Indian Financial System Dba1749

MBA
(DISTANCE MODE)
DBA 1749 INDIAN FINANCIAL SYSTEM
III SEMESTER COURSE MATERIAL
Centre for Distance Education

Anna University Chennai Chennai 600 025
Author Mr . Mahammad R af i Sy ed, AICWA Mr. Raf Syed,

Deputy Manager Finance, ETA General (P) Ltd, Seethakathi Chamber, 5th Floor, 688, Anna Salai, Chennai - 600 006
Reviewer Dr . J . Gopu Dr. J.

Assistant Professor, Management Studies, BSA Crescent Engineering College Chennai - 600 048
Editorial Board Dr .T .V .Geetha Dr.T .T.V .V.Geetha

Professor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025
Dr .H.P eer u Mohamed Dr.H.P .H.Peer eeru

Professor Department of Management Studies Anna University Chennai Chennai - 600 025
Dr .C . Chella ppan Dr.C .C. Chellappan

Dr .A.K annan r.A.K

Copyrights Reserved (For Private Circulation only) ii
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ACKNOWLEDGEMENT
The author has drawn inputs from several sources for the preparation of this course material, to meet the requirements of the syllabus. The author gratefully acknowledges the following sources: (i) (ii) Indian Financial System by M Y Khan, the McGraw-Hill Companies. The Indian Financial System Markets, Institutions and Services by Bharati V. Pathak, Pearson Education. Financial Management by Ravi M. Kishore, Taxmans Publicaion. Professional Approach to Corporate Laws and Secretarial Practice by Munish Bhandari, Bharat Law House Pvt. Ltd, New Delhi. Advanced Accounting Volume I issued by the Institute of Chartered Accountants of India. SEBI website, RBI website, BSE, NSE and OTCEI websites.
(iii) (iv)
(v) (vi)
In spite of at most care taken to prepare the list of references any omission in the list is only accidental and not purposeful.
Mr. Mahammad Rafi Syed Author
DBA 1749 INDIAN FINANCIAL SYSTEM

UNIT I INTRODUCTION Indian financial system- Introduction Institutional setup-savings and instruments- Money, Inflation and Interest, Banking and Non-Banking financial intermediaries- Financial markets-classification Financial sector reformsinstitutional structure- Discount Finance House of India (DFHI)- SEBI Stock exchange- OTCEI money and Capital markets Characteristics and objectives money market instruments securities market in India Regulatory framework. UNIT II COMMERCIAL BANKS Commercial banks Functions and roles-Sources and application of funds-asset structure Profitability Regulatory reforms Deposits and advances Lending rates Reserve Bank of India. UNIT III DEVELOPMENT BANKING Development banking Features, functions and roles-Term loans- Appraissal- Industrial Development Bank Of India State Financial Corporation Specialised development Finance insitutions Investment banking-Merchant banking- Institional framework- Venture capital- Credit ranking Factoring services leasing and hire purchase Insurance services. UNIT IV NEW ISSUES MARKET New issues market- Functions and issue mechanism- Book building Reforms and investor protection Relationship between new isues market and stock exchange. UNIT V MUTUAL FUNDS Mutual funds in India Regulatory mechanism SEBI mutual fund guideliness Mutual fund schemes IRDA (Insurance Regulatory and Development Authority) regulations Securitisation and assets reconstruction companies. REFERENCE 1. Indian Financial System, M.Y.Khan, Tata Mcgraw Hill.
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CONTENTS
UNIT - I FINANCIAL SYSTEM IN INDIA
1.1 1.2 1.3 INTRODUCTION LEARNING OBJECTIVES INDIAN FINANCIAL SYSTEM 1.3.1 Savings and Investments 1.3.2 Types of Savings 1.3.3 Investments 1.3.4 Interest Rates and Inflation FINANCIAL INSTITUTIONS 1.4.1 Financial Intermediaries 1.4.2 Financial Markets 1.4.3 Financial Instruments 1.4.4 Financial Services FINANCIAL SECTOR REFORMS BANKING SECTOR REFORMS DISCOUNT AND FINANCE HOUSE OF INDIA (DFHI) MONEY LAUNDERING DERIVATIVES MARKETS OVER THE COUNTER EXCHANGE OF INDIA (OTCEI) SECURITIES MARKET IN INDIA REGULATORY REFORMS REFORMS IN THE SECONDARY CAPITAL MARKET UNIT II COMMERCIAL BANKS 2.1 2.2 2.3 2.4 INTRODUCTION LEARNING OBJECTIVES BANKING HISTORY AND ITS DEVELOPMENT IN INDIA TYPES OF BANKS 2.4.1 Public Sector Banks 2.4.2 Private Sector Banks 47 47 47 49 49 53 1 2 2 5 8 9 10 11 11 18 27 28 28 30 31 32 33 35 37 39
1.4
1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12
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2.5 2.6 2.7 2.8
2.9 2.10
2.4.3 Foreign Banks in India 2.4.4 Regional Rural Banks FUNCTIONS OF COMMERCIAL BANKS ROLE OF COMMERCIAL BANKS CHARACTERISTICS OF BANKS SOURCES AND APPLICATION OF FUNDS 2.8.1 Source of Funds its Structure 2.8.2 Application of Funds and its structure BANKING REGULATORY REFORMS RESERVE BANK OF INDIA 2.10.1 Central Board 2.10.2 Functions Of The Board For Financial Supervision (Bfs) 2.10.3 The Main Functions Of The Reserve Bank Of India Are 2.10.4 Subsidiaries Of Reserve Bank Of India UNIT III DEVELOPMENT BANKING
53 58 59 63 64 64 65 66 69 70 70 71 72 74
3.1 3.2 3.3 3.4 3.5
3.6
3.7
3.8 3.9
INTRODUCTION LEARNING OBJECTIVES FEATURES OF DEVELOPMENT BANKS FUNCTIONS OF DEVELOPMENT BANKS DEVELOPMENT BANKS 3.5.1 The Industrial Development Bank Of India(Idbi) 3.5.2 Industrial Investment Bank of India (IIBI) 3.5.3 Industrial Financial Corporation of India (IFCI) 3.5.4 The Export Import Bank of India (EXIM) 3.5.5 Tourism Finance Corporation of India (TFCI) REFINANCE INSTITUTIONS 3.6.1 Small Industrial Development Bank of India (SIDBI) 3.6.2 National Bank for Agriculture and Rural Development (NABARD) SPECIALIZED FINANCIAL INSTITUTIONS 3.7.1 Infrastructure Development Finance Company (IDFC) 3.7.2 IFCI Venture Capital Funds 3.7.3 ICICI Venture Capital Fund MERCHANT BANKING VENTURE CAPITAL
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77 78 78 78 79 79 80 81 82 83 84 84 85 86 86 87 87 88 90
3.10 3.11
3.12
CREDIT RANKING 3.10.1 Credit Rating Agencies in India FACTORING SERVICES 3.11.1 International Factoring: 3.11.2 Forfaiting: LEASING AND HIRE PURCHASE 3.12.1 Leasing: 3.12.2 Hire Purchase UNIT IV NEW ISSUE MARKETS
93 95 105 108 109 109 109 112
4.1 4.2 4.3
4.4
4.5
4.6
INTRODUCTION LEARNING OBJECTIVES NEW ISSUE MARKETS 4.3.1 Primary Stock Market 4.3.2 Secondary Stock Market NEW ISSUE MARKET ISSUE MECHANISM 4.4.1 Un-listed Companies Initial Public Offer 4.4.2 Pricing of Issues 4.4.3 Initial Public Offer (IPO) PRIVATE PLACEMENT 4.5.1 Preferential Issues 4.5.2 Qualified Institutional Placements (QIPs) 4.5.3 Issue of capital by designated financial institution 4.5.4 OTCEI issues SEBI (DISCLOSURE AND INVESTOR PROTECTION) GUIDELINES 2000 UNIT V MUTUAL FUNDS
117 117 117 118 118 120 121 123 126 134 134 135 135 135 136
5.1 5.2 5.3 5.4
INTRODUCTION LEANING OBJECTIVES MUTUAL FUNDS IN INDIA ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS 5.4.1 Advantages of Mutual Funds 5.4.2 Disadvantages of Mutual Fund
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139 140 140 141 141 143
5.5 5.6 5.7 5.8 5.9 5.10 5.11
5.12
TYPES OF MUTUAL FUNDS NET ASSET VALUE SEBI (MUTUAL FUND) REGULATIONS, 1996. ASSET MANAGEMENT COMPANY SEBI (MUTUAL FUND) REGULATIONS, 1996 MUTUAL FUNDS AND CREDIT RATING INSURANCE 5.11.1 Introduction 5.11.2 Life Insurance Businesses in India. 5.11.3 Type of products under Life Insurance Business 5.11.4 Types of general insurance policies 5.11.5 Insurance Regulatory and Development Authority Act, 1999 SECURITISATION AND ASSETS RECONSTRUCTION COMPANIES 5.12.1 Guidelines: Issued by the RBI Has Been Reproduced Which are In The Nature of Recommendatory
145 148 149 154 159 165 167 167 169 170 172 173 175 177
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INDIAN FINANCIAL SYSTEM
UNIT I
NOTES
FINANCIAL SYSTEM IN INDIA

1.1 INTRODUCTION In general to survive and success we need to have an adequate finance and in fact the credibility of an enterprise depends upon its sound financial position. The term Finance can be expressed as mobilization of funds to meet the desired objectives and goals of the organization. The financial functions can be viewed as Investment decisions, Financial Mix decisions, Dividend or Profit allocation decisions and short-term asset mix decision. It may be difficult to separate the finance functions from the other functions like production; marketing and so on. For example, recruitment of skilled and unskilled employees in the production department is clearly a responsibility of the production department with the help of human resource department; but it requires payment of wages and salaries and other monetary benefits, and hence involvement of finance is an inseparable in the entire organization system. A system may be viewed as a set of sub-systems with so many elements which are interdependent and interlinking with each other to produce the purposeful result with in the boundary. Hence, the term system in the context of finance means a set of complex and closely connected financial institutions, instruments, agents, markets and so on which are interdependent and interlinking with each other to produce the economic growth with in the country. A well organised financial system provides adequate capital formation through savings, finance and investments. An investment depends upon Savings and inturn Savings depends upon earnings of an individual or profits of the organisation. For example Mr. X current earnings Rs 10 lac per annum and his current expenditure is Rs 9 lac per annum then his savings becomes Rs 1 lac, which he can invest, like wise if the company earns more profits it leads to more investments into various sectors. In fact savers may or may not have technical or professional skills to convert or transfer their savings into active investments. This transfer process is effectively fulfilled by the financial system to facilitate economic growth through the channel of finance. We can
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recollect at this point of time the term Financial Management which means procurement of funds and their effective utilization to maximize the profit of the organisation. 1.2 LEARNING OBJECTIVES: (1) Learn the concept of financial growth in India (2) Understand about the financial intermediaries (3) Under standing about various financial instruments and services (4) Understand the regulations framed by the SEBI with respect to capital market and financial market. 1.3 THE INDIAN FINANCIAL SYSTEM AN OVERVIEW In the early 1950s India adopted a closed-circle character which denotes narrow growth in industrial entrepreneurship, limited industrial securities market and more restrictions on financial intermediaries and so on. In the recent past the Indian Financial System has under gone sea changes and invented many new channels of financial sub-systems through the process of financial reforms. Institutional Setup: The concept of nationalization came in the year 1948 by nationalizing the Reserve Bank of India. The Reserve Bank of India was set up in the year 1935 with the share capital of Rs 5 Crore which was entirely owned by the private share holders in the beginning. The Reserve Bank of India is acting as central bank in India and it is different from the Central Bank of India. After Indias Independence, in the context of close integration its policies and those of the Government, the Reserve Bank became a state owned institution from 1st January 1949. The Banking Regulation Act was enacted in the same year (1949) to provide regulations and supervision of Commercial Banks. In 1951, there were 566 private commercial banks in India and majority of which were confined to major cities, however the savings in the form of bank deposits accounted even less than 1% of the national income, whereas expected 12% savings from household sector. At this point of time, the RBI as well as Government of India emphasizes to prepare plans which will facilitate to mobilise savings in order to raise the investment rate and channel resource to identified sectors of the economy, notably agriculture and industry. In this context the first Five Year Plan was taken birth in the year 1951, the planning strategy was based on the concept of a mixed economy were the public and private sectors plays vital role with regard to mobilization of savings and enhancing the investment activities in India. Hence, the Reserve Bank of India was took the responsibility of developing the institutional infrastructure in the financial system. The Commercial Banking system in India was expanded to take care of general banking activities of accepting the deposits and facilitating the short term working capital loans to the industry. In the absence of well
developed capital market, establishment of Development Finance Institutions (DFIs) and State Finance Corporations (SFCs) are inevitable to cater the long term financing needs of the industry at the national and state level respectively. The concept of nationalization was followed in the subsequent period by setting up of the State Bank of India in the year 1956 by taking over the then Imperial Bank of India. In fact the Imperial Bank was formed in the year 1921 by the process of amalgamation of three presidency banks (namely the Bank of Bengal, the Bank of Bombay and the Bank of Madras). The State Bank of India is not a nationalized bank; however it was set up by the Government of India by taking over the Imperial Bank of India. It is important to note that the establishment of Unit Trust of India in the year 1963 by an Act of Parliament to provide a channel for retail investors for participating in the primary as well as secondary market (namely capital market). The Unit Trust of India has been established with the purpose of promoting the development of securities markets, by mobilizing household savings for investment in corporate stocks and bonds market. Initially the UTI was set up by the RBI and later on in the year 1978 UTI de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in the place of RBI. Further the UTI has been bifurcated into two separate entities in the year 2003. One is the Specified Undertaking of the Unit Trust of India which comes under the rules framed by the Government of India and other one is called UTI Mutual Funds Ltd which is functioning under the Mutual Funds Regulations. The Unit Trust of India is Indias first Mutual Fund Organisation. The unforgettable history in the Indian Financial System is nationalization of 14 private banks in the year 1969 by way of an ordinance issued by the Government of India, which was later on replaced by an act of parliament. Further six major commercial banks in the private sector whose deposits worth more than or equal to Rs 200 crore were nationalised in the year 1980. For the purpose of providing the risk coverage security for the life of Individuals the Life Insurance Corporation of India was set up in the year 1956 by merging 245 domestic and foreign insurance companies that were operated in India. The Life Insurance of India is the largest Non-banking Financial Institution which mobilizes the huge savings from the public at large and the funds will be deployed to the best advantage of the investors as well as with the best interest of the nation. In order to provide the security to non-life segment the General Insurance Corporation (GIC) was established in the year 1972. The General Insurance Corporation is not meant to offer returns but is a protection against contingencies like accidents, illness, fire, burglary etc. The General Insurance Corporation has four subsidiaries namely (i) The National Insurance Company Limited (ii) New India Assurance Company Limited (iii) Oriental Insurance Company and (iv) United India Insurance Company Limited.
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In December, 2000, the subsidiaries of the General Insurance Corporation of India were restructured as independent companies and at the same time GIC was converted into a national re-insurer. Parliament passed a bill de-linking the four subsidiaries from GIC in July, 2002. At present there are 14 general insurance companies including the ECGC and Agriculture Insurance Corporation of India and 14 life insurance companies operating in the country. A land mark in the history of co-operative credit system was the establishment of National Bank for Agriculture and Rural Development (NABARD) in the year 1982 with the objectives to create institutional arrangements at national level for financing, guiding and controlling the co-operative credit system. The need to catering the capital market or securities market in India was fulfilled by the stock exchanges; in fact the Bombay Stock Exchange (BSE) is the 1st stock exchange in India which was established in the year 1875. The main objectives of BSE are to promote, develop, and safeguard the interest of members as well as investors. Subsequently the National Stock Exchange (NSE) was established in the year 1992 with the intention to provide a nation wide stock trading facilities to the participants. Over The Counter Exchange of India (OTCEI) was incorporated in 1990 under the Companies Act 1956 and is recognized as a stock exchange under Section 4 of the Securities Contracts Regulation Act, 1956. The OTCEI was set up to aid small companies or enterprising promoters in raising finance for new projects in a cost effective manner and to provide investors with a transparent & efficient mode of trading. Investors attention is highly dragged by the credit rating agencies in India. Credit Rating is the assessment of a borrowers credit performance. Credit Rating helps investors to decide their investment pattern. Basically the credit rating has symbols which denote the performance or credit worthiness of the respective companies. These symbols may be AAA, AA, BBB, B, C, D to denote the performance of the respective companies to the investor. For example AAA which means highest safety in terms of repayment of principal and interest and in case of BBB which means moderate safety in terms of timely payment of interest and principal. In India the rating will start with the request of the company, however, the Reserve Bank of India and Securities and Exchange Board of India made credit rating as mandatory for the issue of commercial paper and certain categories of securities and debentures. Accordingly following credit rating institutions are established in India namely (a) Credit Rating Information Services of India Limited (CRISIL) was established in the year 1988, (b) Investment Information and Credit Rating Agency of India Limited was established in the year 1990 and (c) Credit Ratings Analysis and Research Limited (CARE) was established in the year 1993.
Apart from the above, the Non-Banking Financial Institutions namely the Development Financial Institutions or Term lending financial institutions and Non-Banking Financial Companies (NBFCs) are taken the birth since 1950. These institutions are playing vital role in the Indian Financial System by providing medium and long term financial assistance and engaged in promotion and development of industry, agriculture and other key sectors. The Development Financial Institutions so called development banks performs the special tasks which generally not undertaken by commercial banks. These financial institutions can be grouped into all India Financial Institutions as well as State Level Institutions which can be discussed in detail under Unit III. It is needless to say that The Indian Financial System highly regulated by the regulating authorities namely Reserve Bank of India (RBI), The Securities Exchange Board of India (SEBI), Securities Contract (Regulation) Act, The Insurance Regulatory and Development Authority (IRDA), The Foreign Exchange Management Act (FEMA), Companies Act and other regulatory bodies from time to time. 1.3.1 Savings and Investments Domestic savings are inevitable for putting India on a high growth path. Substantial savings are possible with liberalization of financial markets and strong structural reforms. Financial Intermediaries provide a link in between saving and investment. Basically the saving of individuals depends on their income, their occupation and size of the city in which they resides. Like wise investments also depends on return, liquidity and security. At this junction we would like to discuss three types of saving (economic) units which are essential to understand relationship between savings and investments. (i) Saving-surplus units or Surplus Spending Economic Units (ii) Saving-deficit units or Deficit Spending Economic Units (iii) Neutral Units (i) Saving-surplus units or Surplus Spending Economic Units: Excess of income over expenditure of house hold sectors and other sectors can be classified as Saving-surplus units. These units try to lend or invest their surplus into profitable investments with the help of financial intermediaries. These financial intermediaries play a vital role to transfer the savings of the Savings-surplus units to the Savings Deficit units. This process is Called capital formation. (ii) Saving-deficit units or Deficit Spending Economic Units: Excess of expenditure over income of the units or sectors. These units finance their need by borrowing or by decreasing their financial assets. The surplus saving units and deficit units can be brought together by the Financial Intermediaries. In India, the corporate sectors and the Government sectors can be categorized as saving-deficit units.
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(iii) Neutral Units: Means those units whose expenditures are equal to savings. The role of financial system in the saving and investment can be measured in terms of National Income Accounts and Flow of Funds Accounts. (i) National Income Accounts: In India, the national income accounts prepared by the Central Statistical Organisation (CSO) and the same published by the Government of India. The National Income Accounts prepared based on the entire production in the Indian economy and earnings derived from the production. The Indian Economy can be classified into six categories: (i) Agricultural Sectors, Mining Sectors, Fishing Sector and so on (ii) Manufacturing Sector, Real Estate Sector and Power Sector and so on. (iii) Service Sector, Transport Sector and Trade or commerce Sector etc. (iv) Banking and Insurance Sector and Development Banking sector etc., (v) Public Administration and Defense Sector etc., (vi) Export and Import Sector namely Foreign Sector. On combination of all the above sectors out put net result can be termed as Gross National Product (GNP). If we deduct from the GNP the non cash expenditure (monetary savings) namely the depreciation we will get the Net National Product (NNP). The Net National Product can be measured as net production of goods and services in the Indian Economy during the year. It gives an idea of the net increase in the total production in the country. So many times we use to read in the news papers and hear from our friends regarding the Gross Domestic Product (GDP). It is nothing but gross out put of the Indian Economy except Foreign Sector. It means to say increase in savings causes increase in investments which ultimately causes increase in agriculture yield, manufacture and service sectors out put, as a result growth in trade and commerce, which leads to increase in the Gross Domestic Product (GDP). The National Income Accounts represents macro economic data such as Gross Domestic Product, Gross National Product and Net National Product along with savings and investments. The National Income Accounts also provide us the information regarding Surplus Saving Units and Surplus Deficit Units but does not provide us link between these units. This gap can be filled up by the Flow of Funds Accounts by interlinking various sectors of the Indian Economy.
(ii) Flow of Funds Accounts: The flow of funds explains us the role of financial system in the generation of income, savings and investments. These accounts highlight the channel of cross intersection comparison between savings and investments. The nature of financial activities in the Indian Economy can be studied under the flow of funds accounts. Flow of Funds accounts provides the information regarding the savings and investments of the Indian Economic Sectors namely Hose-hold Sectors, Private Sectors, Banking sectors, Public Sectors and so on so forth. These sectors participate in the financial activities by borrowing from surplus saving units for the purpose of lending to the saving deficit units. Domestic Savings: Savings can be broadly based on the three sectors namely (i) Household Savings (ii) Private Corporate Savings (iii) Public Sector Savings (i) Household Savings: (a) The household sector savings are a predominant source of domestic savings (about 76 percent in 2004-05) and a substantial part of the growth in the GD rate emanates from the growth. The latest annual report of the Reserve Bank of India gives the data on household savings which forms the largest component of aggregate savings in India. The savings of households can be viewed as Individuals, Proprietor ship or Partnership firms and all Non-corporate enterprises. (b) Household savings consist of two segments namely savings in the form of physical assets and financial assets. The physical assets include land and buildings, plant and machinery and stocks held by individuals, firms and other non-corporate enterprises. The financial assets consists of currency holdings of households, deposit holdings of banks and non-bank companies, life insurance fund, provident and pension funds, the Unit Trust of India and other financial institutions, claims on Government consisting of net purchases of bonds and small savings assets by households, and the net purchases of shares and debentures by households. (c) Prior to financial sector reforms, household savings will primarily be in the form of physical assets and as the financial system matures, financial intermediation will channelise more savings into the financial side and finance more productive investments. Till the midnineties, household savings in financial assets were more than household savings in the form of physical savings. Now as per the latest estimates available, it is the physical savings that are more than those in financial assets. In fact more than 52 per cent of the total household savings are in the form of physical assets compared to 44 per cent in the early
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nineties. This shift in saving towards physical assets shows is that, at present household savings in the system are being driven not by current incomes, but on expected future cash flows. (ii) Private Sectors Savings: Private corporate savings comprises of savings from private financial institutions, nongovernment institutions and non financial companies and so on so forth. As per the Central Statistical Organisation, data on corporate finances indicate a general improvement in corporate profitability during the current year. The rate of private corporate savings stood at around 3.7 per cent of GDP in the 1990s improved to 4.8 per cent in 2004-05. This rate could be slightly lower in 2005-06 as reflected in a slowdown in profitability of the corporate sector as compared to 2004-05. Yet, corporate results for the first two quarters of 200607 indicate a buoyant growth in company profits which could translate into improved rate of corporate savings for the current financial year (2006-07). (iii) Public Sector Savings: Public Sector Savings consist of savings from Government sectors, Administrative Departments and so on. The increases in public sector savings have been the result of significant reductions in the dissavings of the government administration. The reduction in dissavings by the government as mirrored in reducing revenue deficits of the central and state governments have halved from 7 per cent of GDP in 2001-02 to 3.7 per cent in 2004-05; it was further fallen to 3.1 per cent in 2005-06. Savings from department enterprises like railways, telecom and infrastructure developments remained largely stagnant contributors to the Gross Development Product (GDP). With efforts being directed to meet the targets, public sector savings can be expected to be further consolidated in the current year; the budget estimates for 2006-07 have pegged revenue deficits of the central government (as a percentage of GDP) at 2.1 per cent. As per the RBIs latest compilation of state budgets data reveal that the combined revenue deficits of states have declined from 1.2 per cent in 2004-05 to 0.5 per cent each in the next two years. 1.3.2 Types of Savings We have various types of savings which can be expect from the household savings, private sector savings and public sector savings as follows:(a) a)Regular Savings Accounts: These accounts are termed as Savings Bank Account, Recurring Deposits and Current Accounts. Saving account and Recurring Deposits gives some interest, but current account gives nil rate of interest but it allows you to operate with negative balance. Savings Bank accounts are sometimes called passbook accounts. It is an easy way to start a saving
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program because of low opening deposit requirements. There may be limitations on the number of withdrawals. Today banks offer a wide range of financial services to help you to save. (b) Certificates of Deposit (CDs): Savings can be parked in the form of term deposit accounts in the banks because you agree to leave your money in the account for a specified period (called the term or maturity) in return the institution giving you a higher rate of interest. Terms vary from 1year to 10 years. Some CDs do not allow additional deposits. Typically, the funds are reinvested after the term is reached, unless you specify otherwise within a given period. Usually, there are also penalties for early withdrawal. (c) Savings in the Bonds: Savings can be converted into the various bonds like Government Bonds, Public Sector Undertaking Bonds, Corporate Bonds, State Loans, Treasury Bills and so on. (d) Savings in the Institutional Investments: The Life Insurance Corporation of India (LIC), The Unit Trust of India and Employees Provident Fund (EPF) bagged nearly one third of total financial savings in India. Savings in the form of Insurance policies are products designed to cover the risks of losses from certain predetermined events. Savings in the form of Mutual Funds is an emerging area and still 80% of the mutual funds market occupied by the UTI. Savings in the form of Pension plans are designed to provide for the retirement of the investor. These institutional investors procure the savings from the household sectors, private sector and public sector units. (e) Savings in company shares and securities: Savings of the household, private and public sector units can be invested in to the company shares, debentures, bonds and deposits etc,. These savings may be short term; medium term or long term depends on the interest of investors. 1.3.3 Investments The investment process starts when savings facilitate to invest in various profitable ventures. Banks and financial institutions lend their funds to the household units and corporate units. The investments should earn reasonable and expected rate of return on investments. Certain investments like bank deposits, public deposits, debentures bonds etc., will carry fixed rate of return namely interest payable periodically. In case of investments in shares of companies, the periodical payments in the form of dividend are not assured, but it may ensure higher return than fixed income investments but carries higher risk.
