredrick E, Schuster, Human Resource Management, Reston Publishing Company, Virginia, 1985. Monappa and Saiyadain Mirza, S Arun, Personnel Management, Tata McGraw-Hill Publishing Company Ltd., Ìlth edition, 1991. Venkataratnam, C S and Srivastava, B K; Personnel Management and Human Resources, Seventh Reprint, 1997, Tata. McGraw-Hill Publishing Co. Ltd. END O+ CGA*TER !( H ADVANCED BAN/ MANAIEMENTE CAIIB *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 24 - Performance Management Part 1 of 2 STRUCTURE !..0 Objectives !..1 Ìntroduction !..! Appraisal Systems Check Your Progress (A) !..( Performance Review !... Counselling Check Your Progress (B) Let Us Sum Up Keywords Answers to Check Your Progress (A and B), Terminal Questions Suggested for Further Reading !..0 OBJECTIVES After studying this unit, you should be able to: 1. Understand the objectives and uses of the performance appraisal system. 2. Gain familiarity with the different appraisal methods, 3. Learn the techniques of performance review, 4. Appreciate the counseling process and its importance in motivating people, and characterize an effective performance appraisal system. !..1 INTRODUCTION Performance of employees is the key to the success of any organization. The main purpose of Human Resource Development is to develop people in the organization and to ensure that an atmosphere is created and maintained in which the employees contribute their best. Ìt is, therefore, logical that their performance on the job is measured so that what they have contributed is known and made known. Ìf there are any areas of improvement, they have to be afforded an opportunity to do so. Flippo says, 'no company has a choice as to whether or not it should appraise its personnel and their performance it is inevitable that the performance of the hired person will be evaluated by someone at some time. The choice is one of the methods.' He further describes the choices the organization has in this regard: 1. A casual, unsystematic and haphazard appraisal, !. A traditional and systematic measurement of employee characteristics and employee contribution, (. Mutual goal setting, i.e. Management by Objectives (MBO). Performance appraisal is a process by which the management finds out how effective it has been in hiring and placing the employees. Definitions Heyel defines performance appraisal as 'a process of evaluating the performance and qualifications of the employees in terms of requirements of the job for which they are employed, for the purposes of administration including placement, selection for promotions, providing financial rewards and other actions which require differential treatment among the members of a group as distinguished from actions affecting all members equally.' Monappa and Mirza Saiyadain put it as 'a systematic evaluation of personnel by supervisors or others familiar with their performance because employers are interested in knowing about employee performance. Employees also wish to know their position in the organization.' From these definitions it is clear that performance appraisal is an important tool by which the organizations review employee performance, take corrective steps through training, interventions or placement decisions, reward good performance and attempt to take the employee performance to a higher level. !..! A**RAISAD S)STEMS Performance appraisal is an organizational necessity. Various appraisal systems have evolved over a period of time. These systems vary from simple to complex, from vague to objective, from unstructured to structured and from confidential to open. An organization has the option to device its own system or can adopt, with certain modifications, some other's system. What system one should choose will depend on whether it fulfills the objectives the organization wants the system to serve. Ìndeed, the system's success depends on the time it takes to carry out the appraisal exercise and how easily people adopt the system. An informal appraisal system is possible in a very small organization where the employee's contribution is readily visible. However, this is not a scientific way. The organization may grow over a period of time and it may be*necessary to have a record of one's achievements or failures. This emphasizes the need for having a systematic appraisal system. O"Ae%ti=es of *erfor'an%e A55raisal S3ste' Ìt is possible to achieve several objectives with a well designed performance appraisals. As observed by McGregor the performance appraisal plans meet three needs: 1. Judgemental - for salary increases, transfers and promotions; !. Developmental - telling an employee how is he doing and suggesting changes in his skills, attitudes, behaviour; (. Counseling by superior - for giving feedback and understanding problems for poor performance. Many of the experts, however, consider that it serves two needs, i.e. judgmental and developmental; counseling being part of developmental need. The overall objective of the performance appraisal is to improve the efficiency of the organization. The specific objectives the system achieves could be summarized as under: 1. to enable the organization to maintain an inventory of the quality and skills of people and identify and meet their training needs; !. to determine the performance-linked increments and provide data for promotions and transfers; (. to maintain individual and group development and fulfill their aspirations by sharing with them their standard of observed performance and help them reach the benchmarks by skill up gradation programmes. Performance appraisal is an important tool both for the organization and the employee. Ìf the objectives are well defined and understood by the parties concerned, its implementation becomes easy and meaningful. Ìt will then be in a position to reach a multi-useable level. Uses of *erfor'an%e A55raisal Having seen the objectives of the performance appraisal system, it is relatively easy to list down its various uses. Ìt is a tool to evaluate objectively the performance of the employees on the given job. While doing so, it also throws light on the characteristics and traits of the employees. Data on these aspects of the employee's personality can be useful for certain personnel decisions. Viewed from this angle, the wide range uses of the system are: 1. Ìt rates all the employees in a unified manner by using the same rating scales and thus making them comparable on a common footing. !. Ìt provides information which could be critical while deciding on promotion, pay increases, transfers, training, etc. (. Ìt provides information about the areas of weaknesses of the employee to enable initiation of corrective steps. .. Ìt improves the quality of supervision as the supervisor becomes a keen observer. ?. The system, if implemented with openness and trust, ensures better interpersonal relations between the employee and his supervisor. However, in practice, the system is generally criticized by the employees due its failure to meet one or the other objectives mentioned above. *erfor'an%e A55raisal Metho&s To achieve the objectives and to be in a position to use the system to the fullest extent, the organization has to choose an appropriate method from the various alternative methods. Depending on its requirements and objectives, the chosen method can be modified suitably. However, before deciding upon which method to adopt, it is necessary to understand the evaluation process. There are following steps in the evaluation process: 1. The process begins with the organization setting the 'performance standards' in advance. These standards should be clear, realistic and measurable. Ìt is advisable to involve the line managers in the exercise as they understand the nuances and nitty- gritty of the job. !. The performance standards then are required to be communicated to the employees. (. The next stage is to measure the performance. Ìt can be done through the data available with the department, personal observations, and feedback from the appraises. .. Performance level of the employee is then compared with the benchmark or standard already established. Deviations are discussed and the reasons for deviations are noted. ?. The outcome is discussed with the employee, emphasising the strong points and counselling him on the weak points. @. The last step is to initiate corrective measures and act on the positive performance by deciding on various incentives like increments, promotions, training needed, etc. The above steps seem quite simple and logical to be followed. But there are only few organizations that take the appraisal process seriously and observe all these stages. Apart from this, there are genuine difficulties in setting performance standards as many of the jobs involve sets of steps or actions which cannot be quantified or measured easily. Special attention needs to be paid to these steps as otherwise the tool loses its credibility and the employee loses his faith in the system. Many a problem stem from such dissatisfaction of the staff with respect to the appraisal system. Metho&s There are different methods of performance appraisal. They can be grouped as traditional methods and modern methods. While the traditional methods emphasize on rating the individual's personality traits, the modern methods lay importance on the results - job achievement rather than on personality. Ìt is believed that concentrating more on the end results makes the process more objective. Following is the list of the traditional and modern methods: Tra&itional Metho&s 1. Free Form Essay Method !. Straight Ranking Method (. Comparison Method .. Grading Method ?. Graphic or Linear Rating Scales @. Forced Choice Description Method B. Forced Distribution Method C. Group Appraisal Method Mo&ern Metho&s 1. Assessment Centre Workshops !. Management by Objectives (. Human Asset Accounting Method .. Behaviourally Anchored Rating Scales ?. 360 Degree Appraisal Method Let us now discuss these 'etho&s with their 'erits and &e'erits: Tra&itional Metho&s +ree +or' Essa3 Metho&: Ìt is totally unstructured method of appraisal. Ìn this method, the appraiser makes a free form, open-ended appraisal of the employee. The system thus gives absolute freedom to the superior to write about the job knowledge, employee's attitudes, development needs, etc. The drawback of the system is that it could lead to a totally subjective evaluation and comparison between two employees is difficult. This type of appraisal system is generally used to appraise the top management. Strai,ht Ran2in, Metho&: This is the oldest and simple method of performance appraisal. The relative position of each employee is assessed. People are rated in order of merit and placed in a grouping. The system obviously suffers from numerous drawbacks such as it is difficult to compare an individual with others having varying behaviour traits. Co'5arison Metho&: This is a modification of the earlier method where each employee is compared on certain selected factors such as leadership, initiative, etc. This method is also known as 'Factor Comparison Method'. When the number of employees is large it becomes difficult to compare and rank them on different attributes. Ira&in, Metho&: This is a simple method where certain features are considered for grading, such as analytical ability, job knowledge, etc. Certain scales are then decided and the employee is graded on those features on the scale. The scale could be A: outstanding; B: very good; C: average; D: below average. This is a widely used method. Ira5hi% or Dinear Ratin, Metho&: This is another most commonly used method. The method considers two factors: employee characteristics and contribution. Personal qualities such as initiative, dependability, decisiveness, etc., are measured. With regard to contribution, both quality and quantity of work are considered. While measuring contribution, weightages are assigned to both the quality and quantity. Rating is on a continuous scale. The drawback of the system is that the rating generally tends to be subjective. The system assumes each character to be equally important for all jobs. +or%e& Choi%e Des%ri5tion an& +or%e& Distri"7tion Metho&: These methods force the superior to make his choices. The underlying idea is to minimize the bias. The employee is rated on a predetermined distribution scale. The factors normally considered are job performance and suitability for promotion. Ìn the choice description method the superior is asked to select the statements which best describe the employee. The statements are predetermined sets of description of people. Iro75 A55raisal Metho&: This is a method in which employees are rated by -a group of appraisers consisting of the immediate supervisor and three or four others, who have some knowledge of the performance of the employee. The advantage is that it is a thorough method with least bias as it involves multiple raters. But it is a very time consuming process and may get reduced to just a ritual if the number of employees to be rated is high. Mo&ern Metho&s Assess'ent %entre 8or2sho5s: This is a modem method of assessment. Ìt is a radically different method from the traditional appraisal techniques. The method uses a number of assessors and different activities. Ìn a job-related simulated situation the behaviour of the employee is assessed through their performance of different activities/exercises such as group discussion, business games, in-basket exercise, committee meetings, psychometric tests, etc. *7r5ose of Assess'ent Centre 1. to measure the potential of the candidate for higher managerial position; !. to assess training and development needs; (. to select candidates in campus recruitment or fresh students for employment; .. to identify future potential leaders. The Assessment Centre generally measures interpersonal skills, leadership qualities, organizing and planning abilities, problem-solving abilities, stress tolerance capacity, motivational orientation and communication skills of the candidates. The drawback of the Assessment Centre is that it is a time consuming activity. Good performers are averse to the idea of exam-taking. Ìt also requires highly trained observers to assess various personality traits and behaviour pattern of candidates. To make Assessment Centres successful the objectives of the centre must be clearly stated. Ìt is a system which can be used in conjunction with the appraisal system for taking career progression decisions. Mana,e'ent "3 O"Ae%ti=es #MBO$: This method attempts to minimize external controls and emphasizes on the motivation levels of the employees. This is sought to be achieved through joint goal setting and the employee participation in the decisions that directly affect him. The objective of the MBO is to change the behaviour and attitude in respect of getting the results. Ìt is a result-oriented system. The system emphasizes on goal achievement rather than the method involved. MBO *ro%ess 1. The organizational goals are first set and are clearly stated in measurable targets. These goals have to be realistic and achievable, although challenging. 2. The goal setting process is a joint process. The short-term performance goals are set jointly by the employees and their superiors. 3. There are frequent reviews of performance through one to one meetings. 4. Sharing of feedback in such meetings helps in altering the course of action, if required. Ìt acts as a motivating factor as one gets to know where he stands through the feedback session. Ìt is, therefore, a process of setting goals, exchanging feedback and seeking participation of employees. A&=anta,es of MBO 1. Ìt involves participative approach in goal-setting. !. Ìt enhances the motivational levels of the employees. (. Ìt creates an atmosphere of competition within the organization for enhanced performance. .. Ìt provides objective appraisal method. ?. Problems can be identified in the early stages through reviews and feedback sessions. @. Ìt is an effective tool for identifying the training and development needs. Disa&=anta,es of MBO 1. Ìt is a system which concentrates on results and not on the process. !. Ìt may lead to unhealthy competition amongst the employees. (. Ìt may create a conflicting situation when it comes to goal-setting. .. Sometimes, very soft targets are set to show higher performance achievement. G7'an Asset A%%o7ntin, Metho&: Ìn this method the employees of the organization are treated as Human Capital and money estimates are attached to the value of an organization's personnel and its external goodwill. The principle behind this system is that like any other asset, human asset is also valuable to the organization. Ìf any trained and experienced employee leaves, the human asset value depreciates and if someone joins the organization bringing with him the skills and experience important to it, the human asset value increases. The current value of the human asset is appraised by undertaking periodic measurements of two variables called 'key causal' and 'intervening enterprise'. The first variable includes management policies, strategies, skills, etc. The later includes loyalty, attitudes and motivation level, effective interaction, etc. Again, this is not a method for individual performance measurement. At best it can measure human performance of organization as a whole in terms of increase or decrease in human asset or human capital value. Beha=io7rall3 An%hore& Ratin, S%ales #BARS$: This is a new appraisal technique. The jobs are described through illustrations or by giving critical incidents of effective and ineffective performance. Based on these incidents a rating scale is devised. A set of incidents are used as 'behaviour anchors' for the performance dimensions. While the system is reasonably objective, it is very time consuming. (@0 De,ree A55raisal Metho&: 360 degree refers to full circle or all around the employee and the employee is in the centre. Under this appraisal system an employee is rated by people who are affected by the performance of the employee and have adequate knowledge about his working and performance. The appraisal is generally done by the seniors, colleagues (peers), subordinates, suppliers, customers and all other stakeholders. Ìt also includes the self-assessment by the employee himself. Besides the performance appraisal, this system serves as a good feedback mechanism for the employee and the organization for taking corrective measures and developmental initiatives to improve the performance. Being a multi-rater appraisal system, it is likely to minimize human bias. We have briefly seen traditional and modem appraisal methods. Ìt is necessary for each organization to adopt one of these systems, may be with a few modifications. Ìt is imperative that the objectives of the performance appraisal system are well defined and clearly understood by all the concerned parties, including the employees. The success of the system depends not only on the method adopted but also on how it is implemented by the line managers and how open and transparent they are in giving the feedback. Ìt has generally been found that even the best of the appraisal systems designed with all sincerity have suffered because of their poor implementation. The system loses credibility if the employees find that it has become a ritual and it is not open and trustworthy. Ìt is common for organizations to use a combination of some of the traditional methods and taking the ingredients of the modem methods as well. Ìt is essential that the appraisal system should be objective as far as possible add should be perceived so by the appraisee. The commonly used performance appraisal method in the service industry including banking is the one which is in three parts. The first part consists of self- appraisal by the appraisee. The second part is appraisal of the performance by the reporting authority of the employee. The third part is the review by the superior of the reporting authority. This type of system envisages employee participation in this important exercise. The self-appraisal gives the employee an opportunity to assess his own performance - dispassionately. The appraisal by reporting authority in many cases includes appraisal interview and goal setting. While we will study more about appraisal interview subsequently, goal setting means the employee and the reporting authority discuss and decide the broad objectives the employee is supposed to achieve in the following year. Ìn the banking industry, goal setting is not an easy task. Ìt is relatively simpler when it comes to the goal-setting of a branch manager where the business parameters are projected in absolute terms and the goal is thus quantified. But for the other types of employees it is rather difficult. Depending on the department in which he is posted qualitative goals can be decided. The third part, i.e. review by the superior of the reporting authority ensures that subjectivity or bias can be reduced or minimized to some extent. The method may include both descriptive and scalar appraisal of the performance against the set goals. Ìt serves the purpose of self-checking both for the employee and the superior. Many banks have now adopted a method of giving feedback to the officers about their performance. Thus there is an element of openness and transparency. Ìn the private sector, the performance appraisal is carried out with more seriousness as the financial rewards are directly linked to one's performance. Assessin, *otential While discussing the Assessment Centre Method we have seen that its objective is to assess the potential of the employee for higher managerial position through simulation processes. The performance appraisal system is basically focused on measuring the present performance of the employee on the given assignment. The measuring takes place against certain job-related benchmarks. While the results of appraisal system are useful to know his performance on the current job, they do not throw much light on the potential of the candidate in taking up higher assignment. Ìt may happen that an employee is extremely good at his present position but has little potential for a higher job. This is because the attributes and skills required for the higher position may be totally different than the one required in performing the present job. An excellent salesman need not necessarily be an excellent sales manager. Ìf we take a decision to promote a salesman solely based on his performance appraisal to the post of sales manager who does not have potential for higher post, we will lose a good salesman and create a bad sales manager. Basing the promotion decisions only on performance appraisal system is a judgmental prediction that the employee may perform well in the higher capacity as he is presently doing. Thus, potential appraisal becomes an important aspect of the performance appraisal system. Ìt is to be used in conjunction with the performance appraisal techniques. There are many organizations which have a regular potential appraisal system in place. Potential Appraisal Report (Annexure) shows one such form used for potential appraisal. Assessment Centre Method used in conjunction with the performance appraisal system, is of great use in such circumstances. Potential appraisal thus helps in arriving at more appropriate decisions. *erfor'an%e A55raisal =ers7s Confi&ential Re5ort Ìn a large number of organizations the annual performance appraisal exercise is carried out as a confidential activity. Ìn fact, the form in which the performance of the employee is evaluated and reported is called confidential report. This report is submitted to the head office. As the name suggests, the system is surrounded with a lot of mystery and the employees tend to dislike it. There is no transparency at all. The superior assumes greater importance and wields power as he can make the career of the employee through this tool of confidential report. No feedback is given to the employee as to how is he performing his work. Thus there is no developmental consideration. This is a very old form of reporting on the employee. Ìts disadvantages outweigh any positive sides. Slowly the organizations are moving towards more open and transparent performance appraisal systems involving employees in goal setting, providing for self- appraisal and regular feedback, and taking corrective steps jointly with the employees, for better results. Merits an& De'erits While the merits of the performance appraisal system have been obvious and many, as in any system, it has a few demerits too. The 'erits are: 1. Ìt reveals a concern for performance and creates an atmosphere of openness and trust in the organization. !. Gives feedback to the employee and ensures that corrective steps are taken in time. (. Ìt raises the general motivation level of the employees if implemented properly. The &e'erits are: 1. The halo effect ÷ a tendency to allow one trait or characteristic of an employee to influence the assessment. The halo is to rate an employee consistently high or low. !. The leniency or strictness tendency of the superior interferes with the appraisal and accordingly the assessment gets influenced. The superior is unable to come out of these tendencies. (. The central tendency problem refers to assigning average ratings to all the employees without properly evaluating each aspect of appraisal carefully and fearlessly. .. Similar error is the tendency of comparing the employee with oneself on various traits and parameters. Those who show the similar characteristics are normally rated high. Appraising an employee is an art. One needs to do this job sincerely and faithfully. The objective is to reflect the true performance of the employee in the report. Avoiding the personal liking or disliking to influence the rating is a must. With some practice one can be a good appraiser. He needs to learn the art of objectively distinguishing the good and not-so-good performers to avoid the effect of central tendency. Che%2 )o7r *ro,ress #A$ State 8hether the +ollo8in, state'ents are Tr7e or +alse: 1. Performance appraisal is not required in most of the organizations because performance cannot be measured objectively. .. False. !. Performance appraisal system can be widely used for employees' development. .. True. (. Appraisers do not devote much time on appraisal due to their busy schedule. .. True. .. There is no need to make the system open and transparent; it may spoil the relations at workplace. .. False. ?. The system generally suffers from the halo effect. .. True. @. Performance and potential appraisals are more or less the same .. False. B. Performance appraisal has no other use except that in case of promotions .. False. C. MBO process does not involve seeking participation .. False. This is the en& of *art 1 of !0 of %ha5ter !.0 of ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1. ADVANCED BANK MANAGEMENT UNÌT 24 - Performance Management Part 2 of 2 !..( *ER+ORMANCE REVIE; We have seen various methods of performance appraisal. All these methods envisage performance review. Appraising the performance of the employee is reviewing his performance during a specified period. The review however could be at frequent intervals. Reviewing how the employee is performing his job, giving him instant feedback, taking corrective steps and ensuring that results are achieved at the end of the year is also part of performance management. Performance management is possible through constant performance review, which includes the yearly exercise of performance appraisal or assessment. Ìn this context, performance review means appraisal of the performance of the employee by his superior. Let us now see what are the steps involved in the review. *re5aration for Re=ie8 Preparation refers to obtaining information by the superior before he actually appraises the performance of the subordinate. Ìt may be worthwhile at this stage for the superior to take a break from his routine activities and devote some time for the review. The previous year's appraisal will give him the goals set for the current year. Ìf there are other documents which have recorded the goal setting activity, the same may also be referred to. As against the set goals, he may have information about the performance of the employee through various statements, quarterly reports, etc. These documents are the testimony of the performance of the employee. The superior should study them carefully. This will give him an insight as to how the employee has completed his assignments as against the set goals. Ìt may be good for the appraiser to have an overall view as to how the organization is performing or what is the industry level performance. The review for higher level jobs may involve such inputs. At this stage the appraiser is in a position to have a fair idea as to the performance of the employee. Ìf there have been periodical reviews (mid-term reviews) of the employee's performance, these reports should also be perused. The superior is thus in a position to form preliminary impression about the performance of the employee. But it is incorrect for him to treat this data as the final one and form his opinion about the employee's performance. He needs to have a hearty discussion with the employee, understand his point of view about the success or failure, and then come to the final conclusion. Straightaway proceeding to fill in the appraisal report of the employee may not be a right course of action. Thus, it is better to have an appraisal interview with the appraisee. There are certain prerequisites for conducting the appraisal interview and we will now refer to that. A55raisal Inter=ie8 Appraisal interview refers to the meeting of the appraiser and appraisee for getting information and clarifications for the purpose of appraising the performance. As mentioned earlier, it is helpful if the superior prepares himself for the performance review and the interview. While preparation for review puts him up to date on the performance as revealed through various MÌS, the interview gives him an opportunity to get to know as to how the employee feels about his performance and the overall scenario. The appraisal interview also affords him a chance to give feedback to the employee both on the positive and negative aspects noted by him and also the expectations. The appraiser should be trained for conducting such interview and providing feedbacks. The appraisee should also be prepared to receive the interview in a right spirit to take it positively for his self-development. The interview thus assumes a critical importance in the process of performance appraisal system. This is a modern technique and requires to be handled carefully. Ìf so handled, the benefits are significant. However, there are certain basic precautions one needs to take about the interview: 1. The venue of the interview should be the place of the appraisee or at least a neutral place but not the room of the appraiser. This is likely to ensure some amount of comfort and freedom to the appraisee. !. The timing of the interview should be so scheduled that there is no disturbance at all. Ìt is necessary to undertake this exercise with due seriousness. Unless the earnestness is demonstrated, the employee is not likely to open up. Preferably, interview should be arranged in a place where there could be no disturbance from outside. (. The appraiser should adopt the role of a listener and allow the employee to speak to the maximum extent. He should try to understand what the employee has to say before the appraisal review starts taking place. .. He should adopt an encouraging role of a senior colleague and try to understand what the employee has to say. He should avoid passing judgmental remarks which may put off the employee. ?. At an appropriate time he should start giving feedback to the employee. We will now see as to how feedback can be given effectively, without affecting the motivational level of the employee. Ii=in, +ee&"a%2 Giving a feedback without hurting a person's feelings is an art. The points covered above in respect of appraisal interview are also relevant for giving feedback to the employee. To give feedback, it is necessary to arrange the meeting in a congenial environment. After carefully listening to the employee, the appraiser should take command of the situation and give an honest feedback to the employee with an objective to help his development. The following points are crucial for giving feedback: 1. The feedback should be objective and should help employee in reaching appropriate level of performance in future. !. The feedback should be suggestive in nature rather than judgemental and should focus on the training and developmental needs of the employee. (. The superior should adopt a problem-solving approach and not fault-finding approach. The trust of the employee will be reinforced if a sincere attempt is made in giving feedback with an intention to help him. .. The superior should never lose sight that his aim is to improve the performance of the appraisee and not to criticize him. Dos an& Donts Based on what has been discussed above, the DO's and DON'Ts of the appraisal interview and giving of feedback can be easily summarized: Dos 1. allow the employee to do the maximum talking, !. encourage him to describe his success and failure, (. create an atmosphere where he will open up. .. praise him for his achievements. ?. tell him honestly what you think where he could have done well, @. ask him what kind of help he expects from you. B. extend to him all that you can do for him. Donts 1. arrange a meeting when you are unable to devote time undisturbed. !. allow any kind of disturbance once the meeting starts, (. adopt judgmental role, .. criticize him for his failures. Ìt can be seen that the above tenets are basically good etiquettes which pleases anyone. Treating people well is one of the duties cast upon the seniors and they should perform it without demur. Similarly, it is the duty of the senior to ensure good performance from his subordinates and to train and develop them to that end. !... COUNSEDDINI The dictionary meaning of the word 'counsel- means to 'advise'. Ìn the context of our subject it means advising the employee about his performance. Ìn other related context counselling assumes importance in respect of disciplinary matters in employment. For the present, let us understand counselling with reference to performance review. As the term indicates it may be clear that this step comes after the step of appraisal interview and giving feedback though, practically, it may take place along with appraisal interview. To put it in other words, the superior decides to do the role of a counsellor where he comes to the conclusion that the performance of the employee requires immediate and major corrective actions. While the appraisal interview and giving feedback is a normal course of action, in a case where the employee performance is falling much below the expected level, a serious attempt is made to understand the reasons and to take salvaging action. Counselling has been defined as an activity where one individual uses a set of skills to help another to take responsibility for, and to manage his own work and behaviour related decision-making. Co7nsellin, *ro%ess The prime purpose of counselling is to communicate to employee the feedback of the performance and expectations and, help the employee to understand the areas of concern with the sole objective of improvement of his performance. Ìf the feedback system is effective, the employee not performing up to the mark gets to know clearly where he stands against the set benchmarks. Ìf the key result areas or key responsibility areas are clearly defined. there is a lesser chance of falling short in the performance level due to ambiguity. Once the superior has come to the conclusion that the case on hand requires serious handling, he has to carefully evolve a process where he will speak to the employee. give him straight feedback, seek to understand the employee's point of view and guide and advise him so that the employee is in a position to do his best and reach the benchmark level. Thus, the counselling process is self- defined by the superior. Ìt may consist of three stages: (a) recognizing the problem or issue, (b) helping the employee to realize the problem and (c) managing the problem. The following could be considered as counselling skills: 1. Ìt is essential to follow the stages mentioned earlier in respect of appraisal interview and feedback session. Ìt helps in creating conducive atmosphere. The appraiser should realize that it is a common human tendency to react negatively to the feedback process, and particularly to the counselling process. !. The process should start by communicating the purpose of the counselling. (. The appraiser should be specific and descriptive when he is evaluating the performance. .. Appraiser should avoid commenting on the person and centre his discussion on the issues related to performance. ?. His intention should be to assist the employee to overcome his problems. With this prime objective, even when he is criticizing the behaviour (and not the person) he should do it carefully. Criticizing without crippling should be the motto. @. He should listen to the employee and try to help him. B. He should offer workable solutions and act where the appraises can initiate improvement. C. Appraiser should not have any prejudice about the employee and try to evaluate the employee's version objectively. F. Successful counselling is effective listening. Mana,in, A=era,e *erfor'ers One needs to admit and accept that the level of performance of employees differ from person to person. Despite the similar work environment a few employees are in the bracket of 'average performers.' While both the employee and the organization may genuinely wish improvement, many a time only marginal improvement is registered with great difficulty. Ìt will depend on the organization's philosophy as to how it handles average or below average performers. The organization should try various means to improve the performance of these average performers. Ìt may include rotation in job, transfer to another location, training intervention in the classroom environment, special skill up-gradation training programmes, etc. But after taking all these steps if there is no marked improvement, it becomes necessary to handle them with care. With large scale technology implementation, many good performers could not cope up with the new challenges and requirements due to their age and became average or low performers. Normally, the performance linked pay or rewards will differentiate these employees from the rest. Ìf the performance is of acceptable level and the employees are devoted and loyal, the tendency is to continue them in the jobs which best suit them. No organization in the Ìndian culture takes a drastic step of removing people just because they are average performers. But in the changing scenario of mergers and acquisitions and highly competitive environment, these are the types of people on whom the axe may fall. Humane handling is what is recommended. The organization should also realize that it may have a sizeable number of average performers. But they lend stability to the organization by their loyalty. While the organization should incessantly continue the effort for improved performance, a more practical and sympathetic approach is called for. These are the type of employees whose motivational levels are low. Ìf the average level of performance is an attitudinal problem, it can be addressed through counselling. Ìn case of bank employees in Ìndia, most of the average performers are surviving with moderate performance because of feeling of job security and ineffective reward and punishment system. The situation may not continue for long. Moti=atin, thro7,h Co7nsellin, Motivation is an emotional need. Ìt explains how in the same work environment, people of apparently similar capability register different levels of performance. Take for example the hundred meter sprint race. The runners participating in the final race record almost similar finish time. Many a times, it is a photo-finish kind of a race, indicating that at least the first two-three runners are probably of equal capability. How that is someone does it in a record time? The answer probably is motivation. Ìt may be called dedication or inspiration. Counselling, we have seen, is helping an individual realize his problems and issues which are acting as a hurdle in his capability and the end results. Counselling, if successful, is likely to remove these hurdles. As a result, the employee will be in a position, theoretically, to perform to the full extent of his capability. Good results beget good feelings. A reputation of good performance results in building of confidence. Thus, counselling helps in unleashing the potential of the employee and through this process his performance level may be raised to acceptable levels. Che%2 )o7r *ro,ress #B$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Giving feedback is an art; the appraiser should avoid criticism of the person and focus on his performance. ---- True. 2. Conducting appraisal interviews is waste of time. ---- False. 3. Even negative feedback can help an employee to improve his performance. ---- True. 4. Counselling of low performers do not yield any results. ---- False. 