FUNDS MANAGEMENT BY

BANKS IN INDIA:
SOLUTION TO A PERSISTING
OPTIMIZATION PROBLEM

ABHINAV PANDEY
Banking in India
• Commercial banks in India as universal
banks
• Comprehensive financial services under
one roof
• Reserve Bank of India (RBI) regulates the
fund-based activities
• Securities and Exchange Board of India
(SEBI) regulates the fee-based activities.
Working Capital Loan And Cash Credit System

• Working capital lending still a major

functional area for commercial banks
• Conventionally, working capital financing in
India is in the form of cash credit facility
• Under the cash credit system, the lending
bank sanctions a maximum loan limit to a
customer
• Utilisation is subject to availability of
adequate assets pledged or hypothecated
Working Capital Loan And Cash Credit System

• The drawing power is adjusted at regular

intervals (normally once a month) by
considering the level of current asset that has
been paid for and deducting margin(s) therefrom
at stipulated rate(s)
• These margins are worked out in line with
the lending norms of Tandon Committee.
• The amount of loan outstanding can vary
freely within the drawing power and at times
the balance in the cash credit account can
even be in credit
Working Capital Loan And Cash Credit System
Interest is payable based on the actual level of
loan enjoyed on a daily product basis
Thus, a fixed limit is worked out for any loan
account by assessing the customer’s peak
requirement on the basis of its projected holding of
current asset
Once this limit is set, the borrower becomes
virtually entitled to draw, subject to sufficient
current asset holding, any amount up to the limit.
Working Capital Loan And Cash Credit System
The borrower has
the option to draw at any point of time,
without any prior notice, up to the extent of the
limit
but no corresponding obligation either to
compensate the banker for this option or to
ensure an optimum utilization of the facility at
all points of time
Working Capital Loan And Cash Credit System
Therefore, a banker may be called upon to arrange
for large amounts of funds at short or no notice at
pre-determined rate of interest.
In such a situation, funds management and
financial planning become relatively low priority
issues for the borrowers
They can pass on the consequences of
inadequate planning and inefficient management
on their part to the banking system
The problem may manifest itself in the form of a
serious strain on the bank’s cash management
system.
Working Capital Loan And Cash Credit System
The lending bank may try hard to arrive at a
realistic estimate of the working capital
requirement of a client company over a certain
length of time in future
But the latter has hardly any stake in the accuracy
of this exercise so long as the sanctioned limit is
set at a sufficiently high level
The profitability of the lending bank may be
adversely affected due to such indifference and
inefficiency of its clientele.
This is a drawback of the cash credit system
Working Capital Loan And Cash Credit System
This is at variance with the cash loan system
prevalent in various countries whereby the entire
amount of loan limit is disbursed in one shot
subject to renewal/review at regular intervals.
Besides, in India, credit is considered a scarce
commodity and need-based financing is one of the
major planks underlying the central bank’s credit
policy even in the liberalized regime.
Systematic planning of credit and optimal
utilization thereof are considered quite vital.
Working Capital Loan And Cash Credit System

Any arbitrary break-up of working capital facility

into fixed and variable components will thus not be
in line with the spirit of the policy of the central
bank.
Tandon Committee Norms – Style Of Credit

The first and the most substantial work in the field

of working capital finance in India was done by the
Tandon Committee

The Committee aimed at inculcating in the

borrowers the habit of making an effective financial
planning through a system of reward and penalty

It suggested that the working capital facility should

be bifurcated into two components
Tandon Committee Norms – Style Of Credit

(i)                   A fixed or demand loan component,

interest on which is to be charged at a certain fixed
rate throughout the year

(ii)                 A variable or cash credit component,

interest on which is to be charged at a somewhat
higher rate. This component would indicate by
what amount the level of borrowing for a particular
customer exceeds the demand loan component
Tandon Committee Norms – Style Of Credit

If a borrower projects the demand loan component

at a “higher than necessary” level, he would end
up paying interest on amounts not actually
required by it.