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Sources of Investible Funds Apart from the indicators of domestic savings, the other widely quoted indicators of investment activities are the direct sources of investible funds, namely, capital raised by companies in the primary markets, loan disbursements by various financial institutions as well as the banking sector and foreign investment inflows. While equities in capital markets are an avenue for household sector savings, they also represent a portion of the investible funds available to the corporate sector. Investments in the shares and securities can be directly invest by the Foreign Direct Investments and indirectly invest by the Foreign Institutional Investors. Investments highly influenced by the interest rates and inflation. 1.3.4 Interest Rates and Inflation There is linear relationship between interest rates and inflation. In other words, both tend to move either up or down together. However, the caveat is that interest rates will always follow inflation rates or, put simply, when inflation goes up, interest rates go up and when inflation comes down, interest rates tend to fall. This relation ship can be explained in the following chart.
Inflation rates increases when the economy is overheating. It means to say that when Reserve Bank of India prints lot of money or when macro economic policies go bad. For example we assume that the Reserve Bank and Government of India follows the right economic policies. hence, money becomes cheaper because of more printing or there is low interest rate. This position can be described as Loose Money Policy. We know that Money is the back bone of any economy. When the interest rate is low, persons start to borrow the money to invest into their business or buy things which they like. Over a period of time the price they pay for the money is interest. In India for the past few years the interest rates were low and people and corporate entities has been increased their borrowings for various purpose. For example People bought residential houses, cars, air conditioners television set and so on and companies built factories, purchase plant and machineries, furniture and fixtures and so on.
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This situation denotes the economic growth which results rapid increase in incomes and profits as a whole increase in Gross Domestic Product. At this point of time prices for the product will go up, as we know if demand increases the price of the product also increases. Over a period of time, prices of goods tend to go up and that results in inflation because most of these goods are usually part of a basket that constitutes the Wholesale Price Index or the Consumer Price Index. The Reserve Bank of India will take steps to increase the interest rates so as to cool the economy. However, interest rates can not be increased beyond a particular level which causes the recession. At the level of higher interest rates money becomes costly this situation can be called tight money policy. The intention of the Reserve Bank of India is that when it increases rates, people and companies will borrow less and therefore there will be less purchases and investments. Then over a period of time incomes of the people and profits of the companies will come down as a result slow growth in Gross Domestic Product. At this point of time inflation drops and the Reserve Bank of India will usually lower interest rates to strengthen the economy. This cycle continues round the clock. This is an example through which we can understand the interest, money and inflation relation ship. There are some other factors may also describe the relationship of interest, money and inflation. 1.4 FINANCIAL INSTITUTIONS The Financial Institutions can be broadly grouped under (1) Financial Intermediaries, (2) Financial Markets, (3) Financial Instruments and (4) Financial Services which are main pillars to the Indian Financial System
NOTES
Financial Internediaries Finanacial Markets Financial Inrtruments 1.4.1 Financial Intermediaries
Financial Services
Financial Intermediaries also termed as Financial Institutions. We can classify the financial intermediaries into two groups one is organized financial intermediaries and other one is unorganized financial intermediaries. Organized financial intermediaries comes under the purview of regulating authorities namely Reserve Bank of India, Securities Exchange Board of India, Companies Act, Securities Contract (Regulation) Act and so on. Whereas unorganized financial institutions are not cover under the purview of these regulating authorities, such type of institutions are
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called local money lenders, pawn brokers etc. Our study is mainly focusing on formal or organized financial intermediaries only. Organised financial intermediaries can be classified as Banking Institutions, NonBanking Financial Institutions, Insurance Companies and Housing Finance Companies. These financial intermediaries plays vital role in the capital formation by means of mobilizing savings and facilitating the allocation of funds in an effective manner. These intermediaries provide the convenience to the small investors by mobilizing their savings in the form of divisibility and distribute the claims at the time of maturity or redemption. The Structure of the Financial Intermediaries or Institutions can be depict as follows:
(A) Term Lending Financial Institutions (ie Development Banks) (a) Industrial Financial Corporation of India (IFCI) (b) Industrial Investment Bank of India (IIBI) (c) Infrastructure Development Finance Company (IDFC) (d) Small Industrial Development Bank of India (SIDBI) (e) National Bank for Agriculture and Rural Development (NABARD) (f) The Export Import Bank of India (g) Industrial Development Bank of India (IDBI) (h) State Financial Corporations (i) State Industrial Development Corporations (SIDCs) etc, (B) Non-Banking Financial Companies (NBFCs) (a) (b) (c) (d) (e) Hire Purchase Finance Company Equipment Leasing Companies Housing Finance Companies Venture Capital Fund Companies Chit Fund Companies
(f) Stock Broking Firms (g) Merchant Banking Companies etc, (C) Investment Institutions (a) Mutual Fund Companies (c) Pension Funds (d) Insurance Companies etc, 1.4.1.1 Banking Institutions The term Financial Intermediary is handicapped in the absence of the banking sectors. The Indian Banking System regulated and monitored by Reserve Bank of India. The term banking has been defined by the Banking Regulation Act as the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise. From this definition we came to know two important functions of the banks one is acceptance of deposits and lending of funds. The essential characteristics of banks: (i) (ii) (iii) (iv) Acceptance of deposits from the public. Investment or lending the money to meet the short term, medium and long term requirements. Repayable the deposits on demand or otherwise and Withdrawable by means of any instrument whether a cheque or otherwise.
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(a) Public Sector Banks in India Public Sector Banks are those banks in which Government of India has major share holding. No doubt public sector banks came to occupy dominant role in the banking structure. Before 1969, State Bank of India (SBI) was the only public sector bank in India, since then the following banks joined in the public sector banks list. List of Public Sector Banks in India (1) Indian Bank (2) Bank of India (3) Union Bank (4) Syndicate Bank (5) State Bank of Saurashtra (6) State Bank of Travancore (7) Bank of Maharashtra (8) Vijaya Bank (9) UCO Bank (10) Indian Overseas Bank (11) Punjab National Bank (12) Dena Bank (13) State Bank of Hyderabad (14) State Bank of Bikaner & Jaipur (15) State Bank of India (16) State Bank of Mysore (17) State Bank of Indore (18) Corporation Bank (19) Allahabad Bank (20) Andhra Bank (21) Canara Bank (22) Bank of Baroda (23) Oriental Bank (24) Punjab & Sind Bank (25) Industrial Development Bank of India (26) Industrial Credit and Investment Corporation of India (27) Unit Trust of India Bank (28) United Bank.
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(b) Private Sector Banks: Private Banks have played a major role in the development of Indian banking industry. They have made banking more efficient and customer friendly. In the process they have jolted public sector banks out of complacency and forced them to become more competitive. We have the following major private banks in India: (1) Bank of Rajasthan (2) Bharat Overseas Bank (3) Catholic Syrian Bank (4) Centurion Bank of Punjab (5) Dhanalakshmi Bank (6) Federal Bank (7) HDFC Bank (8) ICICI Bank (9) IDBI Bank (10) IndusInd Bank (11) ING Vysya Bank (12) Jammu & Kashmir Bank (13) Karnataka Bank (14) Karur Vysya Bank (15) Kotak Mahindra Bank (16) SBI Commercial and International Bank (17) South Indian Bank (18) United Western Bank (19) UTI Bank (20) YES Bank (c) Regional Rural Banks: Regional rural banks in India penetrated every corner of the country and extended a helping hand in the growth process of the country. Regional rural banks initially started its business to promote agricultural sector development. The State Bank of India has 30 Regional Rural Banks spread over across 13 states in the country. There are other banks which function for the development of the rural areas in India. These Regional Rural Banks plays a vial role in rural banking in the economy of the country by providing the help and financing farmers, rural artisans, agriculturists, entrepreneurs and so on. They are The Haryana State Co-operative Apex Bank Ltd, The National Bank for Agriculture and Rural Development, The Haryana State Co-operative Apex Bank Ltd. commonly called as HARCOBANK, National Bank for Agriculture and Rural Development (NABARD), United Bank of India and Sindhanur Urban Southarda Co-operative Banks etc., (d) Co-operative Banks Co-operative Banks in India are registered under the Co-operative Societies Act. The cooperative bank is also regulated by the RBI. They are governed by the Banking Regulations Act 1949 and Banking Laws (Co-operative Societies) Act, 1965. Cooperative banks in India finance rural sectors in the areas such as farming, Cattle, Milk, personnel finance, consumer finance and so on so forth. By virtue of specialised knowledge, training, ability and professionalism these intermediaries easily mobilise the funds in small denominations from the public at large and invest in various types of investments by diversifying the risk involved in the investments to generate optimum returns on investments which can be distributed by way of dividends or interest to the investors at large.
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A well developed financial intermediary system promotes the sound financial markets which causes the economical growth in the country. Financial Intermediaries offer the following services namely Issue Management, Underwriting, Portfolio Management, Corporate Advisory, Stock Broking, Capital Re-structuring, Merger and Acquisitions and so on so forth. We will discuss in detail regarding banking sectors in the unit II. 1.4.1.2 Non Banking Financial Intermediaries The term Non-Banking Financial Intermediaries can be bifurcate into three sub parts namely (a) Term Lending Financial Institutions, (b) Non-Banking Financial Companies and (c) Investments Institutions. Term Lending Financial Institutions These institutions also called as Development Banks. They are Industrial Financial Corporation of India (IFCI), Industrial Investment Bank of India (IIBI), Infrastructure Development Finance Company (IDFC), Small Industrial Development Bank of India (SIDBI), National Bank for Agriculture and Rural Development (NABARD), The Export Import Bank of India, Industrial Development Bank of India (IDBI), State Financial Corporations, State Industrial Development Corporations (SIDCs) etc, Industrial Finance Corporation of India (IFCI) The Industrial Finance Corporation of India was established in the year 1948 as Indias first development bank. The main objective for which IFCI was established, are to make medium and long term credit available to the industrial undertakings. The main functions are direct financial support to industrial units for undertaking new projects, expansion, modernization, diversification etc., subscription and underwriting of public issues of shares and debentures, guaranteeing of foreign currency loans and also deferred payment guarantees, merchant banking, leasing and equipment finance. Industrial Investment Bank of India (IIBI) This institution was established in the year 1997 by converting the erstwhile Industrial Reconstruction Bank of India. The main functions of the Industrial Investment Bank of India are; invest in the capital market instruments, leasing and hire purchase business, providing the short, medium and long term loans and underwriting the shares and so on. Infrastructure Development Finance Company (IDFC) IDFC was established in the year 1997 with the intention to promote consultancy and advisory services to state governments for formulating a power sector strategy, to integrate the entire logistics chain in India, to provide the financial assistance to various telecommunication and Information Technology sectors, providing finance and project services for the development urban infrastructure and so on .
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Small Industrial Development Bank of India (SIDBI) SIDBI was established by passing an Act under parliament in the year 1989. The SIDBI provides services such as the principal financial institution for the promotion, financing and development of industries in the small scale sectors and to coordinate the functions of other institutions engaged in similar activities. National Bank for Agriculture and Rural Development (NABARD) NABARD also came into exist in the year 1982 by an Act of parliament. It serves as an apex refinancing agency for the institutions providing investment and credit for promoting development activities in rural areas, coordinates and supervise the rural financing activities of all institutions engaged in developmental work etc,. The Export Import Bank of India (EXIM Bank) The Export Import Bank of India is a public sector financial institution was set up in the year 1981. The main objective of this bank is financing, facilitating and promoting Indias trade and commerce, provides the project finance, Trade finance, Exim bank also act an intermediary for facilitating the forfeiting transaction between the Indian exporter and the overseas forfeiting agency etc., Industrial Development Bank of India (IDBI) Industrial Development Bank of India (IDBI) was set up by an Act of parliament as a wholly owned subsidiary of the Reserve Bank of India. Later on in the year 1976, the IDBI ownership was transferred to the Government of India. The main functions of IDBI are vested with the responsibility of co-ordinating the working of institutions engaged in financing, promoting and developing industries. It has evolved an appropriate mechanism for this purpose. IDBI also undertakes/ supports wide-ranging promotional activities including entrepreneurship development programmes for new entrepreneurs, provision of consultancy services for small and medium enterprises, up gradation of technology and programmes for economic upliftment and so on. IDBI can finance all types of industrial concerns covered under the provisions of the IDBI Act. With over three decades of service to the Indian industry, IDBI has grown substantially in terms of size of operations and portfolio. IDBI has directly or indirectly assisted all companies that are presently reckoned as major companies in the country.
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State Financial Corporations State Financial Corporations were established in the respective states to meet the financial requirements of small and medium enterprises. The State Financial Corporations provide financial assistance by way of term loans, equity subscription, debentures, discounting of bills of exchange seed capital assistance. State Industrial Development Corporations (SIDCs) SIDCs are incorporated under the Companies Act 1956 as wholly owned undertaking of the respective state governments. These corporations provide tax benefits under the state governments schemes to attract the investments. State Industrial Development Corporations provide the rupee loans, direct subscription to shares and securities and they also borrow funds from the house hold units, private companies and public sector undertakings by way of issue of bonds or debentures. Students are requested to refer the Unit III for detailed discussion regarding Term lending Financial Institutions. 1.4.1.3 Non-Banking Financial Companies (NBFCs) A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property. A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (Residuary non-banking company). The NBFCs functions are similar to that of Banking Companies; however, there are few differences as follows: The various typer of NBFCS are as follows: (i) Non-Banking Financial Companies (NBFCs) cannot accept demand deposits; whereas Banking Companies accepts deposits. (ii) It is not a part of the payment and settlement system and as such cannot issue cheques to its customers by NBFCs and (iii) Non-Banking Financial Companies are not insured or guaranteed by any government body unlike a bank deposit, where up to Rs 1 lac per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India.
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(a) Hire Purchase Finance Company (b) Equipment Leasing Companies (c) Housing Finance Companies (d) Venture Capital Fund Companies (e) C hit Fund Companies (f) Stock Broking Firms (g) Merchant Banking Companies etc, We have elaborately dealt with each one of the above NBFCs in the Unit III namely Development Banking. 1.4.1.4 Investment Institutions: Investment institutions means procurement of funds from public and institutional investors at large to meet the long term, medium term and short term requirements of the investors by providing reasonable returns with negligible risk. They can be viewed in the following terms. This list is only an illustrative but not exhaustive. The detailed study of these institution are explained in the Unit V. (a) Mutual Fund Companies (c) Pension Funds (d) Insurance Companies etc, 1.4.2 Financial Markets The Indian Financial Market promotes the enormous savings of the economy, by provi ding an effective channel of returns to the investors from whom the savings are mobilized. Hence, the term Financial Markets can be defined as a market for the exchange of capital and credit including the money markets and the capital markets. Financial Markets are facilitating tools for procurement of funds and invest in to various assets. The main activities of Financial Markets can be viewed as sale or purchase of shares or stocks, bonds, bills of exchange, commodities, future and options, foreign currency etc. The Financial Markets can be classified into: (i) Money market, (ii) Credit market, (iii) Capital market, (iv) Government securities market, and (v) foreign exchange market. In view of the importance of Government securities market in the Indian financial system it is bifurcated as separate segment though it is part of debt-market and thus of capital market. Each market is unique in terms of the nature of participants and the instruments in the market. The process of financial sector reforms has aimed at widening and deepening each market and moved towards integrating these markets domestically as also with global markets.
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1.4.2.1 Money Market The Money Market refers to the market for short term debt instrument which has maturity less than one year. The Money Market provides the borrower to borrow the funds for shorter period with lowest cost of funds. At the same time it is also facilitates to the investor a platform to invest his savings which can generate interest thereon. Money Markets does not have an organised trading market place such as the stock exchange for its primary issue and secondary market trades. The participants in the money market are banks, primary dealers, and financial institutions, mutual funds, non-bank financial companies, manufacturing companies, State Governments, provident funds, non-resident Indians, overseas corporate bodies, foreign institutional investors and trusts. The RBI and Securities and Exchange Board of India (SEBI) regulate the participants and use of instruments in the money market depending upon their respective roles in the financial system. For instance, financial institutions and mutual funds are allowed only as lenders in the call money market but are permitted to buy and sell Commercial Paper. Functions of Money Market Money market as we know it is a market for short term funds. The money market generally expected to perform the following functions: (1) It provide as an equilibrium mechanism to even out demand and supply the short term funds. (2) It act as focal point for influencing liquidity and general level of interest rates in the economy. (3) It also provides reasonable access to the users and providers of short term funds to fulfill their investment and borrowing requirements respectively.
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There are several instruments in the money market which can be summarized as follows i) Treasury Bills (T-Bills) ii) Certificate of Deposits (CDs) iii) Gilt-edged Securities iv) Commercial Papers v) Repurchase Agreements (Repos) vi) Bankers Acceptance vii) Inter Bank Participation Certificate viii) Money Market Mutual Funds (MMMFs) (i) Treasury Bills (T-Bills): Treasury Bills are generally issued by the Government for periods ranging from 14 days to 364 days through regular auctions. T-Bills are highly liquid instruments and demand from banks, financial institutions and corporations. These T-Bills are issued by the Reserve Bank of India on behalf of the Government of India. For mobilizing short term cash these bills are created by the Government to meet its short term requirements. Treasury Bills can be redeemed prior to the final date of maturity. (ii) Certificate of Deposits (CDs) Certificate of Deposits are popular money market instruments having lock in period of 15 days after which they can be sold. The Scheme of Certificate of Deposits was introduced by the Reserve Bank of India. As per the Reserve Bank of India these Certificate of Deposits can be issued by any scheduled commercial banks, co-operative banks but other than Land Development Banks. Certificate of Deposits can be subscribed by an individual as well as by an institution. The minimum size of the deposit is Rs 5 lakhs and thereafter in multipules of Rs 5 lakhs. Premature closure of Certificate of Deposits is not permitted and buy back of these deposits is prohibited. Certificate of Deposits can be compared with the Fixed Deposits of the banks and the major difference between the two being that CDs are transferable from one party to another, where as Fixed Deposits are non-transferable. Certificate of deposits are unsecured negotiable promissory notes issued by commercial banks and development financial institutions while the commercial banks CDs are issued on discount to face value basis. The discount rates of commercial deposits are market driven. The maturity period ranges from 91 days for the CDs issued by the banks, one to 3 years if CDs issued by the Development Financial Institutions. Investing into the CDs is use full to the investors which can be explained in the following example.
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For Example: X ltd has Rs 20 lacs to invest in Certificate of Deposit of a leading nationalized bank @8% per annum. What money is required to be invested now? Answer: Rate of interest No of days to maturity Interest on Re 1 for 91 days Maturity value after 91 days on Re 1 Investment today = 8% = 91 days = 0.08 x 91/365 = 0.019945 = Re. 1.019945 = Rs 20 lacs / 1.019945
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If we want Rs 20 lakhs after 91 days our investment today is Rs 19,60,890/(iii) Gilt-edged Securities The Government securities and fixed rate bonds, floating rate bonds, zero coupon bonds, capital index bonds etc., can be grouped under Gilt-edged securities. These are risk less securities. The maturity pattern of Government securities are ranging from 1 year to 10 years. These securities are less liquid than treasury bills and demand for these securities is mainly from banks. (iv) Commercial Papers The concept of commercial paper was introduced in India during the year 1990 on the recommendation of Vaghul Committee. Commercial Papers are now popular debt instrument for short term borrowing which is one of the source of mobilizing the short term funds to the highly rated corporate borrowers. Commercial papers are generally allowed to issue by the corporate borrowers having good ranking in the market as established by a credit rating agency. Now a days Primary Dealers (PDs) and Satellite Dealers (SDs) were allowed to issue the commercial papers for short term borrowing. Commercial Papers are issued at discount rate which is determined by the issuing company based on its credit rating. Banks and companies are allowed to buy the commercial papers and the company which is issuing commercial paper has to have not less than Rs 4 crores Net Worth. The commercial papers can be issued in denominations of Rs 5 lakh The concept of issue of commercial papers can be explained with the help of the following example: Example: X Ltd issued Commercial Paper worth Rs 10 crores as per the following details: Date of issue Date of maturity : : 17th January. 2008 17th April, 2008
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No of days Rate of interest
: :
90 days (from 17th Jan 08 to 17th April 08) 11.25% per annum.
Net amount will best received by the company on issue of commercial paper is as follows: 90 days 11.25 Interest for 90 days = x = 2.7740 365 days 100
2.7740 Rs10 crores x = Rs 26, 99,126 or say Rs 27 lakhs 100 + 2.7740 Net amount will be received by the company is Rs 9.73 crores (ie Rs 10 crores less Rs 27 lakhs). (v) Repurchase Agreements (Repos) Repurchase Agreements also called as buy back or ready forward and in short Repos. Repurchase Agreement arises when one party sells a security to another party with an agreement to buy it back at a specified time and price. Like wise the buyer purchases the securities, with an agreement to resell the same to the seller on an agreed date and at a predetermined price. The same transaction is called as repo from the seller point of view and reverse repo from the viewpoint of the buyer. Basically repos are short term instrument with risk free for balancing short term liquidity needs. Banks have often resorted to ready forward deals among themselves, as also with Discount and Finance House of India (DFHI) and Securities Trading Corporation of India (STCI) to overcome short term financial crunches. At present the Reserve Bank of India is allowed repos trading between banks, cooperative banks, Discount and Finance House of India and Securities Trading Corporation of India. Repos are usually entered into with a maturity of 1-14 days. Initially, there were lot of restrictions on banks to deal with repos because securities scam and other scams. Later on due to libaralisation the restrictions are gradually reduced. Types of Repos: we have at present two types of repos namely Inter-Bank Repos and Reserve Bank of India Repos.
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Inter-Bank Repos Banks, along with primary dealers are permitted to undertake ready forward transactions through the Special General Ledger (SGL) account maintained by the Reserve Bank of India. At present all Central Government dated securities, State Government Securities and T-bills of all maturities have been made eligible of repos. The non bank entities holding SGL account with the Reserve Bank of India can enter into reverse repo transactions with banks or primary dealers, in all Government securities. Reserve Bank Repos Reserve Bank of India undertake the repos or reverse repos with the banks and Primary Dealers as part of Open Market Operations (OMOs). It is a mechanism through which the Reserve Bank of India borrows money from banks. This process can be done by selling the government securities to repurchase later to influence the short term liquidity. Primary dealers include Discount and Finance House of India, Securities Trading Corporation of India, ICICI Securities, SBI Gilts, PNB Gilt and Gilt securities Trading Corporation. (vi) Bankers Acceptance A bankers acceptance is a draft against a bank ordering the bank to pay some specified amount of at a future date. The bankers acceptance is very safe security and is used as a money market instrument. Banker Acceptance (BA) is an order to pay a specified amount of money to the holder of the instrument on a given date. These are usually used in foreign trade transactions in which the seller wants to insure they will be paid for the goods sent. A commercial bank issues the BA to the seller in place of the buyer, who pays for the BA, and whose credit rating may not be as strong as the bank. This is especially useful when the creditworthiness of a foreign trade partner is unknown. Acceptances sell at a discount from the face value:
NOTES
One advantage of a bankers acceptance is that it does not need to be held until maturity, and can be sold off in the secondary markets where investors and institutions constantly trade BAs.
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(vii) Inter Bank Participation Certificate The Inter Bank Participation Certificate is yet another short term money instrument by which the banks can raise money or deploy short term surplus. Inter Bank Participation Certificates can be issued only by scheduled commercial banks these can be on risk sharing basis and other one is without risk sharing basis. (viii) Money Market Mutual Funds (MMMFs) Money Market Mutual Funds acts as bridge in-between small investors and money borrowers. MMMFs mobilizes the funds from small saving savers and invest into short term debt instruments or money market instruments. MMMFs are allowed to offer a cheque writing facility in a tie up with banks to provide more liquidity. 1.4.2.2 Credit Markets The credit market can be classified by maturity of finance - short-term and long-term. The distinction between the short-term and long-term credit institutions is increasingly getting blurred, but it is still possible to classify them in terms of their traditional objectives. Shortterm finance is extended in the form of cash credit limits and term loans with maturity of less than one year. Institutions mainly extending such loans are commercial banks, cooperative banks and non-bank finance companies. Recently, development financial institutions have also entered into this foray. Longterm finance is extended in the form of term loans technically for a period of over one year but substantively and in practice for a period of over three years. Institutions extending such loans are developmental financial institutions, specialized financial institutions and investment institutions. Recently, commercial banks are extending their operations in this area. Sources of credit can be classified into internal (rupee credit) and external (foreign currency loans through external commercial borrowings and foreign currency denominated non-resident deposits under FCNR-B). Significant changes have been brought about in credit markets, particularly since April 1997. Banks are easily the most critical players in this market. The RBI is moving away from micro regulation to macro management of banks. All deposit rates are freed except for savings accounts and term deposits up to 30 days. Banks have been given the freedom to evolve their own methods of assessing working capital and also the freedom for credit dispensation without consortium obligations. Banks are now allowed to freely fix their lending rates beyond Rs. 2 lakh, and within a ceiling of 13.5 per cent for loans amounting to Rs. 25,000 - Rs. 2 lakh. Of course, some lending rates for export activity are also regulated.