5. The main purpose of performance review is to do mid-course correction. ---- True. 6. Counselling does not help an individual to realize his problems and issues which are acting as a hurdle in his performance ---- False. Det Us S7' U5 Ìn this unit we have seen the important personnel function of performance appraisal. We studied the objectives of the performance appraisal system, its uses and various methods used in performance appraisal. We considered merits and demerits of different methods of performance appraisal. We also saw how potential can be assessed and how it is different from the normal performance appraisal system. Thereafter, we considered the implementation part of performance appraisal to prepare for review, how to conduct appraisal interview, and techniques of giving feedback. Lastly, we studied the counseling process and how it helps in motivating employees. The single most important central point in this entire discussion has been the need for the appraisers to be objective, fair, open and trustworthy in the process of performance appraisal. The organizations and the appraisers need to take the system more seriously and take greater pain in finalizing its design and implementation so that it is perceived as a fair system and is able to serve its intended objectives. Case A large Public Sector Bank (PSB) intended to introduce fast-track merit-based selection process at all the stages in officers' promotion to ensure that the progress was based on merit, ability, performance and adherence to bank's code of business principles. The values of honesty, sincerity, commitment, courage, action and customer care formed the bedrock of these business principles. Besides the performance appraisal system to judge the current performance, the bank decided to introduce interviews to assess the potential of the officers to handle higher responsibilities. So far the seniority and the performance appraisal reports (PAR) were the main criteria for granting the promotion to the next grade and the officers were generally getting promotion mainly on seniority basis. Ìt was also decided to increase the zone of consideration so that more officers may be considered and the bank may select better officers. The proposal was strongly opposed by the Officers' Association on the grounds that even performance appraisal system itself lacks objectivity and transparency, the interview system will add to the problems of non-selection of good performers. They suggested continuance of seniority-based promotions, which according to them was the only objective criterion. The bank had Lone ahead with the introduction of interview system by constituting an interview panel comprising senior officers, at least two grades above the post for which the interview was to be taken. The Bank also included one expert from outside in each panel to have independent and impartial views.. Since there were a large number of officers required to undergo the interviews (due to larger Lone of consideration), the process started in a big way to complete the whole exercise in a specified time frame and to cover all the officers who were otherwise eligible for the promotion to the next higher grade. The interview started at different centres simultaneously, therefore, the Bank could not keep the same panel. The selection results were surprising not only to the concerned officers but to their seniors to whom they were reporting. A large number of quite junior and young officers were selected while a number of seniors with longer experience could not make it. Some of the officers with average track record were found highly suitable for the promotion to the next higher grade due to their extraordinary performance in the interview. Critics strongly felt that the questions which were asked in the interviews were theoretical and did not have much bearing with the measurement of performance or potential of the officers. Ìt was also argued that the 5 to 10 minutes interaction with the interview panel was not sufficient to them to assess the candidates. Moreover, they felt that the interviewers were not properly trained in interviewing techniques and some of the interviewers created lot of stress to the candidates. Such cases, though less in number, made the case of the officers' association stronger for continuance of seniority based system supported by performance appraisal system. The management, though not admitting openly, also realized that something had gone wrong with the whole process. Keeping in view the facts of the case discuss the merits and demerits of different methods of performance and potential appraisals. /e38or&s Potential; Feedback; 360 degree appraisal; MBO; Appraisal Ìnterview; Counselling; Self-Appraisal; Performance Review; Answers to Check Your Progress 1. False; 2. True; 3. True; 4. False; 5. True; 6. False; 7. False; 8. False 1. True; 2. False; 3. True; 4. False; 5. True; 6. False Ter'inal 97estions 1. What are the objectives of Performance Appraisal system? 2. What different purposes the appraisal system serves? 3. Describe various performance appraisal methods. 4. Why is assessing potential important? 5. Discuss the demerits of the appraisal system and state how they can be overcome'? 6. Study the promotion process in your organization. Does it use Assessment Centre Method'? 7. Describe Management by Objectives. 8. Describe the process of performance review? 9. State the significance of appraisal interviews in the performance appraisal system? 10. What precautions should be taken while giving feedback to the appraisee about his performance? 11. Describe the counselling process? How can counselling be used for motivation? 12. What view should the organization take about average performers? How can their performance be enhanced? 13. Study the process in your organization? Do you think it has all the ingredients to make it an appropriate performance appraisal system? S7,,este& for +7rther Rea&in,s 1. Flippo, Edwin B; Principles of Personnel Management, McGraw-Hill Book Company, 6th edition. 1984. 2. Mamoru, C B; Personnel Management, Himalaya Publishing House, 12th edition, 1994. 3. Fisher, Martin; Performance Appraisals, Kogan Page Ltd., London, 1995. 4. Venkataratnam, C S and Srivastava, B K; Personnel Management and Human Resources, Tata McGraw-Hill Publishing Co. Ltd., 1997 Seventh Reprint. *OTENTIAD A**RAISAD RE*ORT Kindly appraise the employee on the following attributes: 1. +7n%tional /no8le&,e (Does he/she possess the functional knowledge required for the next higher level?) !. Mana,in, S2ills 1. Ìs he or she able to delegate work responsibility? !. Ìs he or she able to provide direction under uncertain conditions? (. Ìs he/she able to motivate his/her team members to perform better? (. Initiati=e 1. Does he or she put in efforts to learn what falls beyond the purview of his/her present job requirements or is he or she complacent doing what he or she is asked to do? .. De%isionEMa2in, or *ro"le' Sol=in, S2ills 1. Ìs he or she able to take a decision in the absence of specific guidelines? !. Does he or she identify and anticipate potential problems? (. Does he or she investigate and analyze problems and situations adequately? ?. +le6i"ilit3 1. Ìs he or she willing to accept new assignments and complete them according to set standards? !. Can he or she handle a variety of assignments? (. Ìs he or she open to constructive criticism and suggestions? @. SelfEMana,in, S2ills 1. Does he or she keep calm under pressure? !. Does he or she concentrate and maintain focus, even when constantly interrupted? (. Does he or she deal effectively with personal stress? B. Co''7ni%ation S2ills 1. Does he or she listen carefully to others? !. Does he or she present ideas and information clearly in speech and in writing? C. A%hie=e'ent Orientation 1. Ìs he/she focused in his approach? !. Ìs he/she able to prioritise the tasks assigned to him? (. Does he/she make the best use of resources to achieve objectives? F. Entre5rene7rial S2ills 1. Ìs he or she a self-starter or does he or she await orders? 10. Inno=ation 1. Does he or she recommend new methods and ideas to improve work performance? !. Does he or she accept ideas and build on them? (. Does he or she experiment and learn from mistakes? 11. Trainin, an& De=elo5'ent Nee&s 1. Does he or she require any training at present job or if to be promoted 1!. Dra8"a%2s Are there any reasons as to why he or she should not be promoted in the current year? This could be due to reasons such as: 1. Gross negligence or Persistent negligence !. Error in judgment (. Actions reflecting on integrity .. Any others (Please specify) This is the en& of *art ! of !0 of %ha5ter !.0 of ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1. Advanced Bank Management UNÌT 25 ÷ HRM and Ìnformation Technology STRUCTURE !?.0 Objectives !?.1 Ìntroduction !?.! Role of Ìnformation Technology in HRM Check Your Progress (A) !?.( HR Ìnformation and Database Management Check Your Progress (B) !?.. HR Research Check Your Progress (C) !?.? Knowledge Management !?.@ Technology in Training Check Your Progress (D) Let Us sum Up Keywords Answers to Check Your Progress (A, B, and C) Terminal Questions Suggested for Further Readings !?.0 OBJECTIVES After reading this unit, you should be able to: 1. appreciate and understand the impact of Ìnformation Technology on the Organization and Human Resource Management. !. examine the need for creating technology based data base for Human Resource and HR Ìnformation System. (. appreciate the relevance of research in HRM and the use of technology in this context. .. appreciate the importance and use of Knowledge Management. ?. appreciate application of technology in training. !?.1 INTRODUCTION Ìn the emerging information age the parameters of success have changed and the one who can have access to and can convert and analyze the data into information and then extract knowledge and wisdom out of it, has an edge over those who cannot. An organization, therefore, cannot shy away from information technology. Though initially the use had been concentrated in the area of business related dimensions, its application is possible in practically every activity in the organization. The use of information for decision-making can improve the efficiency and effectiveness of the organization. Left to the imagination of the organizational innovative processes, right from the CEO down to the lowest level employee like the receptionist or telephone operator, can make effective use of ÌT for their personal productivity and efficient decision-making. HRM as a function has dual responsibility in responding to this trend of the twenty first century. As a part of the strategic HRM, the most significant is the transformation required in the mind set of all individuals across the organization since this technology challenges some of the traditional beliefs and attitudes. The second responsibility is its application to HRM function itself for day-to-day decision-making as well as policy decisions. There is an emerging need for data based decisions for which a comprehensive Human Resource Ìnformation System is the answer. Besides this, in response to the external and internal changing environment policy reviews are necessary. Such reviews also need to have research base wherein ÌT can be of immense use. The twenty first century marks the beginning of information age. Ìt has become necessary to make use of extensive information in all the areas for strategic decision making and policy formulation. As the futurist visualized, this age is marked with new criteria of success wherein the access to and interpretation of data would be important determinants of success. 'What the railroad was to nineteenth century enterprise, what the assembly line was to twentyth century manufacturing, knowledge is providing to be just that to twenty first century business' as Khanna puts it (Business Today 1996). Globalization has wiped out the national boundaries linking organizations from all parts of the world. Ìnformation Technology has contributed to a great extent to this process. A time has come, perhaps, where regardless of an ideology not supporting the technology, nations or organizations would be compelled to adopt it. Ìt is a matter of survival as well as achieving excellence. The advent of microprocessor, the dramatic increase in its power in the last two decades and the equally dramatic slide in its prices, are forming the shift of manufacturing economy to information economy. As Thomas Stewart puts it, 'the microchip is going to be the engine around which the information economy will be built and software will be the fuel.' (Prabhat, 1997). Microchip is expected to change business beyond recognition. There is no sector which has not touched by it ÷ however, the banking sector has absorbed the technology in its fullest potential for improving operational efficiency and providing customer service. The role of technology in HR Management has also been quite significant. Ìnformation Technology is the merging of two technologies, namely, communication and computers. Both these technologies have been making advances in their own fields. Developments in communication are aiming at accurate, faster transmission of data/message from one location to another, be it verbal or digital. The computer technology has been advancing in storing volumes of data and doing accurate, faster, simple and complex computing operations. Ìn addition, intelligence in the form of Decision Support System and Expert System is embedded in the technology, to help the machine take human-like decisions with much faster speed. With the synergy of these technologies what has become feasible is storing of voluminous data which can be accessed from any geographically distant place. The speed and ability to process data has been so much enhanced that it can answer most human queries and information needs. When effectively applied, technology is expected to drastically change the concept of 'work' as there may not be any office (physical) but there could be multiple workstations ÷ mainly at homes ÷ from where people can communicate, negotiate, and do the business. Employees may not be meeting each other in the traditional sense. The employees would be basically knowledge workers and quite individualistic in their approach. Flatter and leaner organizations are on the anvil with the introduction of ÌT. Thus to accommodate this new industry (information industry) and the new workforce, the physical and psychological setting of the workplace has to be substantially different from the traditional ones (Mankidy, 1998). The organizational structures would necessarily get modified as so many layers would not be required. This has thrown a great challenge before HR Managers to prepare people to adopt the new order. There is a myth that the ÌT has diluted the importance of Human Resources in the organizations. 'The mechanization of business has not reduced the role of HRM. Computerization cannot replace the strategic decision-making abilities of human beings. The importance of human resources might be reduced in terms of needed quantity but the pressure on the quality has increased hundred fold. So the HRM will continue to occupy an important position in any organization where human beings are considered crucial (Sharad Kumar, Times of Ìndia, 28 October 2003)'. The prerequisite to adoption of the technology would be to understand the qualitative changes which are firstly at the level of understanding the new relationships, and secondly, in realizing the loss of traditional power centres. Visualizing the organizations of tomorrow we cannot but realize that they will be compact, less hierarchical and more egalitarian in structure, and will have a risk taking, confronting, innovative and learning culture. Since the individuals ÷ where knowledge rests ÷ have immense opportunities, enabling them to perform by creating a fostering culture is going to be a formidable challenge. Ìt is evident that moving to the future organization will imply change for the existing workforce and there is every possibility that the change will be resisted. Ìt will be more so if the organization is a successful one today. There can be various reasons for the resistance; part of the resistance could be due to the inability of individuals to chance their thinking. Anxieties, implicit loss of power and fear of unknown could operate at a subconscious level leading to resistance. Similarly, the mind could be blind to the opportunities of improvements and the possibility of creating multiple solutions by playing with the data. Ìf an organization has to adopt technology for survival and also utilize it for excellence, the prime responsibility will be changing the mind-set of individuals across all levels and units in the organization. HRM therefore, has dual responsibility in responding to this revolution. The major one would be to build an organizational culture that will facilitate creativity and innovation thus enabling individuals at all levels to make use of ÌT. Ìmplementation of ÌT initiatives and HRM are closely interdependent. There are instances where the implementation of ÌT suffered due to improper HRM and also FÌRM initiatives could not be implemented effectively due to change in technology. Thus, these two need to be properly interlinked for their individual success. Utilization of technology is bound to release excess staff, will have increasing need for officer staff, will release a lot of space, and will render certain branches and its employees surplus. This group of employees will act as a damper on the enthusiasm of the organization. This has to be appropriately managed by H.R. strategies including exit policy. One of the foreign banks had handled this issue quite successfully. The banking sector worldwide has absorbed maximum technology for their operations. Technology has also provided variety of delivery channels to support customers' needs in an efficient and effective manner. The banks in Ìndia are also increasingly being driven by power of information technology. However, the applications are limited to the core banking operations, the power of technology has not been utilized to the desired extent for Human Resource Management and Development. There is need to do a lot in this area to get best out of the people within the organization. !?.! RODE O+ IN+ORMATION TECGNODOI) IN GRM To envisage this qualitative change, HR departments have to be transformed to set an example for the entire organization. Ìt has to become a `learning' set-up with all its ingredients like self-introspection, sensitivity to environmental changes, and openness to accept new ideas and systems. As such its first responsibility would be to adopt the ÌT orientation within the department. There is tremendous scope to use ÌT in a whole range of HRM functions. viz. recruitment, training, placement, appraisal and reward systems, organizational development initiatives, etc. The need for use of ÌT can be seen through the following observations: 1. Certain basic information about an employee is used by number of functionaries within and outside the HR department. For instance, if the organization has a geographical spread, the information about an employee is floated at field units, maintained and processed at field administrative units as well as at the corporate (control) office. This means that same database is used for different purposes. Conventionally, the data collection took place from both these sources involving duplication of efforts. This could definitely be avoided if database is regularly updated and shared. !. The database related to an employee is becoming broad-based as various dimensions are getting added. e.g. along with the traditional data regarding salary, allowances, increments, leave, etc., information about his work experience, training, competencies, skills, performance, expectations, etc. need to be stored. This makes the entire HR database voluminous. (. Updating the data could be done partially by different individuals from different locations. .. The decisions related to HR ÷ day-to-day or policy reviews ÷ need to be embedded in databases to achieve objectivity and consistency in decisions. Such objectivity is imperative and can be achieved as ÌT enhances transparency. For example, if someone has to be deputed for training, the database can help in choosing the right person for the right training at the right time. ?. Human Resources being one of the significant components of internal environment, policy review must be undertaken to respond to the changes. To examine how the existing practices or policies are functioning and whether there are biases/prejudices in any one, the database available could be analyzed. @. To ensure adherence to statutory requirements, maintaining of such database is needed. From the points observed above, it is evident that just like any other MÌS, a comprehensive computer based Human Resource Ìnformation System (HRÌS) is the need of the hour. Proper security measures are required to be implemented to ensure the confidentiality, integrity, availability and access control of data/information stored. Che%2 )o7r *ro,ress #A$ State whether the following statements are True or False: 1. The information technology is relevant only to developed countries not developing ones. .. False. !. Ìnformation Technology is a merging of computing and communication technology. .. True. (. ÌT can effectively, substitute our present manual systems and no other change will be required. .. False. .. ÌT can be used in HRM to reduce the drudgery of accounting and preparing salaries. .. False. ?. There is a certain loss of power in ÌT as no single one has exclusive authority and access to information. .. True. @. The positive aspect of ÌT is that more number of people can be utilized for strategic decision making. .. True. B. ÌT has reduced the importance of human resources in organizations. .. False. !?.( GUMAN RESOURCE IN+ORMATION S)STEM #GRIS$ Human Resource Ìnformation System (HRÌS) has become an organizational necessity. The need for HRÌS is an offshoot of the requirement to take frequent strategic decisions concerning employees. Decisions taken on the basis of information, whether it is concerning, posting, training, compensation, job rotation, promotion, etc, need the background of the person in terms of his competence, training needs, performance appraisal, etc. A computer based data can enhance such decisions and make them objective. When the criteria are known and systems are used, the decisions are perceived to be unbiased and fair. A typical Human Resource Ìnformation System (HRÌS) includes the Bio-data (Name, Gender, Address, Age, Ìnsurance Policy, Blood Group, etc.), Educational and Professional Qualifications, Organizational History (Placements, Promotions, Training, Competencies, Performance Appraisal), Salary and Allowances, etc. Maintenan%e of Data"ase0 A%%ess Control an& Use for De%ision Ma2in, Ìt is evident from the contents of HRÌS database mentioned above that all data do not need updating frequently. Some of the static data required to be entered only once in master file, viz., name, date of birth, date of joining, etc. Data on placement, training, etc., are upgraded frequently. Secondly, all sections of data are not needed by all. The computer technology gives scope for having partial access to such sections enabling a number of individuals to have simultaneous access to basic data for upgrading or analysis. Ìt can also be possible to maintain the confidentiality of some part of data like performance appraisal data, etc., which can be allowed to be accessed by selected persons through implementing software supported access control measures through assignment/restriction of permissions. The database also makes it possible to have any kind of analysis. For instance, for any reviews, the analysis could be done on variables like age, gender, geographical regions, level in the organization, etc. Such simple analysis can enhance reviews. The analysis could also help in deciding about training placement or career planning of an individual as it can consider the past experience of an individual and indicate the gaps that need to be filled. HRÌS, thus, is not only a desired database system but an imperative decision support system. Newer and newer software tools are available to help in organizing, classifying, analyzing, querying and mining the data from the databases. The Decision Support System (DSS), Expert Systems, Structured Query Language (SQL), Artificial Ìntelligence, Data warehouse and Data Mining tools help not only in accessing the relevant data but also help the decision-maker to take a better and well informed decision. Thus, the database does not remain passive on the hard disk of the computer, it is kept in such an active way that it itself prompts the decision-maker to use it from time to time depending upon the need of any activity involving use of data for arriving at a decision. Che%2 )o7r *ro,ress #B$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Database is useful only for taking decisions regarding training and placement. .. False. !. Decisions based on computerized data can improve the objectivity, fairness and perceived as unbiased in decision-making. .. True. (. Human Resource Ìnformation System (HRÌS) can be used for taking vital decisions relating to individual employees. .. True. .. Computerized database can allow only one person to access it at a time. .. False. ?. Confidentiality cannot be maintained in computerized data as it can be accessed by anyone from any location. .. False. @. Ìntelligence for decision making cannot be embedded into the computerized systems. .. False. !?.. GR RESEARCG One of the primary orientations of the future organizations is to develop a problem-solving perspective. As such a research orientation is a necessity in all functions ÷ all the more in HRM. For instance some problems related to business parameters would get such attention through the usual activities of market share analysis, surveys, etc., as they are reflected obviously in the tangible dimensions of the business performance. But for HRM, a conscious effort to identify the issues is required. Research in HRM areas can be undertaken to understand: (a) trends of existing systems like recruitment, promotion, training, appraisal system, etc., and (b) to feel the pulse of the workforce in terms of their motivation, commitment, expectations, frustration and so on. With reference to systems, a regular review by looking at the analysis of 'what is happening' can also be undertaken. For instance, a comparison of the applicant population and finally the selected one can indicate biases or prejudices ÷ if any, that are present in the selection strategy being used. Ìt will help to understand the profile of new entrants which can then be compared with the existing one to identify if there is any mismatch that might affect their working together. The analysis on the variables like education (discipline and level of achievement), gender, regional representation, can be valuable for taking proactive steps. The research on methods and the best practices adopted by different organizations and their relevance and applicability can also be studied through HR research initiatives as part of organizational development and change management process. Other important subsystems in this regard are: Promotions, Performance, Appraisal and Training. Very simple analysis and research can, at times throw up a problem, indicating the need for a policy revision. For a better understanding of the intangible environment which is very critical, a climate or a job satisfaction survey can provide data for action. Ìt can also be a meaningful feedback to the management to ensure that some of the things stated in the HR philosophy are actually being felt by the employees or otherwise. Ìn the framework of strategic FÌRM too, research is viewed as an integral component. Since one of the functions of HRM is to remain sensitive to internal and external environment, a research perspective is imperative. HR functionaries cannot afford to be happy while maintaining a status quo. Dynamism is an imperative for progress and growth. To remain sensitive to internal environment, regular opinion surveys, benchmarking, climate studies, etc., have to be conducted. Ìn the proactive approach to FÌRM these surveys would throw signals of change which the HR functionaries need to pick-up for drawing up future strategies. Che%2 )o7r *ro,ress #C$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Research orientation in HRM is not as necessary as in other functions. .. False. !. HR research is helpful to feel the pulse of the workforce. .. True. (. Cost of HR Research is much higher than its perceived benefits. .. False. .. HR research has not been given due importance in banks. .. True. ?. To remain sensitive to internal environment, regular opinion surveys, climate studies, etc., should be conducted. .. True. @. People do not take interest in surveys, therefore the surveys are useless. .. False. B. For a better understanding of the intangible environment which is very critical, a climate or a job satisfaction survey can provide data for action. .. True. !?.? /NO;DEDIE MANAIEMENT The information and the knowledge are considered most active resources for competitive success and strategic decision-making. Ìn this knowledge era, knowledge creation and deployment has certainly moved to the centre stage of organization's priorities. Thus, the Organizational experts are talking about knowledge management as a vital task for organizations. Primarily knowledge management refers to the process of creating knowledge, storing, distributing and pooling it (Wilcox, 1997). These processes have implication for all the subsystems of the organizations. The people in an organization are the sources of creating knowledge, while the storing and distributing the information is the responsibility of information technology machinery of the organization. Pooling the knowledge depends on the culture, inter-personal interaction and other management processes. Ultimately, the individuals have to explicitly state their thinking, rationale, basis of judgment so that it can be stored and used in similar situations by others. Obviously, management of the 'knowledge workers' is a very critical issue and cannot be done by the traditional, bureaucratic processes. The knowledge based economy needs to recognize the value of human capital and the knowledge workers need to be continually re-skilled'. Thus, the knowledge management is the process of capturing the tacit knowledge of people in a systematic manner for future use. New knowledge and new skills are required to manage the new challenges due to deregulation, globalization and technological advancements for speeding up of processes and acquiring competitive edge. Knowledge management is gaining more and more prominence in the light of the fact that it is not sure whether an employee who has been developed by the organization will remain for long with the organization. The obvious and direct implications of this are visible in ÌT industry. With the attrition rate going higher particularly in the Ìnformation Technology Ìndustry, this trend is already visible. However, it is applicable everywhere else too. The banks in Ìndia have also been affected by this trend. Public Sector Banks have lost a good number of competent employees who have joined the new private sector banks and foreign banks at lucrative remunerations. The work will not remain the same when we put *Knowledge' and 'Ìnnovations' as strategies to face competition. Ìn any service industry particularly in banks the knowledge management will become a need as well as a strategy. These had been aptly highlighted by Nonaka and others (1995) in their book titled 'The Knowledge-Creating Company' wherein they have documented their exploration of success of Japanese companies. They have defined the Organizational knowledge creation as 'the capability of a company as a whole to create new knowledge, disseminate it through the organization and embody it in products, services and systems'. This implies that an industry or organization which adopts 'Knowledge Management' as a strategy will have to do the basic exercise of identifying who are the knowledge workers. They could be seen in different categories as knowledge creators, handlers, processors and so on. Since knowledge is critical, managing all these is critical too. Organizations will have to examine their management processes with a view to utilizing their knowledge workers. !?.@ TECGNODOI) IN TRAININI Developments in technology have dramatically increased the potential leverage of trainer and opened up a number of new and more sophisticated options for learning. The opportunities presented by technological advancements could bring about drastic changes in training techniques and could substantially bring changes in training methodology. The technology offers an opportunity in tailoring and designing training intervention to suit individual learners. Ìts main advantage is its cheap mass production of user friendly learning material. Ìt allows an element of choice to the learner. Trainer and trainee(s) are physically separate. Technology has provided a lot many opportunities for open learning. Trainee has the flexibility to chose time, place and form convenient for learning. Technology based training methods help in Distance learning. Communication technology facilitated anywhere learning. Graphic user interface (GUÌ) and interactive software have helped in developing e-Learning packages. Ìt is a powerful tool for distance learning. The learner has the choice of control and routing through the programme depending upon his individual needs. The use of multimedia has improved the effectiveness of the e-Learning packages. Communication technology has provided the facility of remote logging. ÌT has provided various technology driven options for learning in the form of interactive multimedia (i.e. audio, interactive video, animation, graphics), electronic publishing, video conferencing, computer simulation and virtual reality that enhances the speed and quality of learning and training at work place. A&=anta,es of EEDearnin, 1. Enables learner to study at his convenient time and place and can have privacy !. Enables him to study at his own pace (. Can offer high level inter-action with immediate feedback and provide opportunity to check his understanding .. Can be simulated to real life situation ?. Can be cost effective depending upon its use Disa&=anta,es of EEDearnin, 1. Relatively inflexible depending on a pre-produced programme !. Requires greater self-discipline and commitment by the learner (. May induce a sense of isolation .. Does not permit personal reinforcement, therefore, the motivational effects are forgone ?. Can prove costly as expensive H1W and S/W are required E'er,in, Tren&s Animation software, fusion of computer and communication technology, image processing and video conferencing all will simulate the learning to the real life situation. Artificial Ìntelligence (AÌ) technologies viz. Expert/Knowledge-based systems, speech and natural language understanding, user interfaces, sensory perception, will be commonly available. The interactive video disc with a video camera can help in role- play exercises. The multimedia aids will be the part and parcel of any training exercise. Che%2 )o7r *ro,ress #D$ State 8hether the follo8in, state'ents are Tr7e or +alse: 1. Knowledge management most closely refers to capturing tacit knowledge of people for future use. .. True. !. Technology offers an opportunity in tailoring and designing training intervention to suit individual learner. .. True. (. Enables learner to study at his convenient time and place and can have privacy. .. True. .. Cannot simulate to real-life situation. .. False. ?. Communication technology facilitated anywhere learning. .. True. @. Technology-driven training has made the trainers totally redundant. .. False. Det Us S7' U5 Ìn this unit we have discussed the use and application of Ìnformation Technology in HRM. The HR Research is getting prominence as a feedback mechanism for the management to review the HR policies. The Use of HRÌS as a database for HR related decisions like posting, promotions, performance appraisal, etc has been highlighted in this unit. We have also examined how the twenty first century is going to have knowledge workers pivotal to the economy and how the Ìnformation Technology is going to play a critical role in transforming the entire concept of work. Ìnformation will play an important role in strategic decision-making. The organizations will have to be geared for this change and the challenge before HR functionaries would be to prepare the individuals and, create conditions and processes that will enable the individuals to contribute to the environment where innovations and risk-taking are encouraged. The HRM can initiate this orientation by adopting ÌT in its own functioning. Even otherwise, there are reasons why HR database needs to be created and maintained. Ìndeed, data-based decision-making is going to be the order of the day. Such database can also be meaningfully utilized for research in HRM. HR research can help the organizations to feel the pulse of the workforce. The application of technology in training for enhancing effectiveness of training has also been discussed. The computer and communication technology has created immense opportunities for the trainers and the learners where the trainer has access to variety of training tools and the learner has the flexibility to chose time, place and form convenient for learning. /e38or&s Ìnformation Age; Ìnformation Technology; Computer Technology; Ìnformation Highway; Human Resource Ìnformation System; Database Management; Structure of HR Database; Decision Support System; Expert System; Artificial Ìntelligence; HR Research; Climate Studies; Knowledge Management; Data warehouse and Data Mining; E-learning. Answers to Check Your Progress 1. False; 2. True; 3. False; 4. False; 5. True; 6. True; 7. False 1. False; 2. True; 3. True; 4. False; 5. False, 6. False 1. False; 2. True; 3. False; 4. True; 5. True; 6. False; 7. True 1). 1. True; 2. True; 3. True; 4. False; 5. True; 6. False Ter'inal 97estions 1. How is twenty first century going to be a different challenge of HR management? Why? !. Does ÌT have any relevance to HRM besides the activity of developing computer related skills in the employees'? (. Briefly describe the use of ÌT in different HRM functions. .. Why does HRM need an information system? ?. What is the significance of having HR database? What kind of data can be stored? @. What is the significance of HR Research? Describe briefly the areas of HR research which can be useful in Ìndian Banks for HR policy formulation. B. What is Knowledge Management (KM)? Describe the need, structure and use of KM system in present context. C. Discuss the application of technology in training. Can technology replace human interface completely? S7,,este& for +7rther Rea&in,s Prabhat, G B, The 3-D Competitive Space ÷ Managing in the New Economy, Tata McGraw-Hill, New Delhi, 1997. Mankidy, J, 'Employment Relations: The Trend Towards Ìndividualism'. Ìndian Journal of industrial Relations, Vol. 33, No. 3, Jan. 98. This is the en& of %ha5ter !?0 of ADVANCED BAN/ ANAIEMENTE C A I I B *A*ER 1 E GRM an& Infor'ation Te%hnolo,3. Advanced Bank Management 26 UNÌT Overview of Credit Management STRUCTURE 26.0 Objectives 26.1 Ìmportance of Credit 26.2 Historical Background of Credit in Ìndia 26.3 Principles of Credit 26.4 Types of Borrowers 26.5 Types of Credit 26.6 Components of Credit Management 26.7 Role of RBÌ Guidelines in Bank's Credit Management
[email protected] OBJECTIVES After reading this chapter, you will have better understanding of: 1. the importance of credit and its historical background in Ìndia, !. types of credit, types of borrowers, principles of lending, (. RBÌ influence in credit management of a bank, .. components of credit management.