If he projects the demand loan at a low level, much

of its withdrawals will attract a higher rate of
interest and the overall interest cost over the year
would not be minimized.
Tandon Committee Norms – Style Of Credit

It would, therefore, be in the interest of the

borrowing company to ensure an efficient financial
planning and to project correct levels for its
projected fund requirement

Once the monthly requirement of working capital is

submitted by a borrowing company, the lending
bank has to work out the optimum level for
demand loan that will minimize the annual interest
burden
Formulation Of The Problem
Once a customer submits the pattern of the
working capital requirement over the next one
year, the question arises as to how a practical
banker will bifurcate the working capital
requirement into a fixed and a variable
component to minimise the annual interest
burden
Formulation Of The Problem
Let W(t) = working capital finance required by
a borrowing company, expressed
as a function of time, over the next
one year,
x = level of demand loan or fixed
component,
W(t) – x [where W(t) > x] = level of variable
component,
I = Interest burden for the company
for the next one year
a = Rate of interest for the fixed
component
(a + b) = Rate of interest for the variable component
Formulation Of The Problem
Then,
(1) I=∫a.x.dt + ∫[W(t) – x].θ [W(t) – x]. (a+b) dt,
where θ[W(t) – x] is the well-known step function
Or,
12 12
(2) I=Σ (a/12).x + Σ [(a+b)/12].[Wi – x]. θ[Wi – x].
i=1 i=1

whereWi=level of working capital finance for the ‘i’th

month
The Solution
If a company works out its requirement of working capital
finance for the next twelve months i.e. Wi for i=1,2, ….,
12, then the total interest burden for the company during
the next twelve months works out to:
12 12
(3) I(x) = Σ x.(a/12) + Σ (Wi – x). θ(Wi – x). [(a+b)/12].
i=1 i=1

12
= a.x +[(a+b)/12] Σ (Wi – x). θ(Wi – x),
i=1
The Solution
Or, 12
(4) dI = a -[(a+b)/12] Σ[ θ(W – x) + (W – x)δ(W – x)]
i i i
dx i=1

12
= a – [(a+b)/12] n - [(a+b)/12] Σ (Wi – x)δ(Wi – x)
i=1

= a – [(a+b)/12] n
where n = number of months for which Wi >x
The Solution
Or,
dI
(5) n/12 = a/(a+b) for =0
dx
The Solution

In other words, for I to be minimum, x is to be so

chosen that for n months Wi>x, where n/12 =
a/(a+b)
The Implementation
A. Let the levels of borrowing projected by a
company for the next twelve months be 41, 42, 43, 44,
45, 46, 47, 48, 49, 50, 51 and 52 units (the levels of
borrowing need not occur in this chronological order).
Also, let a = 10% p.a. and b=2% p.a.
In such a situation, n/12 = 10/(10+2), or n=10. In other
words, the demand loan component should be set at
such a level that the level of borrowing would exceed
the demand loan for 10 months. Thus, x0 = 42 units or
more but less than 43 units.
The actual solution will be corresponding to the lowest
value of x0, i.e. x0 = 42 units
The Implementation
B. If the levels of borrowing be 45 units for 6 months
and 50 units for the other 6 months, n/12 = 1 if the
demand loan component is set below 45 units; n/12 = ½
if the demand loan component is set at 45 units or
above, but below 50 units.
Let a = 10% p.a. and a+b = 12% p.a. Then n/12 = 10/12
as per our formula. But, n/12 can be equal to only 1, ½,
or 0.
We shall choose the next lower permissible value for
n/12, viz. ½. Further, as n/12 = ½ for all values of the
demand loan from 45 units and above but less than 50
units, we shall select the lowest permissible value, viz.
45 units as the desired value of x0.
The Final Prescription
The readymade prescription for minimizing I now
becomes:
(i)                   Select x at such a level that n/12 =
a/(a+b) or, if a/(a+b) is not available, the next lower
available value.
(ii)                If a certain range of values of x satisfies
(i), choose the lowest value of x from the range.
Once we set the optimal of x i.e. x0 at 45 units, the
interest burden for the borrowing company over the
next one year comes to (45 × 10% + 5 × 12% ×
6/12) = 4.8 units.
The Final Prescription
If the demand loan component were set at 44
units, the overall burden of interest would have
been (44 × 10% + 1 × 12% × 6/12 + 6 × 12% ×
6/12) = 4.82 units.
On the other hand, if the demand loan
component were set at 46 units, the overall
interest burden would have been (46 × 10% + 4 ×
12% × 6/12) = 4.84 units.
Obviously, the overall burden due to interest is
minimized if the demand loan is set at 45 units.
Conclusion
The practical problem of banking can thus be
solved by using a rather simple technique of
optimization used so often in Physics.
The result is perfect in the sense that no
approximation is involved in its derivation.
Also, the result is simple enough to be
implemented by any practical banker.
The outcome is thus interesting not only for its
mathematical exactitude but also for its easy
applicability.
Conclusion
With such an easy and exact methodology
available, banks can now go for a full-
fledged implementation of the
recommendations of the Tandon Committee,
without having to resort to any arbitrary
thumb rule