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1.4.2.3 Capital Market Capital Market is the market for long term finance with the maturity period more than one year. The Capital Market deals with the stock markets which provide financing through the issuance of shares or common stock in the primary market, and enable the subsequent trading in the secondary market, Capital Markets also deals with Bond Market which provide financing through issuance of Bonds in the primary market and subsequent trading thereof in the secondary market. Functions of Capita Markets: 1. The organised and regulated capital market motivates individual to save and invest funds. The availability of safe and profitable source of investment is an essential criteria to create propensity to save and invest on the part of the earning public. It provides for the investors a safe and productive channels for investment of savings and secure the recurring benefit of return thereon, as long as the savings are retained. It provides liquidity to the savings of the investors, by developing a secondary capital market, and thus makes even short term savings, consistently available for long-term users It thus mobilises savings of large number of individuals, families and associations and make the same available for meeting the large capital needs of organised industry, trade and business and for progress and development of the country as a whole and its economy. The primary financial assets in the capital market include the following: (i) Treasury Bonds: (ii) Common Stock: (iii) Corporate Long Term Bonds (iv) Mortgages 1.4.2.4 Government Securities Market The Government Securities market constitutes the principal segment of the debt market. The participants in this market as issuers are the Central and State Governments. The main investors are the RBI, insurance companies, banks, State Governments, provident funds, individuals, corporates, NBFCs, financial institutions, and to a limited extent FIIs and NRIs. Reforms initiated in the recent period include, introduction of Treasury Bills of varying maturities, abolition of tax deduction at source on interest income from Government securities, and permitting FIIs to invest in debt instruments including dated Government securities as also allowing them to hedge their foreign currency risk in the forward markets.
NOTES
2. 3.
4.
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The monetary policy of October 1997 announced the introduction of uniform price auction in respect of 91-Day Treasury Bills as an experimental measure with a view to broadening the investor base and removing the winners curse; the introduction of preannounced notified amounts for all auctions of Government securities, and the intention to accept non-competitive bids outside the notified amount in order to ensure more transparency in the primary auction process. FIIs with 30 per cent ceiling on investment in debt, are being allowed to invest in Government securities in addition to corporate debt. 1.4.2.5 Foreign Exchange Market When an organization or person in one country wants to buy goods or services in another, they must normally exchange their own currency for that of the country they are buying from. As a result, those who are dealing with foreign trade or commerce have a need to buy the currency of another country to make transactions. This exchange is done in the foreign currency market. State Bank of India is the single-largest participant in the forex market, accounting for about 40 per cent of the value of total customer transactions. In the inter-bank segment of the market, SBI along with a few other banks constitute the market-makers, i.e., banks which are always ready to quote two-way price both in the spot and forward markets. Foreign banks are predominant among the other participants. The customer segment is dominated by the Indian Oil Corporation and certain other large public sector giants like Oil and Natural Gas Commission, Bharath Heavy Electricals Ltd., Steel Authority of India Ltd., Maruti Udyog, etc. There is a perceptible presence of large private sector corporates like, Reliance Group, Tata Group, and Larsen and Tubro. Of late, foreign institutional investors have accounted for a large supply in the market. The RBI also buys and sells foreign exchange at its discretion to ensure orderly conditions in the market. Till recently, the market was dominated by trade-related flows and was not driven by financial market expectations inasmuch as the arbitrage opportunities between the Indian and offshore money (financial asset) markets were highly restricted. Nevertheless, the market-makers are now better-placed to give quotes with narrower spreads than before. Some major initiatives in the Foreign Exchange Market (i) Corporates are now allowed to sell and buy in the forward market beyond six months on a presumptive basis, subject to certain conditions. This has resulted in extending the forward market beyond six months. (2) In fact, forward quotes for periods of more than six months and up to 12 months are now available on a regular basis and at narrower spreads. (3) Authorised Dealers (ADs) are now allowed to run long-term rupee-forex swap books.
(4) This has resulted in better avenues of forex exposure management. Forward cover for FIIs in debt instruments and for NRI depositors in respect of deposits held in NRI and FCNRB schemes has been allowed enabling these participants to hedge their exposures. 1.4.3 Financial Instruments Financial instruments can be broadly divided into two parts namely primary securities and secondary securities. Primary securities are further divided into equity shares, preference shares, debt instruments and various combinations of these. Secondary markets further divided into time deposits, Mutual Funds and insurance polices. Some of the various financial instruments deal with in the international market also briefly discussed below: (i) Euro Bonds (ii) Foreign Bonds (iii)Fully Hedged Bonds (iv)Floating Rate Notes (v) Euro commercial Papers (vi)Foreign currency options (vii)Foreign currency futures (i) Euro Bonds Euro bonds are debts instruments denominated in the currency issued out side the country of the that currency. For examples a Yen note floated in the Germany. (ii) Foreign Bonds These are the debts instruments denominated in a currency which is foreign to the borrower and is sold in the country of that currency. For example a British firm placing dollar denominated bonds in USA. (iii) Fully Hedged bonds In foreign bonds, the risk of currency fluctuation exist. Fully hedged bonds eliminates the risk by selling in the forward markets the entire steam of principal and interest payment. (iv) Floating Rate Notes These are issued up to 7 years maturity. Interests are adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans. (v) Euro commercial papers Euro Commercial Papers are short term money market instruments. They are for maturities less than one year. They are usually designated in US dollars.
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(vi) Foreign Currency Option: A foreign currency option is the right to buy or sell, spot, future or forwards, a specified foreign currency. It provides a hedge against financial and economic risks. (vii) Foreign currency Futures: Foreign currency Futures are obligations to buy or sell a specified currency in the present for settlement at a future date. 1.4.4 Financial Instruments Financial services have been growing rapidly with the emergence of new investment flows in financial reconstitute a large and growing sector in almost all economies. Trade and investment flows in financial services have been growing rapidly with the emergence of new and growing markets in developing and transition economies, with modernization, rapid technological change, use of new financial instruments, and financial and trade liberalization. The financial services sector is also quite large and complex and covers a wide range of activities and instruments, including for instance, corporate banking, derivatives, factoring, foreign exchange trading, pensions and investment fund management, advisory and consultancy services, insurance broking and underwriting, project finance, securities trading, venture capital, and wholesale and retail banking services. Given the range of instruments and activities that fall under the purview of the financial services sector, there are also a large number of players 1.5 FINANCIAL SECTOR REFORMS Financial Reforms has been excellently explained by Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India at the International Monetary Fund, Washington D.C.2004. We have discussed some of important issues dealt by him in the Reserve Bank of India bulletin regarding financial reforms in India. The initiation of financial reforms in the country during the early 1990s was to a large extent conditioned by the analysis and recommendations of various Committees/Working Groups set-up to address specific issues. The process has been marked by gradualism with measures being undertaken after extensive consultations with experts and market participants. From the beginning of financial reforms, India has resolved to attain standards of international best practices but to fine tune the process keeping in view the underlying institutional and operational considerations. Reform measures introduced across sectors as well as within each sector were planned in such a way so as to reinforce each other. Attempts were made to simultaneously strengthen the institutional framework while enhancing the scope for commercial decision making and market forces in an increasingly competitive
framework. At the same time, the process did not lose sight of the social responsibilities of the financial sector. However, for fulfilling such objectives, rather than using administrative fiat or coercion, attempts were made to provide operational flexibility and incentives so that the desired ends are attended through broad interplay of market forces. The major aim of the reforms in the early phase of reforms, known as first generation of reforms, was to create an efficient, productive and profitable financial service industry operating within the environment of operating flexibility and functional autonomy. While these reforms were being implemented, the world economy also witnessed significant changes, coinciding with the movement towards global integration of financial services. The focus of the second phase of financial sector reforms starting from the second-half of the 1990s, therefore, has been the strengthening of the financial system and introduction of structural improvements. Two brief points need to be mentioned here. First, financial reforms in the early 1990s were preceded by measures aimed at lessening the extent of financial depression. However, unlike in the latter period, the earlier efforts were not part of a well-thought out and comprehensive agenda for extensive reforms. Second, financial sector reform in India was an important component of the comprehensive economic reform process initiated in the early 1990s. Whereas economic reforms in India were also initiated following an external sector crisis, unlike many other emerging market economies where economic reforms were driven by crisis followed by a boom-bust pattern of policy liberalisation, in India, reforms followed a consensus driven pattern of sequenced liberalisation across the sectors. That is why despite several changes in government there has not been any reversal of direction in the financial sector reform process over the last 15 years. The main objectives of the financial reforms in India are a. Drepression that existed earlier; b. Create an efficient, productive and profitable financial sector industry; c. Enable price discovery, particularly, by the market determination of interest rates that then helps in efficient allocation of resources. d. Provide operational and functional autonomy to institutions. e. Prepare the financial system for increasing international competition. f. Open the external sector in a calibrated fashion. g. Promote the maintenance of financial stability even in the face of domestic and external shocks. We can classify the reforms in financial sectors into banking sector reforms, reforms in the government securities market and reforms in the foreign exchange market.
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1.6 BANKING SECTOR REFORMS: (i) Granting of operational autonomy to public sector banks, reduction of public ownership in public sector banks by allowing them to raise capital from equity market up to 49 per cent of paid-up capital. (ii) Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities. (iii) Settling up of Lok Adalats (peoples courts), debt recovery tribunals, asset econstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring. Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest(SARFAESI), Act and its subsequent amendment to ensure creditor rights. (iv) Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) System. Reforms in the Government Securities Market: (i) Administered interest rates on government securities were replaced by an auction system for price discovery. Automatic monetization of fiscal deficit through the issue of ad hoc Treasury Bills was phased out. (ii) Primary Dealers (PD) were introduced as market makers in the government securities market. (iii) For ensuring transparency in the trad MSS) has been introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system. (vi) 91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced. (vii) Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits. Reforms in the Foreign Exchange Market: (i) Replacement of the earlier Foreign Exchange Regulation Act (FERA), 1973 by the market friendly Foreign Exchange Management Act, 1999. Delegation of considerable powers by RBI to Authorised Dealers to release foreign exchange for a variety of purposes. (ii) Introduction of additional hedging instruments, such as, foreign currency-rupee options. Authorised dealers permitted to use innovative products like cross-currency options, interest rate and currency swaps, caps/collars and forward rate agreements (FRAs)in the international forex market.
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(iii) Permission to various participants in the foreign exchange market, including exporters, Indians investing abroad, FIIs, to avail forward cover and enter into swap transactions without any limit subject to genuine underlying exposure. (iv) FIIs and NRIs permitted to trade in exchange-traded derivative contracts subject to certain conditions. (v) Foreign exchange earners permitted to maintain foreign currency accounts. Residents are permitted to open such accounts within the general limit of US $ 25,000 per year. 1.7 DISCOUNT AND FINANCE HOUSE OF INDIA (DFHI) With an objective to strengthen the infrastructure of fixed income securities market in India, Discount and Finance House of India (DFHI) was incorporated by Reserve Bank of India (RBI) along with other Public Sector Banks (PSBs) and All-India Financial Institutions (FIs) under the Companies Act 1956, on March 8, 1988. After receiving certificate of commencement of business on April 25, 1988, the company started its operation with an initial paid up capital of Rs 100 crore (RBI Rs 51 crore, PSBs Rs 33 crore and FIs Rs 16 crore). However, in order to broad base the activity of the company, the paid up capital was subsequently increased to Rs 150 crore in 198990 and further to Rs 200 crore during 1991-92. DFHI since its inception has been actively trading in all the money market instruments (viz. call/notice/term money, commercial bills, treasury bills, certificate of deposit and commercial paper) and its business turnover has grown progressively over the years. With effect from the year 1992-93, DFHI has been authorised to deal in Dated Government Securities also. After the company was accredited as a Primary Dealer (PD) in February 1996, its operations have increased significantly particularly in Treasury Bills and Dated Government Securities. Meanwhile, over a period of time RBI took a policy decision to divest their shareholdings in favor of the existing share holders. Thus State Bank of India (SBI) became the major shareholder and DFHI became a subsidiary of SBI from 31.03.2003. SBI Gilts Ltd. a subsidiary of SBI and established in the year 1996 was also an active participant in the market and one of the top five PDs. As both the companies were engaged in the same line of business, it was decided to merge SBI Gilts Ltd with DFHI Ltd in April 2004. Accordingly, from June 2004 the name of the merged entity was changed to SBI DFHI Ltd. SBI DFHI Ltd, now a subsidiary of SBI is the largest PD in the market in terms of net worth. The company is a major participant in the wholesale Debt Market both in the Primary and Secondary Market segment
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SBI DFHI is one of the leading player in the fixed income securities market and market maker in Government Securities and Treasury Bills. The company deals with the following: Treasury Bills Central Government Dated Securities State Government Securities PSU Bonds Inter-Corporate Deposits Commercial Paper Interest Rate Swaps
Besides, participation in Repo Market of GOI Securities and Treasury Bills as well as the participation in the Inter-Bank Call/Notice/Term Money market, both as a borrower and as a lender is possible through the company. SBI DFHI also provides the Constituent Subsidiary General Ledger (CSGL) account facility which enables even those entities which otherwise do not have an SGL Account facility with the RBI to reap the full benefits of investing in Government Securities. On purchase of Treasury Bills/Government Securities, they will be credited to the CSGL account, whereas on sale they will be debited from the CSGL account. Moreover, SBI DFHI will receive coupon payments/redemption proceeds from RBI and pass on to the CSGL account holder as and when such payments fall due. Advantages in dealing with SBI DFHI Promoted as a subsidiary by Reserve Bank of India and at present a subsidiary of State Bank of India, the largest Commercial Bank in India. Hence, enjoys an excellent credit rating in the market. Since there is no brokerage or any other hidden charges price transparency is assuredin our transactions. It take care of the entire procedural formalities involved in securities purchase / sales to the best satisfaction of our customers. Good branch network for easy interface across the country 1.8 MONEY LAUNDERING It is a serious threat not only to the financial system of countries, but also to their integrity and sovereignty. Money Laundering means the process involves cleaning of money earned through illegal activities like extortion, cross border terrorism etc. To prevent money laundering and connected activities, confiscation of proceeds of crime, and Act has been passed in the Parliament called the Prevention of Money Laundering Act, 2002.
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1.9 DERIVATIVES MARKETS The Derivatives Market commenced in India in the year 2000 after the Securities Exchange Board of India granted the permission. Derivatives market has had a slow growth in India in the initial period. The International Monetary Fund defines the term Derivatives as financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of financial derivatives derives from the price of an underlying item, such as asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues. The current price of an asset is determined by the market demand and supply of the asset. However, the future price of an asset is difficult to ascertain, which means unknown. The price of an asset after one month or six months may increase, decrease or remains the same. Buyers and sellers often like to hedge their bets against this uncertainty about future price by making a contract for future trading at a specified price at the present this type of contract can be termed as Derivatives. For Example Suppose you expect that six months from now the price of the U.S. dollar with respect to the Canadian dollar will be higher than it is today, and would like to purchase US $1,000 six months from now at todays rate. Suppose the current price of US $1,000 is CAN $1,200. Another person expects that the price of the U.S. dollar will decrease over the coming six months, and is willing to sell U.S. dollars at todays rate. Both of you can make a contract that will be exercised six months from now. Interestingly, neither of you needs to put down any currency today when signing the contract. When the contract matures, transactions must be carried out at the agreed-upon rate. This type of contract is called a forward contract. Alternatively, suppose the contract is sold for a non-refundable fee of $25. If the price of the U.S. dollar goes up, you are likely to exercise your right. On the other hand, if the price of the U.S. dollar goes down, you will be better off not exercising your right; in this case, you are losing only the fee. This type of contract is known as a call option. Similarly, a put option gives the owner the right to sell rather than buy. Types of Derivatives The most common Derivative contracts are forwards, futures, options and swap
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Forward Contracts A forward contract is an agreement between two parties namely a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. For example, an equipment lease is a forward commitment. By signing a one-year lease, the lessee agrees to use the equipment for the next twelve months at a predetermined rate. Like-wise, the lessor agrees to provide the equipment for the next twelve months at the agreed price. Now suppose that six months later the lessee finds better equipment and decides to switch over. The forward commitment remains in effect, and the only way the lessee can get out of the contract is to sublease the equipment. Because there is usually a market for subleases, the lease is even more like a futures contract than a forward contract. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract. Future Contracts A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts, however, futures contracts trade on organized exchanges, called future markets. For example, the buyer of a future contact, who has the obligation to buy the good at the later date, can sell the contact in the future market, which relieves him or her of the obligation to purchase the good. Likewise, the seller of the futures contract, who is obligated to sell the good at the later date, can buy the contact back in the future market, relieving him or her of the obligation to sell the good. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who makeprofits. Options Contracts Options are of two types namely call option and put option. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
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Swap Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 1.10 OVER THE COUNTER EXCHANGE OF INDIA (OTCEI) OTCEI was incorporated in 1990 as a Section 25 company under the Companies Act 1956 and is recognized as a stock exchange under Section 4 of the Securities Contracts Regulation Act, 1956. The Exchange was set up to aid enterprising promoters in raising finance for new projects in a cost effective manner and to provide investors with a transparent & efficient mode of trading. It allows listing of small and medium sized companies. The minimum issued share capital required of a company that wants to be listed on OTCEI is Rs.3 million and the maximum Rs.250 million. Companies engaged in investment, leasing, finance, hire purchase, amusement parks etc.and companies listed on any other recognized stock exchange in India are not eligible for listing on OTCEI. Also, listing is granted only if the issue is fully subscribed to by the public and sponsor. OTCEI is promoted by the Unit Trust of India, the Industrial Credit and Investment Corporation of India, the Industrial Development Bank of India, the Industrial Finance Corporation of India and others and is a recognised stock exchange under the SCR Act. OTCEI is a role model of the NASDAQ market of USA; OTCEI introduced many novel concepts to the Indian capital markets such as screen-based nationwide trading, sponsorship of companies, market making and scripless trading. As a measure of success of these efforts, the Exchange today has 115 listings and has assisted in providing capital for enterprises that have gone on to build successful brands for themselves like VIP Advanta, Sonora Tiles & Brilliant mineral water, etc. Need of OTCEI: Innovative companies are critical to developing economies like India, which is undergoing a major technological revolution. With their abilities to generate employment opportunities and contribute to the economy, it is essential that these companies not only expand existing operations but also set up new units.
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The key issue for these companies is raising timely, cost effective and long term capital to sustain their operations and enhance growth. Such companies, particularly those that have been in operation for a short time, are unable to raise funds through the traditional financing methods, because they have not yet been evaluated by the financial world. At this point of time the concept of OTCEI was rightly thought off. OTCEI, with its entry guidelines and eligibility requirements tailored for such innovative and growth oriented companies, is ideally positioned as the preferred route for raising funds through Initial Public Offer (IPOs) or primary issues, in this country. The Exchange has three types of intermediaries namely Members, Dealers and Sponsors, who contribute to the Exchanges activities by trading and enabling listing of companies on the Exchange. Members and Dealers may carry out the activities of trading, underwriting, market making and participation in bought out deals, but Dealers cannot sponsor an issue for listing. Sponsors can perform the function of sponsorship of issues, but are not permitted to participate in second market activities. Benefits a. The OTCEI has set up a national, automated screen based and ringless stock market. It helps companies raise finance from the capital market in a cost effective manner and provides a convenient and effective avenue of capital market investment for investors at large. b. While the other recognised stock exchanges require that in order to have its securities listed the company should have an issued capital of not less than Rs. 3 crores out of which normally 25% is to be offered to the public, the minimum issued equity share capital of a company for eligibility for listing on the OTCEI is Rs 30 lacs. c Listing on OTCEI is advantageous to companies because of the high liquidity of these securities, which is a result of compulsory market making, improved access and speed of transactions resulting from the extensive network of electronically interlinked counters.arial d Companies can obtain a fair price of their securities by negotiating the same with the sponsors (who are members of the OTCEI) and save unnecessary issue expenses by placing their securities with the sponsors who will in turn off load the securities to the public. This mechanism is now popularly known as a bought out deal. e. OTCEIs wide computerized net work will be spread all over India and will make investment easier. All deals will be entered into through remote terminals which will be connected to the mainframe computer of the OTCEI. The exchange will enable transactions to be completed quickly and investors can settle the deals across the counter within a few days. The exchange will also provide liquidity to investors as every scrip listed on the OTCEI will have at least two makers who will continuously give two way quotes.
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1.11 SECURITIES MARKET IN INDIA REGULATORY REFORMS Indian securities market has been adequately strengthened by regulatory and supervisory framework through the legislative and administrative measures in the recent past. These legislations are prepared based on the international standards prescribed by the International Organization of Securities Commissions (IOSCO). We can view these regulatory reforms in the following lines. The securities market in India is under the eye sight of the following regulatory authorities namely Companies Act, Securities Contract (Regulation) Act, Securities and Exchange Board of India.
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Reforms in the capital market or securities market can be enlighten in the primary market as well as secondary market.
Reforms in the primary capital market (1) The Securities and Exchange Board of India came into existence as statutory body in the year 1992 for regulating the securities market in India. The SEBI was formed to meet the objectives of investor protection and orderly development of the capital market. (2) SEBI is the primary body responsible for regulation of the securities market, deriving its powers of registration and enforcement from the SEBI Act. There was an existing regulatory framework for the securities market provided by the Securities Contract Regulation (SCR) Act and the Companies Act, administered by the Ministry of Finance and the Department of Company Affairs (DCA) under the Ministry of Law, respectively. SEBI has been delegated most of the functions and powers under the SCR Act and shares the rest with the Ministry of Finance. It has also been delegated certain powers under the Companies Act. (3) With the help of merchant bankers, investment and consulting agencies and the registrar to the issue the scope of primary market has been widened. (4) Many mutual funds sponsored by banks and financial institutions leads the institutionalization process begins in early 1990s. (5) Companies having dematerialized form of shares are not required to quote face value per share of Rs 10 and Rs 100, this concept was withdrawn. The companies which have already issued shares in the form of Rs 10 or Rs 100 as face value can also be eligible to split their shares into any denomination and at the same time they are allowed
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to consolidate. However, shares can not be issued in the decimal of rupees say per share is Rs 10.50. (6) A significant change in the capital market reforms is the granting of permission to foreign institutional investors such as mutual funds, pension funds, and country funds, to function in the Indian market. In this process the ceiling on the foreign institutional investors has been increased from 40% to 49%. (7) Reforms also facilitated the Indian companies to procure funds at internationally by issuing the Global Depository Receipts (GDRs), American Depository Receipts (ADRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs). (8) Infrastructure companies allowed their debt securities to list on stock exchanges even prior to the listing of equity shares. (9) RBI also has regulatory involvement in the capital markets regarding foreign exchange control, liquidity support to market participants and debt management through primary dealers. It is RBI and not SEBI that regulates primary dealers in the Government securities market. (10) SEBI Act of 1992 has introduced self-regulatory organizations [SROs] for regulating various participants in the securities market. But they are not yet operational. A clear regulatory framework has yet to be set up, and relevant market participants are not ready to regulate themselves for professional purposes. The only market related SROs in India whose regulatory frameworks have been well established and which are actually functioning are the recognized stock exchanges. (11) In respect of unlisted companies, the existing requirement of a tract record of dividend payout ratio in the last 3 years out of 5 years for initial public offer has been relaxed. Under the new norms, the company will have to demonstrate an ability to pay dividend rather than to show the past history. (12) The major reforms which have taken place in Indian markets include screen based trading, electronic transfer of securities, dematerialization, rolling settlement., risk management practices and introduction of derivative trading and so on. The net result of these initiatives can be seen in the form of efficient and transparent trading & settlement processes in our exchanges. (13) A code of conduct on advertisement has been issued for mutual funds with the intention that to protect investor from any misleading information. (14) In addition to the merchant bankers various intermediaries namely portfolio mangers, registrars to an issue, share transfer agents, underwriters, debenture trustees, bankers to an issue, custodian of securities, venture capital funds etc are brought under the purview of the SEBI. (15) It is mandatory to those public listed companies coming with Rs 10 crore or more initial public offer is required to make offer through dematerialized form.
(16) Incorporation of Securities Contracts (Regulation) Act, 1956 with the object to prevent undesirable transactions in securities by regulating the business of dealing therein, by providing for certain other matters connected therewith. (17) SEBI (Disclosure and Investor Protection) Guidelines, 2000 provides the process of book building wherein allocation of 5% for mutual funds, proportionate allotment to Qualified Institutional Buyers and margin requirement for Qualified Institutional Buyers. (18) Securities Appellate Tribunal (SAT) is formed to help or for justification to any person aggrieved with the orders of the SEBI or an adjudicating authority. Such aggrieved person against the order of SEBI or an adjudicating authority prefer to appeal in the prescribed form by accompanied the prescribed fee to a Securities Appellate Tribunal with in 45 days from the date on which a copy of the order is received by him. (19) During the year 2003, SEBI has brought sweeping changes in the initial public offer norms. According to the new norms, companies floating IPOs should have net tangible assets of Rs 3 crore in each of the preceding two years of which not more than 50% should be held in monetary assets. (20) After the legal framework for derivatives trading was provided by the amendment of SCRA in 1999 derivatives trading started in a gradual manner with stock index futures in June 2000. Later on options and single stock futures were introduced in 20002001 and now Indias derivatives market turnover is more than the cash market and India is one of the largest single stock futures markets in the world. 1.12 REFORMS IN THE SECONDARY CAPITAL MARKET (1) SEBI has taken several measures to improve the integrity of the secondary market. Legislative and regulatory changes have facilitated the corporatization of stockbrokers. Capital adequacy norms have been prescribed and are being enforced. A mark-tomarket margin and intra day trading limit have also been imposed. (2) The Securities Contract (Regulation) Act, 1956 provides the broad frame work of the present scheme of stock exchange regulation in India. As per SCRA stock exchange means any body of individuals, whether incorporated or not, constituted before corporatisation and demutualization or a body corporate incorporated under the Companies Act for the purpose of assisting or regulating or controlling the business of buying, selling or dealing in securities. For our understanding corporatisation means the succession of a recognized stock exchange, being a body of individuals or a society registered under the Societies Registration Act by another stock exchange, being a company incorporated for this purpose. Likewise demutualisation means the segregation of ownership and management from the trading rights of the members of a recognized stock exchange in accordance with a scheme by the SEBI.