[email protected] IM*ORTANCE O+ CREDIT Credit plays an important role in driving the national economy. Ìt provides leverage to an entrepreneur to undertake a project larger than what he could have undertaken without availability of credit. This results in accelerated industrial production and services. Ìt also enables individuals to first purchase/create assets and repay the loan from their future earnings. Credit also enables a consumer to spend more than what he would have otherwise spent. The increased demand drives the producers to step up the production. Thus, adequate and cheap availability of credit propels the economy to higher growth trajectory. But, let us also look at the other side of the coin. There is always a time lag between increase in demand and creation of supply to meet that demand. That is why excessive availability of credit, specially, for nonproductive purposes, puts inflationary pressure on the economy. Sometimes, Reserve Bank of Ìndia has to use the monetary tools available to it, like Bank rate, CPR, SLR, etc., to control credit so as strike a balance between economic growth and inflation. !@.! GISTORICAD BAC/IROUND O+ CREDIT IN INDIA Private moneylenders have traditionally played an important role in meeting the credit requirements of individuals in Ìndia, though it has caused its own socio-economic problems like rural indebtedness and creation of rural landless population. The problem was aggravated due to high level of illiteracy/financial illiteracy. With the growth of banking sector, this problem has been tackled to a great extent even though the banking sector credit has sometimes been misused as a means of achieving political ends. Nationalization of banks in 1969 was a watershed event in the history of credit flow from the banking sector. Prior to nationalization, the flow of credit was more towards big business houses who often had an ownership/management interest in the banks. After nationalization, RBÌ exercised greater control on the banks and ensured that more credit flows to the hitherto neglected sectors of the economy. The concept of 'Priority Sector' became an integral part of the banking system as RBÌ ensured that a substantial portion of bank credit flows to this sector. !@.( *RINCI*DES O+ CREDIT Over a period of time, bankers have evolved certain basic principles for their lending operations. Bank's loan policies, and other aspects of credit management, are influenced to a great extent by these unwritten principles, which are as under: 1. safety of funds !. purpose (. profitability .. liquidity ?. security @. risk spread !@.. T)*ES O+ BORRO;ERS A borrower can be: 1. An individual !. Sole proprietary firm (. Partnership firm and joint ventures .. Hindu undivided family ?. Companies @. Statutory corporations B. Trusts and co-operative Societies The laws applicable to all these different kinds of borrowers are different. Ìndividuals are governed by the Ìndian Contract Act, partnership firms by the Ìndian Partnership Act, Hindu undivided family by the customary laws pertaining to Hindus, companies by the Companies Act, statutory corporations by the Acts that created them, trusts by the Ìndian Trusts Act, Public Trusts Act, Religious and Charitable Endowments Act, Wakf Act and Co-operative Societies by the Co-operative Societies Act or the Societies Registration Act. !@.? T)*ES O+ CREDIT Bank credit can be either fund-based or non fund-based. Ìn fund-based credit, there is actual transfer of money from the bank to the borrower. Ìn non fund based credit, there is no transfer of money, but the commitment by the bank on behalf of the client, may result in future transfer of money to the beneficiary of such a commitment. Example of this is a bank guarantee issued in favour of government departments (or any other beneficiary) on behalf of a contractor, who is bank's customer. Ìf the beneficiary invokes the guarantee, the bank will have to remit the amount to it and the client, for whom guarantee was issued, will be liable to pay this amount to the bank. Thus, a non fund-based credit always has a possibility of getting converted into a fund- based credit. Apart from guarantees, the other forms of non fund based credit are letters of credit, co-acceptance of bills, forward contracts, and derivatives. The fund based credit can be further divided, based on period, as short term credit or long term credit (term loan) Credit can also be classified based on purpose, like working capital finance, project finance, export finance, crop loan, etc. Banks often classify their credit portfolio based on the type of the customers like, Corporate, retail, agriculture, international, institutional credit, etc. RBI ,7i&elines The banks have to report their business, for public reporting purposes, based on the geographical segments, as 'domestic' and 'international'. Ìn addition, as per RBÌ guidelines, banks have adopted the following business segments, for public reporting purposes, from March 31, 2008: 1. Treasury !. Corporate/Wholesale Banking Retail Banking (. Other Banking Business An indicative list of items to be included under each category is as under: #a$ Treas7r3 'Treasury' for the purpose of Segment Reporting should include the entire investment portfolio. #"$ Retail Ban2in, The Retail Banking would include exposures which fulfill the following four criteria of orientation, product, granularity and low value of individual exposures for retail exposures laid down in Basel Committee on Banking Supervision document 'Ìnternational Convergence of Capital Measurement and Capital Standards: A Revised Framework': 1. Orientation Criterion: The exposure is to an individual person or persons or to a small business; Person under this clause would mean any legal person capable of entering into contracts and would include but not be restricted to individual, HUF, partnership firm, trust, private limited companies, public limited companies, co-operative societies, etc. Small business is one where the total annual turnover is less than Rs. 50 crore. The turnover criterion will be linked to the average of the last three years in the case of existing entities and projected turnover in the case of new entities. !. *ro&7%t Criterion: The exposure takes the form of any of the following: revolving credits and lines of credit (including overdrafts), term loans and leases (e.g. instalment loans and leases, student and educational loans) and small business facilities and commitments. (. Iran7larit3 Criterion: No aggregate exposure to one counterpart should exceed 0.2 per cent of the overall retail portfolio. 'Aggregate exposure' means gross amount (i.e. not taking any benefit for credit risk mitigation into account) of all forms of debt exposures (e.g. loans or commitments) that individually satisfy the three other criteria. Ìn addition, 'one counterpart' means one or several entities that may be considered as a single beneficiary (e.g. in the case of a small business that is affiliated to another small business, the limit would apply to the bank's aggregated exposure on both businesses). .. Do8 Val7e of In&i=i&7al E65os7re: The maximum aggregated retail exposure to one counterpart should not exceed the absolute threshold limit of Rs.5 crore. #%$ Cor5orate an& ;holesale Ban2in, Wholesale Banking includes all advances to trusts, partnership firms, companies and statutory bodies, which are not included under 'Retail Banking'. #&$ Other Ban2in, B7siness 'Other Banking Business' would include all other banking operations not covered under 'Treasury', 'Wholesale Banking' and 'Retail Banking' segments. Ìt will also include all other residual operations such as para banking transactions and activities. !@.@ COM*ONENTS O+ CREDIT MANAIEIMENT Doan *oli%3 of the Ban2 Each bank formulates its own loan policy and sanction of any credit proposal has to be within the framework of this policy. The formulation of loan policy is influenced by various factors like market conditions, policies of the competitors, bank's own SWOT analysis and, of course, the RBÌ guidelines. The loan policy normally contains guidelines about the following aspects: 1. Exposure limits for single borrowers and groups !. Exposure limits for individual sectors like real estate, capital market, steel, cement, software etc. This is under constant watch of the bank and if bank's perception about any particular sector deteriorates, the exposure limit is reduced suitably and fresh sanctions of credit proposals, pertaining to that sector, are curtailed. Ìn such cases, bank may even decide to exit some of the existing accounts by formulating suitable exit strategies .The loan policy also covers the thrust areas, low priority areas etc. (. Discretionary powers at various levels for sanctioning of credit proposals. Normally, the policy also lays down the powers of various authorities for allowing over drawings/ad-hoc limits. A55raisal Before a lender agrees to give his money to a borrower, as per his proposal, a few questions arise in his mind. Normally, these questions are as follows: 1. Ìs the borrower trustworthy? !. What is he going to do with my money'? Ìs the project/activity, where he is going to put this money, viable? What are the risks involved? (. Should Ì give him the amount he has asked for or, a different amount? .. What should be the terms of repayment, interest rate etc. ?. What covenants should be prescribed to have effective monitoring of the project and activity in which money is invested @. Should Ì take any collateral security or personal guarantee. B. How should charge be created over primary/collateral security? What documents should be taken to enforce my claim in a court of law in case of default? The process of finding the answers to the above questions is credit appraisal. The complexity of this appraisal will depend on various factors like, amount involved, duration and purpose of loan, category of borrower, risks involved, security available, RBÌ guidelines etc. Thus, appraisal for a small crop loan or a vehicle loan will be different from that for an industrial project. For appraisal, the tender will normally depend on some or all of the following information/records, depending upon the uniqueness of each case. 1. The background, credit history, market reports of the borrower. !. The financial track record of the borrower as represented by the financial statements. Where these statements are not available, as in case of most of the individuals, the net worth and repayment capacity is judged by collecting details of assets and liabilities and sources of income. (. Techno-economic feasibility report of the activity proposed; The details required in this depend on the nature of activity and amount of loan. The purpose is to ensure that there is reasonably high probability of the activity being successful and bank getting back its principal and interest in time. Mostly, in case of industrial projects only a detailed project report is prepared by the competent agency. Ìn other cases, the viability is judged by the analysis of past track record, present financial position, sources of income, expenditure and bank's own judgment .. Securities available, their value and realisability. Deli=er3 This relates to legal aspects of documentation and creation of charge over security .This also covers the method of delivery ( like loan or cash credit in case of working capital limits) and procedures for disbursal of a term loan. Control an& Monitorin, This is necessary not only to ensure end use of the bank's funds but also to ensure safety of it. An efficient monitoring is in the interest of the borrower as well, as the bank can provide timely help in case of unforeseen difficulties. Ìt is very important for the bank as any delay in taking suitable action in cases of activity not being carried out as projected, reduces the chances and amount of recovery of bank's funds. Reha"ilitation an& Re%o=er3 Even with best of loan policies, appraisal, delivery, control and monitoring, credit default is possible either due to genuine business problems or due to intentional (called willful) default. Ìn the first case, the banks normally examine the feasibility of providing additional assistance, concessions, re-phasing etc. to help the enterprise to make its operations viable again. The widely known terms like rehabilitation of sick SSÌ units and Corporate Debt Restructuring (CDR) are part of this process. However, if rehabilitaion is not considered feasible or, if the rehabilitation process does not yield the desired results, and in case of willful defaults, bank has to start the recovery process. Cre&it Ris2 Mana,e'ent Credit risk is a major risk faced by a bank and it is very important that suitable policies are put in place to identify, measure and control this risk within acceptable limits. Refinan%e 'This aspect of credit management assumes importance in times of tight liquidity position. There are elaborate norms for availing refinance from NABARD, SÌDBÌ, RBÌ etc., in respect of certain priority sector advances. However, even if a bank avails of refinance for eligible advances, the risk remains with the bank. Therefore, this aspect does not affect bank's decision on a credit proposal.
[email protected] RODE O+ RBILS IUIDEDINES IN BAN/S CREDIT MANAIEMENT RBÌ has a direct influence on credit management of any bank in Ìndia. Ìn fact, keeping abreast with RBÌ guidelines and ensuring their compliance is an important work of the credit department of any bank. Following are some of the important RBÌ and Government guidelines or policies, which directly influence the credit management of a bank. En& Use of the +7n&s Ìt is the primary responsibility of banks to ensure proper end use of bank funds/monitor the funds flow. Ìt is, therefore, necessary for banks to evolve such arrangements as may be considered necessary to ensure that drawals from cash credit/overdraft accounts are strictly for the purpose for which the credit limits are sanctioned by them. There should be no diversion of working capital finance for acquisition of fixed assets, investments in associate companies/subsidiaries, and acquisition of shares, debentures, units of mutual funds, and other investments in the capital market. *riorit3 Se%tor (For complete details, RBÌ Master circular dated 1 st July, 2009,, available on their website www.rbi.org.in may be referred.) RBÌ, as regulator of banks in Ìndia, decides about the sectors which are included in the priority sector, as also, the minimum percentage of total credit of a bank which should go to this sector. Priority sector lending by commercial banks is monitored by Reserve Bank of Ìndia through periodical 'Returns' received from them. Performance of banks is also reviewed in the various forums set up under the Lead Bank Scheme (at State, District and Block levels). The main sectors, included in the priority sector are as follows: 1. Agricultural finance !. Finance to micro and small enterprises (. Housing finance [( loans up to Rs 20 takh to individuals for purchase or construction of dwelling unit), Loans up to Rs Ì lakh and Rs 2 lash for repairing of houses in rural or semi-urban and urban areas respectively]. .. Educational loans(up to Rs 10 lakh for studies in Ìndia and Rs 20 lakh for studies abroad) ?. Export credit: export credit by domestic banks is not treated as finance to priority sector for the purpose of priority sector target. But, export credit by foreign banks is treated as finance to priority sector. @. Micro-credit provided by banks either directly or through any intermediary: Loans to self help groups (SHGs) [Non Governmental Organizations (NGOs) for on-lending to SHGs B. Retail trade C. Khadi and Village Ìndustries Sector (KVÌ);All advances granted to units in the KVÌ sector, irrespective of their size of operations, location and amount of original investment in plant and machinery, are covered under priority sector advances and are eligible for consideration under the sub-target (60 per cent) of the small enterprises segment within the priority sector. Bank's lending to medium enterprises is not included for the purpose of reckoning under the priority sector. Tar,ets for *riorit3 Se%tor Den&in, The targets and sub-targets set under priority sector lending for domestic and foreign banks operating in Ìndia are furnished here: (Figures are given as per cent of Adjusted Net Bank Credit (ANBC) or credit equivalent amount of Off-Balance Sheet Exposure, whichever is higher) Se,'ent KaL, Total Priority Sector advances,, Target for Domestic Banks, both public and private sectors, 40 per cent and Target for Foreign Banks operating in Ìndia, 32 per cent. Se,'ent K"L, Total Agricultural advances,, Target for Domestic Banks, both public and private sectors, 18 per cent and Target for Foreign Banks operating in Ìndia, No target. Se,'ent K%L, Small enterprise advances,, Target for Domestic Banks, both public and private sectors, No target and Target for Foreign Banks operating in Ìndia, 10 per cent. Se,'ent K&L, Export Credit,, Export credit does not form part of priority sector. Se,'ent KeL, Advances to weaker sections,, Target for Domestic Banks, both public and private sectors, 10 per cent and Target for Foreign Banks operating in Ìndia, No target. The weaker sections under priority sector include the following: 1. Small and marginal farmers with land holding of 5 acres and less and landless labourers, tenant farmers and share croppers. !. Artisans, village and cottage industries where individual credit limits do not exceed Rs 50,000/- (. Beneficiaries of Swarnjayanti Gram Swarojgar Yojana (SGSY) .. Scheduled Castes and Scheduled Tribes ?. Beneficiaries of Differential Rate of Ìnterest (DRÌ) scheme @. Beneficiaries under Swama Jayanti Shahari Rojgar Yojana (SJSRY) B. Beneficiaries under the Scheme for Liberation and Rehabilitation of Scavangers (SLRS). C. Self Help Groups (SHGs) MSMED A%t !00@ The MSMED Act, 2006 has modified the definition of micro, small and medium enterprises engaged in manufacturing or production and providing or rendering of services. This Act provided the comprehensive rules pertaining to both the manufacturing and service enterprises in the MSM sector and has cleared much of the apprehension/confusion in the minds of bankers regarding definition, guidelines, credit targets etc pertaining to this sector .The details can be seen in Master Circular No. RPCD.SME & NFS. BC. No. 10/ 06.02.31/ 2009-10 dated 1 st July 2009 on RBÌ website www.rbi.org.in The definition of Micro, Small and Medium Enterprises is as follows: #a$ Enter5rises en,a,e& in the 'an7fa%t7re or 5ro&7%tion. 5ro%essin, or 5reser=ation of ,oo&s 1. A 'i%ro enter5rise is an enterprise where investment in plant and machinery does not e+ceed Rs) -? lakhF !. A s'all enter5rise is an enterprise where the investment in plant and machinery is more than Rs) -? lakh but does not e+ceed Rs) ? crore; (. A 'e&i7' enter5rise an enterprise where the investment in plant and machinery is more than Rs) ? crore but does not e+ceed Rs)(> crore. Ìn case of these enterprises, investment in plant and machinery is the original cost excluding land and building and the items specified by the Ministry of Small Scale Ìndustries. #"$ Enter5rises en,a,e& in 5ro=i&in, or ren&erin, of ser=i%es and whose investment in equipment (original cost excluding land and building and furniture, fittings and other items not directly related to the service rendered or-as may be notified under the MSMED Act, 2006) are specified as follows: 1. A 'i%ro enter5rise is an enterprise where investment in equipment does not e+ceed Rs) (> lakhF !. A s'all enter5rise is an enterprise where the investment in equipment is more than Rs) (> lakh but does not e+ceed Rs) - crore< (. A 'e&i7' enter5rise an enterprise where the investment in equipment is more than Rs) - crore but does not e+ceed Rs)? crore. These include small road and water transport operators, small business, professional and self-employed persons and all other service enterprises. Cre&it E65os7res Nor's 1. +or In&i=i&7al or Iro75 Borro8ers: The exposure ceiling limits are 15 per cent of capital funds in case of a single borrower and 40 per cent of capital funds in the case of a borrower group. The capital funds for this purpose comprise of Tier Ì and Tier 11 capital as defined under capital adequacy standards .Credit exposure to a single borrower may exceed the exposure norm of 15 per cent of the bank's capital funds by an additional 5 per cent (i.e. up to 20 per cent) and to borrowers belonging to a group may exceed the exposure norm of 40 per cent of the bank's capital funds by an additional 10 per cent (i.e., up to 50 per cent), provided the additional credit exposure is on account of extension of credit to infrastructure projects. Ìn addition to the exposure permitted above, banks may, in exceptional circumstances, with the approval of their Boards, consider enhancement of the exposure to a borrower (single as well as group) up to a further 5 per cent of capital funds subject to the borrower consenting to the banks making appropriate disclosures in their Annual Reports. With effect from May 29, 2008, the exposure limit in respect of single borrower has been raised to twenty five per cent of the capital funds, only in respect of Oil Companies who have been issued Oil Bonds (which do not have SLR status) by Government of Ìndia. Ìn addition to this, banks may, in exceptional circumstances, consider enhancement of the exposure to the Oil Companies up to a further 5 per cent of capital funds. The bank should make appropriate disclosures in the 'Notes on account' to the annual financial statements in respect of the exposures where the bank had exceeded the prudential exposure limits during the year. !. +or E65os7res to NB+Cs: The exposure (both lending and investment, including off balance sheet exposures) of a bank to a single NBFC/NBFC-AFC (Asset Financing Companies) should not exceed 10 per cent/ 15 per cent respectively, of the bank's capital funds, as per its last audited balance sheet. Banks may, however, assume exposures on a single NBFC/NBFC-AFC up to 15 per cent/20 per cent respectively, of their capital funds provided the exposure in excess of 10 per cent/15 per cent respectively, is on account of funds on-lent by the NBFC/NBFC-AFC to the infrastructure sector. Further, banks may also consider fixing internal limits for their aggregate exposure to all NBFCs put together. Ìnfusion of capital funds after the published balance sheet date may also be taken into account for the purpose of reckoning capital funds. Banks should obtain an external auditor's certificate on completion of the augmentation of capital and submit the same to the Reserve Bank of Ìndia (Department of Banking Supervision) before reckoning the additions to capital funds. The exposure limits are also applicable to lending under consortium arrangements and bills discounted under Letter of Credit (LC) (where the payment to the beneficiary is made 'under reserve'). However, the ceilings on single/group exposure limits are not applicable to existing/additional credit facilities (including funding of interest and irregularities) granted to weak/sick industrial units under rehabilitation packages .These are also not applicable to borrowers to whom limits are allocated directly by the Reserve Bank for food credit as also to loans where principal and interest are fully guaranteed by the Government of Ìndia. Loans and advances (both funded and non-funded facilities) granted against the security of a bank's own term deposits are not to be reckoned for computing the exposure to the extent that the bank has a specific lien on such deposits. The ceiling on single or group borrower exposure limit is also not applicable to exposure assumed by banks on NABARD. Interest Rates on Den&in, (details as per RBÌ circular No. Dir. BC. 14/13.03.00/2008-09 dated 1, July 2008) #1$ Re,7late& Rates An objective of financial sector reform has been to ensure that the financial repression, inherent in administered interest rate, is removed. Accordingly, in the context of granting greater functional autonomy to banks, effective 18, October 1994, it was decided by the RBÌ to free the lending rates of scheduled commercial banks for credit limits of over Rs. 2 lakh. For loans up to Rs. 2 lakh, it was decided that it was necessary to 'continue to protect these borrowers by prescribing the lending rates. For credit limits up to Rs.2 lakh, banks should charge interest not exceeding their BPLR. For credit limits of over Rs.2 lakh, the prescription of minimum lending rate was abolished and banks were given the freedom to fix the lending rates for such credit limits subject to BPLR and Spread guidelines . Banks are now required to obtain the approval of their respective Boards for the Benchmark Prime Lending Rate (BPLR), which would be the reference rate for credit fruits of over Rs.2 lakh. Each bank's BPLR has to be declared and be made uniformly applicable at all branches. Banks have to declare the maximum spread of interest rates over BPLR. Banks are free to determine the rates of interest without reference to BPLR and regardless of the size in respect of loans for purchase of consumer durables, loans to individuals against shares and debentures/ bonds, other non-priority sector personal loans, etc. The interest rate directives on advances granted by banks are also not applicable to loans or advances or other financial accommodation provided by a scheduled bank to its own employees or co-operative credit societies formed by the banks' staff members for lending to constituents (i.e. staff of the bank). Intro&7%tion of Base Rate: The BPLÌZ system, introduced in 2003, fell short of its original objective of bringing transparency to lending rates. This was mainly because under the BPLR system, banks could lend below BPLR. For the same reason, it was also difficult to assess the transmission of policy rates of the Reserve Bank to lending rates of banks. Ìn view of this, RBÌ has decided that banks switch over to the system of Base Rate with effect from 1, July 2010. The Base Rate system is aimed at enhancing transparency in lending rates of banks and enabling better assessment of transmission of monetary policy. Accordingly, the following guidelines are issued for implementation by banks as per RBÌ circular RBÌ / 2009-10/390, DBOD. No. Dir. BC M 113.03M/2009- 10 dated April 9, 2010). 1. The Base Rate system will replace the BPLR system with effect from 1, July 2010. Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers. Banks may choose any benchmark to arrive at the Base Rate for a specific tenor that may be disclosed transparently. Banks are free to use any other methodology, as considered appropriate, provided, it is consistent and is made available for supervisory review or scrutiny, as and when required. !. Banks may determine their actual lending rates on loans and advances with reference to the Base Rate and by including such other customer-specific charges as considered appropriate. (. Ìn order to give banks some time to stabilize the system of Base Rate calculation, banks are permitted to change the benchmark and methodology any time during the initial six month period, i.e. end-December 2010. .. The actual lending rates charged may be transparent and consistent and be made available for supervisory review/scrutiny, as and when required. ?. All categories of loans should henceforth be priced only with reference to the Base Rate. However, the following categories of loans could be priced without reference to the Base Rate: #a$ DRÌ advances #"$ loans to banks' own employees #%$ loans to banks' depositors against their own deposits. @. The Base Rate could also serve as the reference benchmark rate for floating rate loan products, apart from external market benchmark rates. The floating interest rate based on external benchmarks should, however, be equal to or above the Base Rate at the time of sanction or renewal. B. Changes in the Base Rate shall be applicable in respect of all existing loans linked to the Base Rate, in a transparent and non-discriminatory manner. C. Since the Base Rate will be the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate. Accordingly, the current stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh stands withdrawn. Ìt is expected that the above deregulation of lending rate will increase the credit flow to small borrowers at reasonable rate and direct bank finance will provide effective competition to other forms of high cost credit. F. Reserve Bank of Ìndia will separately announce the stipulation for export credit. 10. Banks are required to review the Base Rate at least once in a quarter with the approval of the Board or the Asset Liability Management Committees (ALCOs) as per the bank's practice. Since transparency in the pricing of lending products has been a key objective, banks are required to exhibit the information on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Banks are required to provide information on the actual minimum and maximum lending rates to the Reserve Bank on a quarterly basis, as hitherto. 11. The Base Rate system would be applicable for all new loans and for those old loans that come up for renewal. Existing loans based on the BPLR system may run till their maturity. Ìn case existing borrowers want to switch to the new system, before expiry of the existing contracts, an option may be given to them, on mutually agreed terms. Banks, however, should not charge any fee for such switch-over. 1!. Ìn line with the above Guidelines, banks may announce their Base Rates after seeking approval from their respective ALCOs/ Boards. #!$ *erio&i%it3 of Char,in, interest on A&=an%es The interest at the specified rates should be charged at monthly rests (subject to certain conditions ) and rounded off to the nearest rupee. Banks should club term loans and working capital advances together for the purpose of determining the size of the loan and the applicable rate of interest. Ìnstructions on charging interest at monthly rates are not applicable to agricultural advances and banks should follow the practice of charging/compounding of interest on agricultural advances linked to crop seasons. Banks should charge interest on agricultural advances for long duration crops at annual rates. As regards other agricultural advances in respect of short duration crop and allied agricultural activities such as dairy, fishery, piggery, poultry, bee-keeping, etc., banks should take into consideration due dates fixed on the basis of fluidity with borrowers and harvesting/marketing season, while charging interest and compounding the same, if the loan or installment becomes overdue. Further, banks should ensure that the total interest debited to an account should not exceed the principal amount in respect of short term advances granted to small and marginal farmers. #($ +i6e& or +loatin, Rate of Interest on Doans RBI ,7i&elines in this re,ar& are as 7n&er: 'Banks have the freedom to offer all categories of loans on fixed or floating rates, subject to conformity to their Asset-Liability Management (ALM) guidelines. Ìn order to ensure transparency, banks should use only external or market-based rupee benchmark interest rates for pricing of their floating rate loan products. The methodology of computing the floating rates should be objective, transparent and mutually acceptable to counter parties. Banks should not offer floating rate loans linked to their own internal benchmarks or any other derived rate based on the underlying.' #.$ *enal rate of Interest With effect from 10, October 2000, banks have been given the freedom to formulate a transparent policy for charging penal interest with the approval of their Board of Directors. However, in the case of loans to borrowers under priority sector, no penal interest should be charged for loans up to Rs.25,000. Penal interest may be levied for reasons such as default in repayment, non-submission of financial statements, etc. However, the policy on penal interest should be governed by well- accepted principles of transparency, fairness, incentive to service the debt and genuine difficulties of customers. Collateral Se%7rit3 Banks are free to decide about the collateral security to be obtained for the loans granted by them. However, RBÌ has instructed that banks should not obtain collateral security for certain categories of loans. The exemption limit for all MSME(as defined under MSMED Act) borrowal accounts (both manufacturing or production and providing or rendering of services), for obtaining collateral security, is Rs 5 lakh.RBÌ has clarified that these guidelines are mandatory and not advisory. Monetar3 an& Cre&it *oli%3 Traditionally, RBÌ announces its monetary at the beginning of the financial year (reviewed quarterly) and credit policy twice a year. The contents of these policies are very important for the banks and they adjust their loan policy and lending rates, if considered desirable, based on these. Stat7tor3 an& Other Restri%tions on So'e Cre&its The following credit restrictions have been placed on the banks: (details as per RBÌ circular No. Dir. BC. 13113.03.00/2009-10 dated 1, July 2009) 1. Advances against bank's own shares: Ìn terms of Section 20(1) of the Banking Regulation Act, 1949, a bank cannot grant any loans and advances on the security of its own shares. !. Restrictions on granting loans and advances to relatives of Directors (. Restrictions on Grant of Loans & Advances to Officers and Relatives of Senior Officers of Banks .. Restrictions on Grant of Financial Assistance to Ìndustries Producing or Consuming Ozone Depicting Substances (ODS) ?. Restrictions on Advances against Sensitive Commodities under Selective Credit Control (SCC) @. Advances against Fixed Deposit Receipts (FDRs) Ìssued by Other Banks B. Loans against Certificate of Deposits (CDs) C. Restrictions on Credit to Companies for Buy-back of their Securities Metho&s of Cre&it Assess'ent For quite a long time, credit was considered to be a scarce commodity and RBÌ had a tight control over the methods of credit assessment by the banks. The guidelines on MPBF first or second or third method of lending, permissible inventory levels, etc. originated in this period. RBÌ has since relaxed the rules in this area and the banks are now free to adopt their own method of credit assessment. However, for loans and advances to Small Scale Ìndustries, RBÌ guidelines are as under: 'SS1 units having working capital limits of up to Rs. 5 crore from the banking system are to be provided working capital finance computed on the basis of 20 per cent of their projected annual turnover. The banks should adopt the simplified procedure in respect of all SSÌ units (new as well as existing).' Deli=er3 of Cre&it RBÌ has advised the banks to follow, as far as feasible, the loan system, for delivery of bank credit. RBÌ guidelines in this respect are as under: 1. Ìn the case of borrowers enjoying working capital credit limits of Rs. 10 crore and above from the banking system, the loan component should normally be 80 per cent. Banks, however, have the freedom to change the composition of working capital by increasing the cash credit component beyond 20 per cent or to increase the 'Loan Component' beyond 80 per cent, as the case may be, if they so desire. Banks are expected to appropriately price each of the two components of working capital finance, taking into account the impact of such decisions on their cash and liquidity management. !. Ìn the case of borrowers enjoying working capital credit limit of less than Rs. 10 crore, banks may persuade them to go in for the 'Loan System' by offering an incentive in the form of lower rate of interest on the loan component. as compared to the cash credit component. The actual percentage of 'loan component' in these cases may be settled by the bank with its borrower clients. (. Ìn respect of certain business activities, which are cyclical and seasonal in nature or have inherent volatility, the strict application of loan system may create difficulties for the borrowers. Banks may, with the approval of their respective Boards, identify such business activities which may be exempted from the loan system of delivery. In%o'e Re%o,nition an& Asset Classifi%ation One of the important functions of RBÌ is to ensure the stability of financial sector and thus ensuring the interests of the depositors. Banks are required to present their financial position in a fair and transparent manner. A crucial factor, affecting the health of a bank, is the quality of its assets. As these assets are formed mainly with depositors' money( bank's capital in formation of these assets can be as low as 9 per cent, which is the mandatory CAR), even a small deterioration in the quality of these assets can affect the interests of the depositors very badly. RBÌ has, therefore, prescribed guidelines for the banks to classify their assets depending on the conduct of each account. A provision, out of bank's profit, has to be made to provide for the possibility of default The amount of provision depends on the classification of the asset. Similarly, there are norms prescribed for not recognizing some of the perceived incomes so that the profit of the bank is not inflated unduly. For example, in an account where the principal itself is doubtful of recovery, there is no point in considering the interest receivable as part of the accrued income. There are elaborate RBÌ guidelines on these matters and all the banks have to compulsorily follow them. #%onsoli&ate& ,7i&elines are %ontaine& In RBI NI aster %ir%7lar No. DBOD.s o$.BIEBC.I B4 !1.0..0.S4!00FE10 &ate& J7l3 1. !00F. +i&e 01 N111! %ir%7lar is Master Cir%7lar — *r7&ential nor's on In%o'e Re%o,nition— Asset Classifi%ation an& *ro=isionin, 5ertainin, to A&=an%e$ +air *ra%ti%es Co&e (Details in RBÌ circulars dated 5/5/03 and 6/3/07) RBÌ has issued guidelines on fair practices code for lending. These are to be compulsorily followed by all banks in Ìndia. These guidelines pertain to: #1$ application for loans and their processing #!$ loan appraisal and terms and conditions #($ disbursements of loans #.$ post disbursement supervision #?$ general guidelines relating to discrimination based on sex, caste and religion. harassment in recovery, transfer/takeover of accounts, etc. S7''ar3 Ìn banking business, the main source of income is still the income on advances given by the bank and, therefore, efficient credit management is very important in achieving the financial objectives of any bank. But, it is also a fact that credit involves some peculiar inherent risks which should be understood, measured and managed. Each bank formulates its own elaborate loan policy detailing the organizational set up for credit administration, and prudential norms for single/group borrowers, as also for specific activities. The policy also lays down the appraisal standards, delegation of sanctioning powers, credit risk parameters and guidelines for delivery and monitoring . Appraisal of a credit proposal plays a major role in ensuring timely repayment of money lent by the bank and interest on it. Analysis of financial statements, both past and the projected, help the bank in appraisal of the viability of the proposal as also the amount needed by the borrower. The main methods used for this analysis are trend and ratio analysis. Banks also provide non fund based credit like guarantees, Letters of credit, co- acceptance of bills, etc. The fund based credit is mainly in the form of working capital finance or term loans, which include project and infrastructure finance. Despite all precautions taken in appraisal, delivery, monitoring and various other risk management measures, sometimes, there is default in timely repayment of principal and interest. Management of these problematic assets is also an important part of credit management. RBÌ, being the regulator of financial system in Ìndia, still has great influence on credit management of any bank despite relaxation of controls over the period of time. Knowledge and compliance of relevant RBÌ guidelines is essential for credit management department of any bank. /e38or&s Prudential norms; Asset classification; Provisioning; Collateral security; Priority sector; MSM enterprises; Rehabilitation; Regulated interest rates; Principles of credit; types of borrowers; Appraisal; Delivery; Monitoring and supervision; Credit Risk Management. Che%2 3o7r 5ro,ress +ill in the "lan2s 8ith %orre%t %hoi%e: 1. As per RBÌ guidelines, the turnover method of assessment should be applied for working capital limit of up to Rs ...in case of SSÌ units. (a) One Crore (b) Two Crores (c ) 0ive /rores (d) Ten Crores !. Ìnterest rates, regulated by RBÌ, are applicable for credit limit up to Rs ... lakh. (a) One (b) Two (c ) Five (d) Ten (. The total priority sector target fore foreign banks, operating in Ìndia, is ... (a) 20% (b) .-G (c ) 40% (d) 18% State Tr7e or +alse: .. As per RBÌ guidelines, the assets should be classified as Standard, Non-standard and doubtful. .. False. ?. As per RBÌ guidelines, no provision is required for Standard Assets. .. False. @. As per MSMED Act 2006, small manufacturing enterprise is an enterprise where the investment in plant and machineryis more than Rs 25 lakh but dos not exceed Rs 5 crore. .. True. B. Fair practices code provides guidance and is not compulsory for the banks in Ìndia. .. False. Answer to Check Your Progress 1. (c); 2. (b); 3. (b); 4. False; 5. False; 6. True; 7. False This is the en& of %ha5ter !@0 of ADVANCED BAN/ ANAIEMENTE C A I I B *A*ER 1 E Overview of Credit Management. ADVANCED BANK MANAGEMENT UNÌT 27 ÷ Analysis of Financial Statements Part 1 of 2 STRUCTURE !B.0 Objectives !B.1 Ìntroduction !B.! Which are the Financial Statements? !B.( Users of Financial Statements !B.. Basic Concepts Used in Preparation of Financial Statements !B.? Legal Position Regarding Financial Statements !B.