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(3) The Over The Counter Exchange of India was established in the year 1992 to meet the small corporate sectors needs followed by the National Stock Exchange of India (NSE) in the year 1994 and the interconnected stock exchange of India (1999). (4) In fact, on almost all the operational and systemic risk management parameters, settlement system, disclosures, accounting standards, the Indian Securities Market is at par with the global standards. Indeed, on a few paradigms, it is ahead of the global benchmarks. Some of those initiatives are: - T+2 settlement cycle. - On line monitoring of positions and margins and automatic disablement of terminals. - Corporate governance index as a measure of wealth creation, management and distribution. - Establishment of CLA. - Central counterparty. - Commencement of Straight Through Processing (5) The National Stock Exchange set up a separate clearing corporation namely The National Securities Clearing Corporation to act as a counter party to all trades executed in the capital market segment of the exchange. (6) To safe guard the investor protection, to enhance the process of dematerialization of securities through depository system, the National Securities Depository Limited was set up in the year 1996. (8) All listed companies are required to disclose or furnish to stock exchanges the material changes and also publish un-audited financial statements on a quarterly basis. (9) Significant change in secondary market is introduction of corporate governance. Corporate Governance is a system and process design to protect the interest of stakeholders of the company. In this process the SEBI has appointed under the Chairmanship of Kumar Mangalam Birla on corporate governance in India and the committee suggested the implementation of the code through stock exchanges. (10) SEBI strictly prohibited the insider trading treating it as a criminal offence. Insider trading means an insider namely any person who is a director or deemed director or officer or employee who has reasonably expected to have access to or who has received or has had access to unpublished sensitive information in respect of securities of a company deal in securities (subscribing, buying or selling or agreeing to subscribe or buy or deal in any securities by any person either as a principal or agent) of a the said listed company. (11) The Securities Contract (Regulation) Act, 1956 has been amended for introduction of the derivatives trading through the stock exchanges. Both the NSE and BSE facilitated the derivatives trading in addition to the regular trading.
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(12) In the year 2001, the Central Government of India has established the Investor Education and Protection Fund, with the objectives to promote the awareness among the investors and safeguard the interests of the investor. 13) Stock exchanges were advised to amend the Clause 41 of the Listing Agreement to make it mandatory for listed companies to publish the number of investor complaints received, disposed of, unresolved along with the quarterly result. (14) As per the delisting rules the stock exchanges will have to compulsorily delist a company if has suffered losses during the preceding three consecutive years and its networth has turned negative, trading in its securities has remained suspended for more than 6 months or infrequently traded during the last 3 years, violates the regulations framed by the SCR Act, SEBI Act or Depositories Act, the public share holding in the company fallen down the minimum level prescribed by the listing agreement. (15) Foreign Institutional Investors (FIIs) and NRIs are permitted to invest in all exchange traded derivatives. Stock brokers who registered under the stock exchange and SEBI are allowed to trade in commodity derivatives etc. We will overview the reforms and developments which are taken place during the period 1992 -2003
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Source: Chartered Secretary, April 2004.
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Brief summary regarding intermediary role in each market has been given below:
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Summary Indian Financial System is complex and fast chaining. The concept of nationalization came in the year 1948 by nationalizing the Reserve Bank of India. The Reserve Bank of India was set up in the year 1935 with the share capital of Rs 5 Crore which was entirely owned by the private share holders in the beginning. The Reserve Bank of India is acting as central bank in India and it is different from the Central Bank of India. After Indias Independence, in the context of close integration its policies and those of the Government, the Reserve Bank became a state owned institution
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from 1st January 1949. The Banking Regulation Act was enacted in the same year (1949) to provide regulations and supervision of Commercial Banks Credit Rating is the assessment of a borrowers credit performance. Credit Rating helps investors to decide their investment pattern. Basically the credit rating has symbols which denote the performance or credit worthiness of the respective companies. These symbols may be AAA, AA, BBB, B, C, D to denote the performance of the respective companies to the investor. For example AAA which means Highest safety in terms of repayment of principal and interest and in case of BBB which means moderate safety in terms of timely payment of interest and principal. Hence under the entire concept by putting in to the following formatted so as we can able to understand The Structure of the Financial Intermediaries or Institutions can be depict as follows:
(A) Term Lending Financial Institutions
(ie Development Banks) a. Industrial Financial Corporation of India (IFCI) b. Industrial Investment Bank of India (IIBI) c. Infrastructure Development Finance Company (IDFC) d. Small Industrial Development Bank of India (SIDBI) e. National Bank for Agriculture and Rural Development (NABARD) f. The Export Import Bank of India g. Industrial Development Bank of India (IDBI) h. State Financial Corporations i. State Industrial Development Corporations (SIDCs) etc, (B) Non-Banking Financial Companies (NBFCs) (a) Hire Purchase Finance Company (b) Equipment Leasing Companies (c) Housing Finance Companies (d) Venture Capital Fund Companies
(e) Chit Fund Companies (f) Stock Broking Firms (g) Merchant Banking Companies etc, (C) Investment Institutions a) Mutual Fund Companies b) Pension Funds c) Insurance Companies etc, We also understand the financial markets by splitting it into four parts as follows
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Self examination questions (1) (2) (3) (4) (5) (6) Explain the financial growth in the Indian Financial System Explain the Indian Financial Markets What role the financial intermediaries are playing in the Indian Financial Market. Explain the NBFCs Give the list of Nationalized Banks Explain the role of Development banks in India and their importance in the Indian Financial System (7) Comment on the regulatory frame work in the context of financial reforms (8) Explain the DFHI and importance in the financial system (9) Explain the Regulatory frame work in the context of securities market. (10) Explain the term savings and investments. (11) Elucidate the relationship between interest and inflation. (12) Explain the types of savings (13) Please explain the credit market and capital market and distinguish between these two. (14) Write short notes on i. Treasury Bills (T-Bills) ii. Certificate of Deposits (CDs) iii. Gilt-edged Securities iv. Commercial Papers v. Repurchase Agreements (Repos) vi. Bankers Acceptance vii. Inter Bank Participation Certificate viii. Money Market Mutual Funds (MMMFs)
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(15) What do you mean by NBFCs and how they are differ with normal banks (16) Please list out few NBFCs and their purpose of incorporation. (17) Write some thing about Derivatives market (18) Explain the OTCEI and how it functions in the secondary market (19) List out the Development banks and their objectives.
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COMMERCIAL BANKS
2.1 INTRODUCTION For the past three decades Indias banking system has several outstanding achievements to its credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system has reached even to the remote corners of the country. This is one of the main reason of Indias growth process. A well organized banking system is a pre-requisite for economic growth of any country. Banks play an important role in the functioning of organized money markets. They act as a conduit for mobilizing funds and channelising them for productive purposes. The Indian banking can be broadly categorized into four types namely 1. 2. 3. 4. Commercial Banks Regional Rural Banks Co-operative Banks Development Banks (ie Term-lending institutions)
2.2 LEARNING OBJECTIVES After this study you should understand the important role playing by the commercial banks understand the regulatory reforms of the banking regulation authority you should be familiarize with Bank assets and liability structure learn the role of Reserve Bank of India in the Indian Financial System. 2.3 BANKING HISTORY AND ITS DEVELOPMENT IN INDIA The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay (1840) and Bank of Madras (1843) as independent units and called it Presidency Banks. These three banks were amalgamated in 1920 and Imperial Bank of India was established which started as private shareholders banks, mostly Europeans shareholders. the Government of India brought The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of
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1965). The Reserve Bank of India was set up in the year 1935 with the share capital of Rs 5 Crore which was entirely owned by the private share holders in the beginning. The Reserve Bank of India is acting as central bank in India and it is different from the Central Bank of India During the period 1955, the Government of India nationalized Imperial Bank of India with extensive banking facilities on a large scale specially in rural and semi-urban areas. It formed State Bank of india to act as the principal agent of RBI and to handle banking transactions of the Union and State Governments all over the country. In the process of nationalization 14 major banks has been nationalized and six banks later on nationalized. The following are the steps taken by the Government of India to Regulate Banking Institutions in the Country: I. 1949 : Enactment of Banking Regulation Act. II. 1955 : Formation of State Bank of India. III. 1959 : Formation of SBI subsidiaries. IV. 1961 : Insurance cover extended to deposits. V. 1969 : Nationalisation of 14 major banks. VI. 1971 : Creation of credit guarantee corporation. VII.1975 : Creation of regional rural banks. VIII1980 : Nationalisation of six banks with deposits over 200 crore. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks or the nationalized banks have acquired a place of prominence and has since then seen tremendous progress. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. The unleashing of products and services through the net has galvanized players at all levels of the banking and financial institutions market grid to look anew at their existing portfolio offering. Conservative banking practices allowed Indian banks to be insulated partially from the Asian currency crisis. Indian banks are now quoting at higher valuation when compared to banks in other Asian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problems linked to huge Non Performing Assets (NPAs) and payment defaults. Co-operative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the high revenue niche retail segments. The Indian banking has finally worked up to the competitive dynamics of the new Indian market and is addressing the relevant issues to take on the multifarious challenges of globalization. Banks that employ IT solutions are perceived to be futuristic and proactive players capable of meeting the multifarious requirements of the large customers base. Private
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banks have been fast on the uptake and are reorienting their strategies using the internet as a medium The Internet has emerged as the new and challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium. The Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances. Indian nationalized banks (banks owned by the government) continue to be the major lenders in the economy due to their sheer size and penetrative networks which assures them high deposit mobilization. The Indian banking can be broadly categorized into nationalized, private banks and specialized banking institutions. 2.4 TYPES OF BANKS 2.4.1 Public Sector Banks Public sector banks comprise the State Bank of India, its seven subsidiaries also called associated banks of State Bank of India. These are State Bank of (1) Bikaner and Jaipur, (2) State Bank of Hyderabad, (3) State Bank of Indore, (4) State Bank of Maysore, (5) State Bank of Patiala, (6) State Bank of Saurashtra and (7) State Bank of Travencore and nineteen nationalized banks and other public sector banks namely IDBI, ICICI and UTI and so on. Fourteen banks were nationalized on 19th July 1969 and another six on 15th April 1980. However, with the merger of New Bank of India with Punjab National Bank, the number of nationalized banks presently stands at nineteen. the entire share capital of most of these banks is entirely held by the Central Government of India. However, there are indications of reduction in government stake in these banks. For ready reference we have mentioned a list of nationalized banks.
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Types of banks can be broadly bifurcated into schedule commercial banks and non scheduled commercial banks. The entire banking system in India can be explained in the form of following chart.
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BANKS
Note: Non-scheduled bank in India means a banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled bank Our study in this unit is permitted to the scheduled commercial banks only. We are placing here for our understanding purposes regarding consolidated balance sheet of scheduled commercial banks prepared by the RBI
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2.4.2 Private Sector Banks Under the Indian Financial System the private banks contribution is un-detachable from the economic growth of the country. They are playing a vital and crucial role by serving to household units and corporate sectors. It is important to make a list of those private banks. (1) Bank of Rajasthan (2) Bharat Overseas Bank (3) Catholic Syrian Bank (4) Centurion Bank of Punjab (5) Dhanalakshmi Bank (6) Federal Bank (7) HDFC Bank (8) ICICI Bank (9) IDBI Bank (10) IndusInd Bank (11) ING Vysya Bank (12) Jammu & Kashmir Bank (13) Karnataka Bank (14) Karur Vysya Bank (15) Kotak Mahindra Bank (16) SBI Commercial and International Bank (17) South Indian Bank (18) United Western Bank (19) UTI Bank (20) YES Bank 2.4.3 Foreign Banks in India There were 29 foreign banks in India operating the banking activities. The presence of foreign banks in India has benefited the financial system by enhancing competition, transfer of technology and specialized skills resulting in higher efficiency and greater customer satisfaction. Foreign banks are enabled large Indian companies to access foreign currency resources from their overseas branches in times of foreign currency constraint. New foreign banks are allowed to conduct business in India after taking into consideration the financial soundness of the bank, international and home country ranking, rating, international presence and political relation ship between two countries.
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Foreign banks and their performance have been explained with the numeric values;
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Statement II : Foreign Banks : Total Assets,Gross NPA,Net NPA
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Statement III : Foreign Banks : Expenditure
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Statement IV : Foreign Banks : Expenditure
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2.4.4 Regional Rural Banks Rural Banking in India started since the establishment of banking sector in India. Rural Banks in those days mainly focused upon the agro sector. Regional rural banks in India penetrated every corner of the country and extended a helping hand in the growth process of the country. SBI has 30 Regional Rural Banks in India known as RRBs. The rural banks of SBI are spread in 13 states extending from Kashmir to Karnataka and Himachal Pradesh to North East. The total number of SBIs Regional Rural Banks in India branches is 2349. Till date in rural banking in India, there are 14,475 rural banks in the country of which 2126 are situated in remote rural areas. Apart from SBI, there are other few banks which functions for the development of the rural areas in India. Few of them are as follows. Regional Rural Banks (RRBs) growth in terms of number of branches Expansion of Regional Banking: 1975-1990
Purposewise Advances of RRBs, Outstanding (end of Sept, 1990)
The Haryana State Co-operative Apex Bank Ltd: The Haryana State Cooperative Apex Bank Ltd. commonly called as HARCOBANK plays a vital role in rural banking in the economy of Haryana State and has been providing aids and financing farmers, rural artisans, agricultural labourers, entrepreneurs,etc. in the state and giving service to its depositors.
NABARD National Bank for Agriculture and Rural Development (NABARD) is a development bank in the sector of Regional Rural Banks in India. It provides and regulates credit and gives service for the promotion and development of rural sectors mainly agriculture, small scale industries, cottage and village industries, handicrafts. It also finance rural crafts and other allied rural economic activities to promote integrated rural development. It helps in securing rural prosperity and its connected matters. Sindhanur Urban Souharda Co-operative Bank Sindhanur Urban Souharda Co-operative Bank, popularly known as SUCO BANK is the first of its kind in rural banks of India. The impressive story of its inception is interesting and inspiring for all the youth of this country. United Bank of India: United Bank of India (UBI) also plays an important role in regional rural banks. It has expanded its branch network in a big way to actively participate in the developmental of the rural and semi-urban areas in conformity with the objectives of nationalisation. Syndicate Bank Syndicate Bank was firmly rooted in rural India as rural banking and have a clear vision of future India by understanding the grassroot realities. Its progress has been abreast of the phase of progressive banking in India especially in rural banks. 2.5 FUNCTIONS OF COMMERCIAL BANKS: Banks borrow the money and lend the money is the main business of the banks, to achieve this banks generally perform the following function. (1) Accepting the deposit: banks borrowing the money from the saving surplus units in the different forms in which the investors or customers are interested to invest. In this process banks are accepting the following kinds of deposits from the boanks (a) Demand Deposits (b) Fixed Deposits (c) Saving Bank Deposits (i) Demand Deposits: These are deposits which are in the nature of current account which can be facilitated to the investors to withdraw the money at given point of time without giving any prior notice to the bank. These deposits are highly liquid therefore banks are advised to have hundred percent reserve for these type of deposits since depositor have right to withdraw money at any given point of time.
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Generally these types of accounts are maintain by the investors who are in running the business. Moreover the banks should provide the cheque facility to the customers, that is the account holders make payment to the parties. Further on behalf of the holders of demand deposits (current accounts) banks collect cheques, demand drafts, dividend warrants, postal orders and so on. These deposit holders did not get any interest on their savings. (ii) Fixed Deposits: These deposits are those deposits which are time bound and matured only after some specified period of time. However, there is possibility of taking loan against these deposits by the investors from the banks. These deposits time period start from 15 days to few years. (iii) Saving Bank Deposits: These are deposits generally made by the investors whose income is constant namely salary, service income etc. for their short term holding. Banks are providing the cheques to these holders and paying interest on the sum of savings deposits. (2) Advancing Loans: Another main function of commercial bank is to give loans to the needy. Banks will lend the money to the house hold sectors and corporate sectors at the specified rate of interest. Hence, we can say that main revenue of the commercial bank is the interest on their lending. At the same time banks also keep with them some amount of money to meet the demand of their depositors and running expenses and so on. The banks generally allowed the loans to the household sectors and corporate sectors in the following channels: (i) Over draft:
This is a very good facility provided by banks to their customers who has current account with the them. Banks are generally honour the cheques drawn by the customers of current account even though sufficient cash is not available in the said account whose credit terms are good with the bank. However, banks will charge the interest at higher rate than the interest on deposits. (ii) Cash credit loans: This is an ideal facility providing by the banks, hence, borrower is sanctioned a credit limit up to which he is allowed to borrow the money. Cash Credit (CC) will be sanctioning by banks only after thorough verification of the credit worthiness of the borrower who should have to have the current account with such bank. Banks will charge the interest only on the portion of actual money withdrawn from the CC account but not the entire amount sanctioned to the borrower. Of course the banks allow the CC only against the hypothecation of current assets of the borrower for example stock of raw material, semi finished goods and finished goods.
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(iii) Demand Loans: These are those types of loans which can be given to the borrower at a time the entire amount and recollect from them on demand by the banks at any time. interest will be charged by the banks on the entire amount of loan. Generally, these loans are required by the stock brokers to meet the short term credit requirements. (iv) Secured Loans: These can be classified as personnel loans and short term business loans. For example vehicle loan to the individuals, working capital requirement to firms and so on so forth. Banks will charge interest on the entire amount loan sanctioned to the borrowers. (v) Mortgage loan: A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase property. Commercial banks, however, are given security - a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. In the past, commercial banks have not been greatly interested in real estate loans and have placed only a relatively small percentage of their assets in mortgages. As their name implies, such financial institutions secured their earning primarily from commercial and consumer loans and left the major task of home financing to others. However, due to changes in banking laws and policies, commercial banks are increasingly active in home financing. (3) Credit Creation: Commercial banks functions as credit creation treating as very important. Credit creation means banks create deposits in the process of their lending operations, when the banks mobilize savings; it lends the funds that remain after providing for reserves. The amount lent is either deposited in the same bank or in some other bank. For example: A bank mobilizes the funds from some depositors worth Rs 110,000 in the form of deposits. The banks as per bank norms after taking say 10% towards reserve, lend the remaining money of Rs 99,000 either in the form of deposit in the same bank or in some other bank. The bank again, after keeping aside reserve of 10%, lends the remaining amount of Rs 89,100. this process continues and repeats in all banks simultaneously which will result in credit creation.
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(4) Transfer of Money Banks are acting as cheaper source of fund transfer by way of demand drafts, cheques, Electronic Clearance (ECS), ATM and so on so forth. In fact if we have an account in the form of savings bank or current bank account through which fund transfer can be done from one account to another with in the same bank without any charge within a shorter period of time. (5) Ancillary Functions Apart from the above, the following ancillary functions also undertaking by the commercial banks. (A) Collection & Payment of Cheques. (B) Standing instruction to subsidiaries. (C) Acting as correspondence. (D) Collecting of bills- electricity, gas, VAT, telephone etc. (E) Purchase & sales of stocks/ share-act as a banker to issue (F) Miscellaneous or general services (i) Safe custody- bailee (ii) Lockers-trustee (iii) Remittance facilities DD, TT, MT and PO (iv) Advisory services Providing credit reports Opening L/C. Demand in forese Travers Cheque only Authorized Dealer branches. Complete service in Foreign Trade. Other services: Debit Card, Credit Card, On-line banking SMS banking.
Creation of credit: a multiplier effect, Deposit creates credit and credit creates deposits derivative deposit. From the above we came to know that the commercial banks functions mainly based on the following which are generally not performing by Non Banking Financial Companies.
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(A) Acceptance of deposit: (B) Lending (C) Investment Apart from the various functions as listed out above carried out by the commercial bank, the two important ones are those relating to discounting of bills and acceptance and endorsement of bills on behalf of customers. Discounting and Collection of Bills: A bank may either straightaway purchase a bill or any other credit instrument from a customer or may collect it on his behalf. If it purchases or discounts the bill the amount would be immediately credited to the account of the customer less discount charges and debited to Discounted Bills Account. If on the other hand, a bill is to be collected for a customer, the particulars of the bill would be recorded in a special book called as Bills for Collection Register. Rebate on bills discounted: If a bank discounts a bill of exchange, the full amount of the discount earned is credited to discount account but some of the bills discounted may not mature for payment by the close of the year, as a result, the amount of discount in respect of such bills would not have been earned during the year. On this consideration, the unexpired portion of such discount is carried forward by debiting the discount account and crediting rebate on bills discount account. 2.6 ROLE OF COMMERCIAL BANKS (1) Promotion of Savings: Investors will save their money for various future needs like pension, education, marriage, and so on. Commercial banks promote the savings by providing the wide range of deposits with varying combinations of liquidity and interest to suit the requirement of investors. Commercial banks play a vital role during the period of inflation. (Students are advised to refer the unit I regarding interest and inflation). (2) Mobilization of Savings: As we know the banks are playing an important role as financial intermediaries. These banks so called financial intermediaries provide the link between the surplus saving units and surplus deficit units by transferring the funds from surplus units to deficit units. The excess of interest collected by the banks from the barrowers exceeds the interest paid to the depositors is the margin or profit to the banks.
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(3) Allocation of Funds: Corporate sectors to the grate extent depend on the funds mobilization from the out side. Mobilization of funds by issuing the shares is generally insufficient hence; these units depend on commercial banks for further funding. Commercial banks cater the needs of the firms by allocating the funds in the form of long term loans, medium and short term loans. The interest collected by the banks based on the rate suggested by the Reserve Bank of India. (4) Promotion of Trade, Production and Investments: Commercial banks are those financial intermediaries who encourage the savings to enhance investments. Banks are not only generating savings by collecting from others but also they themselves create deposits when they lend money to investors or other users. Now days the bank deposits especially demand deposit as much good money as the currency printed by the Reserve Bank of India. This leads to more investments which causes more productivity ultimately results economic growth in the country. 2.7 CHARACTERISTICS OF BANKS Banks have the following characteristics which distinguish them from most other commercial enterprises: 1. Banks have custody of large volumes of monetary items, including cash and negotiable instruments, whose physical security has to be ensured. It means to say banks need to posses formal operating procedures, well defined limits for individual discretion and rigorous system of internal control. 2. Banks engages in a large volume and variety of transactions in terms of both number and value. 3. Banks normally operate through a wide net work of branches and departments which are geographically dispersed. 4. They often assume significant commitments without any transfer of funds. These items commonly called off-balance sheet items, may not involve accounting entries. 5 Banks in India are regulated by governmental authorities and the resultant regulatory requirements frame 2.8 SOURCES AND APPLICATION OF FUNDS Form A of the Third Schedule to the Banking Regulation Act 1949, contains the form of balance sheet and Form B contains the form of profit and loss account. The Sources of Funds and Application of Funds for the commercial banks can be described as follows:
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2.8.1 Source of Funds ITS Structure (a) Capital The main source of funds for commercial banks is the capital which has to disclose in the balance sheet as per the following structure. (i) For Nationalized banks the capital owned by the Central Government as on the date of balance sheet including contribution from Government, if any for participating in World Bank Projects should be shown. For Banks Incorporated Outside India the amount brought in by banks by way of start up capital as prescribed by RBI should be shown under this head. For other banks the capital must be comprises of Authorised Capital Issued Capital Called up Capital less calls unpaid Add: forfeited shars
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(ii) (iii)
(b) Reserves: The commercial banks source of finance is the reserves which need to show in the balance sheet as per the structure required by the Banking Regulation Act. Statutory Reserves Capital Reserves Share Premium Revenue and other Reserves In the Revenue and other reserves opening balance, additions during the year and deductions during the year are to be shown separately in respect of each item. (c) Deposits The commercial bank mobilizes the source of funds through the following deposits which can be classified as follows; (a) (b) (c) (d) (e) Demand deposits which consist of deposits from banks and other banks. Savings bank deposits Term deposits which consist of deposits from banks and other banks Deposits of branches in India Deposits of branches outside India
(d) Borrowings Another main source of funds for the commercial banks are borrowings which has to disclosed in the balance sheet as follows:
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g.
h.
Borrowings India Reserve Bank of India Other Banks Other institutions and Agencies Borrowings outside India.
(e) Other Liabilities and Provisions These are also for the time being as source of funds only. For example; Bank suppose to pay in the year 2006 07 the interest to the other banks but not paid during the same year it means the money not gone out which can be considered as source for the year 2006 07. As per the Banking Regulation Act 1949, the other liabilities and provisions has to show in the bank books as follows: (A) Bills Payable (B) Inter-office adjustments (C) Interest accrued (D) Other provisions 2.8.2 Application of funds and struture (i) Cash, Bank Balances and Money at call and Short Notice:
The commercial banks invest or spend their funds into other banks most liquid funds, as per the Banking Regulation Act, 1949 the asset structure should be as follows Cash and Bank Balances with Reserve Bank of India (1) Cash in hand (including foreign currency) (2) Balances with Reserve Bank of India a. In Current Account b. In Other Account Balances with Banks and Money at Call and Short Notice (i) In India a.Balances with banks i .In current Accounts ii In other Current Accounts b.Money at call and short notice i.With banks ii.With other institutions
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Out side India (i) in Current Account (ii) in other Deposit Accounts (iii) Money at call and short notice (b) Investments The application of fund for the commercial banks is the investments into various assets as follows: (I) Investments in India in: (i) Government Securities (ii) Other approved securities (iii) Shares (iv) Debentures and Bonds (v) Subsidiaries and / joint ventures (vi) Others if any (II) Investments outside India in (i) Government securities (ii) Subsidiaries and / or joint ventures abroad (iii) Other investments if any (c) Advances: The commercial banks are extending the advances and loans to the clients to mobilize profits. It is one of the sources of application of fund for the banks. the assets structure in case of advances has to show as follows. (A) (i) Bills purchased and discounted (ii) Cash credits, overdrafts and loans repayable on demand (iii) Term loans (I) Secured by tangible assets (II) Covered by bank or government guarantee (III) Unsecured (C ) Advances in India (i) Priority sectors (ii) Public Sectors (iii) Banks (iv) Other advances if any
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Advances out side India (i) Due from Banks (ii) Due from others (iii) Bills Purchased and discounted (iv) Syndicated banks (v) Others if any (ii) Fixed Assets: The commercial bank generally has to invest to purchase the fixed assets which include land and buildings, furniture and fixtures and so on. Hence, there is an application of funds which can be properly structured in the balance sheet of the respective banks (i) Fixed Assets (ii) Other Assets ii. Inter office adjustments iii. Interest accrued iv. Tax paid in advance or tax deducted at source v. Stationery and stamps vi. Non-banking assets acquired in satisfaction of claims vii. Others. As per the Banking Regulation Act the income or profitability structure is as follows I. Income Interest on deposits Interest on Reserve Bank of India or inter bank borrowings II. Other income III. Expenditure Interest expended Operating expenses Provisions and contingencies IV. Profit or Loss Net Profit or loss for the year Profit or loss brought forward V. Appropriations Transfer to statutory reserves Transfer to other reserves Transfer to Government or Proposed Dividend Balance carried over to balance sheet.
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2.9 BANKING REGULATORY REFORMS Banking regulatory reforms we have referred here, with reference to various speeches and seminars given by our honorable Dr. Y V Reddy Governor of the Reserve Bank of India. (1) The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991), essentially catered to the needs of planned development in a mixed-economy framework where the public sector had a dominant role in economic activity. (2) The interest rates in the banking system have been largely deregulated except for certain specific classes; these are: savings deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2 lakh and export credit. (3) As part of the reforms programme, initially, there was infusion of capital by the Government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors. (4) One of the major objectives of banking sector reforms has been to enhance efficiency and productivity through competition. Guidelines have been laid down for establishment of new banks in the private sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new private sector banks have been set up. As already mentioned, an element of private shareholding in public sector banks has been injected by enabling a reduction in the Government shareholding in public sector banks to 51 per cent. (5) As a major step towards enhancing competition in the banking sector, foreign direct investment in the private sector banks is now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time. (6) Consolidation in the banking sector has been another feature of the reform process. This also encompassed the Development Financial Institutions (DFIs), which have been providers of long-term finance while the distinction between short-term and long-term finance provider has increasingly become blurred over time. The complexities involved in harmonising the role and operations of the DFIs were examined and the RBI enabled the reverse-merger of a large DFI with its commercial banking subsidiary which is a major initiative towards universal banking. (7) In 1994, a Board for Financial Supervision (BFS) was constituted comprising select members of the RBI Board with a variety of professional expertise to exercise undivided attention to supervision. (8) The Credit Information Companies (Regulation) Bill, 2004 has been passed by both the Houses of the Parliament (9) Major amendments relate to requirement of prior approval of RBI for acquisition of five per cent or more of shares of a banking company with a view to ensuring fit and
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proper status of the significant shareholders, aligning the voting rights with the economic holding and empowering the RBI to supersede the Board of a banking company (10) There have been a number of measures for enhancing the transparency and disclosures standards. Illustratively, with a view to enhancing further transparency, all cases of penalty imposed by the RBI on the banks as also directions issued on specific matters, including those arising out of inspection, are to be placed in the public domain. (11) The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent i.e., one percentage point above the international norm; and second, the banks are required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits, towards interest rate risk, at five per cent of their investment portfolio under the categories held for trading and available for sale. This was prescribed at a time when interest rates were falling and banks were realizing large gains out of their treasury activities (12) The regulatory framework in India, in addition to prescribing prudential guidelines and encouraging market discipline, is increasingly focusing on ensuring good governance through fit and proper owners, directors and senior managers of the banks. Transfer of shareholding of five per cent and above requires acknowledgement from the RBI and such significant shareholders are put through a `fit and proper test. Banks have also been asked to ensure that the nominated and elected directors are screened by a nomination committee to satisfy `fit and proper criteria. (13) Directors are also required to sign a covenant indicating their roles and responsibilities. The RBI has recently issued detailed guidelines on ownership and governance in private sector banks emphasizing diversified ownership. The listed banks are also required to comply with governance principles laid down by the SEBI the securities markets regulator. 2.10 RESERVE BANK OF INDIA The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934 as the Central Bank. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Reserve Bank of India describes the basic functions of the Reserve Bank as: ...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. 2.10.1 Central Board To monitor, effective supervision of functions and direction of the bank affairs the Reserve Bank of India formed a Board. The Reserve Banks affairs are governed by a central
board of directors. The board is appointed by the Government of India in keeping with the Reserve Bank of India Act. i. Appointed/nominated for a period of four years ii. Constitution: (b) Official Directors Full-time : Governor and not more than four Deputy Governors (c) Non-Official Directors Nominated by Government: ten Directors from various fields and one government Official Others: four Directors - one each from four local boards Local Boards (a) One each for the four regions of the country in Mumbai, Calcutta, Chennai and New Delhi (b) Membership consist of five members each appointed by the Central Government for a term of four years 2.10.2 Functions of the Board for Financial Supervision (BFS) To advise the Central Board on local matters and to represent territorial and economic interests of local cooperative and indigenous banks; to perform such other functions as delegated by Central Board from time to time. The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India. The objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies. The Board is constituted by co-opting four Directors from the Central Board as members for a term of two years and is chaired by the Governor. The Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of banking regulation and supervision, is nominated as the Vice-Chairman of the Board. (a) (b) (c) (d) restructuring of the system of bank inspections introduction of off-site surveillance, strengthening of the role of statutory auditors and Strengthening of the internal defences of supervised institutions.
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Legal Framework Umbrella Acts Reserve Bank of India Act, 1934: governs the Reserve Bank functions Banking Regulation Act, 1949: governs the financial sector
Acts governing specific functions Public Debt Act, 1944/Government Securities Act (Proposed): Governs government debt market Securities Contract (Regulation) Act, 1956: Regulates government securities market Indian Coinage Act, 1906:Governs currency and coins Foreign Exchange Regulation Act, 1973/Foreign Exchange Management Act, 1999: Governs trade and foreign exchange market Acts governing Banking Operations Companies Act, 1956:Governs banks as companies Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980: Relates to nationalisation of banks Bankers Books Evidence Act Banking Secrecy Act Negotiable Instruments Act, 1881 Acts governing Individual Institutions State Bank of India Act, 1954 The Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003 The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act, 1993 National Bank for Agriculture and Rural Development Act National Housing Bank Act Deposit Insurance and Credit Guarantee Corporation Act
2.10.3. The Main Functions of The Reserve Bank of India are 1. 2. The Reserve Bank of India is the regulator and supervisor of the financial system: RBI defines the guidelines according to which the banking operations within which the countrys banking and financial system functions. It tries to protect depositors interests and provides cost-effective banking services to the public by monitoring the functioning of banks. If a bank does not solve a customers problem they can approach the Reserve bank of India through the Banking Ombudsman Scheme Foreign exchange inflow and outflow is regulated by the the Foreign Exchange Management Act, 1999 of RBI. All money transfer out of India, for both personal and trade purposes is subject to limits defined by RBI. The Reserve Bank of India issues currency - notes and coins of various denominations. It also issues and exchanges or destroys damaged currency and coins not fit for
3.
4.
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circulation. The design of the currency is periodically modified to prevent circulation of fake currency. 5. The RBI is the banker to the Government of India. It performs merchant banking function for the central and the state governments. Government departments bank with the Reserve bank of India. For example, in Mumbai, the Income tax department issues tax refunds drawn on the Reserve bank of India. RBI is the banker to all major banks. It maintains banking accounts of all scheduled banks in India. Deposits of up to Rs 1 lakh in scheduled banks are insured. Cash withdrawal tax is applicable only for withdrawals from scheduled banks. Smaller cooperative banks usually are not scheduled banks. Bank interest rates increase or decrease according to the RBI lending rates The Reserve Bank of India also regulates the trade of gold. Currently 17 Indian banks are involved in the trade of gold in India. RBI has invited applications from more banks for direct import of gold to curb illegal trade in gold and increase competition in the market.
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8.
In March 2006, RBI has issued know your customer guidelines for non banking finance companies (NBFC). Customer whose deposit balance with the NBFC is less than Rs 50,000 or outstanding credit more than Rs 1 lakh need not provide all the documents. The customers will be categorized as low risk, medium risk and high risk. Sahara India is one of the largest NBFC in India. 9. RBI buys and sells foreign currency to maintain the exchange rate of Indian Rupee vs foreign currencies like the US Dollar, Euro, Pound sterling and Japanese yen. Trends in exchange rate value for these currencies are available on their website.
10. Depending on the liquidity in the money markets, RBI sets the maximum interest rate , Indian banks can offer on NRI dollar deposits. From March 2006, banks can offer an interest rate equal to the London Interbank Offered Rate (LIBOR) - an international benchmark rate on dollar deposits. 11. The cash reserve ratio (CRR) is the percentage of deposits that banks in India should keep with RBI . This also depends on the liquidity in the money markets and is currently 5%. The reverse repo rate is the rate at which RBI absorbs funds from banks. 12. RBI also regulates the opening /installation of ATM (Automatic Teller Machines). It is trying to increase the density of the ATMs in rural areas. Fresh currency notes for ATMs are supplied by RBI. 13. There are about 1050 clearing houses which settle transactions related to cheques, drafts and pay orders. The State Bank of India manages 567 clearing houses, mainly in the smaller cities and towns. 14. The annual monetary policy is announced in April every year.
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15. An outstation cheque from metro cities (Mumbai, Delhi, Chennai, Kolkatta) costs banks only 50 paise for clearing through the RBI clearing system but banks like ICICI bank charge Rs 100 for clearing the cheque. RBI has asked banks to display the service charges on their website, but only 5 banks have complied so far. 16. RBI regulates the opening of branches by banks and ensures that they follow the Know Your Customer guidelines. 2.10.4. Subsidiaries of Reserve Bank of India The RBI has four fully owned following subsidiaries namely: i. National Housing Bank (NHB) ii. The National Bank for Agriculture and Rural Development (NABARD). iii. The Deposit Insurance and Credit Guarantee for Agriculture and Rural Development Finance Company (IDFC). iv. Bharatiya Reserve Bank Note Mudran Private Limited. The National Housing Bank of India was established in the year 1998 under an act of the Parliament as wholly owned subsidiary of the RBI. It promotes housing finance institutions both at local and regional levels and provides financial and other support to such institutions. As we know about the NABARD which has been discussed in the Unit I. The Deposit Insurance and Credit Guarantee Corporation (DICGC) now converted into the Bank Deposits Insurance Corporation (BDIC) to make it an effective instrument in the banking sector. The main key function of this corporation is to provide the deposit and credit guarantee schemes. During the process of disinvestment RBI disinvested its holding during the period 2001-02 in the Discounted and Finance House of India and Securities Trading Corporation of India which were promoted for activating and expanding the money market and developing an active secondary market for government securities and public sector bonds, respectively. Summary We came to know that the banking system is back bone for any country. Our Indian Banking System highly regulated and monitored by various legal authorities. If the banking system is sound we assume that the countries economy is very strong. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks or the nationalized banks have acquired a place of prominence and has since then seen tremendous progress. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach.
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Self exercise problems Question 1: the following is an extract from Trial Balance of Overseas Bank Ltd. as at 31st March 2007 Rs Rs Bills discounted 12,64,000 Rebate on bills discounted not due on March 31st 2006 22,160 Discount received 1,05,708 An analysis of the bills discounted is as follows; (i) (ii) (iii) (iv) Amount (Rs) 1,40,000 4,36,000 2,82,000 4,06,000 Due date 2007 June 5 June 12 June 25 July 6 Rate of Discount 14% 4% 14% 16%
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Calculate Rebate on Bills Discounted as on 31st March 2007 and show necessary journal entry. Question 2: From the following information prepare a Balance Sheet of International bank Ltd. as on 31st March 2007 giving the relevant schedules and also specify at least four important principal Accounting Policies: Rs in Lakhs Debit Credit 198.00 231.00 150.00 412.00 517.00 450.00 28.00 0.10 812.10 110.00 160.15 37.88 155.87 210.12 55.23
Share capital 19,80,000 shares of Rs 10 each Statutory Reserve Net Profit Before Appropriation Profit and loss account Fixed Deposit Account Savings Deposit Account Current Account Bills Payable Cash credits Borrowing from other Banks Cash in Hand Cash with RBI Cash with other banks Money at Call Gold
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Government securities Premises Furniture Term loan
110.17 155.70 70.12 792.88 2,588.22 2,588.22 ====== ======
Additional information Bills for collection Acceptance and endorsement Claims against the Bank not acknowledge as bed Depreciation charges for premises Depreciation on Furniture Rs 18,10,000 Rs 14,12,000 Rs 55,000 Rs 1,10,000 Rs 78,000
50% of the term loans are secured by government guarantees. 10% of cash credit is unsecured. Also calculate cash reserve required and statutory liquid reserves required. Note cash reserves required 3% of demand and time liabilities; liquid reserve 30%. Self Examination questions: Explain the functions and roles of the commercial banks in India Explain the source of funds and application of funds for commercial banks Explain the regulatory reforms in the banking sector Reserve Bank of India is the central bank comment. List out the various types of banks and their objectives.
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UNIT III
DEVELOPMENT BANKING
3.1 INTRODUCTION Any countrys financial strength depends obviously on the sound system and function of the respective countrys banking system. The concept of Development Banking is not entirely differing with the concept of banking system. Of course there are some minor variations between these two which we have come across in the unit I and unit II. The concept of Development Bank was stared after the Second World War. The World Bank and International Money Fund (IMF) are known as development banks at international level. These Development Banks also called Term Lending Financial Institutions. After independence the need of development banks was felt strongly. The existing industries required long term loans for their reconstruction, modernization, expansion and diversification. At the same time new industries so called new entrepreneurs required enormous investment for setting up their businesses. This industrial requirements unable to meet by our commercial banks because of so many reasons which can be viewed as the commercial banks very much happy by lending the short term loan namely working capital loan, cash credit and so on but not long term loan with higher risk involvement. To fill this gap development financial institutions are emerged as oasis in the drat area. Development Banks are basically financial agencies that provide medium and long term funds and acts as catalytic agents in promoting balanced development of the country. Development Banks the name it self contain the development which means increase or accelerate the growth of an economy which will leads to increase the Gross Domestic Product. Therefore, Development banks take risks that ordinary banks will not. Development bankers should be different; they should lend a helping hand in moments of distress, and make up for the risk they take by extracting larger returns when the borrower recovers. For that reason, development banks should not operate on a fixed rate of interest. They should evolve a mechanism which depends on the health of the borrower. One
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possibility is to take a share of the profits. However, that is highly risky. Profit-related investment is best left to venture capitalists. In risk taking, development banks fall midway between safety-conscious traditional banks and the daredevil venture capitalists. In the Indian Financial System the crucial role playing by the following banks to strengthen the Indian economy. We can group these banks into Development Banks (or Term Lending Institutions), Refinance Institutions, Investment Institutions and Specialized financial institutions. 3.2 LEARNING OBJECTIVES (1) After reading this unit you should be able to understand the concept of development banks in India. (2) Understand the concept of merchant banks (3) Understand the Venture capital companies and the factoring business (4) Learn the concept of leasing, hire purchasing 3.3 FEATURES OF DEVELOPMENT BANKS: (a) To serve as an agent of development in various sectors, namely manufacturing industry, service industry, business process outsourcing (BPO), Knowledge process outsourcing (KPO), agricultural and international trad. (b) Development Banks main objective is to accelerate growth of the Indian economy. (c) To allocate resources to high priority areas namely technology, infrastructure, biotechnology sectors. (d) To promote the employment facilities in the private sector by initiating the steps towards industrialization. (e) To develop entrepreneurial skills in the potential entrepreneurs. (f) To promote and develop the rural areas (g) To finance for infrastructure for small scale units, housing loans, and social utilities etc. 3.4 FUNCTIONS OF DEVELOPMENT BANKS (1) Planning, promoting and developing industries to fill the gaps in between industrial sectors. (2) Coordinating with the institutions engaging in financing, promoting or developing industries, agriculture, trade and commerce and service sectors. (3) By providing innovating services by giving the ideas about new projects, undertaking feasibility studies, and providing technical, financial and managerial aid for successfully implementation of the underlying projects. (4) Development Banks are helping by providing the services like merchant banks, venture capital and so on. (5) Development banks generally undertake high profile projects which involve lesser return higher risk at the initial state of the project which generally commercial banks would not under take.
Development Banks (1) Industrial Development Bank of India (IDBI) (it became commercial bank from 1st October 2004) (2) Industrial Investment Bank of India (IIBI) (3) Industrial Financial Corporation of India (IFCI) (4) The Export Import Bank of India (EXIM) (5) Tourism Finance Corporation of India (TFCI) Refinance Institutions. (a) Small Industrial Development Bank of India (SIDBI) (b) National Bank for Agriculture and Rural Development (NABARD) Investment Institutions or Investment Banks (1) Mutual Fund Companies (2) Pension Funds (3) Insurance Companies etc, Note: we have elaborately discussed regarding above banks in the Unit V Specialized Financial Institutions: (1) Infrastructure Development Finance Company (IDFC) (2) IFCI Venture Capital Funds (3) ICICI Venture Capital Fund Apart from the above we also have state level institutions which are as follows: (1) State Financial Corporations (2) State Industrial Development Corporations (SIDCs) etc, 3.5 DEVELOPMENT BANKS 3.5.1 The Industrial Development Bankof India(IDBI) Industrial Development Bank of India provides financial assistance for the establishment of new projects as well as for expansion, diversification, modernization and technology up gradation of existing industrial enterprises. Main functions of IDBI (1) IDBI is vested with the responsibility of co-ordinating the working of institutions engaged in financing, promoting and developing industries. It has evolved an appropriate mechanism for this purpose. (2) IDBI also undertakes/supports wide-ranging promotional activities including entrepreneurship development programmes for new entrepreneurs, provision of consultancy services for small and medium enterprises, up gradation of technology and programmes for economic upliftment of the underprivileged.
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IDBIs role as a catalyst IDBIs role as a catalyst to industrial development encompasses a wide spectrum of activities. IDBI can finance all types of industrial concerns covered under the provisions of the IDBI Act. With over three decades of service to the Indian industry, IDBI has grown substantially in terms of size of operations and portfolio. Developmental Activities of IDBI (a) Promotional activities In fulfillment of its developmental role, the Bank continues to perform a wide range of promotional activities relating to developmental programmes for new entrepreneurs, consultancy services for small and medium enterprises and programmes designed for accredited voluntary agencies for the economic upliftment of the underprivileged. These include entrepreneurship development, self-employment and wage employment in the industrial sector for the weaker sections of society through voluntary agencies, support to Science and Technology Entrepreneurs Parks, Energy Conservation, Common Quality Testing Centres for small industries. (b) Technical Consultancy Organizations With a view to making available at a reasonable cost, consultancy and advisory services to entrepreneurs, particularly to new and small entrepreneurs, IDBI, in collaboration with other All-India Financial Institutions, has set up a network of Technical Consultancy Organisations (TCOs) covering the entire country. TCOs offer diversified services to small and medium enterprises in the selection, formulation and appraisal of projects, their implementation and review. (c) Entrepreneurship Development Institute Realising that entrepreneurship development is the key to industrial development, IDBI played a prime role in setting up of the Entrepreneurship Development Institute of India for fostering entrepreneurship in the country. It has also established similar institutes in Bihar, Orissa, Madhya Pradesh and Uttar Pradesh. IDBI also extends financial support to various organisations in conducting studies or surveys of relevance to industrial development. 3.5.2 Industrial Investment Bank Of India (IIBI) Industrial Investment Bank of India (erstwhile Industrial Reconstruction Bank of India) was set up in 1985 under the IRBI Act, 1984 as the principal credit and reconstruction agency for aiding rehabilitation of sick and closed industrial units. With a view to converting IRBI into a full-fledged all purpose development financial institution, it was incorporated as a government company in the name of Industrial Investment Bank of India Ltd. (IIBI), under the Companies Act, 1956 on March 17, 1997 thereby providing it with adequate operational flexibility and financial autonomy.
Besides project finance, IIBI also provides short duration non-project asset-backed financing in the form of underwriting/direct subscription, deferred payment guarantees and working capital/other short-term loans to companies to meet their fund requirements. During 1999-2000, while sanctions increased by 7.5% to Rs.23,381 million, disbursements declined by 14.7% to Rs.14,396 million. Up to end March 2000, IIBIs sanctions and disbursements aggregated Rs.1,00,898 million and Rs.72,526 million respectively. As at end-March 2000, assistance of Rs.39,877 million was outstanding. During the year, sanctions for asset creation increased by 7% to Rs.15,917 million, constituting 68.1% of the total. Sanctions by way of rupee loans at Rs.11,944 million constituted 75% of total assistance under asset creation, followed by direct subscription to shares and debentures of industrial concerns at Rs.3478 million (21.8%). Sanctions by way of rupee loans recorded an increase of 44.6%. Disbursements for asset creation totalled Rs.8749 million, forming 60.8% of total disbursements. Disbursements by way of rupee loans increased by 2.9%, while by way of direct subscription to shares and debentures declined by 37.5%. 3.5.3 Industrial Financial Corporation Of India (IFCI) IFCI was set up in the year 1948 to promote institutional credit to medium and large industries. The main functions are direct financial support to industrial units for undertaking new projects, expansion, modernization, diversification etc., subscription and underwriting of public issues of shares and debentures, guaranteeing of foreign currency loans and also deferred payment guarantees, merchant banking, leasing and equipment finance. Industrial Financial Corporation of India has played a vital role in the development of cooperatives in the sugar and textiles industries. It has founded and developed institutions such as the Management Development Institute (MDI), the Investment and Credit Rating Agency (ICRA), the Tourism Finance Corporation of India (TFCI), and the Rashtriya Gramin Vikas Nidhi. Functions of IFCI (1) Project Financing One of the main functions of the IFCI is to fund green field projects. The financial assistance is provided by way of medium or long term credit for setting up new projects, expansion or diversification of business, modernization of existing business etc. (2) Financial Assistance The IFCI assisting various fund based schemes. The various fund based products offered are equipment finance, leasing and hire purchasing and so on.
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(3) Corporate Advisory Services It provides the customized services in the area of investment appraisals, corporatisation, disinvestment, business restructuring, bid process management and formation of joint ventures. (4) Corporate Advisory Services to Foreign Investors IFCI provides a comprehensive range of services to prospective foreign investors in the various fields like facilitating the foreign business entities through information services, necessary office infrastructure for the start up operations of the project, coordination for obtaining the required approval, full filling all legal compliances etc. Due to the challengeable and highly risky projects handled by the IFCI started reporting losses from the year 1999 onwards in addition to these it has faces many difficulties such as operational inefficiency, traditional sector financing, political interference, higher rate of non-performing assets. The IFCI has initiated the process of restructuring of liabilities and is negotiating with the investors for reduction of interest rate on deposit and bonds. IFCI also initiated actions against those defaulted the loans. 3.5.4 The Export Import Bank Of India (EXIM) The Export Import Bank of India is a public sector financial institution was set up in the year 1981. The main objective of this bank is financing, facilitating and promoting Indias trade and commerce, provides the project finance, Trade finance, Exim bank also act an intermediary for facilitating the forfeiting transaction between the Indian exporter and the overseas forfeiting agency etc. Export Import Bank of India is also known as Exim Bank of India and was established by an Act passed by the Indian Parliament in September, 1981. Export Import Bank of India is fully owned by the Indian government and it started its operations in March, 1982. The major objectives of Export Import Bank of India are to provide economic assistance to importers and exporters and to function as the apex financial institution. Its services include export credit, overseas investment finance, agri & SME finance, film finance and finance for units that are export oriented. The total amount of loans disbursed by Export Import Bank of India amounted to Rs. 150,389 million in 2005- 2006 and in the following year, this figure increased to Rs. 220760 million The net profit of the Bank came to around Rs. 2707 million in 2005- 2006. In the following year this figure increased to Rs. 2994 million. The head office of Export Import
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Bank of India is located in Mumbai and its regional offices are located at Pune, Kolkata, Hyderabad, New Delhi, Bangalore, Chennai and Ahmedabad. The Banks overseas offices are located at London, Washington D.C., Dakar, Dubai, Singapore and Johannesburg. 3.5.5 Tourism Finance Corporation Of India (TFCI) TFCI was incorporated as a Public Limited Company under the Companies Act, 1956 on 27th January 1989 and became operational with effect from 1st February 1989 on receipt of Certificate of the Commencement of Business from the Registrar of Companies. TFCI has been notified as a Public Financial Institution under section 4A of the Companies Act, 1956. Tourism Finance Corporation of India Ltd. (TFCI) provides project-related services and tourism-related studies/ services. TFCI provides financial assistance to enterprises for setting up and/or development of tourism-related projects, facilities and services, such as hotels, holiday resorts, multiplexes and entertainment centers, education and sports, safari parks, rope-ways, cultural centers and convention halls. TFCI has been providing consultancy services to different central and state agencies by undertaking assignments to cover macro and micro level tourism-related studies/exercises to facilitate identification, conceptualization, promotion/implementation of specific tourismrelated projects and for taking policy level decisions with respect to investment and infrastructure augmentation. TFCIs range of activities in the consultancy division covers tourism-related studies, surveys and project-related services. Resource mobilization TFCI has been mobilizing resources through a combination of debt and equity. It made a public issue of equity shares in 1994. TFCIs shares are listed in National Stock Exchange, Mumbai, Delhi, Ahmedabad and Madras stock exchanges and dematerialised with National Securities Depositories Ltd. (NSDL and Central Securities Depository Services (I) Ltd. (CSDSL). Besides the paid up capital of Rs. 67.42 crores and the internal generations, TFCI meets its requirements of funds by way of borrowings viz. private placements of bonds, line of credit from institutions /banks, certificate of deposit etc, at competitive rates with a view to keep the cost of funds at minimum level. TFCI provides all forms of financial assistance for new, expansion, diversification/ modernization projects in tourism industry and/ related activities, facilities and services, in the following forms:
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Rupee Loans Underwriting of public issues of share/ debentures and direct subscription of such securities Guarantee for deferred payments and credits raised in India and/or abroad Equipment Finance Equipment Leasing Assistance under Suppliers of Credit Advisory Services
3.6 REFINANCE INSTITUTIONS 3.6.1 Small Industrial Development Bank of India (SIDBI) SIDBI was established by passing an Act under parliament in the year 1989. The SIDBI provides services such as the principal financial institution for the promotion, financing and development of industries in the small scale sectors and to coordinate the functions of other institutions engaged in similar activities Services Providing by SIDBI (1) Refinances Loans granted by PLIs for new SSI projects and for expansion, technology upgradation, modernisation, quality promotion. Loans sanctioned by PLIs to small road transport operators, qualified professionals for self-employment, small hospitals and nursing homes and to promote hotels and tourism-related activities.