@ Balance Sheet !B.B Profit and Loss Account !B.C Funds Flow and Cash Flow Statements !B.F Projected Financial Statements !B.10 Purpose of Analysis of Financial Statements by Bankers BB.11 Rearranging the Financial Statements for Analysis !B.1! Techniques used in Analysis of Financial Statements !B.0 OBJECTIVES After rea&in, this %ha5ter0 3o7 8ill ha=e "etter 7n&erstan&in, of: 1. Types of financial statements !. Funds flow /Cash flow statement (. The importance and uses of financial statements in credit appraisal .. Projected financial statements ?. Analysis of financial statements @. Relationship between items in balance sheet and P & L account B. Trend analysis C. Ratio analysis !B.1 INTRODUCTION Whenever a bank considers a loan proposal, apart from the integrity and K Y C aspects, it has a keen interest in knowing the financial details of the prospective borrower. The extent of these details depends upon the type of loan, type of borrower, purpose of the loan etc. Ìn case of security based lending like loans against fixed deposits, shares etc, these financial details may be few or may not be required at all. But, in all other cases, such details are invariably collected with a view to assessing the following: 1. The Net ;orth of the A55li%ation: For an individual, the excess of his assets over his liabilities is his net worth. The same thing applies to any business entity as well but, prima facie, its financial statement shows assets and liability to be equal as business is considered to be separate legal entity and its net worth is added to liabilities considering that this is the amount payable to the promoters by the business entity. The net worth of an applicant helps the bank in deciding the level of activity which may be desirable by that applicant and the amount of money which can be lent to him. !. Re5a3'ent Ca5ti=it3: Ìn case of an individual, the bank collects information like his income (salary, interest, dividend etc.) as also his expenditure, including repayments of existing borrowings, if any, to assess the surplus available for repayment of installments and interest on bank's loan. Ìn case of a business enterprise, this information is available from its financial statements. (. Via"ilit3: Bank loan mayor may not result in increased earnings for a borrower. For example, a loan for consumer durables will not increase the income while a home loan may result in increased income from rent or reduced expenditure by way of savings on rent. Ìn case of a business enterprise, bank loan is normally intended to increase the income level. A scrutiny of the financial records of the existing activity helps bank in assessing whether the proposed bank loan will result in a viable increase in operations. .. A=aila"ilit3 of Unen%7'"ere& Se%7rities: Ìn case of individuals, where normally no formal statements of their financial position are available, the bank asks questions to find out about their assets, liabilities, sources of income, expenditure, terms of repayment of existing loans, need for the loan, use of the loan, etc., to address the above mentioned questions. Ìn case of other applicants, such information is normally available from the financial statements, which they are required to prepare as per the law. The statutory provisions ions regarding preparation and audit of financial statements are mostly applicable to corporate entities but these provide the directions to the non-corporate entities as well, and most of such entities, having substantial business volume, follow these guidelines, prescribed for the corporate entities. !B.! ;GICG ARE TGE +INANCIAD STATEMENTS There are basically two financial statements which every business enterprise is required to prepare. These are: 1. Balance sheet !. Profit & Loss account (Ìncome & Expenditure statement in case of non-profit organizations) Apart from these, the auditors' report, explanatory schedules and notes on accounts, if applicable, provide useful information to the bankers. A funds flow statement also provides useful information but, this is only a mathematical analysis of changes in the structure of two consecutive balance sheets and can be easily prepared by the banker/ analyst himself if the basic statements, i.e. the balance sheets, are available. Accounting Standard-3 makes it mandatory for some enterprises to prepare Cash Flow statement for the accounting period (these enterprises are those whose equity or debt is listed or is in the process of being listed on a recognized stock exchange and also all other commercial, industrial and business enterprises whose turnover for the accounting period exceeds Rs.50 crore. These enterprises are also required to do segment-wise reporting as per A S -1 7. !B.( USERS O+ +INANCIAD STATEMENTS Apart from bankers, the other users of financial statements are: 1. Other creditors and lenders !. Ìnvestors (. Government agencies .. Rating agencies ?. Customers @. Employees B. General public C. Analysts !B.. BASIC CONCE*TS USED IN *RE*ARATION O+ +INANCIAD STATEMENTS The important concepts are as under: 1. Entity Concept !. Money Measurement Concept (. Stable Monetary Unit Concept .. Going Concern Concept ?. Cost Concept @. Conservatism Concept B. Dual Aspect Concept C. Accounting Period Concept F. Accrual Concept 10. Realization Concept 11. Matching Concept !B.? DEIAD *OSITION REIARDINI +INANCIAD STATEMENTS 1. +or'at: Ìn case of banking companies, the formats of both balance sheet and P&L account are prescribed by the Banking Regulation Act. Ìn case of other companies, while the format of balance sheet is prescribed by the Companies Act, no format for Profit and Loss account is prescribed. However, Schedule VÌ of Companies Act requires that the statements should present a true and fair view of the state of affairs. The Companies Act has also specified that the profit and loss account must show specific information as required by Schedule-ÌV. The format of balance sheet can be either Vertical or Horizontal as illustrated below (activities like banking, insurance, electricity generation etc, which are governed by acts other than Companies Act, need not follow these formats) Gori-ontal +or': Horizontal form is maintained in two columns. The first column shows the Liabilities and the second one shows the Assets. The items shown in the first column against Liabilities are: Share Capital Reserves and surplus Secured loans Unsecured loans Current liabilities Provisions The items shown in the second column against Assets are: Fixed assets Ìnvestments Current assets Loans and advances Miscellaneous expenditure Verti%al +or': Ìn the Vertical Form, the different items are shown one below the other. #A$ Sources of funds 1. Shareholders' funds (a) Share capital (b) Reserves and surplus !. Loan funds (a) Secured loans (b) Unsecured loans #B$ Application of funds 1. Fixed assets !. Ìnvestments (. Current assets, loans and advances Less: Current liabilities and provisions Net current assets .. Miscellaneous expenditures !. A%%o7ntin, As per Ìncome Tax rules, April to March is considered as the financial year for tax purposes. However, as per Companies Act, this can be different. Only restriction, as per Companies Act, is that the maximum duration of the financial year can be 15 months, and can be extended up to 18 months with the permission of Registrar of Companies (ROC). (. +or in%o'5lete *roAe%ts an& no A%ti=it3 Every company has to prepare the financial statements even if there is no activity during the accounting period or the project is not completed. !B.@ BADANCE SGEET Ìt is a statement of assets (what is owned) and liabilities (what is owed to others) of an entity at a particular moment. Ìt is like a snapshot of assets and liabilities and just as one picture may be different from another taken anytime earlier, the balance sheet may also be different at different moments of the same day. Therefore, every balance sheet must indicate the date at the end of which it is prepared. Normally, the balance sheet is prepared at the end of the accounting period for which the Profit & Loss account is prepared. Dia"ilities The Companies Act classifies liabilities as follows: 1. Share capital !. Reserve and surplus (. Secured loans .. Unsecured loans ?. Current liabilities and provisions. Share Ca5ital This is divided into two categories: equity capital and preference capital. The first represents the contribution of equity shareholders who are the owners of the firm. Equity capital carries no fixed rate of return by way of dividend. However, on the preference capital, the dividend rate may be fixed and cumulative. Reser=e an& S7r5l7s Reserves and surplus are profits which have been retained in the firm. There are two types of reserves: revenue reserves and capital reserves. Revenue reserves represent accumulated retained earnings from the profits of normal business operations. These are held in various forms: general reserve, investment allowance reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves arise out of gains which are not related to normal business operations. Examples of such gains are the premium on issue of shares or gain on revaluation of assets. Surplus is the balance in the profit and loss account which has not been appropriated to any particular reserve. Se%7re& Doans These denote borrowings of the firm against which specific securities have been provided. The important examples of secured loans are: debentures, loans from financial institutions and banks. Unse%7re& Doans These are the borrowings of the firm against which no specific security has been provided. The examples of unsecured loans are: fixed deposits, loans and advances from promoters, inter-corporate borrowings, and unsecured loans from banks. C7rrent Dia"ilities an& *ro=isions Current liabilities and provisions, as per the classification under the Companies Act, consist of the following: amounts due to the suppliers of goods and services bought on credit; advance payments received; accrued expenses; unclaimed dividend; provisions for taxes, dividends, gratuity, pensions, etc. Current liabilities for managerial purposes (as distinct from their definition in the Companies Act) are obligations which are expected to mature in the next twelve months. So defined, they include the following: #1$ loans which are payable within one year from the date of balance sheet, #!$ accounts payable (creditors) on account of goods and services purchased on credit for which payment has to be made within one year, #($ Provision for taxation, #.$ accruals for wages, salaries, rentals, interest, and other expenses (these are expenses for services that have been received by the company but for which the payment has not fallen due), and #?$ advance payment received for goods or services to be supplied in the future. Assets Broadly speaking, assets represent resources which are of some value to the firm. They have been acquired at a specific monetary cost by the firm for the conduct of its operations. Assets are classified as follows under the Companies Act: 1. Fixed assets !. Ìnvestments (. Current assets, loans and advances .. Miscellaneous expenditures and losses +i6e& Assets These assets have two characteristics: they are acquired for use over relatively long periods for carrying on the operations of the firm and they are ordinarily not meant for resale. Examples of fixed assets are land, buildings, plant and machinery, office furniture, computer systems etc. In=est'ents These are financial securities owned by the firm. Some investments represent long term commitment of funds. (these may be equity shares of other firms held for investment or control purposes.) Other investments are of short-term nature and may be classified undercurrent assets for the purpose of financial analysis. (As per Companies Act, short-term holding of financial securities also has to be shown under investments). C7rrent Assets0 Doans0 an& A&=an%es This category consists of cash and other resources which get converted into cash during the operating cycle of the firm. Current assets are held for a short period of time as against fixed assets which are held for relatively longer periods. The major components of current assets are: cash, debtors, inventories, loans and advances, and pre-paid expenses. Cash includes credit balances in the bank accounts. Debtors (also called receivables or sundry debtors) represent the amount owed to the firm by its customers who have bought goods, services on credit. Debtors are shown in the balance sheet at the amount owed, less provision for bad debts. Ìnventories/ stocks consists of-raw materials, work-in-process, finished goods, and stores and spares. They are accounted at the lower side of the cost or market value as per the accounting concept of conservatism. Doans an& A&=an%es These are loans to employees, advances to suppliers and contractors, and deposits made with governmental and other agencies. They are shown at the actual amount. Pre-paid expenses are expenditure incurred for services to be rendered in the future, Mis%ellaneo7s E65en&it7res an& Dosses This category consists of two items: #1$ miscellaneous expenditures and #!$ losses. Miscellaneous expenditures represent certain outlays such as preliminary expenses and pre-operative expenses which have not been written off. From the accounting point of view, a loss represents a decrease in owners' equity. Hence, when a loss occurs, the owners' equity should be reduced by that 'amount. However, as per company law requirements, the share capital (representing. equity) cannot be reduced when a loss occurs. So, the share capital is kept intact on the liabilities side of the balance sheet and the loss is shown on the assets side of the balance sheet. !B.B *RO+IT AND DOSS ACCOUNT Ìt is a statement of income and expenditure of an entity for the accounting period. Every P and L account must indicate the accounting period for which it is prepared The items of a P & L account are: 1. Gross and Net sales !. Cost of goods sold (. Gross profit .. Operating expenses ?. Operating profit @. Non-operating surplus/deficit B. Profit before interest and tax C. Ìnterest F. Profit before tax 10. Tax 11. Profit after tax (Net Profit) Iross an& Net Sales The total price of goods sold and services rendered by an enterprise, including excise duty paid on the goods sold, is called Gross sales. Net sales are gross sales minus excise duties. Cost of Ioo&s Sol& This is the sum of costs incurred for manufacturing the goods sold during the accounting period. Ìt consists of direct material cost, direct ]about cost, and factory overheads. Ìt is different from the cost of production, which represents the cost of goods produced in the accounting year, not the cost of goods sold during the same period. Iross *rofit This is the difference between net sales and cost of goods sold. Most companies show this amount as a separate item. Some companies, however, show all expenses at one place without making gross profit a separate item. O5eratin, E65enses These consist of general administrative expenses, selling and distribution expenses, and depreciation. Some companies include depreciation under cost of goods sold as a manufacturing overhead rather than under operating expenses. O5eratin, *rofit This is the difference between gross profit and operating expenses. As a measure of profit, it reflects operating performance and is not affected by non-operating gains/losses, financial leverage, and tax factor. NonEo5eratin, S7r5l7s This represents gains arising from sources other than normal operations of the business. Ìts major components are income from investments and gains from disposal of assets. Likewise, non-operating deficit represents losses from activities unrelated to the normal operations of the firm. *rofit "efore0 Interest an& Ta6es This is the sum of operating profit and non-operating surplus/deficit. Referred to also as earnings before interest and taxes (EBÌT), this represents a measure of profit which is not influenced by financial leverage and the tax factor. Interest This is the expenses incurred for borrowed funds, such as term loans, debentures, public deposits, and working capital advances. *rofit "efore ta6 This is obtained by deducting interest from profits before interest and taxes. Ta6 This represents the income tax payable on the taxable profit of the year. *rofit after ta6 This is the difference between the profit before tax and tax for the year. This is the en& of *art 1 of !0 of %ha5ter !B0 of ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1. ADVANCED BANK MANAGEMENT UNÌT 27 ÷ Analysis of Financial Statements Chapter 27, Part 2 of 2 !B.C +UNDS +DO; OR CASG +DO; STATEMENTS Each item in the balance sheet represents either source of funds or use of funds. All items on the liabilities side represent the funds provided to the enterprise and all items on the assets side (except cash) represent use of these funds. Cash in the balance sheet represents the unutilized portion of funds, available to the enterprise. Ìf cash is also perceived as a use of funds then all the uses of funds are equal to all the sources of funds. This perception of available cash, as a use of funds, is what causes the wide spread confusion about difference in a Funds flow statement and a Cash flow statement. When we compare two balance sheets of different dates, change in each item (or introduction of a new item) in the balance sheet of later date, as compared to that item in the balance sheet of earlier date, will represent either addition of funds or additional use of funds in the intervening period. Any increase in any item on the liabilities side means additional funds available. Please note that additional funds are also available if there is decrease in any item on the assets side. Similarly, any increase in any item on the assets side or decrease in any item on the liabilities side means additional use of funds. A statement of these additional sources of funds and additional uses of funds is called Funds flow statement for the intervening period. Normally, this intervening period is the accounting year, as the balance sheets, which form the basis of this statement, are prepared as on the last day of each accounting period. Ìf we have to prepare the cash flow statement, we start with the cash in the first balance sheet as opening balance, add all the additional sources, excluding cash (cash is also a source of funds if it is at a reduced level in the subsequent balance sheet), and deduct all additional uses (excluding cash), thus arriving at, the closing balance, which will be equal to the cash shown in the second balance sheet. Ìn practice, the statement is prepared perceiving cash as a use or source of funds and it is known as Funds flow or cash flow statement. This should not be confused with the cash budget (which also is referred to as cash flow statement) prepared for the purpose of assessing the need for working capital funds from the bank. Ìn that statement, all cash flows during a period, excluding bank finance, are taken and the deficit shown forms the basis of bank finance. !B.F *ROJECTED +INANCIAD STATEMENTS Actual financial statements are for the past period and analysis of these gives very useful financial information to the banker. But for assessing the need for bank credit and to examine the viability of the activity, it is necessary to anticipate the financial position of the enterprise in future. For example, for assessing the working capital needs, the statement of assets and liabilities of the last year will not be adequate. We will have to anticipate the level of operations during the current year and accordingly project the level of assets and liabilities to arrive at the need for bank's loan. Of course, the financial statements for the past period serve as the most important guide for this estimate. Also, in case of a new enterprise, where no financial statements are available, it becomes necessary to decide on a level of activity and accordingly prepare the projected financial statements. Generally, in case of smaller enterprises, where adequate financial expertise may not be available, the projected financial statements for the next year are prepared by the bank by interviewing the concerned person . Ìn case of term loans for new projects/expansion, the projected financial statements are normally prepared for the entire duration of bank loan to establish the viability of operations as also to determine the disbursal and repayment schedule. Whenever the projected financial statements are submitted by the borrower, these are critically examined for their reasonability and if projections are considered to be unreasonable, the matter is discussed with the borrower and suitable consensus arrived at. !B.10 *UR*OSE O+ ANAD)SIS O+ +INANCIAD STATEMENTS B) BAN/ERS Different users, interested in the financial statements of an entity, may analyze these with focus on evaluation of different aspects. For example, a share market investor may be more interested in Earning Per Share (E P S), while the statutory authorities may be more interested in compliance and provisions. The banker's focus is normally on the following aspects: #a$ Assess'ent of *erfor'an%e an& +inan%ial *osition: An analysis of the financial statements reveals the trend of growth of its business and its profitability. By comparing these to the industry trend, opinion about the management and efficiency of the enterprise is formed. Also, the financial statements reveal the composition of assets and liabilities of the enterprise. By seeing the trend of leverage (Debt/equity), retention of profits etc., the financial health of the enterprise is judged. #"$ *roAe%tion of +7t7re *erfor'an%e: Past performance is often a good indicator of future performance. The financial statement analysis helps in projecting the earning prospects and growth rates in the level of activity and earnings with a reasonable degree of certainty. #%$ Dete%tin, Dan,er Si,nals: Financial statement analysis is an important tool in knowing the direction of business of the enterprise as also to detect any deterioration of its financial health. Being aware of any deterioration of the financial position, the bank can take preventive measures to avoid/ minimize losses. Ìmportant ratios, arrived at from the financial analysis. also help the bank to achieve this goal. #&$ Assess'ent of Cre&it ReJ7ire'ents: One of the difficulties in credit is the accurate assessment of the financial need of the applicant. Over-financing and under- financing both are risky for the borrower and the bank. Financial statement analysis is used by banks to assess the credit requirement more accurately. Banks are also concerned with repayment of loan interest within a reasonable time. Analysis of the financial statements of the borrower helps in assessing the repayment schedule as also to assess credit risk, decide the terms and conditions of loan. #e$ E6a'ine +7n&s +lo8: This is to ascertain that the bank's funds have been used for the intended purposes and there is no diversion. Also, the use of short term sources is examined to find if there is any unacceptable mismatch created in the liquidity position. #f$ Cross Che%2in,: The statements of stocks and book debts. as on the date of the balance sheet, submitted by the borrower. for calculation of drawing power in the cash credit account, are cross checked with the figures given in the balance sheet . Ìf statements of the balance sheet date are not available, the statements of nearest date are used, which give a fair idea if the correct statements are being submitted. !B.11 REARRANIINI TGE +INANCIAD STATEMENTS Ìn keeping with the above objectives, a banker rearranges the figures in the financial statements under distinct groups for a meaningful analysis. Balance Sheet The assets and liabilities are normally regrouped as under: Ìn regrouping, the items shown under Liabilities are: #1$ Net worth, #!$ Long-term liabilities #($ Current liabilities and provisions. Ìn regrouping, the items shown under Assets are: #1$ Fixed assets, #!$ Current assets #($ Non-current assets #.$ Ìntangible assets. *rofit an& Doss A%%o7nt The format prescribed under erstwhile Credit Monitoring Arrangement (CMA) under which banks used to report sanction of large credit proposals to RBÌ, still serves as a useful guide for rearranging the items in Profit and Loss account. The important groups of items are as under: The format is in three columns. The first column shows different items. The second and the third one show the values of these items in the last year and present year respectively. The different items shown in the first column are: 1. Gross sales !. Cost of sales #a$ Raw materials #"$ Power and fuel #%$ Direct labour #&$ Other manufacturing expenses #e$ Depreciation #f$ Sub total #,$ Add opening stocks #h$ Less closing stocks #i$ Total cost of sales (. Selling, general and administrative expenses .. operating profit ?. Ìnterest @. operating profit after interest B. add non operating income C. less non operating expenditure F. Profit before tax 10. tax 1!. Profit after tax I'5ortant *oints for Rearran,in, +inan%ial State'ents While rearranging the financial statements, the following points should be examined by the banker and suitable changes made in different items: #a$ Ìnstalment of term loans due within one year #"$ Advance tax and provision of tax #%$ Deferred tax assets and liabilities #&$ Non moving inventory #e$ Receivables more than 6 months old #f$ Revaluation of assets and Ìntangible assets #,$ Ìnvestments #h$ Bills purchased and discounted #i$ Contingent liabilities #A$ Provisioning #2$ Depreciation method #l$ Ìnventory valuation #'$ Expenses relating to earlier years #n$ Ìmportant events after account period. !B.1! TECGNI9UES USED IN ANAD)SIS O+ +INANCIAD STATEMENTS Bankers mostly use three methods for analysis of financial statements. (a) Funds Flow Analysis (b) Trend Analysis (c) Ratio Analysis +7n&s +lo8 Anal3sis: Ìf the borrower has not submitted the funds flow statement, bank prepares the same from the last two balance sheets. The total sources of funds are categorized as 'Long term' and 'Short term'. Similarly, the total uses are also categorized as 'Long term' and 'Short term'. Ìf the short term sources are more than the short uses it indicates diversion of working capital funds and needs to be probed further. Sometimes, it may be a desirable thing e.g., in case of companies with very high current ratio, it may be desirable to use the idle funds for creating additional capacity. The guiding principle is that this diversion should not affect the liquidity position of the company to unacceptable level. Tren& Anal3sis: Under trend analysis, bankers adopt the following methodology: #a$ The items for which trend is required to be seen, are arranged in horizontal form and percentage increase or decrease from the previous year's figures is indicated below it. Generally, this is used to see the trends of sales, operating profit, PBT, PAT etc. from P and L account. Similarly, the balance sheets, arranged in horizontal order, give the trends of increase or decrease of various items. #"$ Common si@e statements are prepared to express the relationship of various items to one item in percentage terms. For example, consumption of raw materials is expressed as a percentage of sales for different years and comparison of these figures gives indication of trend of operating efficiency. Common size financial statements contain the percentages of a key figure alone, without the corresponding amount figures. The use of percentages is usually preferable to the use of absolute figures. The use of common size statements can make comparisons of business enterprises of different sizes much more meaningful since the numbers are brought to common base, i.e. per cent. Such statement allows an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Ratio Anal3sis: This is the most favourite method of bankers for analysis of financial statements. A ratio is comparison of two figures and can be expressed as a percentage (e.g. profitability is 23.7 per cent), as a number (e.g. current ratio is 1.33) or simply as a proportion (e.g. debt equity is 1: 2).Both the figures,used in calculation of a ratio, can be from either P& L account, or balance sheet or one can be from P& L account and the other from balance sheet. Ratios help in comparison of the financial performance and financial position of an entity with other entities, as also for comparison with its own status over the years. While different users of financial statements are interested in different ratios, the ratios which interests a banker most, are the following: #a$ *rofita"ilit3 Ratios: Operating Profit Margin (OPM) and Net Profit Margin (NPM) are calculated by dividing the figures of operating profit (EBÌT, which means earnings before interest and tax) and net profit respectively by the net sales. OPM is an indicator of the operating efficiency of the enterprise while NPM is an indication of ability to withstand the adverse business conditions. #"$ DiJ7i&it3 Ratios: These are Current ratio (CR) and Acid test ratio or quick ratio. While CR is a ratio of total current assets to total current liabilities, quick ratio is calculated by dividing current assets (excluding inventory) by total current liabilities. These ratios indicate the capacity of an enterprise to meet its short term obligations. #%$ Ca5ital Str7%t7re Ratios: Debt Equity Ratio (DER) is a ratio of total outside long term liability to the Net worth of an enterprise. Bankers are averse to high debt equity ratios as it not only represents high borrowings in relation to the owned funds but also affects the viability of the operation of the enterprise, as higher borrowings mean higher costs and lower operating margins. Ìn case of those enterprises, which are not capital intensive (i.e. the requirement of fixed assets is low), this ratio may not indicate the correct picture as working capital borrowings, which are not indicated by DER, may be disproportionate to the capital. So, bankers use ratio of TOL (Total Outside Liabilities to TNW (Tangible Net Worth). #&$ Ratio In&i%atin, A"ilit3 to Ser=i%e Interest an& Instal'e'ts: Ìnterest Coverage Ratio (ÌCR) and Debt Service Coverage Ratio (DSCR) are the important ratios in this category. ÌCR is calculated by dividing EBÌT (earnings before interest and tax) by total interest on long term borrowings. DSCR is ratio of total cash flows before interest (net profit plus depreciation plus interest on long term borrowings) to total repayment obligation (instalment plus interest on long term borrowings). #e$ T7rno=er Ratios: #1$ In=entor3 T7rno=er Ratio: This is an indicator of movement of inventory. Ìt is calculated by dividing cost of goods sold by average inventory. A higher ratio indicates faster movement of inventory. This is also used for calculating average inventory holding period. #!$ De"torsL T7rno=er Ratio: Ìt is an indicator of how fast the debtors are realized. Ìt is calculated by dividing the net credit sales by average debtors outstanding during the year. A higher ratio indicates faster collection of debts. This is also used for calculating average collection period. Defi%ien%3 in Ratio Anal3sis Metho& The profit and loss account covers the entire fiscal period, whereas the balance sheet is on a particular date. To compare an income statement figure such as sales to a balance sheet figure such as debtors, we need a reasonable measure of average debtors for the year, which is normally arrived at by using an average of beginning and ending balance sheet figures. This approach does not eliminate problems due to seasonal and cyclical changes or bunching of sales near the year end. S7''ar3 Financial statements are prepared on the basis of accounts of financial transactions of an enterprise. The balance sheet depicts the position of its assets and liabilities as on a particular date, while P and L account is prepared for an accounting period and states the position of income, expenses and the profit. By comparing two successive balance sheets, we can calculate the flow of funds in the intervening period. So, the financial statements are effective tools in monitoring of an account. As the credit decisions are applicable for future needs of an enterprise, usually projected financial statements are also prepared, specially, in case of medium and large enterprises. These are based on actual statements for the past period and anticipated performance in the future. Analysis of financial statements helps banks in knowing the financial health and performance and viability of an enterprise and in assessing its credit requirements. The main methods used for this analysis are trend and ratio analyses. The trend analysis shows how the business of an enterprise is growing while the ratio analysis depicts the most critical financial parameters at a glance. Thus, if the key ratios like OPM, debt to equity ratio, current ratio, DSCR, debtors' turnover ratio are seen by a banker, he can form a reasonably correct opinion about the enterprise. However, for a final decision, a more detailed analysis is necessary. While the format for balance sheet is prescribed by law, the format for P&L account is prescribed only for the banking companies. But all entities, including non corporates, usually follow the well established accounting principles and prepare their accounts accordingly. For meaningful analysis, a banker has to rearrange these statements into various groups. /e38or&s Balance Sheet; P and L Account; Funds flow statement: Cash flow statement; Sources and uses of funds; Common size statements; OPM, debt to equity ratio; current ratio: DSCR, debtors' turnover ratio; Contingent liabilities; Ìntangible assets; Pre-operative expenses: Short term liabilities: Long term liabilities: Net worth; TNW; TOL Che%2 )o7r *ro,ress State Tr7e or +alse: State Tr7e or +alse: 1. Companies Act has prescribed the format of the balance sheet. .. True. 2. Format for P & L account for banking companies is prescribed by the Banking Regulation Act. .. True. 3. As per Companies Act, short-term holding of financial securities has to be shown Linder investments. .. True. 4. The furniture available in a furniture shop is classified under Fixed Assets. .. False. 5. For the purpose of analysis, installments of term loan, due within one year, is classified under current assets. .. True. 6. Banks reduce the amount of intangible assets from the Net Worth for the purpose of analysis of financial statements. .. True. 7. The change in the method of inventory valuation does not affect the profit in an accounting year. .. False. 8. The method of ratio analysis is the best method of financial analysis, as it does not suffer from any deficiency. .. False. 9. Debt: Equity ratio (D E R) is a ratio of total outside liability to the net worth of an enterprise. .. False. 10. Ìnterest Coverage Ratio (Ì C R) is calculated by dividing E B Ì T(earnings before interest and tax) by total interest on long term borrowings .. True. 11. D S C R indicates the ability of an enterprise to service interest and installments. .. True. 12. Contingent liabilities of an enterprise do not affect the financial analysis. .. False. 13. Funds flow statement and the statement of Sources and Uses of funds are the same. .. True. 14. Liquidity ratios indicate the capacity of an enterprise to meet its short term obligations. .. True. Key to Check Your Progress 1. True; 2. True; 3. True; 4. False; 5. True; 6. True; 7. False; 8. False; 9. False; 10. True; 11. True; 12. False; 13. True; 14. True This is the en& of *art ! of !0 of %ha5ter !B0 of ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER10 Anal3sis of +inan%ial State'ents. ADVANCED BANK MANAGEMENT Unit 28 - WORKÌNG CAPÌTAL FÌNANCE STRUCTURE !C.0 Objectives !C.1 Concept of Working Capital !C.! Working Capital Cycle !C.( Ìmportance of Liquidity Ratios !C.. Methods of Assessment of Bank Finance !C.? Bills/Receivables Finance by the Banks !C.@ Guidelines of R B Ì for Discounting/Rediscounting of Bills by Banks !C.B Non Fund Based Working Capital Limits !C.C Other Ìssues Related to Working Capital Finance !C.0 OBJECTIVES After rea&in, this %ha5ter0 3o7 8ill ha=e "etter 7n&erstan&in, of: 1. The concept of working capital, total/gross working capital, net working capital !. Working capital cycle (. Components of current assets/current liabilities, liquidity, importance of liquidity ratios .. Various sources of meeting working capital requirements ?. Bank finance for working capital, methods of assessment @. Financing of bills/receivables B. Non fund based working capital limits C. Commercial paper, factoring, forfeiting !C.1 CONCE*T O+ ;OR/INI CA*ITAD Whenever a business enterprise is started, some fixed assets like office, furniture, machines/computers etc, depending upon the need, are acquired. But this alone may not be sufficient for running the business of that enterprise, except for a few activities like broking/commission agent, etc. Most of the business enterprises, in the course of their business, have to carry some current assets like raw materials, finished goods, receivables etc. The money blocked in these current assets is called working capital. Let us take example of an entrepreneur setting up a small manufacturing enterprise for manufacture of polythene bags. He completes the construction of factory shed and puts up all the plant and machinery. At this point, if he takes a snapshot of his assets and liabilities, it will be as under: Balan%e sheet of ABC Dt& as on F Se5te'"er0 !00F Liabilities (Capital) Rs. 25 lakh Assets (Fixed assets) Rs 100 lakh Liabilities (Long term liabilities) Rs. 75 lakh Liabilities Total Rs 100 lakh Assets Total Rs 100 lakh For running the factory, he needs raw material, i.e. the polythene granules. He goes to the dealer and finds out that the rate of granules is Rs 100 per kg and credit of 3 months is available. His requirement is 1000 kg (1 ton) per day. He purchases 30 tons of granules which is the minimum quantity which the dealer sells. He starts manufacture of the bags on 10 September 2009. The process takes very little time, and on the evening of 10 September 2009 he has 1 ton of bags with him. He incurs a cost (power, labour, transport, miscellaneous expenses, but ignoring depreciation) of Rs10,000 for converting 1 ton of granules into bags. He approaches the wholesale dealer of bags for selling the bags to him. The deal is struck at Rs 1,10,000 per ton, but a minimum of 10 tons of bags is to be supplied. Also, credit of one month is to be given to the purchaser. So, the entrepreneur continues to manufacture for 10 days and on 21 September, 2009 supplies 10 tons of bags by raising an invoice of Rs 11 lakh, payable on 21/10/09. The next supply will be made on 1 October, 2009. Ìf he takes a snapshot of his assets and liabilities on the evening of 30 September 2009, the picture will be as under; Balan%e sheet of ABC Dt& as on (0 Se5te'"er0 !00F (Liabilities) Capital Rs 25 lakh (Assets) Fixed assets Rs 100 lakh (Liabilities) Long term liabilities Rs 75 lakh (Assets)Raw material( 10tons) Rs 10 lakh (Liabilities) Amount payable to supplier Rs 30 lakh (Assets) Work in process (0) (Liabilities) Expenses payable Rs 2 lakh (Assets) Finished goods( 10 tons) Rs 11 lakh (Liabilities) Amount receivable Rs 11 lakh (Liabilities) Total Rs 132 lakh. (Assets) Total Rs 132 lakh The amount of raw materials, work in progress, finished goods, receivables totaling Rs 32 lakh, is called the working capital or the current assets required to run the enterprise smoothly. Ìn this example, the entrepreneur has not arranged for any money to run his factory as his entire requirement of working capital is met through the credit provided by the supplier. But, life in business, often, is not as simple as shown here. Ìt is a fact that current assets are required by almost every enterprise to run the business smoothly. How much of current assets are required to be maintained depends on the nature of activity and the market conditions. Working capital finance by the banks is nothing but assessment of total current assets needed and how this need is to be met. Ìn the above example, what happens if the credit is not available from the supplier or, the credit is available only for 10 days? The credit provided to purchaser may not be reduced if the market practice is like that. Ìn such a case, he will approach the bank and request for a working capital loan of Rs 32 lakh. Assuming that bank is convinced about K Y C norms, viability of the project etc, the bank will assess the needs and sanction an amount. How much will that amount be, we will discuss later in the chapter. But, bank will definitely ask him to bring some of his own money either by way of capital or long term borrowings like fixed deposits, loans from friends and relatives. This amount, which is intended to meet part of the working capital, is called Net Working Capital. The other part of the working capital will be met by credit provided by the supplier, other credit available, and the bank finance. Ìn short, we can say that the total requirement of current assets of an enterprise, which is termed as Total or Gross working capital is met by short term credit available (including bank finance) and some amount arranged by the enterprise through long term funds (either capital or borrowings), called Net Working Capital. !C.! ;OR/INI CA*ITAD C)CDE The normal operations of a business enterprise consist of some or all of the actions like, purchase of raw materials, processing and conversion of raw materials into finished goods, selling these goods on cash/ credit basis, receive cash on sale or end of credit period and again purchase raw materials. This is called working capital cycle. The length of this cycle depends on: #a$ the stocks of raw materials required to be held #"$ the work in process, which in turn depends on the process involved in manufacturing and processing the raw materials. #%$ the credit required to be provided to the purchasers The longer the working capital cycle, the more is working capital requirement, i.e., the need for maintaining the current assets. The correct assessment of this cycle is the most important part in a bank's assessment of gross working capital, net working capital and the bank finance. The assessment of working capital finance by the bank follows the assessment of working capital requirement of the enterprise. !C.