(2) Directly finances SSI units for new/expansion/diversification/modernisation projects. Marketing development projects which expand the domestic and international marketability of SSI products. Existing well-run SSI units and ancillaries/sub-contracting units/ vendor units for modernisation and technology upgradation. Infrastructure development agencies for developing industrial areas. Leasing and hire purchase companies for offering leasing/hire purchase facilities to SSI units. Existing export-oriented units to enable them to acquire ISO-9000 Series Certification SSIs to obtain credit rating from accredited credit rating agencies. Small scale entrepreneurs using innovative indigenous technology and expertise
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SIDBI provides foreign currency loans to Import equipment by existing export-oriented SSIs and new units having definite plans for entering export markets. Execute confirmed export orders by way of pre-shipment credit/letter of credit and provides post-shipment facilities. 3.6.2 National Bank For Agriculture And Rural Development (Nabard) NABARD also came into exist in the year 1982 by an Act of parliament. It serves as an apex refinancing agency for the institutions providing investment and credit for promoting development activities in rural areas, coordinates and supervise the rural financing activities of all institutions engaged in developmental work etc,. Functions of NABARD: 1. Serves as an apex financing agency for the institutions providing investment and production credit for promoting the various developmental activities in rural areas. 2. Takes measures towards institution building for improving absorptive capacity of the credit delivery system, including monitoring, formulation of rehabilitation schemes, restructuring of credit institutions, training of personnel, etc. 3. Co-ordinates the rural financing activities of all institutions engaged in developmental work at the field level and maintains liaison with Government of India, State Governments, Reserve Bank of India (RBI) and other national level institutions concerned with policy formulation 4. Undertakes monitoring and evaluation of projects refinanced by it. 5. NABARDs refinance is available to State Co-operative Agriculture and Rural Development Banks (SCARDBs), State Co-operative Banks (SCBs), Regional Rural Banks (RRBs), Commercial Banks (CBs) and other financial institutions approved by RBI. While the ultimate beneficiaries of investment credit can be individuals, partnership concerns, companies, State-owned corporations or cooperative societies, production credit is generally given to individuals. NABARD has its head office at Mumbai, India NABARD operates throughout the country through its 28 Regional Offices and one Sub-office, located in the capitals of all the states/union territories.Each Regional Office[RO] has a Chief General Manager [CGMs]as its head, and the Head office has several Top executives like the Executive Directors[ED], Managing Directors[MD], and the Chairperson.It has 336 District Offices across the country, one Sub-office at Port Blair and one special cell at Srinagar. It also has 6 training establishments.
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3.7 SPECIALIZED FINANCIAL INSTITUTIONS 3.7.1 Infrastructure Development Finance Company (IDFC) IDFC was established in the year 1997 with the intention to promote consultancy and advisory services to state governments for formulating a power sector strategy, to integrate the entire logistics chain in India, to provide the financial assistance to various telecommunication and Information Technology sectors, providing finance and project services for the development urban infrastructure and so on Infrastructure Development Finance Company (IDFC) is a leading infrastructure financing institution providing a wide range of financing products and fee-based services to infrastructure projects and their sponsors. The company works closely with government entities and regulators-central and state, in India to advise and assist in formulation policy and regulatory frameworks in infrastructure development. Functions of IDFC (a) Exclusive focus on infrastructure and leading innovator in infrastructure financing: the company has been founded with the sole objective of providing and promoting private financing of Indian infrastructure. The company has extensive domain knowledge, particularly with regard to project structuring appraisal and risk evaluation. (b) Advisory Role: The Company has strong relationship with the Government that gives access to decision makers in government entities and multilateral development agencies. As a result, the company plays a significant role in the direction of infrastructure policy in the country. (c) Strong Asset Quality: IDFC has the strongest asset quality position that has been achieved due to its strong credit and project appraisal skills and disciplined risk management practices. The company has 0.7% gross and zero net non-performing assets as of March 31, 2004 and 2005. (d) Low Administrative Expenses: The Company has very low establishment and administrative expenses, being only 0.4% of average total assets as of March 31, 2005. (e) Risk Management: The Company has a Project Finance Group, responsible for monitoring credit risk at the transaction level. The Risk Management Group is responsible for managing the portfolio credit risk, market risk and operational risk. These groups are independent from business development groups. The current policy of the company is to limit exposure to any particular sector to 50 percent of total assets. The company has the policy to limit exposure to a single borrower and to a group to 20% and 50% of total capital funds (comprising Tier-I and TierII capital) on their contractual obligations.
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3.7.2 IFCI Venture Capital Funds IFCI Venture Capital Funds Ltd. (IVCF) was originally set up by IFCI as a Society by the name of Risk Capital Foundation (RCF) in 1975 to provide institutional support to first generation professionals and technocrats setting up their own ventures in the medium scale sector, under the Risk Capital Scheme. In 1988, RCF was converted into a company, Risk Capital and Technology Finance Corporation Ltd. (RCTC), when it also introduced the Technology Finance and Development Scheme for financing development and commercialisation of indigenous technology. To reflect the shift in the companys activities, the name of RCTC was changed to IFCI Venture Capital Funds Ltd. (IVCF) in February 2000. Over the years, IVCF has provided financial assistance to new ventures, supported commercialisation of new technologies, helped in widening entrepreneurial base in the country. It is IVCF who has catalysed introduction of concept of venture capital activity in India. 3.7.3 ICICI Venture Capital Fund ICICI Venture (formerly TDICI Limited) was founded in 1988 as a joint venture with the Unit Trust of India. Subsequently, ICICI bought out UTIs stake in 1998 and ICICI Venture became a fully owned subsidiary of ICICI. ICICI Venture also has an affiliation with the Trust Company of the West (TCW), which provides it a platform for networking Indian companies with global markets and technology. Strong parentage and affiliates for ICICI Venture also translates into access to a broad spectrum of financial and analytical resources thus enabling a keen understanding of the Indian financial markets and entrepreneurial ethos. Financial year 2002-3 was a landmark year for ICICI Venture. ICICI Venture raised the largest Indian Private Equity Fund and also engineered effective exits and enhanced the value of its existing portfolio. ICICI Venture Funds launched four new domestic funds whereas six existing funds under management were either liquidated or were in the process of liquidation. The most significant achievement of ICICI Venture was the successful First Closing of the Rs. 750 billion India Advantage Fund launched this year.
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Source: www.icicibank.com 3.8 MERCHANT BANKING A merchant bank is a bank whose function is to provide long term equity and loan finance for industrial and other companies, particularly new securities. Merchant Banker acts as a financial intermediary in providing long term finance to the corporate. The merchant banks are called as investment banks in United State of America. Functions of Merchant Banks (1) Management of issue of corporate securities of existing companies and newly floated companies. (2) Offering financial expertise in merger, takeover, capital reorganization to corporate sectors (3) Management of Investment trusts
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(4) Handling insurance business (5) Loan syndication and corporate advisory services (6) Portfolio management (7) Custodial and Depository Services (8) Broking the corporate securities (9) Advise for foreign funds mobilization (10) Liquidity management (11) Underwriting commission (12) Leasing and financing (13) Acting as trustees for debentures issue (14) Mobilization of funds and maintenance of funds (15) Venture capital financing arrangement. Merchant bankers require compulsory registration with SEBI to carry out the merchant banking activities. In case of category I merchant banker the registration fee is Rs 2.50 lac and the same amount has to pay every year as renewal fee. In case of category II Rs 1.50 lac at the time of registration and for the first two years and Rs 50,000 for the third year. In case category III Rs 1.00 lac annually for the first two years and Rs 25,000 for the third year and category IV Rs 50,000 annually, for the first two years and Rs 1,000 for the third year. These fees are subject to change as per SEBI. Category I merchant bankers means - minimum net worth as per SEBI is Rs 5 crore Category II merchant bankers means - minimum net worth as per SEBI is Rs0.50 crore Category III merchant bankers means - minimum net worth as per SEBI is Rs 0.20 crore Category IV merchant bankers means minimum net worth as per SEBI is Rs nil. A merchant banker who is associated with the issuer company as a promoter or director or associate director should not lead or manage its issue. However, a merchant banker holding securities of a company can lead or manage its issue if the securities are proposed to be listed on the OTCEI and market makers have been proposed to be appointed as per the offer document. The maximum number of lead managers is related to the size of the issue. For example an issue of a size less than Rs 50 crore, two lead managers are appointed. For the size group of Rs 50 crore to Rs 100 crore and Rs 100 crore to 200 crore the maximum permissible lead managers are three and four respectively. In case of issue size is in between Rs 200 crore to Rs 400 crore five lead manages and if the size still increases then maximum number if lead managers will be five or more. We have list of merchant banker in India and whose ranking in the business of merchant banking as follows:
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Ranking of Merchant Banking in India
Note: OE: Overall Excellence; FSS: Financial Soundness; QPS: Quality Product/Service; QM: Quality Management; INN: Innovativeness. 3.9 VENTURE CAPITAL The Venture Capital (VC) Industry is a major source of funding for the entrepreneurial community. The industry itself has evolved over a number of years, but has only recently emerged as a popular career for many professionals. The industry focus is on early stage, pre-IPO funding opportunities. Typically a fund will be raised, that will be invested in a number of different opportunities that are reasonably high risk. In return for the investment, the VC receives an equity stake in the business. The VC also helps the business develop its management team, and takes seats on the board of the company. VCs are typically interested in making few large investments, due to the manpower needed to support each investment (recruiting and board seats). They focus not only on the business opportunity that is presented to them, but closely on the management team that is offered. In order for an entrepreneur to have an audience with a VC, s/he needs to have a pre-existing connection (a reference to the VC). Without this, the VC is unlikely to review the business plan. This further supports the notion that the VC and entrepreneurial community in Silicon Valley is a ecosystem that benefits from the mutual relationships that are already established, and is resistant to outsiders looking in A recent growth of alternative sources of pre-IPO investment is coming from Angel Investors. These are typically successful entrepreneurs (cashed out) who are looking for additional investment opportunities in order to remain connect to entrepreneur community. Venture capital provides a source of funds through investment, usually in panies or projects that are start-up or at a very early stage of product development. These projects and organizations usually would not attract sources of finance such as loans and could not
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raise money in the major public stock markets (such as the London Stock Exchange). Limited equity capital is available to some early companies via AIM or Ofex markets. Definition Venture capital can be defined as funds that are generally invested in the form of equity or quasi-equity which rarely affords any guarantee. Investments may take the form of simple shareholders equity (common or preferred shares), as well as options, warrants, convertible debentures and other vehicles. The structure of the investment generally depends on the companys needs and its stage of development, taking into account the objectives of both the entrepreneur and the investor. As a result, this form of financing is risky, which the investor hopes will be offset by a proportional return on his investment. The return is generally realized out of the capital gain or the increase in the companys share value. Investment strategy of the Venture capital companies With respect to investment strategy, venture capitalists have this in common: 1. They all strive to invest their money in companies that offer strong growth potential and a promising strategic position on their respective markets. 2. They Endeavour to increase the value of their investments by providing the entrepreneur with capital, of course, but also with the expertise, the network and the experience necessary to accelerate the companys growth. 3. They invest for the medium and long term, in order to develop the companys potential to the fullest and thus maximize the return for all shareholders. The usual mechanism for venture investment is through the formation of a new company. The company will own rights to the intellectual property (patents etc.) that stem from earlier research activities and will probably employ or have consultancy contracts with the scientists behind the research work. The venture capital firm buys a shareholding in the new company, thereby providing the company with money for development work. Frequently, more than one venture capital firm may invest in a company, even at an early stage in its development. Venture capital firms are often instrumental in assisting the founders to develop their business. This may involve a range of activities including: (a) strengthening and broadening the management team by recruiting individuals wit specific expertise (b) working with the management team to raise further finance from other investors or by listing on a stock exchange combining specific technologies or projects to expand the companys portfolio
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Advantages of Venture Capital (i) Because the investment is in the form of capital, the companys financial structure and financial ratios are improved accordingly, giving the entrepreneur the necessary flexibility and financial capacity to achieve his objectives; (ii) Little or nothing to repay in the short term, so that the capital invested and funds generated internally can be used exclusively to accelerate the companys growth; (iii) In most leveraged buy-outs and start-ups, it is the principal source of financing available; (iv) The venture capitalist is not there to manage the company, but to stimulate its growth through active strategic support and constructive involvement, by giving the entrepreneur the benefit of his own experience as well as that of his business network; (v) Easier access to additional capital should the need arise. Types of finance (1) Equity Finance The venture capital undertakings generally requires funds for a longer period but may not be able to provide returns to the investors during the initial periods. Therefore the venture capital finance is generally provided by way of equity share capital . (2) Conditional Loan A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India venture capital financiers charges royalty ranging between 2 and 15 percent. (3) Income Note It is a hybrid method of funding which combines the features of both conventional laon and conditional loan. The entrepreneur has to pay both the interest and royalty on sales but at substantially low rates. (4) Participating Debentures The participating debentures means which carries charges in three phases in the start up phase no interest is charged, next stage a low rate of interest is charged up to a particular level of operation, after that, a higher rate of interest is required to be paid. Returns of Venture Capital Company Venture capitalists need high returns on those projects that do succeed because not all projects they back will succeed. Venture firms normally manage money that originates in less-specialised investment institutions, such as those which manage pension funds. The venture capital companies need to deliver a good rate or return to those investors. In evaluating investment prospects, the venture capital firm will weigh up the various risks
(see due diligence), length of time their money is likely to be tied up, and the level of return they need to deliver to their investors. The value of a venture firms shareholding may increase as a new company grows but this is just paper money until there is an opportunity to sell the shares. Typically this comes when a company makes a public offering or when it is acquired by another company. Venture capital firms will expect to sell their shares at many times the price they originally paid. 3.10 CREDIT RATING Credit Rating is assessment of borrowers financial worth. Credit rating enables investors to draw up the credit risk profit and assess the adequacy or otherwise of the risk premium offered by the market. It is really helpful to the investor because of time saving and enables hi take a quick decision and provides him better choice among available investment opportunities. In India credit rating industries got prominent growth namely (a) Credit Rating Information Services of India Limited (CRISIL) (b) Investment Information and Credit Rating Agency of India Limited (ICRA) (c) Credit Analysis and Research Limited (CARE) In India the CRISIL is the market leader in the credit rating industry. In the year 1992 the RBI introduced compulsory requirement of Credit Rating. The SEBI followed the same pattern making it mandatory for bonds. For private placements, rating is not mandatory but banks and mutual funds ask for a rating. The credit rating industry really got good credit rating in the minds of investors because in 1997, the penetration of rating, that is the number of rated issues out of the total number of issues was 35%. In the year 2002, it was 97%. Now the credit rating agencies has transited from a regulatory driven market to an investor driven market. Rating Methodology The rating of financial instruments requires in depth analysis of relevant factors that affect the credit worthiness of the issuer. These analyses can be Business analysis, Financial analysis, Management evaluation and Fundamental analysis. Business Analysis means it covers it may be demand and supply, market position in the industry, operating efficiency of the production processes of the firm, its cost structure so on and so forth. Financial Analysis means accounting quality, income recognition, auditors remarks, off balance sheet items, earning protection, adequacy of cash flows, Audited profit and loss account and balance sheet of the firm, projections prepared and so on.
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Management Evaluation includes a study of track record of promoters, and the top management, managerial skills of the top management to overcome adverse situations, goals, philosophy, strategies. Fundamental analysis means liquidity management, asset quality, profitability management and tax brackets and so on. Rating symbols Investors attention is highly dragged by the credit rating agencies in India. Credit Rating is the assessment of a borrowers credit performance. Credit Rating helps investors to decide their investment pattern. Basically the credit rating has symbols which denote the performance or credit worthiness of the respective companies. These symbols may be AAA, AA, BBB, B, C, D to denote the performance of the respective companies to the investor. For example AAA which means Highest safety in terms of repayment of principal and interest and in case of BBB which means moderate safety in terms of timely payment of interest and principal. In India the rating will start with the request of the company, however, the Reserve Bank of India and Securities and Exchange Board of India made credit rating mandatory for the issue of commercial paper and certain categories of securities and debentures SEBI Regulations for Credit Rating Agencies in India As per the Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 (a) Only commercial banks, public financial institutions, foreign banks operating in India, foreign credit rating agencies, and companies with minimum net worth of Rs 100 crore as per its audited annual accounts for the previous five years are eligible to promote the credit rating agencies in India. (b) Rating agencies should have minimum net worth of Rs 5 crore (c) Rating agencies cannot assess financial instruments of their promoters who have more than 10 per cent stake in them. (d) Rating agencies cannot rate a security issued by an entity which is a borrower of its promoter or a subsidiary of its promoter or an associate of its promoter if there are common chairmen, directors between credit rating agencies. (e) Rating agencies cannot rate a security issued by its associate or subsidiary, if the credit rating agency or its rating committee has a chairman, director or employee, who is also a chairman, director or employee of any such entity. (f) SEBI has the power to cancel the certificate or impose the penalty if rating given by the rating agency proved false or if the agency fails to comply with any condition or contravenes any of the provisions of the act.
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3.10.1 Credit Rating Agencies in India 3.10.1.1 Credit Rating Information Services Of India Limited (Crisil) CRISIL was incorporated jointly by ICICI, UTI, GIC, United India Insurance Company, LIC and domestic and foreign companies as the first credit rating agency in India. CRISIL provides rating and risk assessment services to manufacturing companies, banks, non-banking financial companies, financial institutions, housing finance companies, municipal bodies and companies in the infrastructure sector. CRISILs comprehensive offerings include ratings for long-term instruments such as debentures/bonds and preference shares, structured obligations (including asset-backed securities) and fixed deposits; it also rates short-term instruments such as commercial paper programmes and short-term deposits. As part of bank loan ratings, CRISIL also rates credit facilities extended to borrowers by banks. In addition, CRISIL undertakes credit assessments of various entities including state governments. CRISIL also assigns financial strength ratings to insurance companies. CRISIL through the years has continued to innovate and play the role of a pioneer in the development of the Indian debt market. CRISIL has pioneered the rating of subsidiaries and joint ventures of multinationals in India and has rated several multinational entities, both start-up entities as well as players with a well established track record in India. Over the years, CRIS IL has also developed several structured ratings for multinational entities based on Guarantees from the parent as well as Standby Letter of Credit arrangements from bankers. The rating agency has also developed a methodology for credit enhancement of corporate borrowing programmes through the use of partial guarantees. In essence, CRISIL is uniquely placed in its experience in understanding the extent of credit enhancement arising out of such structures
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Milestones of the CRISIL
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source: www.crisil.com-milestones
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3.10.1.2 Investment Information And Credit Rating Agency Of India (Icra ICRA Limited (formerly Investment Information and Credit Rating Agency of India Limited) was set up in 1991 by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional Investment Information and Credit Rating Agency. Today, ICRA and its subsidiaries together form the ICRA Group of Companies (Group ICRA). ICRA is a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the National Stock Exchange. ICRA Limited (ICRA) ICRA Management Consulting Services Limited (IMaCS) ICRA Techno Analytics Limited (ICTEAS) ICRA Online Limited (Online) Range of Services of ICRA (1) As an early entrant in the Credit Rating business, ICRA Limited is one of the most experienced Credit Rating Agencies in the country today. ICRA Rates rupeedenominated debt instruments issued by manufacturing companies, commercial banks, non-banking finance companies, financial institutions, public sector undertakings and municipalities, among others. ICRA also Rates structured obligations and sector-specific debt obligations such as instruments issued by Power, Telecom and Infrastructure companies. The other services offered include Corporate Governance Rating, Stakeholder Value and Governance Rating, Rating of Claims Paying Ability of Insurance Companies,Poject Finance Rating, and Line of Credit Rating. (2) Recently, ICRA, along with National Small Industries Corporation Limited NSIC), has launched a Performance and Credit Rating Scheme for Small Scale Enterprises in India. The ervice is aimed at enabling Small and Medium Enterprises (SMEs) improve their access to institutionalcredit, increase their competitiveness, and raise their market standing. Grading Services (3) The Grading Services offered by ICRA employ pioneering concepts and methodologies, and include Grading of: Construction Entities; Real Estate Developers and Projects; Mutual Fund Schemes and Fund Houses; Healthcare Entities; Maritime Training Institutes; and Initial Public Offers (IPOs). The Grading of Construction Entities seeks to provide an independent opinion on the quality of performance of the entities Graded. Similarly, the Grading of Real Estate Developers and Projects seeks to make property buyers aware of the risks associated with real estate projects and with the developers ability to deliver in accordance with the terms agreed. ICRAs Mutual Fund Gradings aim at providing an independent opinion on the credit/performance risks associated with investing in various Mutual Fund schemes and on the managerial and governance quality of Asset Management Companies.
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(4) ICRAs Healthcare Gradings present an independent opinion on the quality of care provided by healthcare entities. In the education sector, ICRA offers the innovative service of Grading of Maritime Training Institutes in India. In IPO Grading, an ICRA assigned IPO Grade represents a relative assessment of the fundamentals of the issue Graded in relation to the universe of other listed equity securities in India. (5) Information Services: The Information Services Division focuses on providing authentic data and value-added products used by intermediaries, financial institutions, banks, asset managers, institutional and individual investors, and others. The Divisions portfolio of products includes sector/industry-specific studies/ publications, corporate reports, and mandate-based studies (customised research). (6) Advisory Services: ICRA Management Consulting Services Limited (IMaCS), a subsidiary of ICRA, offers wide-ranging management Advisory Services covering the areas of Strategy Practice, Risk Management Practice, Regulatory Practice, Transaction Practice, and Content. While Strategy Practice focuses on improving an organisations competitiveness across its value chain, Regulatory Practice advises clients like governments and regulators on formulation of economic and financial policies. Under Transaction Practice, IMaCS provides consulting service at a transaction level to infrastructure projects, while under Risk Management Practice advice is offered on the efficient management of risk to banks and other lenders. (7) Online Software and Business Process Outsourcing: ICRA Online Limited, a subsidiary of ICRA, provides technology solutions, both in the form of products and services, targeted at distributors of third-party financial products, insurance brokers, and stock broking houses. The Business Process Outsourcing (BPO) Division of ICRA Online serves financial services companies, financial institutions, investment banks, private equity and venture capital funds, boutique investment advisors, market researchers, financial information vendors, consulting companies, and the like. The focus is on high-end knowledge processing like financial modelling, data analysis, valuation, outsourced research, equity research, fixed income research, financial assets pricing, financial report writing, and econometric analysis. (8) Software Development: ICRA Techno Analytics Limited (ICTEAS), a subsidiary of ICRA, offers a complete portfolio of Information Technology (IT) solutions to meet the dynamic needs of present day businesses. The services range from the traditional development of client-server, web-centric and mobile applications to the generation of cutting edge business analytics. An in-depth knowledge of various technology areas enables ICTEAS provide end-to-end services of excellent quality. ICTEAS uses a mix of onsite/offshore strategies to optimise bottom-line benefits for its customers. 3.10.1.3 Credit Analysis And Research Limited (Care) Credit Analysis & Research Ltd. (CARE Ratings) is a full service rating company that offers a wide range of rating and grading services across sectors. CARE has an unparallel depth of expertise. CARE Ratings has completed over 3850 rating assignments having aggregate value of about Rs 8071 billion (as at December 2007), since its inception in
April 1993. CARE is recognised by Securities and Exchange Board of India (Sebi), Government of India (GoI) and Reserve Bank of India (RBI) etc. CARE was promoted by major Banks/FIs (financial institutions) in India. The three largest shareholders of CARE are IDBI Bank, Canara Bank and State Bank of India. CARE, is set-up with two divisions: 3.11 FACTORING SERVICES Factoring is a unique service which is providing by factor to his clients. The concept of factoring is very popular mechanism of managing, financing and collecting receivables in developed countries like USA and UK and has extended to number of other countries in the recent past including India. Nature of Factoring: Factoring is an innovative financial and management support to a client. It is basically a method of converting a non productive, inactive asset namely receivables into a productive asset namely cash by selling receivables to a company that specializes in their collection and administration. As per this arrangement, the person purchase the firm receivables is called factor and the person selling the receivables (ie Sundry Debtors) is called seller or client. The person who purchases the goods from the seller is called purchaser. Now we will understand in a better manner the definition of factoring as a business involving a continuing legal relationship between a financial institution (the factor) and a business concern (the client) selling goods or providing services to trade customer (the buyer) where by the factor purchases the clients accounts receivable and in relation thereto, controls the credit, extended to customers and administers the sales ledger. The Factoring business allowed to the subsidiary of nationalized banks. Since 1991 factoring services areoffering by SBI Factors (a subsidiary of the SBI) and Canbank Factors Limited (a subsidiary of Canara Bank) Thus factoring means a contract between the suppliers of goods or service and the factor.
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Factoring Services or Functions (1) Credit Administration A factor provides full credit administration services to his client. Since the factory maintains an account for all customers of all items owing to them, they have effective control over it so that collection of dues can be made on or before due date. Factor will inform to the client about the balances in the account, the overdue bills, the financial standing of the buyers and so on. (2) Credit Collection and protection The factor will collects the receivables on behalf of his client and relieves him from the botheration of the bad debts and collection administration and so on. This helps to the client to concentrate more on productivity. (3) Financial Assistance Factoring concept came to meet the financial needs of the firms. On account of purchase of the book debts and receivables from the client the factor will pay part amount or full amount depends upon the factoring agreement. (4) Other functions or services In developed countries like the USA or UK , factor provides multiple services namely providing information on prospective buyer, providing financial counseling, assisting the client in managing its liquidity and preventing sickness, financing acquisition of inventories and providing facilities for opening letter of credit by the client and so on. Types of factoring (1) Notified Factoring In this type of factoring, the customer is intimated about the assignment of debt to the factor and also directed to make payments to the factor instead of the firm. Then the buyer (customer) will make the payment to the factor. (2) Non- notified or confidential Factoring This type of factoring provides that facility to the seller the agreement between him and factor is not disclose to this buyer namely customer. (3) Factoring With-Recourse or Without-Recourse Whether notified Factoring or not can be classified into with recourse factoring and without recourse factoring. In case of with recourse factoring the seller will carry the credit risk in respect of receivables he sold to the factor. The factor will have recourse in the
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event of non payment for whatever reason including the financial inability of the buyer (ie customer). In the case of without recourse factoring the bad debts are borne by the factoring agent or factor. (4) Credit Factoring or Invoice Factoring In this type of factoring the factor purchase the book debts with recourse to the seller and provides finance, interest will be charged by the factor until the bill amount is collected from the buyer of goods. (5) Maturity Factoring It means the seller will handed over the receivables to the factoring but the money will pay by the factor only after collected from the buyer. It is nothing but receivables sent for collection. Benefits of Factoring a) The factor performs the basic functions of administrating the book debts, credit control and collection dues and so on. b) The factor facilitates to reduce the operating cycle by providing the cash in advance ie before due date i) Firms can improve their financial liquidity position and concentrate more on the business activities rather than to waste the valuable time to spend on debtors collection. ii) Due to professionalism and experience of the factor, client will get sound advises on the critical areas like product design, production methods, product mix and so on. iii) Seller can avail the finance from the factor (who pays up to 80% to 95% of the receivable value). The problem of additional working capital does not arise. Illustration 1 A small firm has a total credit sales of Rs 80 lakh and its average collection period is 80 days. The past experience indicates that bad-debt losses are around 1 per cent of credit sales. The firm spends about Rs 1,20,000 per annum on administering its credit sale. This cost includes salaries of one officer and two clerks who handle credit checking, collection, etc., telephone and telex charges. These are avoidable cost& A factor is prepared to buy the firms reveivables. He will charge 2 per cent commission. He will also pay advance against receivables to the firm at an interest rate of 18 per cent after withholding 10 per cent as reserve. What should the firm do?
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Answer: Rs 80 lacs Average level of Receivables = x 80 days = Rs 17, 77,778 360 days Factoring commission Reserve Advance available Advance to be paid = 2% x 17,77,778 = Rs 35,556 = 10% x 17,77,777 = Rs 1,77,778 = Rs 17,77,778 35,556 = Rs15,64,444 = Rs 15,64,444 (18% x 15,64,444 x 80/360) = Rs 15,01,866 Total factoring charges = Rs 35,556 x 360/80 = (comm. + interest) = Rs 62,578 x360/80 = Rs 1,60,002 Rs 2,81,601 Rs 4,41,603
Less firms savings Cost of credit administration Bad debts
Rs2,00,000 Net cost on account of factoring Rs 2,41,603 ========== Effective rate of return = 2,41,603 / 15,64,444 = 15.44% Cost of factoring is 15.44% this can be compare to the other possible source of cost and take the appropriate decision. 3.11.1 International Factoring International Factoring means it is a comprehensive range of receivables management. International factoring is essential to an exporter who requires factoring services to relax from the problems of collecting receivables in a foreign country and tensions arising from the unfamiliarity with customers credit worthiness. Under this type of factoring generally four parties are involved (i) Exporter (seller),(ii) Factor in the exporters Country (iii) Importer and (iv) Factor in the Importers country.
= 1,20,000 = 80,000
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3.11.2 Forfaiting: It means discounting of international trade receivable on 100% without recourse basis. Forfaiting is advantageous to the exporter who converts his export sales receivables into cash sales. Basically it is non-recourse and off-balance sheet financing. It eliminates all risks from the exporters mind. Forfaiting acts as elimination of interest rate fluctuation as it involves upfront discounting. 3.12 LEASING AND HIRE PURCHASE 3.12.1 Leasing Introduction: Lease financing denotes procurement of assets through lease. Leasing business has got tremendous popularity in the USA and UK and spread to other countries including India.. In India, the concept was pioneered in 1973 when the First Leasing Company was set up in Madras. Lease as a concept involves a contract whereby the ownership, financing and risk taking of any equipment or asset are separated and shared by two or more parties. Thus, the lessor may finance and lessee may accept the risk through the use of it while a third party may own it. Alternatively the lessor may finance and own it while the lessee enjoys the use of it and bears the risk. There are various combinations in which the above characteristics are shared by the lessor and lessee. A lease transaction is a commercial arrangement whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The important feature of a lease contract is separation of the ownership of the asset from its usage. Lease financing is based on the observation made by Donald B. Grant: Why own a cow when the milk is so cheap? All you really need is milk and not the cow. As per the Accounting Standard 17 issued by the Institute of Chartered Accountants of India, defines the term lease as an agreement whereby a lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time. Lease finance can be said to be a contract between lessor and lessee whereby the former acquires the equipment or goods or plant as required and specified by the lessee and passes on the goods to the lessee for use for a specific place and in consideration promises to pay the lessor a specified sum in a specified mode at specific interval and at a specified place.
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Features of Lease The important features of lease contract are as follows (a) the lease finance is a contract (b) the parties involved in the contract are lessor and lessee (c) the lease pertaining the specified period of time (d) the lessee uses the equipments under lease for a specified period of time (e) the lessee in consideration pays the lease rentals to the lessor (f) the lessor is the owner of the asset even though the asset is used by the lessee for a specified period of time. Types of Leases Basically there are two types of leases namely (1) Financial Lease and (2) Operating lease. The other types of lease depends upon the lease agreements which may be (3) sale and lease back (4) leveraged leasing and (5) sales aid leasing. (1) Financial Lease Long-term, non-cancelable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as capital lease. In India, financial leases are very popular with high-cost and high technology equipment. (2) Operating Lease An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets.
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Characteristics of Operating Lease (1) The lease can be canceled by the lessee prior to its expiration. (2) The lessor is undertaking the maintenance and up keep the asset (3) The lessee is not given any right to purchase the asset at the end of the lease period (4) The sum of all the lease rental paid by the lessee need not provide for the recovery of the cost of the assets (5) The lessor has the option to lease out the asset again to some other party. (3) Sale and lease back: It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. Under this transaction, the seller assumes the role of a lessee and the buyer assumes the role of a lessor. The seller gets the agreed selling price and the buyer gets the lease rentals. It is possible to structure the sale at agreed value (below or above the fair market price) and to adjust difference in the lease rentals. Thus the effect of profit /loss on sale of assets can be deferred. (4) Leveraged Lease: Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset. (5) Sales aid leasing: A leasing company will enter into an agreement with the seller, usually manufacturer of the equipment, to market the latters product through its leasing operations. The leasing company will also get commission for such sales, which add up to its profits.
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Advantages of leasing: (1) From the view point of lesee: (a) It permits the lessee for altenative use of funds without incurring huge capital investment on an asset (b) It helps to conserve the funds which can be used to improve the liquidity and can be used for some other urgent purposes (c) The lessee can get lease finance upto 100% of the cost (d) It is an easy method of financing capital asset having a heavy cost involved (e) lease rentals are deductible expenses for getting income tax benefits. (2) From the view point of Lessor: (a) It is an asset based financing for a productive purpose and it is safer than normal course of financing business. (b) The Lessor can claim depreciation and will also enjoy the tax benefit (c) Lease rentals provide regular income and there is no liquidity problem. Disadvantages from the leasing business (1) The main disadvantage is accounting procedure and accounting guidelines (2) lease financing compare to other methods is costly for the lessee (3) The financial lease has all the rigidities of other methods of financing (4) As the lessee is not the owner of the asset generally he wound not take care the maintenance of the machine or equipment. 3.12.2 Hire Purchase Hire purchase is a type of installment credit under which the hire purchaser, called the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase. Under this transaction, the hire purchaser acquires the property (goods) immediately on signing the hire purchase agreement but the ownership or title of the same is transferred only when the last installment is paid. The hire purchase system is regulated by the Hire Purchase Act 1972. This Act defines a hire purchase as an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement and includes an agreement under which: (1) The owner delivers possession of goods thereof to a person on condition that such person pays the agreed amount in periodic installments. (2) The property in the goods is to pass to such person on the payment of the last of such installments, and (3) Such person has a right to terminate the agreement at any time before the property so passes.
Hire purchase should be distinguished from instalment sale wherein property passes to the purchaser with the payment of the first instalment. But in case of HP (ownership remains with the seller until the last instalment is paid) buyer gets ownership after paying the last instalment. HP also differs form leasing Small scale firms can acquire industrial machinery, office equipment, vehicles, etc., without making full payment through hire purchase. With the help of assets acquired through hire purchase they can produce and sell. From the earning payments can easily be made in installments. Ultimately the ownership of assets can be acquired. Now several agencies like National Small Industries Corporation (NSIC) provide machinery and equipment to small scale units on hire purchase basis and on lease basis. NSIC follows the following Hire Purchase procedure and Hire Purchase Scheme for financing plant and machinery to small scale units. The concept of the hire purchase has been presented as below:
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Source: lesson 15 Rekha Rani
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Difference Between Lease Financing and Hire Purchase
SUMMARY Development Banks are basically financial agencies that provide medium and long term funds and acts as catalytic agents in promoting balanced development of the country. Development Banks the name it self contain the development which means increase or accelerate the growth of an economy which will leads to increase the Gross Domestic Product. Therefore, Development banks take risks that ordinary banks will not. Development Banks (1) Industrial Development Bank of India (IDBI) (it became commercial bank from 1st October 2004) (2) Industrial Investment Bank of India (IIBI) (3) Industrial Financial Corporation of India (IFCI) (4) The Export Import Bank of India (EXIM) (5) Tourism Finance Corporation of India (TFCI)
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Refinance Institutions. (1) Small Industrial Development Bank of India (SIDBI) (2) National Bank for Agriculture and Rural Development (NABARD) Investment Institutions or Investment Banks (1) Mutual Fund Companies (2) Pension Funds (3) Insurance Companies etc, Note: we have elaborately discussed regarding above banks in the Unit V Specialized Financial Institutions (4) Infrastructure Development Finance Company (IDFC) (5) IFCI Venture Capital Funds (6) ICICI Venture Capital Fund Apart from the above we also have state level institutions which are as follows: (1) State Financial Corporations (2) State Industrial Development Corporations (SIDCs) etc, By this time we have come across the concept of development bank and financial institutions. SELF EXAMINATION QUESTION Problem 1: The past experience indicates that bad debt losses are 1.5% on sales. The expenditure incurred by the firm in administering its receivable collection efforts are Rs 5 lacs. A factor is prepared to buy the firms receivables by charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as reserve. Calculate the effective cost of factoring to the firm and effective interest rate to the firm. Problem 2 A factory needs equipment for use. It has the option of outright purchase or leasing the equipment. Data are given below. Recommend the best option that the factory should choose. Option I Purchase outright for a cost of Rs 80 lacs. It is to be entirely financed by a term loan @ 18% p a. interest on outstanding payable on a yearly basis. The term loan to be repaid in eight equal instalments of Rs 10 lacs each, beginning from second year-end. The economic
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life of the equipment is assessed to be ten years. The equipment will be depreciated @ 10% p a on straight line basis, with insignificant salvage value at the end of the economic life? The essential maintenance express would be as detailed below: Year 1 2 3 4 5 6 7 8 9 10 Option II The equipment may be leased for a ten year period. The maintenance of the equipment will be done by the lessor. The lessee has to be pay Rs 8 lac annual rental at the beginning of each year over the lease period Note: Assume that the lessee is in a tax bracket of 50% and average cost of capital of the lessee firm as 14% p a. Present value table factor for discounting @ 14% pa given below may be used for ready reference. 1 2 3 4 5 6 7 8 9 10 0.877 0.769 0.675 0.592 0.519 0.465 0.400 0.351 0.308 0.270 THEORY QUESTIONS (1) Explain the list of Development and specialized banking institutions (2) Explain the Regional Rural Banks in India (3) Please explain term Venture capital and how it works (4) Who is a merchant banker? what is his role in the Indian Financial System? (5) Define the term lease and explain the leasing business (6) What do you mean Hire purchasing? Explain with suitable examples. (7) Distinguish between the hire purchase and leasing (8) What are the advantages we have in case of leasing and hirepurchase? (9) Explain the concept of factoring and its advantages (10) Explain the concept of factoring. (11) Write short note on ForfeitingInternational Factoring Maintenance Cost in Rs lacs 4.00 4.40 4.88 5.47 6.18 7.05 8.11 9.41 11.01 13.00
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NEW ISSUE MARKETS

4.1 INTRODUCTION Companies incorporated under the Companies Act, 1956 are generally mobilising the share capital and other long term loan funds from out side the organization for capital formation. Generally the procurement of funds will take place through the securities market which has two inter-dependent and inseparable segments namely New Issues Market and the Secondary Market. The securities market, however, refers to the markets for those financial instruments or claims that are commonly and readily transferable by sale. 4.2 LEARNING OBJECTIVES: (1) Understand the new issue market and secondary market (2) After reading this you should be familiar with the primary stock market and secondary market (3) Understand various methods of mobilization of funds through new issue. (4) Know the SEBI guidelines for investors protection. 4.3 NEW ISSUE MARKETS: New issue market is also very often called as primary market. The primary market facilitates the channel for sale of new securities whereas the secondary market deals with in securities previously issued. Companies mobilized the funds with the cheaper cost to maximize the profit of the organization. To provide the funds for the new projects as well as for the existing projects with the intention to expansion, or modernization, diversification and up-gradation of the technology, companies choose the channel of primary market by issuing the new securities. The source of mobilizing the funds by issuing the securities can be take place in any one of the following manner or on combination of all.
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No doubt the new issue market (NIM), become the predominant channel for financing corporate sector investments in India after the liberalization of the capital market from the year 1992. New issue market can be defined as a market that issues new securities on an exchange. Companies, governments and other groups obtain financing through debt or equity based securities. Primary markets are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. As we know that only public limited companies can issue securities to public. Private limited companies should not issue their shares to public. At this point of time it is worthy to know some thing about the Primary Stock Market and Primary Stock Market. 4.3.1 Primary Stock Market Primary stock market also called as public issues. New capital can be raise by issuing of equity shares, preference shares, debentures or Right Issues by corporates. Newly floated companies or existing companies may tap the equity market by offering public issues. When equity shares are exclusively offered to the existing shareholders, it is called Rights Issue. When a Company after incorporation initially approaches the public for the first time for subscription of its public issue it is called Initial Public Officer (IPO). The transactions relating to the primary market i.e. public/rights issues are not carried out through stock exchanges. However, there is an effective control of SEBI at every stage of public issue. The successful floating of a new issue requires careful planning, timing of the issue which will be fulfilled by the specialized institutions such as Underwriters, merchant bankers and registrars of the issue. 4.3.2 Secondary Stock Market Secondary market essentially provides platform for purchase and sale of securities by investors. The trading platform of stock exchanges is accessible only through brokers and trading of securities is confined only to stock exchanges. In fact the secondary market concept begins in the year 1850s with the introduction of joint stock companies with limited liability. The first stock exchange in India was established in the year 1875 by the Native share and stock brokers association now known as the Bombay Stock Exchange. The Secondary Market deals with the sale/purchase of already issued equity/debts by the corporates and others. The sale/purchase of these securities are carried out at the specific Stock Exchange(s), where the companies get their public issues listed for trading. The main function of the secondary market is to provide liquidity to the listed securities by enabling a holder to easily convert the securities into cash through the stock exchanges.
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The secondary market also acts as an important indicator of the investment climate in the economy. When prices of existing securities are rising and there is large trading in the existing shares, such a boom in the secondary market correspondingly signifies that new issues if floated at that point of time would be successfully subscribed. Differences between New Issue Market and Stock exchanges:
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Functions of New issue market or primary market The securities market provides a linkage between the savings and investment across the entities, time and space. The securities market also mobilizes savings and channelises them through securities into preferred enterprises. We can list out the main functions of the new issue market is as follows: (1) Transfer of resources from savers to entrepreneurs: The main function of new issue market is to facilitate the transfer of funds from saving surplus units to entrepreneurs who are intended to start new business or expand existing one. Basically new issue market serves the purpose of mobilizing funds directly or indirectly for those who require them from investors. (2) Origination: It means that the work of investigation and analysis and processing of new proposals. Investigation and analysis of new issue can be performed by sponsors of issues. Investigation means a careful study of technical, financial, and legal aspects of the issuing company. Sponsors to the issue will get adequate satisfaction because in the process of origination they may render some services which are in the nature of advisory they are determination of price and class of security to be issue, the time and place of issue, method of flotation and technique of selling and so on.
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(3) Underwriting: New issue market easily gets underwriters to the issue due to the origination. However, origination by it self will not guarantee the success of an issue. Underwriting an issue of shares or debentures involves entering into a contract with a person known as underwriter, who may be an individual, partnership or company, undertaking that in the event of the shares or debentures not being subscribed by the public or only a part of them being subscribed, he shall take up the balance. Simply underwriting provided a form of guarantee for the new issue market in the event of risk arising from non subscription of public. The one of the important function of new issue market is underwriting from the company point of view as well as from the potential investor point of view. (4) Distribution: the new issue process get complete only when the issuing company successfully allot and distribute the securities to the investors. The sale of securities to the ultimate investors can be described as distribution. This job successfully performed by brokers and dealers in securities. 4.4 NEW ISSUE MARKET ISSUE MECHANISM The issue procedure in case of new issue is considered it is broadly based on the following flow namely: (i) (ii) (iii) (iv) (v) (vi) Eligibility criteria Pricing of Issues Promoters contribution and lock in period Contents of offer document Issue advertisement Initial Public Offer (IPO) and Public issue i. E-IPO ii. FPO iii. Issue of debt instruments iv. Book Building process v. Green Shoe Option (vii) Right Shares (viii) Private Placement i. Preferential Issues ii. Qualified Institutional Placements (QIPs) iii. Issue of capital by designated financial institution iv. OTCEI issues. Eligibility Criteria: The companies which are issuing their securities through offer document namely prospectus in case of public issue or letter of offer in case of Right issue of shares has to
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compulsorily list their securities in the stock exchange(s) and need to full fill following eligibility criterias: (1) If the company going for public issue of securities in excess of Rs 50 lacs, a draft prospectus should be filed with the Securities and Exchange Board of India (SEBI) by their merchant banker at least 21 days prior to the date of filing it with the Registrar of Companies. The same provision is applicable for right issue also, the only difference is instead of prospectus, letter of offer has to file. (2) All companies intending to issue shares and securities to public must enter into an agreement with a depository registered with the SEBI under the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996. (3) The eligibility norms differ based on the status of the company namely unlisted companies and listed companies in case of issue of equity shares and convertible bonds are concerned. 4.4.1 Un-listed Companies Initial Public Offer Un-listed Company coming out with IPO has to compulsorily file offer document with SEBI and the Offer document to be filed with ROC for Registration purpose under Section 60 of the Companies Act. However in the event of Un-Listed Company having a plan to raise money through friend and relatives, they can do so by way filing statement in lieu of prospectus under section 70 of the Companies Act 1956. Every Unlisted Company coming out with IPO has to make the initial listing application to the recognized stock exchange where they want to list their securities. The same details to be mentioned in the offer document Unlisted companies are allowed to issue their new issues in the public as initial public offer only when they satisfy the following conditions: (1) The Net Tangible Assets of the new issue company at least Rs 3 crore in each of the preceding 3 full years, of which not more than 50% is held in monetary assets. (2) The new issue company has to have track record of distributable profits in terms of Section 205 o the Companies Act for at least 3 out of the immediately 5 year. (3) It has a net worth as per the audited balance sheet of at least Rs 1 crore in each of the preceding 3 full years (4) If there is a change in the companys name, at least 50% revenue for preceding one year should be earned from the new activity. (5) The issue size should not exceed 5 times the pre-issue net worth.
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If the above conditions are not satisfied still the unlisted can company go for IPO by satisfying the following two conditions a. The issue is made through the book-building process with at least 50% of the net offer to public being allotted to the qualified institutional buyers namely public financial institutions, banks, mutual funds, foreign institutional investors registered with the SEBI, venture capital funds registered with the SEBI, insurance companies registered with IRDA, state industrial development corporations, provident fund with minimum corpus of Rs 25 crore etc. b. The minimum post issue face value of capital of the company would be Rs 10 crore or there would be a compulsory market making for at least 2 years from the date of listing of the shares. Listed Companies Public Issue Listing means admission of the securities to dealings on a recognized stock exchange. The securities may be of any public limited company, Central or State Government, quasi governmental and other financial institutions/corporations, municipalities, etc. The objectives of listing are mainly to provide liquidity to securities; mobilize savings for economic development; protect interest of investors by ensuring full disclosures. At this junction we have to under stand the initial public offer and public issue. Initial Public Offer will issue by a new public limited company whereas public offer will issue by the existing public limited company. Both the offers are inviting the public at large to invest into their securities. The public limited company which is listed company is allowed to issue the securities in the public issue only when satisfies the following conditions The issue size in terms of the aggregate of the proposed issue and all previous issues made in the same financial year does not exceed 5 times its pre-issue net worth as per the audited balance sheet of the last financial year. In case of name change of the issuer company within the last one year, the revenue accounted for by the activity suggested by the new name should not be less than 50% of its total revenue in the preceding one full financial year.
If the listed company not satisfied the above conditions still it can go for public issue through the process of Book Building. The legibility criteria listed in the above not applicable for the following category entities, they are private limited companies, public sector banks, infrastructure companies and listed companies in case of right issues.
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4.4.2 Pricing of Issues Listed companies can quote the price freely for their securities and unlisted companies which is eligible to make public issue also freely can fix the price their securities. In case of initial public offer by an unlisted company if the issue price is Rs 500 or more per share, the said company would have discretion to fix the face value or par value per below 10 subject to minimum of Re 1 per share, in other words the price is less than Rs 500, the face value would be Rs 10 per share. The same should clearly disclose in the offer document. If the companies already issued their shares at Rs 100 or Rs 10 per share as face value they can change this standard denomination by splitting or consolidating them. Any change in standard denomination can be permissible subject to the following conditions (1) The shares should not be issued in the denomination of fractions (2) There should be one denomination for the shares of a company (3) Any change in denomination is permissible only if article of association and memorandum of association permit the same (4) The company strictly follow the SEBI norms in this regard Promoters contribution and lock in period Promoter may be one who under takes to form a company with reference to a given project, and to set it going, and who takes the necessary steps to accomplish that purpose. Promoters are those persons who initiate the thought of incorporation of the company. They are the first persons to contribute into the given business. In case of public issue by unlisted companies the promoters contribution must be at least 20% of the post issue capital. Similarly in case of public issue by listed companies promotes contribution should be @20% of the proposed issue or share holding to the extent of 20% of the post issue capital. In any case promoters contribution in case of public issue must be minimum contribution of Rs 25,000 per individual and Rs 1 lac in case of firm and companies etc. the following share are generally not to consider for the purpose of finding out the minimum contribution. (a) Bonus Shares (b) Securities allotted to promoters by unlisted at price lower than price at which offered to public. (c) Due to conversion of partnership firm into company promoters who are the partners in the dissolved firm get the allotment lesser than the price at which they offer to the public.
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Lock in period means the contribution of the promoters is remain untouched during a particular period of time. It is essential to safe guard the public fund invested into the new issue company. In any case the minimum lock in period for the promoters contribution is for a period of 3 years. In case of unlisted company promoters contribution is in excess of the required also has minimum lock in period of 1 year. Contents of offer document A public limited company has to compulsorily issue the prospectus to public where it is intended to issue securities to the public. Therefore initial public offer as well as public issue for both purposes issue of prospectus compulsory. A offer document or prospectus as per section 2(36) of the Companies Act means any document described or issued as prospectus and includes any notice, circular, advertisement or other document inviting deposits form the public or inviting offers from the public for the subscription or purchase of any shares or debentures of a body corporate. As per section 56 of the Companies Act the contents of the prospectus has been listed out as follows. Its is only a illustrative list but not exhaustive. (1) Name and address of registered office of the company (2) Name of the stock exchange(s) where application for listing is made (3) Declaration about refund of the issue if the minimum subscription of 90% is not received within 90 days form closure of the issue. (4) Date of opening of the issue and date of closing of the issue (5) Name and address of the auditors and lead managers (6) Name and address of the underwriters and the amount underwritten by them (7) Name and address of the trustees of the debenture trust deed in case of issue of debentures. (8) Authorized, issued, subscribed and paid up capital, also paid up capital after the present issue or after conversion of debentures if any (9) History and main objects and present business of the company, as also name and address of subsidiary if any. (10)Promoters and their background. (11)Nature of the business, size of the business and location of the business. (12)Procedure and time schedule for allotment and issue of certificates. (13)Issue of shares other than for cash.
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(14)Debentures and redeemable preference shares or other instruments issued but remaining outstanding on the date of the prospectus (15)Rights of members regarding voting, dividend, lien on shares and the process ofr modification of such rights and forfeiture of shares etc. Issue advertisement The term advertisement is so popular now days due to unchallengeable end less competition and innovation in technology. The term advertisement can be defined as a notice, brochures, pamphlets, circulars, show cards, catalogues, hoardings, placards, posters, insertions in news papers, pictures, films, cover pages of offer documents, or any other print medium, radio, television programmes through any electronic medium. A lead merchant banker has to ensure the advertisement pattern for the new issue by compliance with the guidelines framed thereon. In general issue advertisement should comply the following compliances. (1) Advertisement pattern should not mislead the potential investor (2) It should be mirror of the offer document by disclosing all relevant information (3) any thing which distract to the investor such as complex and ambiguity language etc (4) It should not motivate in such manner by giving guarantee regarding rapid growth in profit and in the business. (5) Advertisement should not be in the form of run simultaneously with programmes in a narrow strip at the bottom of the television screen. (6) If the data pertaining to financial matter it should show data for the past three years ad include particulars relating to sales, gross profit, net profit, share capital and reserves and so on (7) Advertisement should contain the risk factors in respect of the relevant new issue. (8) No advertisement after 21 days from the date of filling the offer document with the SEBI till the close of the issue is to be issued, unless any risk factor required to be mentioned in offer document are also mentioned in the advertisement. (9) An announcement regarding closure of issue must be made only after lead merchant banker is satisfied that at least 90% of the issue has been subscribed and a certificate to this extent also obtained from the registrar to the issue. (10)Ensure that all legal requirements for the purpose of issue advertisement has been fulfilled etc.