( IM*ORTANCE of DI9UIDIT) RATIOS For a banker, providing working capital finance, the liquidity ratios, specially the current ratio, play a very important role in assessment, sanctioning decision, and monitoring. The assessment involves stipulation of a minimum Net Working Capital (N W C) to be brought in by the enterprise from its long term sources. This results in a minimum current ratio (more than one) which the bank wants the enterprise to maintain at all the times. This is, normally, mentioned in the terms and conditions of sanction and becomes an important tool for the bank to monitor the use of funds by the enterprise. !C.. METGODS O+ ASSESSMENT O+ BAN/ +INANCE Gol&in, Nor's Base& Metho& of Assess'ent of Ban2 +inan%e: #1$ De%i&in, on the le=el of T7rno=er of the Enter5rise: This is a very important step in any method of assessment of working capital limits. Ìn case of existing enterprises, the past performance is used as a guide to make an assessment of this. Ìn case of new enterprises, this is based on the production capacity, proposed market share, availability of raw materials, industry norm etc. Despite analysis of all the data, accurate estimate of future turnover is often an area of disagreement between the bank and the borrower. #!$ Assess'ent of Iross or Total ;or2in, Ca5ital: This is the sum total of the assessment of various components of the working capital: #a$ In=entor3: For assessing the stock levels of raw materials, work in process and the finished goods, information like lead time, minimum order quantity, location and number of suppliers, percentage of imported material, manufacturing process, etc. are taken into account. Tandon committee had prescribed inventory norms for various industries but these are not mandatory now and banks can estimate the levels applicable to each case based on its peculiarities. Ìndustry norms, available in the data base, are also used as a guide for the estimate of inventory level. #"$ Re%ei=a"les an& Bills: This estimate is relatively simpler compared to that of the inventory. This is mostly governed by the market practice applicable to a particular business or place. #%$ Other C7rrent Assets: A reasonable estimate of other current assets like cash level, advances to suppliers, advance tax payment etc is necessary to avoid under-financing. So7r%es for Meetin, ;or2in, Ca5ita ReJ7ire'ent: #a$ O8n So7r%es #N ; C$: The balance sheet of the last accounting year, depicts the position of available N W C. Also, as the estimate of limits is based on the projected balance sheet at the end of the current accounting year, there are some internal accruals which are also taken into account. Depending on the desired current ratio to be maintained, bank may stipulate additional N W C to be brought in if the available N W C and anticipated internal accruals are not considered enough to maintain the desired current ratio. #"$ S755liersL Cre&it: Estimate of this depends on the market practice. #C$ Other C7rrent Dia"ilities like salaries payable, advances from customers, etc. #&$ Ban2 +inan%e Cal%7lation of Ban2 +inan%e Logically, the need for working capital finance from the bank is equal to the gap between total working capital and the availability of funds from all the sources, as mentioned above (of course, excluding bank finance). The enterprise or the bank may not have much control on the 'suppliers' credit' or 'other current liabilities', as these are driven by market conditions or business needs. But banks can prescribe the amount to be brought in by the enterprise through its own long term sources i.e. the N W C. This was at the core of the recommendations of the erstwhile Tandon committee, which dominated the psyche of the bankers for a long time. Though banks are now free to formulate their own policies in this regard, the methods of lending, mentioned there, still find place in the calculations followed by the banks. The methods are; #a$ +irst Metho& of Den&in,: Under this, the enterprise was required to bring in at least 25 per cent of the working capital gap (total current assets minus total current liabilities excluding bank finance) #"$ Se%on& Metho& of Den&in,: Under this, the enterprise was required to bring in at least 25 per cent of the total current assets #"$ Thir& Metho& of Den&in,: Under this, the enterprise was required to bring in 100 per cent of those current assets which are considered 'core assets' and at least 25 per cent of the remaining current assets. Ìt may be noted that while the second method of lending results in current ratio of at least 1.33, in case of first method, it could be less and in the third method it is likely to be more than this. Depending upon the loan policy of the bank, the working capital limit can be arrived at by deducting from the total projected current assets, the stipulated NWC and the projected short term liabilities. Cash B7&,et Metho& of Assess'ent Any economic activity, however small it may be, involves outflows ( expenditure) of money for procurement of inputs and inflows of money (income) from the sale of output The nature, amount and periodicity of outflows and inflows is peculiar to the type of activity, level of operations, market conditions and the policies adopted by the owners/managers etc. The genesis of an enterprise's requirement for the working capital funds, from the bank, lies in the fact that during a particular day, its opening cash balance and cash inflows are not sufficient to meet its normal cash outflows. Short term bank finance, called working capital finance, fulfils this requirement of excess cash outflows. Therefore, an ideal way to assess the need for bank finance is to precisely project the cash inflows and outflows for each day and provide finance to meet the cash deficit. But, projection of daily cash flows is not a feasible option because market conditions are not perfect. Therefore, the periodicity of estimating cash flows is increased to a more feasible level of a month or a quarter. A statement of estimated cash inflows and outflows is prepared for this period and bank finance equal to the cash deficit, if any, is sanctioned. A normal statement / budget, will look as under; 1 2 3 5 Inflo8s 1. Opening balance 2. Term loan from Bank 3. Sales (Total sales-credit sales + realization for ealier sales) 4. Other cash inflows Total inflows O7tflo8s 1. Capital expenditure 2. R. M. Purchase 3. Labor 4. Power and fuel 5. Payment of Ìnterest 6. Repayment of Term loan installment 7. Other cash outflows Total outflows Cash s7r5l7s or #&efi%it$ Bank finance needed Closing balance T7rno=er Metho& of Assess'ent The assessment of working capital limit by the banks, in some cases, is influenced by the guidelines of R B Ì. For working capital advances to Small Scale Ìndustries. R B Ì guidelines are as under: `SSÌ units having working capital limits of up to Rs.5 crore from the banking system are to be provided working capital finance computed on the basis of 20 per cent of their projected annual turnover. The banks should adopt the simplified procedure in respect of all S S Ì units (new as well as existing).' The R B Ì guidelines may result in under-financing for those S S Ì units where the working capital cycle is more than 3 months. Therefore, the banks, normally, also assess the requirement on the basis of holding norms also and sanction the limit whichever is higher. Co'5arison of the Three Metho&s of Assess'ent Ìt is easy to infer from the above that there is no basic difference between the holding method and the cash budget method of assessment of bank finance. Both involve the essential steps of projecting the level of activity, credit provided to customers, credit received from suppliers, requirement of other current assets and liabilities. The preciseness of the assessment in both the methods depends on how precisely the credit officer estimates these parameters. However, the holding method is based on the estimate of average of all these parameters over next one year, which may be too long a period for correct assessment, specially, for seasonal industries. Therefore, this method is more suitable for those activities which have relatively uniform operations and for which the market conditions are not very volatile. The cash budget method may be more suitable for activities which have wide fluctuation from month to month in the level of activities or market conditions, like seasonal industries or execution of project contracts. The turnover method is more suitable for Small enterprises where detailed financial records may not be available. !C.? BIDDS 4 RECEIVABDES +INANCE B) TGE BAN/S Receivables are part of the current assets of a business enterprise. These arise due to sales on credit basis to the customers. Ìf the credit sales are based on invoices alone, the amount receivable from the customers is represented in the accounts as 'book debts' or 'sundry debtors'. The bank provides finance against these in a fashion similar to that for inventory. The borrower submits a statement of book debts and bank calculates the drawing power by deducting the applicable margin. Another method of sales is through Bills of exchange drawn by the seller on the purchaser in the following manner; #a$ Ìf no credit is to be provided to the customer, a demand bill is drawn. This, along with the transport document like MR, RR etc, is given to bank either for collection or purchase. Ìf bank purchases the bill, it provides immediate credit to the seller (drawer of bill), which may be even 100 per cent of the bill amount, after collecting the usual charges. Ìn case of either purchase or collection, the bank's branch at the purchaser's place presents the bill to him and delivers the transport documents to him against payment of the bill. Ìn case of collection, till the payment is credited to the seller's account, the amount is shown as book debt in his books. Ìn case of purchase of the bill by the bank, the amount of bill is not represented in the books. #"$ Ìf the credit is to be provided on the sales, a bill of exchange, called usance bill, mentioning the period of payment, is drawn on the purchaser and is accepted by him The outstanding amount is shown in the accounts as 'bills receivables'. The advantage of sales under bills of exchange, which are governed by the NÌ Act, is the increased legal protection in case of default by the customer. For bank finance, either the accepted bill is given to the bank or the documents are sent through bank which delivers the same to the purchaser against his acceptance of usance bill. Bank provides finance to the seller by discounting the usance bill after deducting the usual charges and interest for the usance period. The terms used in bills finance are purchase, discount and negotiation. Normally, 'purchase' is used in case of demand bills, 'discount' in case of usance bills and 'negotiation' in case of bills which are drawn under letters of credit opened by the purchaser's bank. Ìn case of purchase/discount/negotiation of the bill by the bank, the outstanding amount of bills is not represented in the assets in the accounting books of the drawer (i.e., the seller, who is customer of the financing bank). Ìt may be represented in his contingent liabilities if the bills are not 'without recourse to drawer'. To get a realistic picture, at the time of assessment of working capital finance, the amount of bills purchased/discounted is added to both current assets and liabilities, depending on the bank's loan policy. However, the bills negotiated are normally not added as the counterparty is another bank and the probability of recourse to drawer will be extremely low. !C.@ IUIDEDINES O+ RBI +OR DISCOUNTINI 4 REDISCOUNTINI O+ BIDDS B) BAN/S The gist of R B Ì guidelines to banks, while purchasing / discounting / negotiating / rediscounting of genuine commercial / trade bills, are as under: #a$ Banks may sanction working capital limits, as also bills limit, to borrowers after proper appraisal of their credit needs and in accordance with the loan policy as approved by their Board of Directors. Banks should clearly lay down a bills discounting policy approved by their Board of Directors, which should be consistent with their policy of sanctioning of working capital limits. Ìn this case the procedure for Board approval should include banks' core operating process from the time the bills are tendered till these are realized. Banks may review their core operating processes and simplify the procedure in respect of bills financing. Ìn order to address the often-cited problem of delay in realization of bills, banks may take advantage of improved computer/communication networks like the Structured Financial Messaging System (S F M S) and adopt the system of 'value dating' of their clients' accounts. (b) Banks should open letters of credit (L Cs) and purchase / discount / negotiate bills under L Cs only in respect of genuine commercial and trade transactions of their borrower constituents who have been sanctioned regular credit facilities by the banks. Banks should not, therefore, extend fund-based (including bills financing) or non-fund based facilities like opening of L Cs. providing guarantees and acceptances to non- constituent borrower or/and non-constituent member of a consortium / multiple banking arrangement. However, in cases where negotiation of bills drawn under L C is restricted to a particular bank and the beneficiary of the L C is not a constituent of that bank, the bank concerned may negotiate such an L C, subject to the condition that the proceeds will be remitted to the regular banker of the beneficiary. However, the prohibition regarding negotiation of unrestricted L Cs of non-constituents will continue to be in force. #%$ Sometimes, a beneficiary of the LC may want to discount the bills with the LC issuing bank itself. Ìn such cases, banks may discount bills drawn by beneficiary only if the bank has sanctioned regular fund-based credit facilities to the beneficiary. With a view to ensuring that the beneficiary's bank is not deprived of cash flows into its account, the beneficiary should get the bills discounted/ negotiated through the bank with which he is enjoying sanctioned credit facilities. #&$ Bills purchased/discounted/negotiated under L C (where the payment to the beneficiary is not made 'under reserve') will be treated as an exposure on the L C issuing bank and not on the borrower. All clean negotiations as indicated above will be assigned the risk weight as is normally applicable to inter-bank exposures, for capital adequacy purposes. Ìn the case of negotiations 'under reserve', the exposure should be treated as on the borrower and risk weight assigned accordingly. #e$ While purchasing / discounting / negotiating bills under L Cs or otherwise, banks should establish genuineness of underlying transactions/documents. #f$ The practice of drawing bills of exchange claused 'without recourse' and issuing letters of credit bearing the legend 'without recourse' should be discouraged because such notations deprive the negotiating bank of the right of recourse it has against the drawer under the Negotiable Ìnstruments Act. Banks should not therefore open L Cs and purchase/discount/negotiate bills bearing the 'without recourse' clause. On a review it has been decided that banks may negotiate bills drawn under L Cs, on 'with recourse' or 'without recourse' basis, as per their discretion and based on their perception about the credit worthiness of the L C issuing bank. However, the restriction on purchase/discount of other bills (the bills drawn otherwise than under L C) on 'without recourse' basis will continue to be in force. #,$ Accommodation bills should not be purchased/discounted/negotiated by banks. The underlying trade transactions should be clearly identified and a proper record thereof maintained at the branches conducting the bills business. #h$ Banks should be circumspect while discounting bills drawn by front finance companies set up by large industrial groups on other group companies. #i$ Bills rediscounts should be restricted to usance bills held by other banks. Banks should not rediscount bills earlier discounted by non-bank financial companies (N B F Cs) except in respect of bills arising from sale of light commercial vehicles and two/three wheelers. #A$ Banks may exercise their commercial judgment in discounting of bills of the services sector. However, while discounting such bills, banks should ensure that actual services are rendered and accommodation bills are not discounted. Services sector bills should not be eligible for rediscounting. Further, providing finance against discounting of services sector bills may be treated as unsecured advance and, therefore, should be within the norm prescribed by the Board of the bank for unsecured exposure limit. !C.B NONE+UNDEBASED ;OR/INI CA*ITAD DIMITS Ìn the course of its business, an enterprise may sometimes need bank guarantees or letters of credit or bank's co-acceptance of bills drawn on the enterprise. Ìn providing such facilities, there is no outlay of funds by the banks. Therefore, in the balance sheet, these do not appear in the assets of the bank or the liabilities of the enterprise. However, these appear in the contingent liabilities of both bank and the enterprise because in case of any liability arising on account of these items, the bank has to fulfill its obligation and get the reimbursement from the enterprise on whose behalf this obligation was taken. I7arantees Banks issue guarantees on behalf of their customers for various purposes. The guarantees executed by banks comprise both performance guarantees and financial guarantees. The guarantees are structured according to the terms of agreement, viz., security, maturity and purpose. Sometimes, it becomes difficult to distinguish between performance and financial guarantees but broadly, the difference between the two is as under; The performance guarantee guarantees, to the beneficiary, reimbursement of monetary loss arising due to non performance or under performance of a contract by the customer( applicant). Examples of performance guarantees are guarantees issued towards completion of a contract within a time limit, or with certain quality or for the satisfactory performance of any equipment, project etc. The financial guarantee, on the other hand, is for meeting certain financial obligations or dues of the customer (applicant) to the beneficiary. Examples of financial guarantees are guarantees issued in lieu of security deposits, earnest money or payment of dues in case of default by the client. CoEa%%e5tan%e of Bills A supplier of goods will be more willing to provide credit to the purchaser (bank's customer), if the bill of exchange drawn by him on purchaser and accepted by him is also accepted by the bank. Bank's co-acceptance acts like a guarantee for him against non payment by the purchaser. By providing this facility to the customer, the need for working capital finance from the bank is reduced due to credit provided by the supplier. RBI I7i&elines on I7arantees an& CoEa%%e5tan%es #Details a=aila"le in Master %ir%7lar no. DBOD. No. Dir. BC. 1C41(.0(.004!00CE0F &ate& 10 J7I3 !00C$ A gist of the guidelines, which banks should comply with, in the conduct of their guarantee business is given below: Ieneral I7i&elines As regards the purpose of the guarantee, as a general rule, the banks should confine themselves to the provision of financial guarantees and exercise due caution with regard to performance guarantee business. No bank guarantee should normally have a maturity of more than 10 years. *re%a7tions for Iss7in, I7arantees Banks should adopt the following precautions while issuing guarantees on behalf of their customers. #a$ As a rule, banks should avoid giving unsecured guarantees in large amounts and for medium and long-term periods. They should avoid undue concentration of such unsecured guarantee commitments to particular groups of customers and / or trades. #"$ Unsecured guarantees on account of any individual constituent should he limited to a reasonable proportion of the bank's total unsecured guarantees. Guarantees on behalf of an individual should also bear a reasonable proportion to the constituent's equity. #%$ Ìn exceptional cases, banks may give deferred payment guarantees on an unsecured basis for modest amounts to first class customers who have entered into deferred payment arrangements in consonance with Government policy. #&$ Guarantees executed on behalf of any individual constituent, or a group of constituents, should be subject to the prescribed exposure norms. While issuing guarantees on behalf of customers, the following safeguards should be observed by banks: #1$ At the time of issuing financial guarantees, banks should be satisfied that the customer would be in a position to reimburse the bank in case the bank is required to make payment under the guarantee. #!$ Ìn the case of performance guarantee, banks should exercise due caution and have sufficient experience with the customer to satisfy themselves that the customer has the necessary experience, capacity and means to perform the obligations under the contract, and is not likely to commit any default. #($ Banks should, normally, refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. Ban2 I7arantee S%he'e of Io=ern'ent of In&ia Banks should adopt the Model Form of Bank Guarantee Bond given in Annexure 1 (Please refer R B Ì circular mentioned above). The Government of Ìndia have advised all the Government departments/ Public Sector Undertakings, etc. to accept bank guarantees in the Model Bond and to ensure that alterations/additions to the clauses whenever considered necessary are not one-sided and are made in agreement with the guaranteeing bank. Banks should mention in the guarantee bonds and their correspondence with the various State Governments, the names of the beneficiary departments and the purposes for which the guarantees are executed. Ìn regard to the guarantees furnished by the banks in favour of Government Departments in the name of the President of Ìndia, any correspondence thereon should be exchanged with the concerned ministries/ departments and not with the President of Ìndia. Ìn respect of guarantees issued in favour of Directorate General of Supplies and Disposal, the following aspects should be kept in view: #1$ Ìn order to speed up the process of verification of the genuineness of the bank guarantee, the name, designation and code numbers of the officer/officers signing the guarantees should be incorporated under the signature(s) of officials signing the bank guarantee. #!$ The beneficiary of the bank guarantee should also be advised to invariably obtain the confirmation of the concerned banks about the genuineness of the guarantee issued by them as a measure of safety. #($ The initial period of the bank guarantee issued by banks as a means of security in Directorate General of Supplies and Disposal contract administration would be for a period of six months beyond the original delivery period. Banks may incorporate a suitable clause in their bank guarantee, providing automatic extension of the validity period of the guarantee by 6 months, and also obtain suitable undertaking from the customer at the time of establishing the guarantee to avoid any possible complication later. #.$ A clause would be incorporated by Directorate General of Supplies and Disposal in the tender forms of Directorate General of Supplies and Disposal (Ìnstruction to the tenderers) to the effect that whenever a firm fails to supply the stores within the delivery period of the contract wherein bank guarantee has been furnished, the request for extension for delivery period will automatically be taken as an agreement for getting the bank guarantee extended. Banks should make similar provisions in the bank guarantees for automatic extension of the guarantee period. I7arantee on Behalf of Share an& Sto%2 Bro2ers 4 Co''o&it3 Bro2ers Banks may issue guarantees on behalf of share and stock brokers in favour of stock exchanges in lieu of security deposit to the extent it is acceptable in the form of bank guarantee as laid down by stock exchanges. Banks may also issue guarantees in lieu of margin requirements as per stock exchange regulations. Banks have further been advised that they should obtain a minimum margin of 50 per cent while issuing such guarantees. A minimum cash margin of 25 per cent (within the above margin of 50 per cent) should be maintained in respect of such guarantees issued by banks. The above minimum margin of 50 per cent and minimum cash margin requirement of 25 per cent (within the margin of 50 per cent) will also apply to guarantees issued by banks on behalf of commodity brokers in favour of the national level commodity exchanges, viz., National Commodity Derivatives Exchange (N C D E X), Multi Commodity Exchange of Ìndia Limited (M C X) and National Multi-Commodity Exchange of Ìndia Limited (N M C E Ì L) in lieu of margin requirements as per the commodity exchange regulations. A55raisal of I7arantee 4 CoEa%%e5tan%e Di'it The bank guarantees may be required by the enterprise either on regular basis or ad-hoc basis. For example, a normal manufacturing enterprise may require guarantee in favour of Customs department for release of imported good, for which no regular assessment can be made. The sanction of regular B G limit is required for some businesses like contractors, who have to provide the guarantees on a regular basis for security deposits of tenders, receipt of advance payment or return of retention money, as also performance guarantees for execution of projects. The assessment in such cases depends on the nature of business and the terms of contracts. The bank has to examine the impact of sanction of guarantee limit on the fund based requirements of the borrower. For example, a guarantee issued in respect of receipt-of advance payment will reduce the fund based need of the enterprise. So, a part of the B G limit may be carved out of its total fund based W C limits. The co-acceptance limit helps the borrower to get more credit from the supplier and, therefore, is carved out of the fund based W C limit, if this credit was not taken into account at the time of assessment. Detters of Cre&it The genesis a letter of credit lies in the fact that a seller of good is worried about receipt of money from the buyer if he supplies the goods first, and the buyer is worried about non receipt of contracted goods if he makes the payment first. The bank acts as an intermediary between the two by using its credibility, as it is acceptable to both buyer and the seller. Letter of Credit (L C) is an undertaking by the bank, at the request of the buyer( applicant, who is customer of the bank), to the seller, to pay him the contracted amount if he supplies the goods as per the terms specified and submits the required documents, including the documents of the title of the goods. The conduct of LC business is governed by the publication no.600 of the Ìnternational Chamber of Commerce (Ì C C), commonly known as U C P D C 600. A55raisal of DC Di'it An L C is used for purchase of goods either through imports or local purchase. For assessing the L C requirement of an enterprise, we have to know the following; #1$ A=era,e A'o7nt of Ea%h D C: This is dependent on the monthly consumption of goods and the economic order quantity. Economic order quantity (E O Q) is estimated by examining the sources of supply, means of transport, discount etc. Ìn case of imports, the E O Q is often larger in comparison to indigenous purchases. #!$ +reJ7en%3 of D C O5enin,: Once E O Q is estimated, the number of Ì-Cs to be opened in a year can be calculated by dividing annual consumption by E O Q. Frequency of opening L Cs will be 12 divided by the number of Ì-Cs to be opened in a year. #($ Go8 'an3 D Cs 8ill "e o7tstan&in, at a 5arti%7lar ti'e: The time taken for one L C to remain in force depends upon the lead time (time taken from the date of opening L C to shipment of goods), the transit time and the usance available to purchaser from the date of receipt of goods. Ìf the frequency of opening L C is less than this, bank will have more than one L C outstanding at any point of time. E6a'5le: Ìf lead time is 10 days, transit is 20 days and usance period is six months, the total time for which an L C will remain outstanding is seven months. Ìf consumption of goods is Rs 6 crore per year and E O Q is Rs one crore, the frequency of opening L C is every 2 months. Ìt means that at any point of time, there will be four L Cs outstanding ( 7divided by 2 and rounded off to next figure). As the amount of each L C is Rs one crore, the total L C limit will be Rs 4 crore. While sanctioning L C limit, its impact on the fund based requirements of the borrower should be examined. Ìn view of the increased credit available to him through L C, normally, an L C limit is carved out of the total fund based W C limit sanctioned. !C.C OTGER ISSUES REDATED TO ;OR/INI CA*ITAD +INANCE Co''er%ial *a5er Commercial Paper (C P), an unsecured money market instrument issued in the form of a promissory note, was introduced in Ìndia in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings. The cost of borrowing through C P is normally lower compared to other sources of short term finance and therefore, it serves as a useful tool in working capital management of the corporate. Guidelines for issue of C P are governed by directives issued by the R B Ì. A master circular of all these guidelines issued up to 30/6/09, has been issued by RBÌ on 1 July, 2009 and is posted on their website www.mastercirculars.rbi.org.in +a%torin, This is a method of financing the receivables of a business enterprise. The financier is called 'Factor' and can be a financial institution. Banks are not permitted to do this business themselves but they can promote subsidiaries to do this. Under factoring, the factor not only purchases the book debts/receivables of the client, but may also control the credit given to the buyers and administer the sales ledger. The purchase of book debts/receivables can be with recourse or without recourse to the client. Ìf it is without recourse, the client is not liable to pay to the factor in case of failure of the buyer to pay. +orfaitin, This is similar to factoring but is used only in case of exports and where the sale is supported by bills of exchange/promissory notes. The financier discounts the bills and collects the amount of the bill from the buyer on due dates. Forfaiting is always without recourse to the client. Therefore, the exporter does not carry the risk of default by the buyer. S7''ar3 Most of the business enterprises need to maintain some current assets like, cash, raw materials, work-in-process, finished goods and receivables for smooth functioning of their business. The cycle starting from purchase of raw material and culminating in receipt of sales proceeds from the customer, is called working capital cycle. The longer this cycle, larger is the amount of money blocked in the current assets, and vice versa. The amount of money blocked in the current assets is called total or gross working capital. A part of this money may come from credit provided by suppliers, advances from customers and any other short term liability. Also, the enterprise is also required to arrange for some long term funds (called N W C) to meet part of this requirement. The gap, if any, is provided by the banks as working capital finance. Ìn the past, when credit was scarce, R B Ì provided elaborate guidelines for calculation of bank finance for W C. This has been relaxed substantially over a period of time but the guiding principles are still used by many banks for the assessment. Banks also provide non-fund-based working capital limits. These are mainly, guarantees, L Cs and co-acceptance of bills. The appraisal of these limits is also done by detailed analysis as these carry risks similar to fund based limits. Some of the instruments/ methods used in working capital finance are bills financing, factoring, forfaiting and commercial paper. R B Ì has issued guidelines in respect of all of these. /e38or&s Working capital cycle; N W C; Gross W C; Working capital gap; M P B F; First, second and third methods; Turnover method; Cash budget; Guarantees; Letters of credit; Co- acceptance of bills; Liquidity, Current ratio Che%2 )o7r *ro,ress 1. Net Working Capital (N W C) means . The choices are: (a) Total current assets minus bank finance (b) Total current assets minus credit from suppliers (c) Total current assets minus total current liabilities (d) Short term sources brought in by the promoters The correct choice is: #%$ Total %7rrent assets 'in7s total %7rrent lia"ilities 2. Which of the following statements is not true for efficient inventory management? The choices are: (a) Ìt results in reduction in inventory (b) Ìt reduces the working capital requirements of the enterprise (c) Ìt reduces the N W C available with the enterprise (d) Ìt increases the Ìnventory Turnover Ratio if the level of sales remains same. The correct choice is: #%$ It re&7%es the N ; C a=aila"le 8ith the enter5rise 3. Which of the following is not a source for meeting working capital requirements? The choices are: (a) Suppliers' credit (b) Bank finance (c) Other current liabilities (d) Advance payment to suppliers The correct choice is: #&$ A&=an%e 5a3'ent to s755liers (4) Which of the following is a liquidity ratio? The choices are: (a) Quick ratio (b) T O L / T N W (c) D S C R (d) Other current liabilities The correct choice is: #a$ 97i%2 ratio (5) Which of the following is not correct regarding Current Ratio? The choices are: (a) For same level of current assets, increase in N W C results in increased current ratio. (b) The current ratio can be less than one (c) The current ratio can be negative (d) Current ratio is an indicator of liquidity The correct choice is: #%$ The %7rrent ratio %an "e ne,ati=e (6) The commercial paper can be issued by The choices are: (a) Corporates (b) Corporates and partnership firms (c) Any business entity (d) None of the above The correct choice is: #a$ Cor5orates (7) Which of the following is not correct regarding Forfaiting? The choices are: (a) Ìt a form of working capital finance (b) Ìt is used in export finance (c) Ìt is with recourse to the drawer of the bill (d) Under this financier discounts the bills drawn on buyer. The correct choice is: #%$ It is 8ith re%o7rse to the &ra8er of the "ill. (8) Which of the following is correct regarding Letters of Credit. The choices are: (a) These are opened by a bank for export sales by the client (b) These are opened by a bank for local sales by the client (c) Letters of Credit do not carry much risk for the opening bank (d) Letters of Credit are opened by a bank for purchase of goods by the client The correct choice is: #&$ Detters of Cre&it are o5ene& "3 a "an2 for 57r%hase of ,oo&s "3 the %lient. (9) Under Turnover method of assessment, the limit is sanctioned at per cent of the projected turnover. The choices are: (a) 25 (b) 20 (c) 30 (d) 35 The correct choice is: #"$ !0 (10) Cash budget method of assessment is more suitable for those business enterprises which have .. The choices are: (a) uniform level of operations (b) High level of operations (c) Low level of operations (d) Seasonal operations The correct choice is: #&$ Seasonal o5erations. Answer to Check Your Progress 1. (c); 2. (c); 3. (d); 4. (a); 5. (c); 6. (a); 7. (c); 8. (d); 9. (b); 10. (d) END O+ CGA*TER !C H ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT ÷ 29 Term Loans STRUCTURE !F.0 Objectives !F.1 Ìmportant Points about Term Loans !F.! Deferred Payment Guarantees (D P Gs) !F.( Difference between Term Loan Appraisal and Project Appraisal 29.4 Project Appraisal !F.? Appraisal and Financing of Ìnfrastructure Projects !F.0 OBJECTIVES After reading this chapter, you will have better understanding of: #1$ The meaning of term finance #!$ Deferred payment guarantees #($ Assessment of term/project finance #.$ Techno-economic feasibility study #?$ Ìnfrastructure finance !F.1 IM*ORTANT *OINTS ABOUT TERM DOANS 1. Banks provide term loans normally for acquiring the fixed assets like land, building, plant and machinery, infrastructure etc., (personal loans, consumption loans, educational loans etc. being exceptions) while the working capital loans are provided for sustaining the working capital i.e. current assets level. !. Ìn exceptional cases, banks provide term loans for current assets also. This is called Working Capital Term Loan(W C T L) As we are aware, the business enterprise is supposed to bring a part of its funds required to maintain the desired level of current assets from its long term sources (capital or term liabilities), called N W C, so that the stipulated current ratio can be maintained. Ìf the enterprise is not able to bring in the required amount of N W C, it will feel liquidity crunch and business operations will be affected. Ìn such cases, banks may provide W C T L. (. Working capital loans are normally sanctioned for one year but are payable on demand. Term loans are payable as per the agreed repayment schedule, which is stipulated in the terms of the sanction. Therefore, for the purpose of matching assets and liabilities of the bank, term loans are considered long term assets while working capital loans are considered as short term assets. Practically, however, an enterprise continues to enjoy the working capital loan till its working is satisfactory, while the term loan gets repaid over a period of time. .. As a term loan is expected to be repaid out of the future cash flows of the borrower, the D S C R assumes great importance while considering term loans, while for working capital loans, the liquidity ratios assume greater importance. ?. There is no uniform repayment schedule for all term loans. Each term loan has its own peculiar repayment schedule depending upon the cash surplus of the borrower. Thus, in case of a salaried person, where income level is constant, the repayment can be through E M Ì system and in case of a farmer, the repayment of principal and interest may coincide with the cropping pattern. Ìn case of industrial enterprises, normally, banks stipulate monthly/quarterly repayment of principal along with all the accumulated interest. Ìn some cases, the entire repayment may be stipulated in one installment only, called the bullet repayment. !F.! DE+ERRED *A)MENT IUARANTEES # D * Is$ When the purchaser of a fixed asset does not pay to the supplier immediately, but pays according to an agreed repayment schedule, and the bank guarantees this repayment, the guarantee is called D P G. This is a Non-fund based method for financing purchase of fixed assets. However, if the purchaser defaults in payment of any amount, the bank has to pay the same to the supplier and the exposure becomes fund based till the amount is recovered from the client. The risks involved in a D P G are same as those in a term loan and therefore, the appraisal for a D P G is same as that for a term loan. !F.( DI++ERENCE BET;EEN TERM DOAN A**RAISAD AND *ROJECT A**RAISAD For appraising a stand alone term loan proposal, all the concepts involved in a project appraisal may not be necessary to be applied though all concepts of a term loan appraisal are applicable to project finance also. The differences can be summarized as under: #a$ Ìn project finance all the financial needs of the enterprise, including working capital requirements, are appraised. This is because the total requirement of long term funds includes margin money for working capital. After assessing the total requirement of long term funds, the banks decide upon the amount of term loan to be sanctioned and the contribution of the promoters. #"$ Ìf an existing enterprise wants to purchase a few machineries, which are not going to have a major impact on the volume or composition of the business, it will serve little purpose to have a detailed examination of techno- economic feasibility, managerial competence, Ì R R etc. Ìt may be enough for the bank to examine the projections for next 2 to 3 years to find out that D S C R is at satisfactory level. Ìn case of loans to individuals also, like housing loans, educational loans etc., it may be enough to examine the projected D S C R to judge the viability. However, the basic principles of appraisal of a project or a standalone term loan are not different and if one is clear about project appraisal, the appraisal of a standalone term loan proposal is even simpler. !0.. *ROJECT A**RAISAD Project appraisal can be broadly taken in the following steps: #1$ Appraisal of Managerial Aspects #!$ Technical Appraisal #($ Economic Appraisal A55raisal of Mana,erial As5e%ts: The appraisal of managerial aspects involves seeking the answer to the following questions: #a$ What are the credentials of the promoters'? #"$ What is the financial stake of promoters in the project? Can they bring additional funds in case of contingencies arising out of delay in project implementation and changes in market conditions? #%$ What is the form of business organization? Who are the key persons to be appointed to run the business? Te%hni%al A55raisal: The technical feasibility of a project involves the following aspects: #a$ location #"$ products to be manufactured, production process #%$ availability of infrastructure #&$ provider of technology #e$ details of proposed construction #f$ contractor for project execution #,$ waste-disposal and pollution control #h$ availability of raw materials #i$ marketing arrangements E%ono'i% A55raisal: The economic or financial feasibility of a project involves the following aspects: #a$ Ret7rn on In=est'ent: The usual methods used are the NPV, ÌRR, payback period, cost benefit ratio, accounting rate of return etc. #"$ Brea2Ee=en Anal3sis: A project with a high break-even point is considered more risky compared to the one with lower break-even point. #%$ Sensiti=it3 Anal3sis: As market conditions are uncertain, a small change in the prices of raw materials or finished goods may have a drastic impact on the viability of a project. Sensitivity analysis examines such impact. !F.? A**RAISAD AND +INANCINI O+ IN+RASTRUCTURE *ROJECTS Ìnfrastructure sector deals with roads, bridges, power, transport, telecommunication, etc. (This is defined in Section 10 of ÌT Act). Ìnfrastructure projects involve some distinct features like exceptionally long implementation, gestation and pay back periods, high debt equity ratio etc. While the basic principles of appraisal of an infrastructure project are same as those involved in a normal project appraisal, there are some additional points to be considered, as highlighted in R B Ì guidelines R B Ì guidelines to the banks for financing infrastructure projects, are as follows: #A$ T35es of +inan%in, "3 Ban2s Ìn order to meet financial requirements of infrastructure projects, banks may extend credit facility by way of working capital finance, term loan, project loan, subscription to bonds and debentures/ preference shares/ equity shares acquired as a part of the project finance package which is treated as 'deemed advance' and any other form of funded or non-funded facility. #a$ Ta2eEo7t +inan%in,: Banks may enter into take-out financing arrangement with Ì D F C & other financial institutions or avail of liquidity support from Ì D F C & other F Ìs. A brief write-up on some of the important features of the arrangement is given in paragraph 2.3.7.8(i). Banks may also be guided by the instructions regarding take-out finance contained in Circular No. DBOD. BP.BC. 144 / 21.04.048 / 2000 dated 29, February 2000. #"$ InterEinstit7tional: Guarantees Banks are permitted to issue guarantees favouring other lending institutions in respect of infrastructure projects, provided the bank issuing the guarantee takes a funded share in the project at least to the extent of 5 per cent of the project cost and undertakes normal credit appraisal, monitoring and follow-up of the project. #%$ +inan%in, *ro'oterLs EJ7it3: Ìn terms of Circular No. DBOD. Dir. BC. 90/ 13.07.05/ 99 dated August 28, 1998, banks were advised that the promoter's contribution towards the equity capital of a company should come from their own resources and the bank should not normally grant advances to take up shares of other companies. Ìn view of the importance attached to the infrastructure sector, it has been decided that, under certain circumstances, an exception may be made to this policy for financing the acquisition of the promoter's shares in an existing company, which is engaged in implementing or operating an infrastructure project in Ìndia. The conditions, subject to which an exception may be made, are as follows: #1$ The bank finance would be only for acquisition of shares of existing companies providing infrastructure facilities as defined in paragraph (a) above. Further, acquisition of such shares should be in respect of companies where the existing foreign promoters (and/ or domestic joint promoters) voluntarily propose to disinvest their majority shares in compliance with SEBÌ guidelines, where applicable. #!$ The companies to which loans are extended should, inter alia, have a satisfactory net worth. #($ The company financed and the promoters or directors of such companies should not be defaulters to banks or Financial Ìnstitutions. #.$ Ìn order to ensure that the borrower has a substantial stake in the infrastructure company, bank finance should be restricted to 50 per cent of the finance required for acquiring the promoter's stake in the company being acquired. #?$ Finance extended should be against the security of the assets of the borrowing company or the assets of the company acquired and not against the shares of that company or the company being acquired. The shares of the borrower company or company being acquired may be accepted as additional security and not as primary security. The security charged to the banks should be marketable. #@$ Banks should ensure maintenance of stipulated margins at all times. #B$ The tenor of the bank loans may not be longer than seven years. However, the Boards of banks can make an exception in specific cases, where necessary, for financial viability of the project. #C$ This financing would be subject to compliance with the statutory requirements under Section 19(2) of the Banking Regulation Act, 1949. #F$ The banks financing acquisition of equity shares by promoters should be within the regulatory ceiling of 40 per cent of their net worth as on 31 March of the previous year for the aggregate exposure of the banks to the capital markets in all forms (both fund based and non-fund based). #10$ The proposal for bank finance should have the approval of the Board. #B$ A55raisal #1$ Ìn respect of financing of infrastructure projects undertaken by Government owned entities, banks or Financial Ìnstitutions should undertake due diligence on the viability of the projects. Banks should ensure that the individual components of financing and returns on the project are well defined and assessed. State government guarantees may not be taken as a substitute for satisfactory credit appraisal and such appraisal requirements should not be diluted on the basis of any reported arrangement with the Reserve Bank of Ìndia or any bank for regular standing instructions or periodic payment instructions for servicing the loans or bonds. #!$ Ìnfrastructure projects are often financed through Special Purpose Vehicles. Financing of these projects would, therefore, call for special appraisal skills on the part of lending agencies. Ìdentification of various project risks, evaluation of risk mitigation through appraisal of project contracts and evaluation of creditworthiness of the contracting entities and their abilities to fulfill contractual obligations will be an integral part of the appraisal exercise. Ìn this connection, banks or Financial Ìnstitutions may consider constituting appropriate screening committees or special cells for appraisal of credit proposals and monitoring the progress or performance of the projects. Often, the size of the funding requirement would necessitate joint financing by banks or Financial Ìnstitutions or financing by more than one bank under consortium or syndication arrangements. Ìn such cases, participating banks or Financial Ìnstitutions may, for the purpose of their own assessment, refer to the appraisal report prepared by the lead bank or Financial Ìnstitutions or have the project appraised jointly. #C$ *r7&ential ReJ7ire'ents #1$ *r7&ential Cre&it E65os7re Di'its: Credit exposure to borrowers belonging to a group may exceed the exposure norm of 40 per cent of the bank's capital funds by an additional 10 per cent (i.e. up to 50 per cent), provided the additional credit exposure is on account of extension of credit to infrastructure projects. Credit exposure to single borrower may exceed the exposure norm of 15 per cent of the bank's capital funds by an additional 5 per cent (i.e. up to 20 per cent) provided the additional credit exposure is on account of infrastructure as defined in paragraph (a) above. Ìn addition to the exposure permitted above, banks may, in exceptional circumstances, with the approval of their Boards, consider enhancement of the exposure to a borrower up to a further 5 per cent of capital funds. The bank should make appropriate disclosures in the 'Notes on account' to the annual financial statements in respect of the exposures where the bank had exceeded the prudential exposure limits during the year. #!$ Assignment of Risk Weight for Capital Adequacy Purposes: Banks are required to be guided by the Prudential Guidelines on Capital Adequacy and Market Discipline- Ìmplementation of the New Capital Adequacy Framework, as amended from time to time in the matter of capital adequacy. #($ Asset Liability Management: The long-term financing of infrastructure projects may lead to asset - liability mismatches, particularly when such financing is not in conformity with the maturity profile of a bank's liabilities. Banks would, therefore, need to exercise due vigil on their asset-liability position to ensure that they do not run into liquidity mismatches on account of lending to such projects. #.$ Administrative arrangements: Timely and adequate availability of credit is the pre-requisite for successful implementation of infrastructure projects. Banks/ Fls should, therefore, clearly delineate the procedure for approval of loan proposals and institute a suitable monitoring mechanism for reviewing applications pending beyond the specified period. Multiplicity of appraisals by every institution involved in financing, leading to delays, has to be avoided and banks should be prepared to broadly accept technical parameters laid down by leading public financial institutions. Also, setting up a mechanism for an ongoing monitoring of the project implementation will ensure that the credit disbursed is utilized for the purpose for which it was sanctioned. #D$ Ta2eEo7t +inan%in, or DiJ7i&it3 S755ort #1$ Take-out Financing or Liquidity Support: Take-out financing structure is essentially a mechanism designed to enable banks to avoid asset-liability maturity mismatches that may arise out of extending long tenor loans to infrastructure projects. Under the arrangements, banks financing the infrastructure projects will have an arrangement with Ì D F C or any other financial institution for transferring to the latter the out standings in their books on a pre-determined basis. Ì D F C and S B Ì have devised different take-out financing structures to suit the requirements of various banks, addressing issues such as liquidity, asset-liability mismatches, limited availability of project appraisal skills, etc. They have also developed a Model Agreement that can be considered for use as a document for specific projects in conjunction with other project loan documents. The agreement between S B Ì and Ì D F C could provide a reference point for other banks to enter into somewhat similar arrangements with Ì D F C or other financial institutions. #!$ Liquidity support from Ì D F C: As an alternative to take-out financing structure, Ì D F C and S B Ì have devised a product, providing liquidity support to banks. Under the scheme, Ì D F C would commit, at the point of sanction, to refinance the entire outstanding loan (principal+ unrecovered interest) or part of the loan, to the bank after an agreed period, say, five years. The credit risk on the project will be taken by the bank concerned and not by Ì D F C. The bank would repay the amount to Ì D F C with interest as per the terms agreed upon. Since Ì D F C would be taking a credit risk on the bank, the interest rate to be charged by it on the amount refinanced would depend on the Ì D F C's risk perception of the bank (in most of the cases, it may be close to Ì D F C's P L R). The refinance support from Ì D F C would particularly benefit the banks which have the requisite appraisal skills and the initial liquidity to fund the project. S7''ar3 Term loans are normally provided by the banks for the acquisition of fixed assets or other long-term requirements (like for education or investments) of a customer. The terms of sanction invariably stipulate schedule of repayment of principal and interest. Ìn appraisal of a term-loan proposal, D S C R is as important a ratio as current ratio is in appraisal of working capital limits. Sometimes, banks issue Deferred payment Guarantees (D P Gs) in favour of suppliers of capital equipments, if he is prepared to accept the sales price on deferred basis. However, the appraisal or a D P G is similar to that of a term-loan as the risks involved are similar. A project appraisal is similar to a term-loan appraisal with some additional points to consider. Project appraisal broadly involves appraisal of managerial aspects and examination of techno-economic feasibility. Ìnfrastructure sector deals with roads, bridges, power, transport, telecommunication etc. Ìnfrastructure projects involve some distinct features like exceptionally long implementation, gestation and pay back periods, high debt equity ratio, etc. R B Ì has issued elaborate guidelines to banks on infrastructure financing. /e38or&s Repayments; D P G; W C T L; D S C R; E M Ì; Project; Ìnfrastructure; Ì D F C; Take out financing; Ìnter-institutional guarantees Che%2 )o7r *ro,ress 1. A D G P is issued by the bank for ----------, by its client. The choices are (a) Sale of goods (b) Purchase of goods (c) Sale of capital goods (d) Purchase of capital goods The correct choice is #&$ *7r%hase of %a5ital ,oo&s !. Which of the following statements is not true for an infrastructure project? The choices are (a) Ìt has long gestation period (b) Ìt reduces the risk for the lender as his funds get assured deployment for a long time. (c) The debt equity ratio is normally high for an infrastructure project (d) The implementation period is usually long The correct choice is #"$ It re&7%es the ris2 for the len&er as his f7n&s ,et ass7re& &e5lo3'ent for a lon, ti'e. (. Which of the following is not a source of funds for meeting the cost of fixed assets by an enterprise? The choices are (a) Credit by supplier of assets (b) Ìnternal accruals (c) Debentures (d) D P G The correct choice is #&$ D*I .. Which of the following is ratio, indicative of the repaying capacity of a borrower? The choices are (a) Quick ratio (b) T O L/T N W (c) D S C R (d) D E R The correct choice is #%$ D S C R ?. Which of the following is not correct regarding term loans by the banks? The choices are (a) Asset liability matching is an important consideration in term financing (b) Ìnstallment of term loan, payable within one year is considered as current liability (c) Repayment of a term loan can be in equated monthly instalments (d) Current ratio is the most important ratio in appraisal of a term loan The correct choice is #&$ C7rrent ratio is the 'ost i'5ortant ratio in a55raisal of a ter' loan @. Project loans can be given by the bank to The choices are (a) Only corporates (b) Only corporates and partnership firms (c) Only corporate, partnership firms and societies (d) Any business entity The correct choice is #&$ An3 "7siness entit3 B. Which of the following is not correct regarding infrastructure project by the banks? The choices are (a) Banks are allowed to funds promoters' equity in certain circumstances (b) Exposure norms are relaxed by R B Ì (c) Asset liability mismatch has been permitted by R B Ì (d) Ì D F C provides liquidity support to banks The correct choice is #%$ Asset lia"ilit3 'is'at%h has "een 5er'itte& "3 R B I C. Which of the following statements is not correct for project appraisal? The choices are (a) Examination of technical feasibility is carried out (b) The contribution of promoters forms a part of economic appraisal (c) Promoters' background is part of the management appraisal (d) Capacity of promoters to arrange for additional funds, in case of contingencies, forms a part of economic appraisal. The correct choice is #&$ Ca5a%it3 of 5ro'oters to arran,e for a&&itional f7n&s0 in %ase of %ontin,en%ies0 for's a 5art of e%ono'i% a55raisal. Key to Check your Progress 1. (d); 2. (b); Ì (d); 4. (c); 5. (d); 6. (d), 7. (c); 8. (d) END O+ CGA*TER !F H ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 30 ÷ Credit Delivery STRUCTURE (0.0 Objectives (0.1 Ìntroduction (0.! Documentation (0.( Third Party Guarantees (0.. Charge over Securities (0.? Possession of Security (0.@ Disbursal of Loans (0.B Lending under Consortium/Multiple Banking Arrangements (0.C Syndication of Loans (0.0 OBJECTIVES After reading this chapter, you will have better understanding of: #1$ Documentation #!$ Third party guarantees #($ Various methods of creating charge over securities #.$ Methods of delivery of bank loans #?$ Consortium / multiple banking and syndication of loan (0.1 INTRODUCTION While, for the safety of an advance, the credit appraisal is critical for selecting the right borrower, assessing his credit needs and the viability of his operations appropriately and prescribing suitable terms and conditions for the credit, there are a few questions to be addressed before the bank parts with its money. These questions are: #1$ What documents should be obtained from the borrower and the guarantor so that in the event of any default, the bank has the legal recourse to recover the money? #!$ Whether any charge is to be created on the primary and collateral security? Ìf yes, how it should be done? #($ Whether the charge of the bank on the securities is to registered with any authority prescribed by the law? #.$ Whether the securities should be in possession of the borrower or the bank'? #?$ How the loan should be disbursed'? Whether we issue a cheque for the loan amount in the name of the borrower or, should his account with the bank be credited or should some other method be adopted? #@$ What are the R B Ì guidelines in this respect? (0.! DOCUMENTATION Documents are to be signed by the borrowers and guarantors so that the bank can establish their liability in a court of law. Ìn addition, the borrower has to sign the documents which create charge over the primary security, i.e. the security created out of the bank finance. For charge over collateral security, the owner of that security should sign the relevant documents. Ìt should be ensured that if the owner of the collateral security is someone other than the borrower, he should first become a guarantor of the loan and then create charge over the security. Each bank's legal department prescribes the standard documents to be taken depending on the type of the loan. Ìn case of a structured loan, the legal department drafts the documents applicable to that particular case. However, a few points, which must be ensured, by the credit officer. in connection with execution of the documents, are as under: #1$ The documents should be properly stamped #!$ The date of execution of documents should never be earlier than the date of stamping. Date and place of execution should be properly mentioned in the documents. #($ Ìt should be ensured that the parties executing the documents have the necessary authority and the capacity to enter into a contract and executed the documents in that capacity. For example, a partner should sign on behalf of the firm and not in his individual capacity. #.$ Ìt should be ensured that the person signing the documents is doing so with his free will #?$ The documents should be filled in before these are signed. #?$ Ìn case of companies, the charge should be registered with ROC. within 30 days from the date of execution of the documents. #@$ Ìf any document is required to be registered with the Sub-registrar, it should be done within the prescribed time limit. (0.( TGIRD *ART) IUARANTEES While the enterprise or individual, who has taken the loan from the bank is legally bound to repay the principal and the interest, in some cases, banks stipulate guarantees of third parties, as an additional safety against default. These third parties can be individuals or any other legal entity. Ìn case of finance to firms, the personal guarantee of proprietor or partners is not stipulated as they have unlimited liability and their personal assets can be attached for recovery of bank loans. However, in case of companies and other legal entities, the promoters/ directors/ trustees do not have unlimited/ any liability towards bank's dues. Therefore, in many cases banks stipulate their personal guarantees. R B Ì suggestions to the banks in this respect are as follows: #1$ Personal guarantees of directors may be helpful in respect of companies, whether private or public, where shares are held closely by a person or connected persons or a group (that being professionals or Government), irrespective of other factors, such as financial condition, security available, etc., the exception being in respect of companies where, by court or statutory order, the management of the company is vested in a person or persons, whether called directors or by any other name, who are not required to be elected by the shareholders. Where personal guarantee is considered necessary, the guarantee should preferably be that of the principal members of the group holding shares in the borrowing company rather than that of the director or managerial personnel functioning as director or in any managerial capacity. #!$ Even if a company is not closely held, there may be justification for a personal guarantee of directors to ensure continuity of management. Thus, a lending institution could make a loan to a company whose management is considered good. Subsequently, a different group could acquire control of the company, which could lead the lending institution to have well-founded fears that the management has changed for the worse and that the funds lent to the company are in jeopardy. One way by which lending institutions could protect themselves in such circumstances is to obtain guarantees of the directors and thus ensure either the continuity of the management or that the changes in management take place with their knowledge. Even where personal guarantees are waived, it may be necessary to obtain an undertaking from the borrowing company that no change in the management would be made without the consent of the lending institution. Similarly, during the formative stages of a company, it may be in the interest of the company, as well as the lending institution, to obtain guarantees to ensure continuity of management. #($ Personal guarantees of directors may be helpful with regard to public limited companies other than those which may be rated as first class, where the advance is on an unsecured basis. #.$ There may be public limited companies, whose financial position and/or capacity for cash generation is not satisfactory even though the relevant advances are secured. Ìn such cases, personal guarantees are useful. #?$ Cases where there is likely to be considerable delay in the creation of a charge on assets, guarantee may be taken, where deemed necessary, to cover the interim period between the disbursement of loan and the creation of the charge on assets. #@$ The guarantee of parent companies may be obtained in the case of subsidiaries whose own financial condition is not considered satisfactory. #B$ Personal guarantees are relevant where the balance sheet or financial statement of a company discloses interlocking of funds between the company and other concerns owned or managed by a group. R B Ì has also advised the banks to obtain an undertaking from the borrowing company as well as the guarantors that no consideration whether by way of commission, brokerage fees or any other form, would be paid by the former or received by the latter, directly or indirectly. This requirement should be incorporated in the bank's terms and conditions for sanctioning of credit limits. During the periodic inspections, the bank's inspectors should verify that this stipulation has been complied with. There may, however, be an exceptional case where payment of remuneration may be permitted, e.g. where assisted concerns are not doing well and the existing guarantors are no longer connected with the management but continuance of their guarantees is considered essential because the new management's guarantee is either not available or is found inadequate and payment of remuneration to guarantors by way of guarantee commission is allowed. (0.. CGARIE OVER SECURITIES Nature of security and the operational convenience often decide the type of charge to be created over a security. The procedure for creation of charge is same for both primary and collateral securities. The point to be kept in mind is that only the owner of an asset can create charge over it. The charge could be any of the following: #1$ Mortgage #!$ Hypothecation Pledge #($ Lien #.$ Assignment (0.? *OSESSION O+ SECURIT) At the time of appraisal, banker has to decide about the possession of the security specially in case of inventory. With legal system in the country being still not perfect, this aspect has a bearing on the overall risk rating of the proposal. Till about a decade ago, a favoured method of finance of many banks used to be the, 'Lock and Key' advances in which the goods are kept in a godown and bank holds the keys of the locks of the godown. Ìf any goods are to be delivered to the borrower, he has to deposit the money in his cash credit account (alternatively, provide a trust receipt) before bank's 'Godown Keeper' goes to the godown and delivers the goods. This system was very inconvenient not only for the borrower but for the bank also and slowly got changed to 'Hypothecation', where possession remained with the borrower. Ìn case of 'Pledge' also, the borrower can have possession, called, 'Constructive Possession', and hold the goods as an agent of the bank. (0.@ DISBURSAD O+ DOANS ;or2in, Ca5ital Doans Ìn case of sole banking, the bank providing working capital limits opens a cash credit account of the borrower and all his financial transactions should be routed through this account. Without bank's permission, no account can be opened with any other bank. Banks give permission to open current account with other bank only if they are convinced about its necessity. Ìn such cases, periodic statements of that account are obtained to keep a tab on the transactions. The drawings in the cash credit account are regulated through the system of 'Drawing power' (D P) which is within the sanctioned cash credit limit. Ìdeally, the DP should be calculated by obtaining a statement of all the current assets and liabilities (excluding outstanding in cash credit account with the bank) and deducting from it the N W C stipulated at the time of assessment of the limit. However, this is not feasible as such a statement is normally available only after accounts are finalized. Even if bank insists for such statement, it will be available after much delay and may not serve the purpose. Therefore, banks obtain the statement of stocks, book-debts/receivables and the sundry creditors (account payable). These three items form major portion of current assets and liabilities in majority of the enterprises. Such statement is normally obtained on monthly basis but the periodicity can be reduced in exceptional cases. By stipulating suitable margins (depending on method of assessment) on stocks and book debts and reducing the amount of sundry creditors, the D P is calculated. Disbursal of entire W C limit by way of cash credit gives wide flexibility to the borrower in his working capital management. But, it creates the problem of fund management for the bank as there could be wide fluctuations in the utilization of limits. This also offers scope for diversion of funds by the borrower. Ìf the liquidity in the market is tight and short-term interest on money market instruments is high, he may tend to utilize the limit fully Ìn situations of abundant liquidity, the situation is reverse and the utilization of limit may tend to be low. The bank loses in such situations as it has to arrange for short term funds when interest rates are high and is left with surplus funds when rates are low. To meet this situation and to ensure that the utilization of limit is more stable, a portion of sanctioned limit is disbursed by way of 'Loan', which is a fixed component, and remaining amount is disbursed as cash credit. With this, if the borrower wants to draw very little amount or no amount, there will be debit in the loan account (fixed amount) while the cash credit account may have credit balance. R B Ì guidelines in this respect are as follows: #1$ Ìn the case of borrowers enjoying working capital credit limits of Rs 10 crore and above from the banking system, the loan component should normally be 80 percent. Banks, however, have the freedom to change the composition of working capital by increasing the cash credit component beyond 20 percent or to increase the 'Loan Component' beyond 80 percent, as the case may be, if they so desire. Banks are expected to appropriately price each of the two components of working capital finance, taking into account the impact of such decisions on their cash and liquidity management. #!$ Ìn the case of borrowers enjoying working capital credit limit of less than Rs. 10 crone, banks may persuade them to go in for the 'Loan System' by offering an incentive in the form of lower rate of interest on the loan component, as compared to the cash credit component. The actual percentage of 'loan component' in these cases may be settled by the bank with its borrower clients. #($ Ìn respect of certain business activities, which are cyclical and seasonal in nature or have inherent volatility, the strict application of loan system may create difficulties for the borrowers. Banks may, with the approval of their respective Boards, identify such business activities, which may be exempted from the loan system of delivery. Ter' loans Ìf the term loan is to be disbursed in one go, e.g. purchase of a machine/ ready house, the borrower is asked to deposit his margin with the bank, his loan account is debited by the amount of the loan and the entire amount to be paid to the buyer, is remitted to him by the bank. Ìf any amount has already been paid to the buyer by the customer, satisfactory proof, like details of bank account etc, of this payment is obtained, and this is considered to be a part of his contribution (margin). Ìn exceptional cases, like personal loans or consumption loans, the amount may be credited to the account of the customer with the bank. Ìn cases where the execution of the project is spread over a period of time, the disbursement is normally related to the progress of the project. RBÌ guidelines in respect of disbursement of project loans are as under: 'At the time of financing projects banks generally adopt one of the following methodologies as far as determining the level of promoters' equity is concerned. #1$ Promoters bring their entire contribution upfront before the bank starts disbursing its commitment. #!$ Promoters bring certain percentage of their equity (40% ÷ 50%) upfront and balance is brought in stages. #($ Promoters agree, a% initio, that they will bring in equity funds proportionately as the banks finance the debt portion. While it is appreciated that such decisions are to be taken by the boards of the respective banks, it has been observed that the last method has greater equity funding risk. Ìn order to contain this risk, banks are advised in their own interest to have a clear policy regarding the Debt Equity Ratio (DER) and to ensure that the infusion of equity/fund by promoters should be such that the stipulated level of DER is maintained at all times. Further they may adopt funding sequences so that possibility of equity funding by banks is obviated' (0 .B DENDINI UNDER CONSORTIUM4MUDTI*DE BAN/INI ARRANIEMENTS The sole banking is suitable for financing working capital needs of an enterprise only if the requirement is within the policy framework of the financing bank. Ìf the requirements grow beyond the comfort level of that bank due to prudential norms or risk perception for a particular segment [borrower, it would like another bank to finance a part of the requirements of that enterprise. Sometimes, even the borrowers may prefer not to depend on one bank and avail facilities from various banks. Ìf two or more banks get into a formal arrangement to finance the working capital needs of a borrower, it is called consortium arrangement. The consortium banks decide on one of the members as 'Lead bank' who not only arranges periodic meetings of the member banks but also takes lead in assessment, documentation, charge creation, monitoring of the account, etc. Ìn case of multiple banking there is no formal arrangement between the banks though they may share the information about the account in their mutual interest. RBI I7i&elines Various regulatory prescriptions regarding conduct of consortium, multiple banking and syndicate arrangements were withdrawn by Reserve Bank of Ìndia in October 1996 with a view to introducing flexibility in the credit delivery system and to facilitate smooth flow of credit. However, Central Vigilance Commission, Government of Ìndia, in the light of frauds involving consortium/multiple banking arrangements, had expressed concerns on the working of Consortium Lending and Multiple Banking Arrangements in the banking system. The Commission had attributed the incidence of frauds mainly to the lack of effective sharing of information about the credit history and the conduct of the account of the borrowers among various banks. Ìt was felt that there is need for improving the sharing/dissemination of information among the banks about the status of the borrowers enjoying credit facilities from more than one bank. Accordingly, RBÌ advised the banks to strengthen their information back-up about the borrowers enjoying credit facilities from multiple banks as follows: #1$ 'At the time of granting fresh facilities, banks may obtain declaration from the borrowers about the credit facilities already enjoyed by them from other banks in the format prescribed (Ref RBÌ circular nos. DBOD No. BP.BC.46/08.12.001/2008-09 dated September 19, 2008 and DBOD. No. BP.BC.94/ 08.12.001/2009-09 dated December 8, 2008.). Ìn the case of existing lenders, all the banks may seek a declaration from their existing borrowers, availing sanctioned limits of Rupees 5.00 crores and above or wherever, it is in their knowledge that their borrowers are availing credit facilities from other banks, and introduce a system of exchange of information with other banks as indicated above. #!$ Subsequently, banks should exchange information about the conduct of the borrowers' accounts with other banks in the format given in Annex 11 of RBÌ DBOD circulars referred to in (i) above at least at quarterly intervals. #($ Obtain regular certification by a professional, preferably a Company Secretary, Chartered Accountant or Cost Accountant, regarding compliance of various statutory prescriptions that are in vogue, as per specimen given in Annex ÌÌÌ of RBÌ circulars referred to in (i) above and DBOD. No. BP.BC. 110/ 08.12.001/2008-09 dated February 10, 2009. #.$ Make greater use of credit reports available from CÌBÌL. #?$ The banks should incorporate suitable clauses in the loan agreements in future (at the time of next renewal in the case of existing facilities) regarding exchange of credit information so as to address confidentiality issues.' Vide circular RBÌ/2008-09/354[UBD.PCB.No.36/13.05.000/2008-09 dated January 21, 2009, in addition to Company Secretaries, banks were permitted to also accept the certification by Chartered Accountants & Cost Accountants. Further, Annex ÌÌÌ ÷ Part Ì and Part ÌÌ has also been modified. (0.C S)NDICATION O+ DOANS The term 'Syndication' is normally used for sharing a long-term loan to a borrower by two or more banks. This is a way of sharing the risk, associated with lending to that borrower, by the banks and is generally used for large loans. The borrower, intending to avail the desired amount of loan, gives a mandate to one bank (called Lead bank) to arrange for sanctions for the total amount, on its behalf. The lead bank approaches various banks with the details These banks appraise the proposal as per their policies and risk appetite and take the decision. The lead bank does the liaison work and common terms and conditions of sanction may be agreed in a meeting of participating banks, arranged by the lead bank. Normally, the lead bank charges 'Syndication fee' from the borrower. S7''ar3 Ìt is anticipated, at the time of sanctioning a loan, that the repayment of principal and interest will be as per the schedule and all other terms of sanction will also be abided by the borrower. However, in some cases, due to malafide intentions or due to business failure, the bank may have to fall back on the securities available and take other legal action depending upon the circumstances of each case. Therefore, before disbursing the money, the bank ensures that it creates appropriate charge over the securities and the documents are executed as per the legal requirement. Personal guarantee of the directors or third party guarantees can also be stipulated. The working capital limits are disbursed as cash credit or a combination of cash credit and loan. RBÌ guidelines for disbursal of both working capital and term loans should be followed. Ìn case of borrowers, whose working capital requirements are large, two or more banks can meet the requirements. This is done under consortium arrangement or under multiple banking. To prevent the misutilisation of banking system, RBÌ has issued guidelines regarding both consortium and multiple banking. RBÌ has also issued guidelines for syndication of loans for both working capital and term loans. But, banks are using syndication only for term loans. /e38or&s Personal guarantee; Third party guarantee; Assignment; Lien; Hypothecation; Pledge; Possession of security; Documents; Consortium arrangement; Multiple banking; Syndication of loans; Lead bank for syndication. Che%2 )o7r *ro,ress State Tr7e or +alse: (1) The stamp duty on documents varies from State to State. .. True. (2) The date of execution of documents can be earlier than the date of stamping. ..False. (3) The parties executing the documents should have the necessary authority and the capacity to enter into a contract and execute the documents in that capacity. .. True. (4) Bank should ensure that the person signing the documents is doing so with his free will. .. True. (5) The documents can be filled in after these are signed. ..False. (6) Ìn case of companies, the charge should be registered with ROC within 60 days from the date of execution of the documents. ..False. (7) Some documents may be required to be registered with the sub-registrar. .. True. (8) Third party guarantees can be taken from individuals only. Any other legal entity can not be third party guarantor. ..False. (9) Bank can create charge over security not belonging to either the borrower or the guarantor. ..False. (10) Under 'Hypothecation', the possession of goods remains with the borrower. .. True. (11) Under 'Pledge', the possession of goods may remain with the borrower depending on bank's decision. .. True. (12) As per RBÌ guidelines, in the case of borrowers enjoying working capital credit limits of Rs. 10 crore and above from the banking system, the loan component should normally be 80 per cent. .. True. (13) Under 'Loan system', the borrower has to maintain a minimum debit balance in his loan account, while the cash credit account may have a credit balance. .. True. (14) Banks disburse the term loans as per the progress of the project .. True. (15) Consortium banking and Multiple banking are same. ..False. (16) RBÌ encourages Multiple or Consortium banking for small loans. .. False. /e3 to Che%2 )o7r *ro,ress 1. True; 2. False; 3. True; 4. True; 5. False; 6. False; 7. True; 8. False; 9. False; 10. True; 11. True; 12.True; 13. True; 14. True; 15. False; 16. False END O+ CGA*TER (0 H ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 ADVANCED BANK MANAGEMENT UNÌT 31 ÷ Credit Control and Monitoring STRUCTURE (1.0 Objectives (1.1 Ìmportance and Purpose (1.! Available Tools for Credit Monitoring/Loan Review Mechanism (1.0 OBJECTIVES After reading this chapter, you will have better understanding of: #1$ Ìmportance and purpose of credit control and monitoring #!$ Various tools used by banks for credit control and monitoring. #($ Credit audit (1.1 IM*ORTANCE AND *UR*OSE Despite an excellent credit appraisal, documentation and attention to security, the risk of default in an advance may go up as the time passes because the assumptions made at the time of appraisal may lose their sanctity, in view of the dynamic nature of business environment. Credit control and monitoring, often referred as Loan Review Mechanism (L R M), plays an important role in the following aspects: #1$ To ensure that the funds provided by the bank are put to the intended use and continue to be used properly. Any diversion of bank's funds out of the business or for unauthorized use within the business should be detected and stopped. #!$ To ascertain that the business continues to run on the projected lines. Ìf there is any deterioration from what was projected at the time of appraisal, the same should be noticed and appropriate action initiated by the bank, in consultation with the borrower, to ensure that the business continues to run on viable lines. #($ Ìf the deterioration of the business continues despite appropriate action, the bank should decide if any harsh action like, recalling the advance or seizing the security, etc. is necessary. Ìn such cases, an early detection of the problem is very important as any delay in necessary action by the bank may result in deterioration of the available security and reduce the chances and amount of recovery. (1.! AVAIDABDE TOODS +OR CREDIT MONITORINI 4 D R M The following records/information /methods are used by the bankers to monitor the credit; #1$ Con&7%t of the A%%o7nts 8ith the Ban2: This gives very useful information about the financial health of the enterprise and use of the funds by it. Frequent over-drawings, return of cheques and bills, delays in submission of statements of stock and receivables, low turnover, routing of transactions with some other bank, delay in payment of interest and installments, devolvement of L Cs, invocation of Bank Guarantees, etc. are some of the unsatisfactory features. Ìn such cases, banks may strengthen their monitoring system by resorting to more frequent inspections of borrowers' go downs, ensuring that sale proceeds are routed through the borrower's accounts maintained with the bank and insisting on pledge of the stock in place of hypothecation. #!$ *erio&i% Infor'ation S7"'itte& as 5er the Ter's of the A&=an%e: The statements of stock and receivables are to be submitted by the borrower at regular intervals (normally, monthly) and the bank calculates the Drawing Power (D P) on the basis of these. A thorough scrutiny of these is necessary to verify their correctness, accumulation of inventory (non-moving stocks) and old receivables (normally receivables above six months are excluded for calculating D P). The detection of non- moving stocks and old receivables is not only necessary for correct calculation of D P but is also warranted to detect the danger signals in the business of the borrower. During periodic inspection of the enterprise, by the bank officials, the latest statement of stocks and receivables are cross checked with the records. Stocks are also physically verified either fully or on random selection basis. #($ A7&it of Sto%2s an& Re%ei=a"les Con&7%te& "3 the Ban2: Stock audit is used by the bank in case of medium and large size accounts where verifying the stocks during normal inspection is not feasible or where the stocks are located at various locations. Similarly, audit of receivables may also be conducted in some cases. The purpose of these audits is to cross check the reliability of the statements submitted by the borrower. #.$ +inan%ial State'ents of the B7siness0 A7&itorsL Re5ort: These are normally available once a year. An analysis of these statements gives useful information about the use and diversion of funds, financial health, realization of debts, profitability, etc. Ìn case of working capital limits, this analysis is a part of the renewal exercise. #?$ *erio&i% Visits an& Ins5e%tion: The purpose of periodic visits is manifold. #a$ Ìt gives an impression about the activity level. The assessment of limits is based on an anticipated level of operations and field visit helps in ascertaining whether activities are at that level or not. #"$ Ìt helps in finding out the position of stocks and other assets charged to the bank. #%$ The fact of bank's charge over the assets should be prominently displayed Yield visits help in finding out this. #@$ Intera%tion: Ìnteraction with select creditors and debtors. #B$ *erio&i% S%r7tin3: Periodic scrutiny of borrowers' books of accounts and the accounts maintained with other banks #C$ Mar2et Re5orts a"o7t the0 Borro8er an& the B7siness Se,'ent: These reports are available from the industry associations and rating agencies. #F$ A55ointin, Ban2Ls No'inee on Co'5an3Ls Boar&: Ìn exceptional cases, or in case of large limits, bank may opt to appoint nominee director on the board to keep a tab on the important decisions. #10$ Cre&it A7&it: (The details given here are based on R B Ì's 'Guidance note on credit risk management') Credit audit is an examination of various credit functions of the bank. Ìt is normally conducted by internal staff having adequate credit experience. Credit Audit examines compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to time. Each bank formulates its own policies, procedures, and organizational set up for credit audit. Ìn some banks, credit audit plays an important role in monitoring of large value accounts also. R B Ì's suggestions in this respect, contained in their 'Guidance note on credit risk management', are as under: #A$ O"Ae%ti=es of Cre&it A7&it (1) Ìmprovement in the quality of credit portfolio (2) Review sanction process and compliance status of large loans (3) Feedback on regulatory compliance (4) Ìndependent review of Credit Risk Assessment (5) Pick-up early warning signals and suggest remedial measures (6) Recommend corrective action to improve credit quality, credit administration and credit skills of staff, etc. #B$ Str7%t7re of Cre&it A7&it De5art'ent: The credit audit and loan review mechanism may be assigned to a specific Department or the Ìnspection and Audit Department. #C $ +7n%tions of Cre&it A7&it De5art'ent (1) To process Credit Audit Reports (2) To analyze Credit Audit findings and advise the departments/ functionaries concerned (3) To follow up with controlling authorities (4) To apprise the Top Management (5) To process the responses received and arrange for closure of the relative Credit Audit Reports (6) To maintain database of advances subjected to Credit Audit #D$ S%o5e an& Co=era,e: The focus of credit audit needs to be broadened from the account level to look at the overall portfolio and the credit process being followed. The important areas are: #1$ *ortfolio Re=ie8: Examine the quality of Credit & Ìnvestment (Quasi Credit) Portfolio and suggest measures for improvement, including reduction of concentrations in certain sectors to levels indicated in the Loan Policy and Prudential Limits suggested by RBÌ. #!$ Doan Re=ie8: Review of the sanction process and status of post sanction processes and procedures (not just restricted to large accounts) (a) all fresh proposals and proposals for renewal of limits (within 3 to 6 months from date of sanction) (b) all existing accounts with sanction limits equal to or above a cut off depending upon the size of activity (c) randomly selected ( say 5-10%) proposals from the rest of the portfolio (d) accounts of sister concerns/group/associate concerns of above accounts, even if limit is less than the cut off #($ A%tion *oints for Re=ie8 (1) Verify compliance of bank's laid down policies and regulatory compliance with regard to sanction (2) Examine adequacy of documentation (3) Conduct the credit risk assessment (4) Examine the conduct of account and follow up looked at by line functionaries (5) Oversee action taken by line functionaries in respect of serious irregularities (6) Detect early warning signals and suggest remedial measures thereof #.$ +reJ7en%3 of Re=ie8: The frequency of review should vary depending on the magnitude of risk (say, for the high risk accounts - 3 months, for the average risk accounts- 6 months, for the low risk accounts- Ì year). (1) Feedback on general regulatory compliance (2) Examine adequacy of policies, procedures and practices (3) Review the Credit Risk Assessment methodology (4) Examine reporting system and exceptions thereof (5) Recommend corrective action for credit administration and credit skills of staff (6) Forecast likely happenings in the near future #?$ *ro%e&7re to "e follo8e& for Cre&it A7&it (1) Credit Audit is conducted on site, i.e. at the branch which has appraised the advance and where the main operative credit limits are made available. (2) Report on conduct of accounts of allocated limits is to be called from the corresponding branches. (3) Credit auditors are not required to visit borrowers' factory or office premises. S7''ar3 Post-disbursal control, supervision and monitoring are very important for the safety of bank's advance. The purpose is to ensure that the funds provided by the bank are put to the intended use and continue to be used properly. This is also intended to ascertain that the business continues to run on the projected lines and continues to be run on viable lines. The deterioration, if any, in the securities charged to the bank can also be detected by efficient monitoring This helps the bank in taking timely action for taking the corrective measures or starting the recovery proceedings. The tools available to the bank for effective monitoring are: #a$ Conduct of the accounts with the bank; #"$ Periodic information submitted as per the terms of the advance; #%$ The statements of stock and receivables submitted by the borrower at regular intervals (normally, monthly); #&$ Stock/receivables audit conducted by the bank; #e$ Financial statements of the business, auditors' report; #f$ Periodic visits and inspections; #,$ Ìnteraction with select creditors and debtors; #h$ Periodical scrutiny of borrowers' books of accounts and the accounts maintained with other banks; and #i$ Market reports about the borrower and the business segment. Ìn rare cases, bank may also appoint its nominee on company's board. The credit audit is also a very effective tool in supervision of credit. /e38or&s Supervision; Monitoring; Control: Loan Review Mechanism(L R M); Stock statement; Receivable statement; Deterioration of security; Ìnspection; Stock audit; Receivables audit; Credit audit Che%2 )o7r *ro,ress 1. ;hi%h of the follo8in, is not a 57r5ose of %re&it 'onitorin,> The choices are: (a) To ensure end use of the funds by the borrower (b) To detect any deterioration in the security charged to the bank (c) To comply with the guidelines of the RBÌ (d) To ascertain that the business continues to run on the projected lines The correct choice is.. #%$ To %o'5l3 8ith the ,7i&elines of the RBI !. ;hi%h of the follo8in, is not a tool a=aila"le to %he%2 the "an2 for %re&it 'onitorin,> The choices are: (a) Sending regular reminders to the borrower (b) Periodic visits to the business place for inspection (c) Analysis of financial statements (d) Examine conduct of borrower's account The correct choice is.. #a$ Sen&in, re,7lar re'in&ers to the "orro8er (. ;hi%h of the follo8in, is not a 'etho& for &ete%tin, 8ron, 'ention of in=entor3 in a sto%2 state'ent> The choices are: (a) Stock audit (b) Ìnspection of stocks (c) Analysis of financial statements (d) Cross-check from the balance sheet figure The correct choice is #%$ Anal3sis of finan%ial state'ents .. ;hi%h of the follo8in, is not a 'etho& for &ete%tin, 8ron, 'ention of re%ei=a"les in sto%2 state'ent s7"'itte& "3 the "orro8er> The choices are: (a) Analysis of financial statements (b) Cross check from the balance sheet figure (c) Receivables audit (d) Ìnspection of books of account The correct choice is.. #a$ Anal3sis of finan%ial state'ents ?. ;hi%h of the follo8in, is not a &an,er si,n a"o7t the &ire%tion of "7siness of the "orro8er> The choices are: (a) Devolvement of L Cs, invocation of Bank Guarantees (b) Demand for higher limit (c) Delays in submission of stock/receivables statements (d) Return of cheques or bills The correct choice is.. #&$ Ret7rn of %heJ7es or "ills @. ;hi%h of the follo8in, is not an 7nsatisfa%tor3 si,n in %on&7%t of the a%%o7nt of the "orro8er> The choices are: (a) Delay in payment of interest or instalments, (b) routing of transactions with some other bank (c) Frequent over drawings (d) High turnover The correct choice is #&$ Gi,h t7rno=er B. ;hi%h of the follo8in, is not the 57r5ose %re&it a7&it> The choices are: (a) Ìmprovement in the quality of credit portfolio (b) Review sanction process and compliance status of large loans (c) Feedback on regulatory compliance (d) Stock inspection The correct choice is #&$ Sto%2 ins5e%tion C. *7r5ose of a55ointin, "an2Ls no'inee on %o'5an3Ls "oar& of "orro8in, %o'5an3 is: The choices are: (a) To keep a tab on the important decisions of the board (b) To be a part of the management (c) To guide the company for better working (d) To safeguard the securities charged to the bank The correct choice is #a$ To 2ee5 a ta" on the i'5ortant &e%isions of the "oar& END O+ CGA*TER (1 H ADVANCED BAN/ MANAIEMENTE C A I I B *A*ER 1 E Cre&it Control an& Monitorin,. ADVANCED BANK MANAGEMENT UNÌT 32 ÷ Risk Management and Credit Rating STRUCTURE (!.0 Objectives (!.1 Meaning of Credit Risk (!.( Factors Affecting Credit Risk (!.. Steps taken to Mitigate Credit Risks (!.? Credit Ratings (!.@ Ìnternal and External Ratings Methodology of Credit Rating (!.B Use of Credit Derivatives for Risk Management (!.C Basel 11 Accord (!.F Ìntroduction of Advanced Approaches of Basel ÌÌ Framework in Ìndia (!.0 OBJECTIVES After reading this chapter, you will have better understanding of: #1$ The various risks faced by the banks #!$ The meaning of credit risk #($ Factors affecting credit risks #.$ Steps taken to mitigate credit risks #?$ The meaning of credit rating #B$ Objectives and importance of credit rating #C$ What is credit scoring #F$ Method of credit scoring (!.1 MEANINI O+ CREDIT RIS/ The risks faced by the business of banking can be classified into three broad categories; #1$ O5erational Ris2s: The examples of such risks are losses due to frauds, disruption of business due to natural calamities like floods etc. #!$ Mar2et Ris2s: These are the risks resulting from adverse market movements of interest rates, exchange rate etc. #($ Cre&it Ris2s: The credit risk can be defined as the unwillingness or inability of a customer or counterparty (e.g. the L C opening bank in a bills negotiation transaction under that L C) to meet his commitment relating to a financial transaction with the bank. For example, in a fund based limit, the credit risk is the non payment of principal and interest by the borrower, as per the agreed terms of repayment. Ìn case of a non fund based limit, the credit risk arises as the customer may not reimburse the bank fully in case of invocation of a guarantee or devolvement of an L C. (!.! +ACTORS A++ECTINI CREDIT RIS/ #1$ E6ternal +a%tors: These factors affect the business of a customer and reduce his capability to honor the terms of financial transaction with the bank. The main external factors affecting the overall quality of the credit portfolio of a bank are exchange rate and interest rate fluctuations, Government policies, protectionist policies of other countries, political risks, etc. These factors look similar to what is mentioned under market risks above. But, whereas the market risks directly affect a bank, the factors mentioned here affect the businesses of the customers thus impairing the quality of the credit portfolio. #!$ Internal +a%tors: These mainly relate to overexposure (concentration) of credit to a particular segment or geographical region, excessive lending to cyclical industries, ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in the loan policy of the bank, low quality of credit appraisal and monitoring, and lack of an efficient recovery machinery. (!.( STE*S TA/EN TO MITIIATE CREDIT RIS/S The major objective of credit risk management is to limit the risk within acceptable level and thus maximize the risk adjusted rate of return on the credit portfolio. Following are the main steps taken by any bank in this direction; #1$ At Ma%ro De=el: The risks to the overall credit portfolio of the bank are mitigated through frequent reviews of norms and fixing internal limits for aggregate commitments to specific sectors of the industry or business so that the exposures are evenly spread over various sectors and the likely loss is retained within tolerable limits. Bank also periodically reviews the loan policies relating to exposure norms to single and group borrowers as also the structure of discretionary powers vested with various functionaries. Many banks classify their credit portfolio based on some parameters of quality and periodically review this to avoid any rude shocks relating to credit losses. Earlier, RBÌ had made it mandatory to classify the portfolio by assigning health codes to each account. This is not mandatory now. Normally, banks also formulate policies relating to rehabilitation, compromise, recovery and write off to get the best out of a worst case scenario. #!$ At Mi%ro De=el: This pertains to policies of the bank regarding appraisal standards, sanctioning and delivering process, monitoring and review of individual proposals/categories of proposals, obtention of collateral security etc. Credit ratings and credit scoring play important role in this area. For dispersion/transfer of risk in large value accounts, bank can resort to consortium/ multiple banking and use of derivatives like credit default swaps. (!.. CREDIT RATINIS The level of credit risk involved in each loan proposal depends on the unique features of that proposal. Two similar projects, with different promoters, may be appraised by a bank as having different credit risks. Similarly, two different projects, with same promoters, may also be appraised by the bank as having different credit risks. While appraising a credit proposal, the risk involved is also measured and often quantified by way of a rating with the following objectives; #1$ To decide about accepting, rejecting or accepting with modifications/ special covenants #!$ To determine the pricing, i.e. the rate of interest to be charged #($ To help in the macro evaluation of the total credit portfolio by classifying it on the ratings allotted to individual accounts. This is used for assessing the provisioning requirements, as also a decision making tool, by the management of the bank, for reviewing the loan policy of the bank. (!.? INTERNAD AND E1TERNAD. Most of the banks in Ìndia have set up their own credit rating models as till recent past, the rating agencies were not equipped well enough to provide the ratings, so reliable as to banks depending on these for credit decisions. However, with experience gained in last few years, these rating agencies have gained confidence of the banks. A few of such rating agencies are CARE, ÌCRA, CRÌSÌL and SMERA. (!.@ METGODODOI) O+ CREDIT RATINI Based on its loan policies and risk perceptions, each bank has its own rating model. Common feature in all the risk models is that a score is given for different perceived risks by allotting different weightages. The sum of all these scores forms the basis for deciding on risk rating of a proposal. Normally, the broad categories of risk areas which are scored are: #a$ Promoters/Management aspects and the securities available #"$ Financial aspects based on analysis of financial statements #%$ Business/project risks Ìn view of the dynamic market scenario, there is need to review the ratings of a borrower at regular intervals upgrade or downgrade or maintain it. (!.B USE O+ CREDIT DERIVATIVES +OR RIS/ MANAIEMENT Credit derivatives are used to hedge the risks inherent in any credit asset without transferring the asset itself. The hedging is comparable to insurance and comes at a cost. Therefore, if the anticipated risk does not materialize, the return from the asset will be less than what it would have been without the hedging. While simple techniques for transferring credit-risk, such as financial guarantees, collateral and credit insurance have been prevalent in the Ìndian banking industry for long, the recent innovative instruments in credit risk transfer (C R T) such as collateralized debt obligations (C D O),), etc. are yet to gain significant currency. However, Credit Default Swaps (C D Ss) finds use as the new hedging instrument. The brief description of two of these new generation credit risk hedging derivatives is given below: #1$ Cre&it Defa7lt S8a5s #C D Ss$: This is a bilateral contract in which the risk seller (lending bank) pays a premium to the buyer for protection against credit default or any other specified credit event. Normally, C D S is a standardized instrument of Ì S D A (Ìnternational Swaps and Derivatives Association).The credit events defined by ÌSDA are, bankruptcy, failure to pay, restructuring, obligation acceleration, obligation repudiation or moratorium etc. As per R B Ì guidelines, plain vanilla C D Ss only are allowed. #!$ Cre&it Din2e& Notes #C D N$: Ìn this, the risk seller gets risk protection by paying regular premium to the risk buyer, which is normally a S P V which issued notes linked to the underlying credit. These notes are purchased by the general investors and the money received from them is used by the SPV to buy high quality securities. The general investors get fixed or variable return on the note during its life. On maturity of the underlying credit, the securities purchased by SPV are sold and money returned to the investors. But, in case of default in the underlying credit, these securities are used to pay to the risk seller. R B Is ;orr3 on Deri=ati=es Ìf the banks use these derivatives to hedge their credit risk by way of purchasing the risk protection, there is no apprehension. But, when the banks start selling the credit protection to other lenders, in respect of their credit risks, there is cause for worry because, often these instruments are so structured that they become very complex to understand and sometimes the liability which arises is many times more than what was anticipated. Therefore, RBÌ is in favour of slow growth of these derivatives in Ìndian financial market. Ìt is not out of place here to quote Warren Buffet, the famous investor, as saying, 'These are weapons of mass financial destruction'. (!.C BASED ! ACCORD The new framework of Basel 2 accord is based on three pillars viz., 1) Minimum capital requirements, 2) Supervisory review and iii) Market discipline. The minimum capital requirement is based on market risk, operational risk and the credit risk. Basel 2 has laid down various approaches for assessment of credit risks. These are; #a$ Standardized Approach #"$ Foundation Ìnternal Rating Based (Ì R B) Approach #%$ Advanced Ìnternal Rating Based (Ì R B) Approach Foreign banks, operating in Ìndia and Ìndian banks having operational presence outside Ìndia have migrated to the simpler approaches available under the Basel 2 Framework, since March 31, 2009. Other commercial banks have also migrated to these approaches from March 31, 2009. Thus, the Standardized Approach for credit risk has been implemented for the banks in Ìndia. (!.F INTRODUCTION O+ ADVANCED A**ROACGES O+ BASED ! +RAME;OR/ IN INDIA Having regard to the necessary up-gradation of risk management framework as also capital efficiency likely to accrue to the banks by adoption of the advanced approaches envisaged under the Basel 2 Framework and the emerging international trend in this regard, R B Ì considered it desirable to lay down a timeframe for implementation of the advanced approaches in Ìndia. This would enable the banks to plan and prepare for their migration to the advanced approaches for credit risk. R B Ì has advised the following time schedule for implementation of the advanced approaches (Foundation as well as Advanced ÌRB); #1$ The earliest date of making application by banks to R B Ì - April 1, 2012 #!$ Likely date of approval by the R B Ì ÷ March 31, 2014 The R B Ì has advised the banks to undertake an internal assessment of their preparedness for migration to advanced approaches, in the light of the criteria envisaged in the Basel 2 document, as per the aforesaid time schedule, and take a decision, with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. The banks deciding to Migrate to the advanced approaches may approach R B Ì for necessary approvals, in due course, as per the stipulated time schedule. Ìf, the result of a bank's internal assessment indicates that it is not in a position to apply for implementation of advanced approach by the above mentioned dates, it may choose a later date suitable to it based upon its preparation. The banks, at their discretion, have the option of adopting the advanced approaches for one or more of the risk categories, as per their preparedness, while continuing with the simpler approaches for other risk categories, and it would not be necessary to adopt the advanced approaches for all the risk categories simultaneously. However, the banks should invariably obtain prior approval of the R B Ì for adopting any of the advanced approaches. S7''ar3 The business of banking is prone to various risks like credit risks, market risks and operational risk. The credit risks to the bank can arise due to internal of external causes. The internal risks are caused by banks own deficiencies like, overexposure (concentration) of credit to a particular segment/geographical region, excessive lending to cyclical industries, ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in the loan policy of the bank, low quality of credit appraisal and monitoring, and lack of an efficient recovery machinery. The main external risks are, exchange rate and interest rate fluctuations, Government policies, protectionist policies of other countries and political risks. A bank takes various measures to mitigate these risks. Some of these are; revision of prudential norms, upgrading the appraisal standards, tightening the monitoring mechanism and strengthening the recovery department .The rating system is introduced with the purpose of quantifying the risks involved in a particular credit proposal. Normally, the scoring system is used for arriving at the credit rating. Ìt gives the risk weightage based score to various risk parameters in a proposal and total of this score is used to award the credit rating. Each bank has its own scale of rating. The derivatives are also used for risk hedging but their use is, presently, limited. Base ÌÌ Accord prescribes Standardized as well as ÌRB approach for management of credit risks. While the standardized approach has already been adopted by the banks, ÌRB approach will take some time for implementation. /e38or&s Credit risk; internal risk; external risks; mitigation of risks; industry concentration; Credit rating, internal rating; external rating; scoring; Credit derivatives; Basel 11; Standardized approach; ÌRB (internal rating based) approach Che%2 )o7r *ro,ress 1. ;hi%h of the +ollo8in, 2 not a ris2 'entione& in the Basel II A%%or& The choices are (a) Operational risk (b) Market risk (c) Default risk (d) Credit risk The correct choice is . #%$ Defa7lt ris2. !. ;hi%h of the follo8in, is not a %re&it ris2> The choices are (a) Unwillingness of a customer to meet his commitment relating to a financial transaction with the bank (b) Ìnability of the customer to reimburse the bank in case of invocation of a guarantee or devolvement of an L.C (c) Ìnability of a customer to meet his commitment relating to a financial transaction with the bank (d) Loss to the bank due to fraud The correct choice is . #&$ Doss to the "an2 &7e to fra7& (. ;hi%h of the follo8in, is an e6ternal fa%tor affe%tin, %re&it ris2> The choices are (a) Government policies (b) Faulty loan and repayment structuring (c) Overexposure (concentration) of credit to a particular segment (d) Lack of an efficient recovery machinery The correct choice is . #a$ Io=ern'ent 5oli%ies .. ;hi%h of the follo8in, is not an internal fa%tor affe%tin, %re&it ris2> The choices are (a) Excessive lending to cyclical industries (b) Low quality of credit appraisal and monitoring (c) Deficiencies in the loan policy of the bank (d) Protectionist policies of other countries The correct choice is . #&$ *rote%tionist 5oli%ies of other %o7ntries ?. ;hi%h of the follo8in, is not a 'a%ro le=el a%tion for 'iti,ation of %re&it ris2> The choices are (a) Periodically reviews of the exposure norms for single and group borrowers (b) Ìmproving appraisal standards of credit proposals (c) Frequent reviews of norms and fixing internal limits for aggregate commitments to specific sectors of the industry or business (d) Periodic review of total credit portfolio based on quality parameters The correct choice is . #"$ I'5ro=in, a55raisal stan&ar&s of %re&it 5ro5osals @. ;hi%h of the follo8in, is not a 'i%ro le=el a%tion for 'iti,ation of %re&it ris2> The choices are (a) Ìmproving sanctioning and delivering process (b) Obtention of collateral security (c) Monitoring and review of individual proposals/categories of proposals (d) Periodical reviews of the exposure limits for business or industry segment The correct choice is . #&$ *erio&i%al re=ie8s of the e65os7re li'its for "7siness or in&7str3 se,'ent B. ;hi%h of the follo8in, state'ents is not tr7e re,ar&in, %re&it &eri=ati=es 5ro&7%ts> The choices are (a) These are used to hedge credit risk to the bank (b) The protection buyer is the lending bank (c) The protection seller can be another bank or any other organization (d) The credit asset is transferred in case of derivatives The correct choice is . #&$ The %re&it asset is transferre& in %ase of &eri=ati=es. C. Cre&it ratin, is a s3ste' of: The choices are (a) Measuring risk (b) Mitigating risk (c) Migrating risk (d) Credit appraisal The correct choice is . #a$ Meas7rin, ris2 F. Internal ratin, 'eans: The choices are (a) Rating the project (b) Rating the promoters (c) Rating the risk for internal use (d) None of the above The correct choice is . #&$ None of the a"o=e. 10. +or e6ternal %re&it ratin,0 "an2s &e5en& on: The choices are (a) Rating agencies (b) Experienced staff of the bank (c) Banking consultants (d) None of the above The correct choice is . #a$ Ratin, a,en%ies 11. ;hi%h of the follo8in, is not an a55roa%h for assess'ent of %re&it ris2s0 lai& &o8n 7n&er Basel ! A%%or&> The choices are (a) Standardized approach (b) Foundation Ìnternal Rating Based (Ì R B) approach (c) Advanced Ìnternal Rating Based (Ì R B) approach (d) Simplified Ìnternal Rating Based (Ì R B) approach The correct choice is . #&$ Si'5lifie& Internal Ratin, Base& #I R B$ a55roa%h 1!. ;hi%h of the follo8in, state'ents is tr7e re,ar&in, Stan&ar&i-e& a55roa%h> The choices are: (a) Ìt has already been adopted by all the banks (b) Ìt has been adopted only the foreign banks operating in Ìndia. (c) Ìt has been adopted by the foreign banks operating in Ìndia and some of the Ìndian banks (d) Ìt has to be adopted by the all the banks by March 2010 The correct choice is . #a$ It has alrea&3 "een a&o5te& "3 all the "an2s 1(. R B I has s7,,este& 8hi%h of the follo8in, earliest &ate of 'a2in, a55li%ation "3 "an2s to R B I re,ar&in, i'5le'entation of the a&=an%e& a55roa%hes #+o7n&ation as 8ell as I R B$ The choices are (a) 1, April 2012 (b) 1, April 2013 (c) 1, April 2014 (d) 1, April 2015 The correct choice is .#a$ 10 A5ril !01! Answer to Check Your Progress 1(c); 2.(d); 3.(a); 4.(d); 5.(b); 6.(d); 7.(d); 8.(a); 9.(d); 10.(a); 11(d); 12.(a); 13.(a) END OF CHAPTER 32 - Risk Management and Credit Rating.÷ ADVANCED BANK MANAGEMENT- C A Ì Ì B PAPER 1 ADVANCED BANK MANAGEMENT UNÌT 33 - Rehabilitation and Recovery STRUCTURE ((.0 Objectives ((.1 Credit Default/Stressed Assets/N P As ((.! Willful Defaulters ((.( Options Available to Banks for Stressed Assets ((.. R B Ì Guidelines on Restructuring of Advances by Banks ((.? Corporate Debt Restructuring (C D R) Mechanism ((.@ S M E Debt Restructuring Mechanism ((.B R B Ì Guidelines on Rehabilitation of Sick S S Ì Units ((.C Credit Ìnformation System ((.F Credit Ìnformation Bureau (Ìndia) Ltd., (CÌBÌL) ((.0 OBJECTIVES After reading this chapter, you will have better understanding of: #1$ The meaning of credit default, stressed assets, non performing assets and the options available to banks for dealing with them. #!$ Meaning of rehabilitation, rescheduling, compromise and write off. #($ Meaning of Debt restructuring, institutional/organizational framework for debt restructuring available for S M Es and Corporates #.$ The legal framework available for recovery. #?$ Credit information system, objectives and procedures for disclosure of list of defaulters, formation of CÌBÌL ((.1 CREDIT DE+AUDT4STRESSED ASSETS4N * As Credit default means the inability or the unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, or any financial transactions. This may take the following forms; #1$ in the %ase of &ire%t len&in,: principal and/or interest amount may not be repaid as per the terms of repayment. #!$ in the %ase of ,7arantees or letters of %re&it: funds may not be forthcoming from the constituents upon crystallization of the liability; #($ in the %ase of treas7r3 o5erations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases; #.$ in the %ase of se%7rities tra&in, "7sinesses: funds/securities settlement may not be effected; #?$ in the %ase of %rossE"or&er e65os7re: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign. Stressed assets are those assets in which the default has either already occurred or which are facing a reasonably certain prospect of default. For example, the term loan for an industrial project, implementation of which has been abandoned, is a stressed asset even though the repayment has not yet fallen due as per the repayment terms. Non *erfor'in, Assets #N * As$ As per R B Ì directives, banks in Ìndia have to classify their assets into Performing or Standard assets or Non performing assets (N P As). N P As are further classified into #a$ Sub-standard, #"$ doubtful and #%$ loss assets. The classification is based on the period of default as also the availability of security. The amount of provision required to be made on the asset portfolio of a bank depends on its classification into the four categories of standard, sub standard, doubtful and loss. The consolidated R B Ì guidelines on this are available in their Master circular Number D B O D.No.B*.BC.1B4!1.0..0.C4!00FE10 &ate& 10 J7l3 !00F ((.! ;IDD+UD DE+AUDTERS The default in payment as per agreed terms could be intentional or due to the reasons beyond the control of the borrower. The intentional default is referred to as willful default. As per R B Ì guidelines, a 'willful default' would be deemed to have occurred if any of the following events is noted: #1$ The unit has defaulted in meeting its payment or repayment obligations to the lender even when it has the capacity to honour the said obligations. #!$ The unit has defaulted in meeting its payment or repayment obligations to the lender and has not utilized the finance, borrowed for the specific purposes for which the finance was availed of but has diverted the funds for other purposes. #($ The unit has defaulted in meeting its payment or repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilized for the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets. #.$ The unit has defaulted in meeting its payment or repayment obligations to the lender and has also disposed off or removed the movable fixed assets or immovable property given by him or it for the purpose of securing a term loan without the knowledge of the bank or lender. (Details available in R B Ì circular D B O D No. DD.BC. 1@
[email protected](4!00FE10 &ate& 10 J7l3 !00F. The Master Circular has been placed on the R B Ì web-site (htt5:44888.r"i.or,.in). ((.( O*TIONS AVAIDABDE TO BAN/S +OR STRESSED ASSETS Every credit default does not necessarily result in loss to the bank. Ìn many cases, bank may be able to recover its dues fully. Ìn other cases, the recovery may be with some loss or, in the worst scenario there may be no recovery at all. The timely action and an appropriate strategy play very important role in achieving the best recovery for any stressed asset. While formulating the strategy, the bank has to keep in mind the legal system as also the social aspects prevailing in the country. Normally, a bank follows the following steps in case of a stressed asset: #1$ Exit from the account #!$ Rescheduling or Restructuring #($ Rehabilitation #.$ Compromise #?$ Legal action #@$ Write off E6it fro' the A%%o7nt: Bank's first effort is to exit from the account which is showing signs of stress. This is possible only when the symptoms of stress are detected at a very early stage so that the borrower is able to shift his account to another bank which has a different credit appetite. Once the symptoms become more pronounced, acceptance of account by another bank may not materialize. Ìn case of consortium/multiple banking, there is good possibility of other banks taking up the share of the bank wanting to exit but in case of sole banking, bank may find it very difficult to exit a problematic account and it has to consider other options for dealing with such accounts. Res%he&7lin, or Restr7%t7rin,: Ìf the default is not willful, the banks normally reschedule or restructure the loans in accordance with the revised cash flow estimates of the borrower. Reha"ilitation: Sometimes, the business enterprises face adverse internal or market conditions and incur losses for a long time, resulting in default in payment of bank's dues. This is, specially true of the manufacturing enterprises, which are considered as 'sick' if there is erosion in the net worth due to accumulated cash losses to the extent of 50 per cent of its net worth during the previous accounting year and the unit has been in commercial production for at least two years. Banks may examine the possibility of 'Rehabilitation' in such cases after undertaking detailed viability study. Co'5ro'ise: Ìf the restructuring or rescheduling or rehabilitation is not considered viable or, does not yield the desired results, banks try to recover their dues by offering some concessions to the borrower. Such decision is influenced by the availability or realisability of the securities, enforceability of the documents etc. De,al A%tion: Ìn cases where even the compromise does not materialize, banks have to initiate recovery proceedings. The forums available to the banks are as under; #1$ Io=ern'ent Ma%hiner3: Ìn case of finance under government sponsored schemes, the recovery officers, appointed by the state governments, help in recovery of bank's dues #!$ Ci=il Co7rts: Banks can file the civil suits for recovery of their dues in the civil courts. This option is used for dues up to Rupees ten lakhs only as Debt Recovery Tribunals (DRTs) are preferred for higher amount. However, the proceedings in the civil courts are very slow. The Committee on Financial Sector Assessment (C F S A) has observed that, 'the average time taken in Ìndia for winding-up proceedings is one of the highest in the world. Ìmprovements in effective enforcement of creditor rights and insolvency systems are critical for strengthening market efficiency and integration and for enhancing commercial confidence in contract enforcement. A quick resolution of stressed assets of financial intermediaries is essential for the efficient functioning of credit and financial markets.' #($ Do2 A&alats: Ìn the area of dispute settlement, the Legal Services Authority Act, 1987 has conferred statutory basis on the Lok Adalats (people's courts). The Reserve Bank has consequently issued guidelines to commercial banks and financial institutions to make increasing use of the forum of Lok Adalats. As per the earlier guidelines, banks could settle disputes involving amounts up to Rupees 5 lakh through the forum of Lok Adalats. This was enhanced to Rupees 20 lakh in August 2004. Further, banks have also been advised by the Reserve Bank to participate in the Lok Adalats convened by various DRTs or DRATs for resolving cases involving Rupees 10 lakh and above to reduce the stock of N P As. #.$ De"t Re%o=er3 Tri"7nals #DRTs$: These are created specially for banks and Financial Ìnstitutions (F Ìs) for expediting the recovery cases involving amounts in excess of Rupees 10 lakh. The Debt Recovery Tribunal (Procedure) Rules 2003 were amended substantially regarding application fee and plural remedies for better administration of the Recovery of Debts due to Banks and Financial Ìnstitutions Act, 2002. #?$ SAR+AESI A%t0 !00!: The passage of the !e#uriti@ation and ?e#onstru#tion of Ginan#ial Assets and Enfor#ement of !e#urity Interest A#t( 2002 (SARFAESÌ Act) has provided the necessary impetus for banks and Financial Ìnstitutions (F Ì s) to hasten the recovery of their dues. This Act, effective from the date of promulgation of the first Ordinance, i.e. 21, June 2002, has been extended to cover co-operative banks by a notification dated January 28, 2003. The Act provides, inter alia, for enforcement of security interest for realization of dues without the intervention of courts or tribunals. The Government has also notified the Security Ìnterest (Enforcement) Rules, 2002 to enable secured creditors to authorize their officials to enforce the securities and recover the dues from the borrowers. Since the Act provides for sale of financial assets by banks or Financial Ìnstitutions (F ls) to Securitization Companies (S Cs) or Reconstruction Companies (R Cs), guidelines have been issued to ensure that the process of asset reconstruction proceeds on sound lines. These guidelines, interFalia, prescribe the financial assets which can be sold to S Cs or R Cs by banks or F Ìs, procedure for such sales (including valuation and pricing aspects), prudential norms for the sale transactions (viz., provisioning or valuation norms, capital adequacy norms and exposure norms) and related disclosures required to be made in the Notes on Accounts to balance sheets. The Ì F C L along with other banking and F Ìs, incorporated an asset reconstruction company called 'Asset Care Enterprise Ltd.' (ACE) in June 2002 with an authorized capital of Rupees 20 crore. More recently, the Ì D B Ì, the Ì C Ì C Ì Bank, the S B Ì and few other banks have jointly promoted the Asset Reconstruction Company (Ìndia) Ltd. (ARCÌL) with an initial authorized capital of Rupees 20 crore and paid-up capital of Rupees 10 crore. Similar asset reconstruction or management companies are also being proposed by other institutions or banks. The Enforcement of Security Ìnterest and Recovery Debts Laws (Amendment) Act, 2004 has amended the SARFAESÌ Act, Recovery of Debts due to banks and financial institutions Act, 1993 and the Companies Act, 1956. By this amendment, the SARFAESÌ Act has been amended, inter alia, to #a$ enable the borrower to make an application before the debt recovery tribunal against the measures taken by the secured creditor without depositing any portion of the money due; #"$ provide that the debt recovery tribunal shall dispose of the application as expeditiously as possible within a period of 60 days from the date of application and #%$ enable any person aggrieved by the order by the debt recovery tribunal to file an appeal before the debt recovery appellate tribunal after depositing with the appellate tribunal 50 per cent of the amount of debt due to him as claimed by the secured creditor or as determined by the debt recovery tribunal, whichever is less. #?$ ;rite off: When all the efforts to recover the dues are exhausted or, the bank is convinced that further pursuit of the case will not result any worthwhile results, the outstanding amount is written off by utilizing the provision made for that account in the books. Ìf the provision is not enough, the excess amount is debited to Profit and Loss account (P & L account). The write off does not mean that the borrower's liability to the bank has ended. Ìf bank is able to recover any amount from him in future, it has the legal right to appropriate that amount. ((.. R B I IUIDEDINES ON RESTRUCTURINI O+ ADVANCES B) BAN/S #Details %ontaine& in R B I %ir%7lar D B O D.No.B*.BC.No.(B 4!1.0..1(!4!00CE0F &ate& A7,7st !B0 !00C$ Banks may restructure the accounts classified under 'standard', 'sub-standard' and 'doubtful' categories. Banks can not reschedule/restructure/renegotiate borrowal accounts with retrospective effect. Normally, restructuring can not take place unless alteration or changes in the original loan agreement are made with the formal consent or application of the debtor. However, the process of restructuring can be initiated by the bank in deserving cases subject to customer agreeing to the terms and conditions. No account will be taken up for restructuring by the banks unless the financial viability is established and there is a reasonable certainty of repayment from the borrower, as per the terms of restructuring package. The viability should be determined by the banks based on the acceptable viability benchmarks determined by them, which may be applied on a case-by-case basis, depending on merits of each case. The accounts not considered viable should not be restructured and banks should accelerate the recovery measures in respect of such accounts. Any restructuring done without looking into cash flows of the borrower and assessing the viability of the projects or activity financed by banks would be treated as an attempt at ever greening a weak credit facility and would invite supervisory concerns/action. BÌER cases are not eligible for restructuring without their express approval. ((.? COR*ORATE DEBT RESTRUCTURINI #C D R$ MECGANISM O"Ae%ti=e The objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring the corporate debts of viable entities facing problems, outside the purview of BÌER, DRT and other legal proceedings, for the benefit of all concerned. Ìn particular, the framework will aim at preserving viable corporates that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme. S%o5e The CDR Mechanism has been designed to facilitate restructuring of advances of borrowers enjoying credit facilities from more than one bank/Financial Ìnstitution (F Ì) in a coordinated manner. The CDR Mechanism is an organizational framework institutionalized for speedy disposal of restructuring proposals of large borrowers availing finance from more than one bank/Fl. This mechanism will be available to all borrowers engaged in any type of activity subject to the following conditions: #1$ The borrowers enjoy credit facilities from more than one bank or F l under multiple banking or syndication or consortium system of lending. #!$ The total outstanding (fund-based and non-fund based) exposure is Rupees 10 crores or above. C D R system in the country will have a three tier structure (a) C D R Standing Forum and its Core Group. (b) C D R Empowered Group. (c) C D R Cell. C D R Stan&in, +or7' The C D R Standing Forum would be the representative general body of all financial institutions and banks participating in C D R system. All financial institutions and banks should participate in the system in their own interest. C D R Standing Forum will be a self-empowered body, which will lay down policies and guidelines, and monitor the progress of corporate debt restructuring. The Forum will also provide an official platform for both the creditors and borrowers (by consultation) to amicably and collectively evolve policies and guidelines for working out debt restructuring plans in the interests of all concerned. Forum shall comprise of Chairman & Managing Director, Ìndustrial Development Bank of Ìndia Ltd; Chairman, State Bank of Ìndia; Managing Director & CEO, ÌCÌCÌ Bank Limited; Chairman, Ìndian Banks' Association as well as Chairmen and Managing Directors of all banks and financial institutions participating as permanent members in the system. Since institutions like Unit Trust of Ìndia, General Ìnsurance Corporation, Life Ìnsurance Corporation may have assumed exposures on certain borrowers, these institutions may participate in the C D R system. The Forum will elect its Chairman for a period of one year and the principle of rotation will be followed in the subsequent years. However, the Forum may decide to have a Working Chairman as a whole-time officer to guide and carry out the decisions of the C D R Standing Forum. The R B Ì would not be a member of the C D R Standing Forum and Core Group. Ìts role will be confined to providing broad guidelines. The C D R Standing Forum shall meet at least once every six months and would review and monitor the progress of corporate debt restructuring system. The Forum would also lay down the policies and guidelines including those relating to the critical parameters for restructuring (for example, maximum period for a unit to become viable under a restructuring package, minimum level of promoters' sacrifice etc.) to be followed by the C D R Empowered Group and C D R Cell for debt restructuring and would ensure their smooth functioning and adherence to the prescribed time schedules for debt restructuring. Ìt can also review any individual decisions of the C D R Empowered Group and C D R Cell. The CDR Standing Forum may also formulate guidelines for dispensing special treatment to those cases, which are complicated and are likely to be delayed beyond the time frame prescribed for processing. A C D R Core Group will be carved out of the CDR Standing Forum to assist the Standing Forum in convening the meetings and taking decisions relating to policy, on behalf of the Standing Forum. The Core Group will consist of Chief Executives of Ìndustrial Development Bank of Ìndia Ltd., State Bank of Ìndia, Ì C Ì C Ì Bank Ltd, Bank of Baroda, Bank of Ìndia, Punjab National Bank, Ìndian Banks' Association and Deputy Chairman of Ìndian Banks' Association representing foreign banks in Ìndia. The C D R Core Group would lay down the policies and guidelines to be followed by the CDR Empowered Group and CDR Cell for debt restructuring. These guidelines shall also suitably address the operational difficulties experienced in the functioning of the CDR Empowered Group. The CDR Core Group shall also prescribe the PERT chart for processing of cases referred to the CDR system and decide on the modalities for enforcement of the time frame. The CDR Core Group shall also lay down guidelines to ensure that over-optimistic projections are not assumed while preparing/approving restructuring proposals especially with regard to capacity utilization, price of products, profit margin, demand, availability of raw materials, input-output ratio and likely impact of imports/international cost competitiveness. CDR E'5o8ere& Iro75 The individual cases of corporate debt restructuring shall be decided by the CDR Empowered Group, consisting of E D level representatives of Ìndustrial Development Bank of Ìndia Ltd., ÌCÌCÌ Bank Ltd. and State Bank of Ìndia as standing members, in addition to E D level representatives of financial institutions and banks who have an exposure to the concerned company. While the standing members will facilitate the conduct of the Group's meetings, voting will be in proportion to the exposure of the creditors only. Ìn order to make the CDR Empowered Group effective and broad based and operate efficiently and smoothly, it would have to be ensured that participating institutions/banks approve a panel of senior officers to represent them in the CDR Empowered Group and ensure that they depute officials only from among the panel to attend the meetings of CDR Empowered Group. Further, nominees who attend the meeting pertaining to one account should invariably attend all the meetings pertaining to that account instead of deputing their representatives. The level of representation of banks/financial institutions on the CDR Empowered Group should be at a sufficiently senior level to ensure that concerned bank/F Ì abides by the necessary commitments including sacrifices, made towards debt restructuring. There should be a general authorization by the respective Boards of the participating institutions/banks in favour of their representatives on the CDR Empowered Group, authorizing them to take decisions on behalf of their organization, regarding restructuring of debts of individual corporates. The CDR Empowered Group will consider the preliminary report of all cases of requests of restructuring, submitted to it by the CDR Cell. After the Empowered Group decides that restructuring of the company is prima-facie feasible and the enterprise is potentially viable in terms of the policies and guidelines evolved by Standing Forum, the detailed restructuring package will be worked out by the CDR Cell in conjunction with the Lead Ìnstitution. However, if the lead institution faces difficulties in working out the detailed restructuring package, the participating banks/financial institutions should decide upon the alternate institution/bank which would work out the detailed restructuring package at the first meeting of the Empowered Group when the preliminary report of the CDR Cell comes up for consideration. The CDR Empowered Group would be mandated to look into each case of debt restructuring, examine the viability and rehabilitation potential of the Company and approve the restructuring package within a specified time frame of 90 days, or, at best within 180 days of reference to the Empowered Group. The CDR Empowered Group shall decide on the acceptable viability benchmark levels on the following illustrative parameters, which may be applied on a case-by-case basis, based on the merits of each case: (a) Return on Capital Employed (R O C E) (b) Debt Service Coverage Ratio (D S C R) (c) Gap between the Ìnternal Rate of Return (Ì R R) and the Cost of Fund (C o F) (d) Extent of sacrifice.. The Board of each bank/Fl should authorize its Chief Executive Officer (C E O) and/or Executive Director (E D) to decide on the restructuring package in respect of cases referred to the CDR system, with the requisite requirements to meet the control needs. CDR Empowered Group will meet on two or three occasions in respect of each borrowal account. This will provide an opportunity to the participating members to seek proper authorizations from their C E O or E D, in case of need, in respect of those cases where the critical parameters of restructuring are beyond the authority delegated to him/her. The decisions of the CDR Empowered Group shall be final. Ìf restructuring of debt is found to be viable and feasible and approved by the Empowered Group, the company would be put on the restructuring mode. Ìf restructuring is not found viable, the creditors would then be free to take necessary steps for immediate recovery of dues and, or liquidation or winding up of the company collectively or individually. CDR Cell The CDR Standing Forum and the CDR Empowered Group will be assisted by a CDR Cell in all their functions. The CDR Cell will make the initial scrutiny of the proposals received from borrowers/creditors, by calling for proposed rehabilitation plan and other information and put up the matter before the CDR Empowered Group, within one month to decide whether rehabilitation is prima facie feasible. Ìf found feasible, the CDR Cell will proceed to prepare detailed Rehabilitation Plan with the help of creditors and if necessary, experts to be engaged from outside. Ìf not found prima facie feasible, the creditors may start action for recovery of their dues. All references for corporate debt restructuring by creditors or borrowers will be made to the CDR Cell. Ìt shall be the responsibility of the lead institution/major stakeholder to the corporate, to work out a preliminary restructuring plan in consultation with other stakeholders and submit to the CDR Cell within one month. The CDR Cell will prepare the restructuring plan in terms of the general policies and guidelines approved by the CDR Standing Forum and place for consideration of the Empowered Group within 30 days for decision. The Empowered Group can approve or suggest modifications but ensure that a final decision is taken within a total period of 90 days. However, for sufficient reasons the period can be extended up to a maximum of 180 days from the date of reference to the CDR Cell. The CDR Standing Forum, the CDR Empowered Group and CDR Cell is at present housed in Ìndustrial Development Bank of Ìndia Ltd. However, it may be shifted to another place if considered necessary, as may be decided by the Standing Forum. The administrative and other costs shall be shared by all financial institutions and banks. The sharing pattern shall be as determined by the Standing Forum. CDR Cell will have adequate members of staff deputed from banks and financial institutions. The CDR Cell may also take outside professional help. The cost in operating the CDR mechanism including CDR Cell will be met from contribution of the financial institutions and banks in the Core Group at the rate of Rupees.50 lakh each and contribution from other institutions and banks at the rate of Rupees.5 lakh each. Other +eat7res The scheme will not apply to accounts involving only one financial institution or one bank. The CDR mechanism will cover only multiple banking accounts or syndication or consortium accounts of corporate borrowers engaged in any type of activity with outstanding fund-based and non-fund based exposure of Rupees. 10 crore and above by banks and institutions. The Category 1 CDR system will be applicable only to accounts classified as 'standard' and 'substandard'. There may be a situation where a small portion of debt by a bank might be classified as doubtful. Ìn that situation, if the account has been classified as ·standard'/ 'substandard' in the books of at least 90 per cent of creditors (by value), the same would be treated as standard/substandard, only lot the purpose of judging the account as eligible for CDR, in the books of the remaining 10 per cent of creditors. There would be no requirement of the account/company being sick, N P A or being in default for a specified period before reference to the CDR system. However, potentially viable cases of N P As will get priority. This approach would provide the necessary flexibility and facilitate timely intervention for debt restructuring. Prescribing any milestone(s) may not be necessary, since the debt restructuring exercise is being triggered by banks and financial institutions or with their consent. While corporates indulging in frauds and malfeasance even in a single bank will continue to remain ineligible for restructuring under CDR mechanism as hitherto, the Core group may review the reasons for classification of the borrower as wilful defaulter specially in old cases where the manner of classification of a borrower as a willful defaulter was not transparent and satisfy itself that the borrower is in a position to rectify the willful default provided he is granted an opportunity under the CDR mechanism. Such exceptional cases may be admitted for restructuring with the approval of the Core Group only. The Core Group may ensure that cases involving frauds or diversion of funds with malafide intent are not covered. The accounts where recovery suits have been filed by the creditors against the company, may be eligible for consideration under the CDR system provided, the initiative to resolve the case under the CDR system is taken by at least 75 per cent of the creditors (by value) and 60 per cent of creditors (by number). BÌER cases are not eligible for restructuring under the CDR system. However, large value B Ì F R cases may be eligible for restructuring under the CDR system if specifically recommended by the CDR Core Group. The Core Group shall recommend exceptional B Ì F R cases on a case-to-case basis for consideration under the CDR system. Ìt should be ensured that the lending institutions complete all the formalities in seeking the approval from B Ì F R before implementing the package. Referen%e to CDR S3ste' Reference to Corporate Debt Restructuring System could be triggered by #1$ any or more of the creditor who have minimum 20 per cent share in either working capital or term finance, or #!$ by the concerned corporate, if supported by a bank or financial institution having stake as in (1) above. Though flexibility is available whereby the creditors could either consider restructuring outside the purview of the CDR system or even initiate legal proceedings where warranted, banksor Fls should review all eligible cases where the exposure of the financial system is more than Rupees.100 crore and decide about referring the case to CDR system or to proceed under the new Securitization and Reconstruction of Financial Assets and Enforcement of Securities Ìnterest Act, 2002 or to file a suit in D R T etc. De,al Basis CDR is a non-statutory mechanism which is a voluntary system based on Debtor- Creditor Agreement (D C A) and Ìnter-Creditor Agreement (Ì C A). The Debtor-Creditor Agreement (D C A) and the Ìnter-Creditor Agreement (Ì C A) shall provide the legal basis to the CDR mechanism. The debtors shall have to accede to the D C A, either at the time of original loan documentation (for future cases) or at the time of reference to Corporate Debt Restructuring Cell. Similarly, all participants in the C D R mechanism through their membership of the Standing Forum shall have to enter into a legally binding agreement, with necessary enforcement and penal clauses, to operate the System through laid-down policies and guidelines. The Ì C A signed by the creditors will be initially valid for a period of 3 years and subject to renewal for further periods of 3 years thereafter. The lenders in foreign currency outside the country are not a part of CDR system. Such creditors and also creditors like G Ì C, L Ì C, U T Ì, etc., who have not joined the CDR system, could join CDR mechanism of a particular corporate by signing transaction to transaction Ì C A, wherever they have exposure to such corporate. The Ìnter-Creditor Agreement would be a legally binding agreement amongst the creditors with necessary enforcement and penal clauses, wherein the creditors would commit themselves to abide by the various elements of CDR system. Further, the creditors shall agree that if 75 per cent of creditors by value and 60 per cent of the creditors by number, agree to a restructuring package of an existing debt (i.e., debt outstanding), the same would be binding on the remaining creditors. Since Category 1 CDR Scheme covers only standard and sub-standard accounts, which in the opinion of 75 per cent of the creditors by value and 60 per cent of creditors by number, are likely to become performing after introduction of the CDR package, it is expected that all other creditors (i.e., those outside the minimum 75 per cent by value and 60 per cent by number) would be willing to participate in the entire CDR package, including the agreed additional financing. Ìn order to improve effectiveness of the CDR mechanism, a clause may be incorporated in the loan agreements involving consortium or syndicate accounts whereby all creditors, including those which are not members of the CDR mechanism, agree to be bound by the terms of the restructuring package that may be approved under the CDR mechanism, as and when restructuring may become necessary. One of the most important elements of Debtor-Creditor Agreement would be 'stand still' agreement binding for 90 days, or 180 days by both sides. Under this clause, both the debtor and creditor(s) shall agree to a legally binding 'stand-still' whereby both the parties commit themselves not to take recourse to any other legal action during the 'stand-still' period, this would be necessary for enabling the CDR System to undertake the necessary debt restructuring exercise without any outside intervention, judicial or otherwise. However, the stand-still clause will be applicable only to any civil action either by the borrower or any lender against the other party and will not cover any criminal action. Further, during the stand-still period, outstanding foreign exchange forward contracts, derivative products, etc., can be crystallized, provided the borrower is agreeable to such crystallization. The borrower will additionally undertake that during the stand-still period the documents will stand extended for the purpose of limitation and also that he will not approach any other authority for any relief and the directors of the borrowing company will not resign from the Board of Directors during the stand-still period. Sharin, of A&&itional +inan%e Additional finance, if any, is to be provided by all creditors of a 'standard' or 'substandard account' irrespective of whether they are working capital or term creditors, on a pro-rata basis. Ìn case for any internal reason, any creditor (outside the minimum 75 per cent and 60 per cent) does not wish to commit additional financing, that creditor will have an option in accordance with the provisions of exit option. The providers of additional finance, whether existing or new creditors, shall have a preferential claim, to be worked out under the restructuring package, over the providers of existing finance with respect to the cash flows out of recoveries, in respect of the additional exposure E6it O5tion As stated in para above a creditor (outside the minimum 75 per cent and 60 per cent) who for any internal reason does not wish to commit additional finance will have an exit option. At the same time, in order to avoid the 'free rider' problem, it is necessary to provide some disincentive to the creditor who wishes to exercise this option. Such creditors can either (a) arrange for its share of additional finance to be provided by a new or existing creditor, or (b) agree to the deferment of the first year's interest due to it after the CDR package becomes effective. The first year's deferred interest as mentioned above, without compounding, will be payable along with the last instalment of the principal due to the creditor. Ìn addition, the exit option will also be available to all lenders within the minimum 75 per cent and 60 percent provided the purchaser (of their share) agrees to abide by restructuring package approved by the Empowered Group. The exiting lenders may be allowed to continue with their existing level of exposure to the borrower provided they tie up with either the existing lenders or fresh lenders taking up their share of additional finance. The lenders who wish to exit from the package would have the option to sell their existing share to either the existing lenders or fresh lenders, at an appropriate price, which would be decided mutually between the exiting lender and the taking over lender. The new lenders shall rank on par with the existing lenders for repayment and servicing of the dues since they have taken over the existing dues to the exiting lender. Ìn order to bring more flexibility in the exit option, One Time Settlement can also be considered, wherever necessary, as a part of the restructuring package. Ìf an account with any creditor is subjected to One Time Settlement (O T S) by a borrower before its reference to the CDR mechanism, any fulfilled commitments under such O T S may not be reversed under the restructured package. Further payment commitments of the borrower arising out of such O T S may be factored into the restructuring package. Cate,or3 ! CDR S3ste' There have been instances where the projects have been found to be viable by the creditors but the accounts could not be taken up for restructuring under the C D R system as they fell under 'doubtful' category. Hence, a second category of CDR is introduced for cases where the accounts have been classified as 'doubtful' in the books of creditors, and if a minimum of 75 per cent of creditors (by value) and 60 per cent creditors (by number) satisfy themselves of the viability of the account and consent for such restructuring, subject to the following conditions: #a$ Ìt will not be binding on the creditors to take up additional financing worked out under the debt restructuring package and the decision to lend or not to lend will depend on each creditor bank or F Ì separately. Ìn other words, under the proposed second category of the CDR mechanism, the existing loans will only be restructured and it would be up to the promoter to firm up additional financing arrangement with new or existing creditors individually. #"$ All other norms under the CDR mechanism such as the standstill clause, asset classification status during the pendency of restructuring under CDR, etc., will continue to be applicable to this category also. No individual case should be referred to R B Ì. CDR Core Group may take a final decision whether a particular case falls under the CDR guidelines or it does not. All the other features of the CDR system as applicable to the First Category will also be applicable to cases restructured under the Second Category. In%or5oration of Ri,ht to Re%o'5ense Cla7se All CDR approved packages must incorporate creditors' right to accelerate repayment and borrowers' right to pre-pay. The right of recompense should be based on certain performance criteria to be decided by the Standing Forum. ((.@ S M E DEBT RESTRUCTURINI MECGANISM Apart from CDR Mechanism, there exists a much simpler mechanism for restructuring of loans availed by Small and Medium Enterprises (S M Es). Unlike in the case of CDR Mechanism, the operational rules of the mechanism have been left to be formulated by the banks concerned. This mechanism will be applicable to all the borrowers which have funded and non-funded outstanding up to Rupees. 10 crores under multiple/consortium banking arrangement. Major elements of this arrangement are as under: #1$ Under this mechanism, banks may formulate, with the approval of their Board of Directors, a debt restructuring scheme for S M Es within the prudential norms laid down by R B Ì. Banks may frame different sets of policies for borrowers belonging to different sectors within the S M E if they so desire. #!$ While framing the scheme, banks may ensure that the scheme is simple to comprehend and will, at the minimum, include parameters indicated in these guidelines. #($ The main plank of the scheme is that the bank with the maximum outstanding may work out the restructuring package, along with the bank having the second largest share. #.$ Banks should work out the restructuring package and implement the same within a maximum period of 90 days from date of receipt of requests. #?$ The S M E Debt Restructuring Mechanism will be available to all borrowers engaged in any type of activity. #@$ Banks may review the progress in rehabilitation and restructuring of S M Es accounts on a quarterly basis and keep the Board informed ((.B R B I IUIDEDINES ON REGABIDITATION O+ SIC/ SSI UNITS As per the definition, a unit is considered as sick when any of the borrowal account of the unit remains substandard for more than 6 months or there is erosion in the net worth due to accumulated cash losses to the extent of 50 per cent of its net worth during the previous accounting year and the unit has been in commercial production for at least two years. The criteria will enable banks to detect sickness at an early stage and facilitate corrective action for revival of the unit. As per the guidelines, the rehabilitation package should be fully implemented within six months from the date the unit is declared as potentially unviable. During this period of six months, of identifying and implementing rehabilitation package, banks or F Ìs are required to do 'holding operation' which will allow the sick unit to draw funds from the cash credit account at least to the extent of deposit of sale proceeds Following are broad parameters for grant of relief and Concessions for revival of potentially viable sick S S Ì units: #1$ Interest on ;or2in, Ca5ital - Ìnterest 1.5 per cent below the prevailing fixed or prime lending rate, wherever applicable #!$ +7n&e& Interest Ter' Doan - Ìnterest Free #($ ;or2in, Ca5ital Ter' Doan - Ìnterest to be charged 1.5 per cent below the prevailing fixed or prime lending rate, wherever applicable #.$ Ter' Doan - Concessions in the interest to be given not more than 2 per cent (not more than 3 % in the case of tiny or decentralized sector units) below the document rate. #?$ Contin,en%3 Doan Assistan%e - The Concessional rate allowed for Working Capital Assistance (Details available in R B Ì circulars R*CD.No. *
[email protected]!001E0! &ate& 1@0 Jan7ar3 !00!0 and R*CD. SMEMN+S.
[email protected]!00CE0F .0 Ma3 !00F) ((.C CREDIT IN+ORMATION S)STEM The need of credit information system was felt in order to alert the banks and financial institutions (F Ìs) and put them on guard against borrowers who have defaulted in their dues to other lending institutions. Ìt was also imperative to arrest accretion of fresh N P As in the banking system through an efficient system of credit information on borrowers as a first step in credit risk management. Ìn this context, the requirement of an adequate, comprehensive and reliable information system on the borrowers through an efficient database system was keenly felt by the Reserve Bank/ Government as well as credit institutions. A Working Group (Chairman: Shri N.H. Siddiqui) with representatives from select public sector banks, Ì D B Ì, Ì C Ì C Ì, Ìndian Banks' Association and Reserve Bank was constituted by the Reserve Bank in the year 1999, to explore the possibilities of setting up a Credit Ìnformation Bureau (CÌB). The Working Group had recommended to set up a C Ì B under the Companies Act, 1956 with equity participation from commercial banks, F Ìs and NBFCs registered with the Reserve Bank. As per the recommendations made by the Working Group, Credit Ìnformation Bureau (Ìndia) Ltd., (CÌBÌL) was set up by State Bank of Ìndia in association with HDFC in January 2001. Ìn order to get over the legal constraints of customer confidentiality vis-a-vis providing information on banks' customers to CÌBÌL, pending enactment on the Credit Ìnformation Companies (Regulation) Act, the Reserve Bank advised banks and financial institutions on October 1, 2002 to obtain consent from all existing borrowers and guarantors at the time of renewal of loans and consent of all the new borrowers and guarantors for sharing the credit information in respect of non-suit filed accounts with the CÌBÌL. A Working Group (Chairman: Shri S.R. Ìyer) set up in 2002 observed that while some modalities like 'consent clause' could be adopted as a base to begin with, for limited operations of a C Ì B, such modalities cannot be a substitute for a special legislation. The Working Group, therefore, recommended the enactment of an appropriate legislation by the Government of Ìndia expeditiously, in consultation with the Reserve Bank. With a view to strengthening the legal mechanism and facilitating the Bureau to collect, process and share credit information on the borrowers of credit institutions, the Credit Ìnformation Companies (Regulation) Act, 2005 was passed in May 2005 by Parliament and notified in the Gazette of Ìndia on 23, June 2005. The Government of Ìndia also notified the rules and regulations for the implementation of the Credit Ìnformation Companies (Regulation) Act, 2005 on December 14, 2006 making the Act operational. Ìn terms of Section 15(1) of the Act, every credit institution has to become member of at least one credit information company within a period of three months from commencement of the Act or any extended time allowed by the Reserve Bank on application As per R B Ì guidelines, each credit institution should provide credit data (positive as well as negative) to the credit information company in the format prescribed by the credit information company. Sub section (1) of Section 21 of the Credit Ìnformation Companies (Regulation) Act, 2005, which provides; ,any person, who applies for grant or sanction of credit facility, from any credit institution, may request such institution to furnish him a copy of the credit information obtained by such institution from the credit information company '. Further, sub-section (2) of the said Section also specifies that every credit institution shall on receipt of request, as indicated in sub-section (1), furnish to such person a copy of the credit information subject to payment of charges specified by the Reserve Bank R B Ì has prescribed a maximum fee of Rupees. 501- (Rupees fifty only) for the purpose. ((.F CREDIT IN+ORMATION BUREAU #INDIA$ DTD. #CIBID$ Credit Ìnformation Bureau (Ìndia) Ltd (CÌBÌL) was set up by State Bank of Ìndia in association with HDFC in January 2001. Presently, Dun and Bradstreet Ìnformation Services Ìndia (P) Ltd. is also their equity holder as well as technology partner. As, presently, this is the only approved credit information company, all credit institutions are required to be its members. The purpose of setting up of CÌBÌL is information sharing on defaulters as also other borrowers as comprehensive credit information, which provides details pertaining to credit facilities already availed of by a borrower as well as his payment track record, has become the need of the hour. CÌBÌLs aim is to fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members. Banks, Financial Ìnstitutions, Non Banking Financial Companies, Housing Finance Companies and Credit Card Companies use CÌBÌL:s services. Data sharing is based on the Principle of Reciprocity, which means that only Members who have submitted all their credit data, may access Credit Ìnformation Reports from CÌBÌL. The relationship between CÌBÌL and its Members is that of close interdependence. R B Ì and CÌBÌL disseminate information on non-suit filed and suit filed accounts respectively, as reported to them by the banks or F Ìs and responsibility for reporting correct information and also accuracy of facts and figures rests with the concerned banks and financial institutions. Therefore, R B Ì has advised the banks and financial institutions to take immediate steps to up-date their records and ensure that the names of current directors are reported. Ìn addition to reporting the names of current directors, it is necessary to furnish information about directors who were associated with the company at the time the account was classified as defaulter, to put the other banks and financial institutions on guard. Banks and F Ìs may also ensure the facts about directors, wherever possible, by cross-checking with Registrar of Companies. As per R B Ì guidelines, bank and FÌs are required to submit the list of suit-filed accounts of willful defaulters of Rupees 25 lakh and above as at end-March, June, September and December every year to Credit Ìnformation Bureau (Ìndia) Ltd. The data on borrowal accounts against which suits have been filed for recovery of advances (outstanding aggregating Rupees. 1.00 crore and above) and suit filed accounts of wilful defaulters with outstanding balance of Rupees 25 lakh and above, based on information furnished by scheduled commercial banks and financial institutions is available at 888.%i"il.%o' S7''ar3 Even with best of loan policies adopted by a bank and with high standards of appraisal, the quality of a few loan accounts may deteriorate as the time passes. This may give rise to actual default or possibility of default in repayment of principal and interest in some of the accounts. As per R B Ì directives, banks in Ìndia have to classify their assets into Performing (standard) assets or Non performing assets (N P As). N P As are further classified into Sub-standard, doubtful and loss assets. The options available to banks in regard to the assets where the quality has deteriorated, are Rescheduling and Restructuring, Rehabilitaion, Compromise, Legal action or Write off. As per R B Ì guidelines, forums are available for restructuring of debts of Corporates and S M Es, in deserving cases. There are also guidelines on rehabilitation of sick S S Ì units. Credit information system has also been introduced to share information about borrowers committing defaults with any of the banks. Under this system, CÌBÌL was formed in January 2001 with the purpose of information sharing on defaulters as also other borrowers by providing details pertaining to credit facilities already availed of by a borrower as well as his payment track record. /e38or&s Rescheduling; Restructuring; Rehabilitation; Compromise; Legal action; Write off; Corporate Debt Restructuring (CDR); S M E Debt Restructuring; CREDÌT ÌNFORMATÌON SYSTEM; CÌBÌL; Performing (standard) assets; Non performing assets(N P As); Sub-standard: Doubtful assets; Loss assets Check Your Progress State tr7e or +alse: 1. Ìn the case of fund based lending, credit default means that principal/and or interest amount may not be repaid as per the terms of repayment. . True. !. Ìn the case of guarantees or letters of credit, credit default means crystallization of the liability. . False. (. As per R B Ì directives, banks in Ìndia have to classify their assets into Performing ( standard ) assets or Non performing assets(N P As). N P As are further classified into Sub-standard, doubtful and loss assets . True. .. The amount of provision required to be made on the asset portfolio of a bank depends on the classification of assets. . True. ?. No provision is required to be made by a bank on its Standard Assets. . False. @. The default due to the reasons beyond the control of the borrower, is referred to as wilful default. . False. B. The default in payment as per agreed terms could be intentional or due to the reasons beyond the control of the borrower. . True. C. Writing off a loan means that the borrower is no longer liable to pay the amount to the bank. . False. F. Ìn case of finance under government sponsored schemes, responsibility for recovery lies with the government. . False. 10..Banks reschedule or restructure the loans in accordance with the revised cash flow estimates of the borrower. . True. 11. The Debt Recovery Tribunals are meant for recovery of dues of the banks and financial institutions only. . True. 1!. For filing cases in the Debt Recovery Tribunals, the amount of claim must be more than Rupees 10 lacs. . True. 1(. SARFAESÌ Act provides for enforcement of security interest for realization of dues without the intervention of courts or tribunals. . True. 1.. Banks can settle disputes involving amounts up to Rupees.20 latch through the forum of Lok Adalats. . True. 1?. As per R B Ì directives, banks can reschedule/restructure/renegotiate borrowal accounts with retrospective effect. . False. 1@. For restructuring of SME loans, no forum like CDR is available. . False. 1B. Credit Ìnformation System was started with the objective of sharing information about borrowers committing defaults with any of the banks. . True. Sele%t the Corre%t Ans8er: 1C. The aim of a rehabilitation programme is: The choices are: (a) To make the operations of the enterprise viable again (b) To help in employment generation (c) To comply with R B Ì guidelines (d) To increase bank's advances The correct answer is . #a$ To 'a2e the o5erations of the enter5rise =ia"le a,ain 1F. Banks enter into compromise with borrowers in case of default, because: The choices are: (a) Recovery through legal action is time consuming (b) Adequate security is not available (c) Realization or security may be difficult (d) All the above The correct answer is . #&$ All the a"o=e END OF CHAPTER 33-Rehabilitation and Recovery, ADVANCED BANK MANAGEMENT- C A Ì Ì B PAPER 1. End of the book Advanced Bank Management, Paper 1.