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Broadly we can identify the source of mobilization of funds for new issue by adopting the sound issue mechanism. In case of Initial Public Offer and Public Issue the methods by which the new issues can be made are as follows: Initial Public Offer (IPO) and Public issue E-IPO FPO Issue of debt instruments Book Building process Green Shoe Option
4.4.3 Inirial Public offer (IPO) This is a mechanism through which the companies are procured the funds to meet their obligations. Funds can be raised through issue of prospectus to the general public at large. The price per share or security initially offer by the company may be at the face value of the securities or it may be at premium or at discount as the case may be. To prevent any misstatement in the prospectus the Securities and Exchange Board of India (SEBI) has laid down the additional disclosure requirements as mandatory, they are i. ii. iii. iv. v. vi. vii. Name and registered office of the issuing company Existing and proposed activities of the issuing company List of Board of directors Location of the industry Authorised, subscribed and proposed issue of capital to public Dates of opening and closing of subscription list Name of Brokers, underwriters from whom application forms along with copies of prospectus can be obtained. viii. Minimum subscription and so on so forth. Issue of securities through IPO is costly. Issue of IPO involves the administrative cost including printing the prospectus, advertisement, legal charges, consultancy charges, underwriting charges, brokerage charges, stamp duty, listing fee, registration charges and so on so forth 4.4.3.1 E- IPO In addition to the above normal IPO there is another system called initial public offer through stock exchange online system (E-IPO) is also available. This means to say that the new issue company can issue securities to the public either trough the online system of the stock exchange or through the existing banking system. SEBI guidelines in this regard applicable to those companies proposing to issue capital to public through the online system of the stock exchange for offer of securities are listed below.
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(a) The company will have to first enter into an agreement with the stock exchange which must clearly address to resolve all kind of possible disputes. (b) The company will have to appoint a registrar to the issue having electronic connectivity with the stock exchange. (c) The stock exchange intern must appoint stock brokers whose names already registered with SEBI and act as collection centers. (d) During the period in which the issue open to for public subscription, applicants may approach brokers of the stock exchange trough which the securities are offered through the online system to place an order (e) The prospectus must clearly disclose list of all brokers appointed for the issue along with the other intermediaries namely lead managers and registrars to the issue. (f) The lead manager is responsible for entire operation to coordinate all activities among various intermediaries who are connected in this issue. 4.4.3.2 Follow on Public Offering (FPO) Follow on Public Offer means an offer of sale by listed companies to mobiles their growth plans. Funds can be mobilised through FPO only highly reputed companies having good track record. Strictly speaking funds mobilsation through this channel is not worthy due to cumbersome procedural requirements and high cost and time. Now a days listed companies are preferring the Qualified Institutional Placement for mobilizing the funds. Issue of debt instruments Any corporate offering the issue of debentures which are convertible or nonconvertible has to fulfill the following requirement before the issue. (1) Credit rating must be obtained from minimum two registered credit rating agencies pertaining to the issue of debt instrument and the same also mentioned in the prospectus also. (2) Before issuing debts to the public the issuing company must appoint the debenture trustees as per the provisions of the Companies Act and the same must be mentioned in the prospectus and in all subsequent communications sent to the debenture holders. (3) With in the 3 months from the closure of the issue, a trust deed must be executed by the company infavour of the debenture trustees. (4) A merchant banker has to ensure that the security created is adequate to cover the amount of debentures. (5) In case of debentures obtained for the purpose of meeting the project finance then the debenture redemption reserve can be created up to the date of commercial production etc.
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4.4.3.3 Book Building Book Building is basically a capital issuance process used in Initial Public Offer (IPO) which aids price and demand discovery. It is a process used for marketing a public offer of equity shares of a company. It is a mechanism where, during the period for which the book for the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The process aims at tapping both wholesale and retail investors. The offer/issue price is then determined after the bid closing date based on certain evaluation criteria. As per the SEBI guidelines book building means as a process under taken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memorandum of offer document. Simply we can say that book building is process of price discovery. Book building is a process by which the issuer company before filing of the prospectus, builds-up and ascertains the demand for the securities being issued and assesses the price at which such securities may be issued and ultimately determine the quantum of securities to be issue. In the book building process, the book runner lead manager (BRLM) maintains a book wherein the bids placed by individual and institutional investors through the syndicate members are recorded. Book Building process: (1) The Issuer (namely company) who is planning an IPO nominates a lead merchant banker as a book runner (namely merchant banker). (2) The Issuer specifies the number of securities to be issued and the price band for orders. (3) The Issuer also appoints syndicate members with whom orders can be placed by the investors. (4) The book runner prepares and submits the draft documents to the SEBI and obtains an acknowledgement. (5) The book runner also circulates the draft prospectus to invite the eligible syndicate members to join the syndicate of buyers. (6) The syndicate members send the draft prospectus to their clients and obtain orders from them for the securities. (7) The final prospectus must be prepare and file with the Registrar of Companies (ROC) along with the procurement agreement (8) The placement portion opens for subscription only after the prospectus is filed with the ROC. (9) The placement portion closes a day before the opening of the public issue portion.
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(10)Investors place their order with a syndicate member who inputs the orders into the electronic book. This process is called bidding and is similar to open auction. (11)A Book should remain open for a minimum of 5 days. (12)Bids cannot be entered less than the floor price. (13)Bids can be revised by the bidder before the issue closes. (14)On the close of the book building period the book runner evaluates the bids on the basis of the evaluation criteria which may include Price Aggression, Investor quality, Earliness of bids, etc. (15)The book runner and the company conclude the final price at which it is willing to issue the stock and allocation of securities. (16)Generally, the number of shares are fixed; the issue size gets frozen based on the price per share discovered through the book building process. (17)Allocation of securities is made to the successful bidders. We will try to explain the entire process of the book building in the following charter in such a manner in a simplified manner.
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Book-building options Corporate sectors may raise capital in the primary market by way of an initial public offer, rights issue or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book building method or a combination of both. In case the issuer chooses to issue securities through the book building route then as per SEBI (Disclosure and Investor Protection) Guidelines, an issuer company can issue securities in two ways:
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(A) 75% Book Building Process: under this process 75% of public issue can be offered to institutional investors through book building process and the balance 25% of public issue can be offered to the public through prospectus and shall be reserved for allocation to individual investors who had not participated in bidding process. (B) Offer to Public through Book Building Process: (i) 100% of the net offer to the public through the book building route. (or). (ii) 75% of the net offer to the public through the book building process and 25% of the net offer to the public at the price determined through book building process. 100% book building means that entire issue is completed in a single stage, without having to make a mandatory fixed price offering. The SEBI granted the permission to the issuer to go for 100 percent book building without offloading any portion of the issue in the market. The main condition here is the size of the issue has to be at least Rs 25 crore and the issue has to be fully underwritten. Generally the 100% book building process is in the form of demat and the allotment in the stipulated proportions to the various categories of investors for example not less than 50% for qualified institutional investors and not less than 25% for the retail segment and balance portion for the non institutional investors. The lead manage has enlarge their operations and increase the concentration on nation wide to collect bids, due to retail participation in the bid. The 100% book building process will takes place quickly because the public offering and allotment process would take place through the stock exchange network. In case of 75% book building, process can be sub divided into two parts namely the placement portion and the public portion (ie the net issue offer to the public). The placement portion means a portion of the issue offered to the pubic through the syndicate by way of the book building process. Underwriters, merchant bankers, financial institutions, brokers and high net worth individual etc can be called as syndicate. The public portion means the offer to the public, it can be viewed as retail offering. The price applicable to the public offer is arrived from the book building process. This 75% book building is available to all corporates but only the condition is the size of the issue should not be less than Rs 100 crore and underwriting is must to the extent of net offer to the public. For example we will present here, how Bombay Stock Exchange (BSE) will function in the case of book building. BSE offers the book building services through the Book Building software that runs on the BSE Private network. This system is one of the largest electronic book building networks anywhere spanning over 350 Indian cities through over 7000 Trader Work Stations via eased lines, VSATs and Campus LANS.
The software is operated through book-runners of the issue and by the syndicate member brokers. Through this book, the syndicate member brokers on behalf of themselves or their clients place orders. Bids are placed electronically through syndicate members and the information is collected on line real-time until the bid date ends. In order to maintain transparency, the software gives visual graphs displaying price v/ s quantity on the terminals Merits of Book Building process Book Building option is a good concept and represents a capital market which is in the process of maturing. It provides to the issuer, intermediary and investor the following benefits or merits. (1) Book building enables issuers to assess the demand and price for their issue. (2) The process cost for issuing the securities under building will reduce (3) Investors will be benefited at large because they can easily trust the price at which the syndicate members have purchased the shares. (4) The price fixed through book building is reliable and the possibility of price falling bellow par after listing is rare. (5) There would be no uncertainties as the issue is pre-sold (6) The issuer company can save advertisement and brokerage commissions (7) Investors have a voice in the pricing of issue (8) The issue price per share is market driven. Therefore reduction in the price below par is also remote. (9) Transparency in allocation of funds is possible. (10)Book building provides a good liquid and buoyant after market, etc. Demerits of Book Building process We have the following demerits also in case of new issue through book building process. (1) Book building is use full to those issuers who are coming with large number of shares and value (2) The book building process works efficiently in matured market conditions, whereas we are not have so matured market where the investor need to understand the various parameters affecting the market price. (3) Transparency may not be available because Issuer Company may bias the syndicate members. llustration: X Limited issued shares of Rs 100 each amounting to Rs1,000 crores. The company appointed a merchant banker as book runner, who collected information from various investors to book building purposes. The quoted price of various investors to their syndicate members are as follows:
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Hence, the price will be calculated as per the weighted average price method as follows
Weighted average price = (95x100) + (98x500) + (101x100) + (100x200) + (99x100) 1,000 = Rs 98.50 per share
This means that the price is derived and recorded by the Issue manager namely book runner. Therefore, the same price is also finalise by the issuer company as issue price. Difference between shares offered through book building and offer of shares through normal public issue:
4.4.3.4 Green Shoe Option: Green shoe option means an option of allocating shares in excess of the shares included in the public issue. Green shoe option is extensively used in international Initial Public Offers as stabilization toll for post listing price of the newly issued shares. It has been introduced in the Indian Capital market in Initial Public Offers using book building method. SEBI has introduced this option with a view to boost investors confidence by arresting the speculative forces which work immediately after the listing. Therefore, green shoe option will ensure the price stability. As per the SEBI (Disclosure & Investor Protection) Guidelines, 2000 the green shoe option mechanism work as follows: some of the guidelines are mentioned below.
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(1) Issuing company is going for IPO of equity shares through Book building process, the said company can avail the green shoe option. (2) The company so particular about the issue of green shoe option has to pass the resolution to this effect authorizing the public issue. (3) The company has to appoint one of the lead manager (book runner) amongst the issue management team, as the Stabilizing Agent (SA). (4) The Stabilized Agent in turn enter into a contract with issuer company, prior to filing of offer document with SEBI, clearly stating all the terms and conditions relating to this option including the fee incurred by SA for this purpose. (5) Issuer Company is allowed to accept oversubscription, subject to 15% of the offer made to public. (6) The Red Herring prospectus and the final prospectus shall contain the all the information as required by the SEBI namely, Name of the SA, The maximum number of shares allotted, the maximum amount of funds to be received and use of these additional funds and the same has to file with Registrar of Companies. (7) The money received from the applicants against the over all allotment in the green shoe option shall be kept in the separate bank account designated for this purpose. (8) The excess money receive from the public must be returned within 2 working days after the close of the stabilization period. (9) The register in respect of each issue having the green shoe option maintain by the S A must be preserved for the period of further 3 years (10)All such other requirements from time to time required by the SEBI have to file. 4.4.3.5 Right Issues This is the cheap way of raising finance. It is an issue of shares in which the existing shareholders have a pre-emptive right to subscribe for the new shares. In case of right issue no prospectus is issued instead, existing equity shareholders are given right in proportion to the existing holding which entails them to take up a specified number of shares at a stipulated price. The price for the share so offered is usually below listed price to make the offer attractive. As per section 81 of the Companies Act, 1956 a company increase its subscribed capital by the issue of new shares, either after two years of its formation or after one year of first issue of shares whichever is earlier, these have to be first offered to the existing shareholders with a right to renounce them in favour of a nominee. A company can do so by passing a special resolution to the same effect. In general these right shares can be issued by the company based on two reasons namely when the company is in need of cash to carry out existing operations and share price of the company are likely to fall since the same amount of profit will be distributed to more number of shareholders.
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Advantages of Right issues Underwriting commission is low in case of right issues are concerned Share holder have right on issue at low price generally lower than the market price. Investor maintains his proportionate ownership in the case of right issue.
This process we can explain with the help of the following example: Illustration: X Limited has 1,00,000 equity shares outstanding and it plans to issue 20,000 new shares, then the number of rights needed to buy each new share is 5 (ie 1,00,000/20,000). Suppose an investor hold 4,000 shares in the X Ltd. (ie 4%) has enough right to buy 800 shares (ie 4,000/5) of the new share. Up on subscribing to the new issue, the investors proportionate ownership is same 4% (ie 4,800/1,20,000). 4.5 PRIVATE PLACEMENT The corporate sectors also find the avenues for mobilization of funds in addition to the above for their new issue. In this process we will discuss the private placement for fund mobilization as one of the source. The private placement may be in the form of Preferential Issues Qualified Institutional Placements (QIPs) Issue of capital by designated financial institution OTCEI issues.
4.5.1 Preferential Issues Preferential issue means is an issue of shares or convertible securities by listed companies to a select group of persons under section 81 (IA) of the Companies Act, 1956 which is neither a right issue nor a public issue. Right issue or pubic issue generally requires more legal compulsions. Hence, many companies opt for preferential allotment of shares for raising funds through private placements. These shares are generally allotted to the promoters, foreign partners, technical collaborators and private equity funds. Approval from the share holder must to issue the preferential shares. Preferential share holders have the preferential right in respect of a claim on available assets before the ordinary share holders. Issuer Company may issue the following types of preferential shares. Cumulative and Non-cumulative preferential shares Cumulative Convertible preferential shares Participating and Non-participating preferential shares Redeemable and Irredeemable preferential shares
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The Companies Act, 1956 prohibits the issue of any preferential shares which is irredeemable or is redeemable after the expiry of a period of twenty years from the date of issue. 4.5.2 Qualified Institutional Placements (QIPs): Qualified institutional Placement is an additional mode of mobilizing the funds by the listed companies from the domestic market. A listed company which fulfils the requirement of minimum public share holding as per the listed agreement after that it can place on a private placement basis specified securities with the Qualified Institutional Buyers only. These securities include shares and other convertible or nonconvertible securities excluding warrants. The Qualified Institutional Buyers (QIBs) are those institutional investors who are generally possess knowledge, experience to evaluate and invest in the capital market. As per the SEBI guidelines qualified institutional buyers may be viewed as follows; Public Financial Institution as defined in section 4A of the Companies Act Scheduled Commercial Banks Mutual Funds Foreign Institutional Investors (FIIs) registered with SEBI Multilateral and Bilateral Development Financial Institutions Venture Capital Funds registered with SEBI State Industrial Development Corporations Insurance Companies registered with the Insurance Regulatory ad Development Authority Provident Funds with minimum corpus of Rs 25 crores Pension Funds with minimum corpus of Rs 25 crores As per the SEBI guidelines the above said QIBs are entitled to participate in the primary issuance process
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4.5.3 Issue of capital by designated financial institution Designate Financial Institutions (DFIs) coming to capital market for mobilization of funds trough an offer document has to comply the guidelines framed by the SEBI in this regard. These are briefly discussed herein. In case of DFIs there is no minimum requirement of promoters contribution. DFI is allowed to allot the shares out of the proposed issue only to their permanent employees including Managing Director or fulltime directors maximum of 20 shares per employee. The DFI s has to have a good track record of consistency profitability in 3 out of immediately 5 preceding years. The offer document of DFI should contain the present equity and equity capital after conversion in the case of fully convertible debentures or partly convertible debentures.
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If the FDIs issuing he new financial instruments for mobilizing funds such as deepdiscount bonds, debentures with warrants, secured premium notes and so on should take adequate steps to disclose in the offer document. All other factors that have been taken into account by the issuer namely (DFIs).
4.5.4 OTCEI issues Corporate sectors mobilizing the funds by issuing their equity shares or convertible securities in an initial public offer by selecting the channel of Over The Counter Exchange of India has to comply the following requirements. (1) Shares and securities offer for sale through OTCEI resulting from a boughtout deal (BOD) are exempted from pricing norms specified for unlisted companies only when the promoters would retain minimum 20% of the total issued capital with a lock in period of 3 years from the date of allotment of securities in the proposed issue and two market makers are appointed in accordance with the guidelines framed by the OTCEI in this regard. (2) The companies issued capital from Rs 30 lacs to 3 crores has to make a minimum public offer 10% or Rs 20 lacs in face value whichever is higher. (3) All other conditions from time to time required by the appropriate authority. 4.6 SEBI (DISCLOSURE AND INVESTOR PROTECTION) GUIDELINES 2000: The new issue market has been regulated by SEBI in terms of SEBI guidelines these are changed many times since inception in 1992 due to inconsistencies, market development ad changing needs of the capital market and so on. SEBI Guidelines 2000 provides us a comprehensive frame work of primary capital issues by the companies. These guidelines are applicable to all public issues by listed and unlisted companies, all offers for sale and right issues exceeding Rs 50 lacs by listed companies whose equity share capital is listed. At the same time these guidelines are not applicable to a banking company, Public Sector Banks, Infrastructure companies and right issue by a listed company. We have discussed relevant guidelines in the above at appropriate places. Investor Education and Protection Fund With the help of section 205C of the Companies Act, 1956 the Central Government of India empowers to form the Investor Education and Protection Fund. This fund is created with the amount of unpaid dividend accounts of companies, the application money received by the companies for allotment of securities and due for refund, unclaimed matured deposits with the companies, interest accrued on the above items, grants given by the state and central government of India and so on. This fund shall be utilized only for the purpose of investors awareness and protection of the investor interest.
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Summary Generally the procurement of funds will take place through the securities market which has two inter-dependent and inseparable segments namely New Issues Market and the Secondary Market. The securities market, however, refers to the markets for those financial instruments or claims that are commonly and readily transferable by sale. To provide the funds for the new projects as well as for the existing projects with the intention to expansion, or modernization, diversification and up-gradation of the technology, companies choose the channel of primary market by issuing the new securities. The source of mobilizing the funds by issuing the securities can be take place in any one of the following manner or on combination of all. The issue procedure in case of new issue is considered it is broadly based on the following flow namely: Eligibility criteria Pricing of Issues Promoters contribution and lock in period Contents of offer document Issue advertisement Initial Public Offer (IPO) and Public issue E-IPO FPO Issue of debt instruments Book Building process Green Shoe Option Right Shares Private Placement Preferential Issues Qualified Institutional Placements (QIPs) Issue of capital by designated financial institution OTCEI issues As per the SEBI guidelines book building means as a process under taken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memorandum of offer document. Self Examination Questions: (1) Explain the concept of Primary and Secondary Market (2) Explain the Initial Public Offer
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(3) Please explain the concept of Book Building and its importance in the case of new issue market. (4) Write short note on Right Shares E-IPO FPO Issue of debt instruments Green Shoe Option (5) Explain the SEBI guidelines regarding new issue of shares.
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MUTUAL FUNDS
5.1 INTRODUCTION The small investors who generally lack expertise to invest on their own in the securities market use to say that dont put trust in money, put your money in trust. In general common investor is not competent enough to understand the intricacies of stock market. This is where mutual funds come to the rescue. A mutual fund is a group of investors operating through a fund manager to purchase a diverse portfolio of stocks or bonds. Mutual funds are highly cost efficient and very easy to invest in. One of the most advantageous factor in the mutual fund is, it reduce the risk by diversification and maximize the returns due to professional expertise of fund managers employed by it. Diversification means spreading out money across many different types of investments. When one investment is down another might be up. Hence, diversification of investment holdings reduces the risk tremendously. As per the definition of the Association of Mutual Funds in India (AMFI) A mutual fund is a trust that pools the savings of a number of investors who share common financial goal. Anybody with an investible surplus of as little as a few thousand rupees can invest in mutual funds. These investors buy units of a particular mutual fund scheme that has a defined investment objective and strategy. The term Mutual Fund also defined by the SEBI Regulations as Mutual Fund means a fund established in the form of a trust to raise monies through the sale of units to the public or a section of public under one or more schemes for investing in securities, in accordance with Regulations. Mutual Fund creates the wealth of the investor and acts simply as financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. When you invest in a mutual fund, you are buying shares or portion of the mutual fund and become a shareholder of the fund.
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The concept of Mutual Fund business started in India since 1963 with the formation of Unit Trust of India (UTI). We can elucidate the history of Mutual Funds in India into four distinct phases. 5.2 LEARNING OBJECTIVES 1.Understand the concept of mutual funds 2.Understand the SEBI regulation regarding mutual funds 3.Understand the Credit Rating concept for mutual funds 4.After learning this you should be in a position to advice profitable investments. 5.Understand the various types of insurances available to minimize the risk and losses. 5.3 MUTUAL FUNDS IN INDIA Phase 1 During 1964 to 1987 the only one company in India ruled the mutual fund business namely the Unit Trust of India. UTI maintained its monopoly and experienced a constant growth till 1987. The first scheme launched by Unit Trust of India was Unit Scheme 1964 (US 64). We are proud to say that Master Share was the first Indian offshore fund launched by the UTI which was listed on the London Stock Exchange in the year 1986. At the end of the financial year 1987-88, the Unit Trust of India had Rs 6,700 crores of assets under its management. Phase 2 During 1987 1993 the mutual fund business was taken over by various public sector undertakings namely banks, Insurance Companies and so on. In this process the State Bank of India Mutual Fund was established in the year 1987 followed by Canbank Mutual Fund in the year 1989, Bank of India in the year 1990, Bank of Baroda Mutual Fund in the year 1992, Life Insurance Corporation of India established its Mutual Fund business in the year 1989 and General Insurance Corporation of India had also set up its Mutual Fund business in the year 1990. At the end of the financial year the entire mutual fund industry had assets under management of Rs 47,004 crores. Phase 3 In the history of mutual funds a new era was started with the entry of private sectors in the mutual funds industry during 1993 2003. During this period private domestic and foreign players were allowed in the mutual fund industry. The erstwhile Kohtari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993. It is important to note that in the year 1993 The Securities Exchange Board of India (SEBI) notified regulations bringing all mutual
funds except UTI under a common regulatory frame work by issuing the Mutual Fund Regulations. The 1993 SEBI (Mutual Fund) Regulations was substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The Mutual Fund industry now functions under the SEBI (Mutual Fund) Regulations 1996. As at the end of January 2003, there were 33 mutual funds with total assets of Rs1, 21,805 crores out of this the Unit Trust of India alone with Rs 44,541 crores of assets under its management. Phase 4 During this phase (ie after the year 2003) the flow of funds into the mutual funds industry sharply increased. This positive growth in the mutual funds is due to tax benefits and improvement in quality of investor service and so on and so forth. In 2003, following the repeal of the Unit Trust of India Act, 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under its management of Rs.29,835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme. These specified undertaking functions under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations. The other one is called the UTI Mutual Fund Limited, sponsored by the State Bank of India, Punjab National Bank, Bank of Baroda, and Life Insurance Corporation of India. It is registered under the Securities Exchange Board of India and functions under the Mutual Fund Regulations. The entire mutual funds industry assets under management as at the end of financial year 2006-2007 is Rs 3,26,388 which occupies major portion of the Indian economy. As a whole mutual funds industry provides many advantages due to its nature and size of the business. 5.4 ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS 5.4.1 Advantages of Mutual Funds (1) Professional Management In general we may not have the skill to find good stocks that suit our risk and return and more over we find it difficult to find the time to track our investments but still want returns that can be had from equities. Hence, this need is successfully full filled by our fund manager who will take care of our investments. A fund manager is an investment specialist, who provides us an in-depth understanding of the various securities and bonds.
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(2) Small Investments Mutual Funds are very advantageous to those investors whose savings are very small say Rs 1,000 to 5,000 per month. These investors if they want to buy directly Government Securities which comes to minimum Rs 25,000 or to buy blue chip companies shares which also need more investment, thus mutual fund gives you an ownership by investing the same Rs 1,000 to 5,000. That is; the mutual fund pools the savings from several investors and invest the same at large into the number of securities. (3) Diversified Portfolio Mutual Funds invest in a number of companies across a broad cross-section of industries and sectors. This diversification reduces the risk because seldom all investments decline at the same time and in the same proportion. In other words, dont put all your eggs in one basket. The rationale for this is that even if one investment in your portfolio turns bad, the other investments will mitigate this loss. (4) Liquidity In open ended schemes, investors can get their money back promptly at net asset value related prices from the mutual fund itself within three to five working days from the date of putting the request for redemption. In case of close ended schemes, investors can sell their units on a stock exchange at the prevailing market price or avail of the facility of direct repurchase at net asset value (NAV) related prices. (5) Tax Benefits There are many more tax saving mutual funds available and in fact dividends distributed by the mutual fund company are tax free in the hands of the investor. Mutual Fund also gives us the advantage of capital gain taxation. If we hold units beyond one year, we get the benefit of indexation. (6) Convenient Administration Basically Mutual Fund reduce paper work and help investors to avoid many problems such as delayed payment, unnecessary follow up with brokers and companies and so on. More over Mutual Funds save investors time and make investing easy and convenient. (7) Return Potential Mutual Fund gives us a constant potential growth in our investments due to their portfolio management. Return on investments in Mutual Fund is relatively less when we compare with the investments in to primary market as well as secondary market.
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(8) Low Costs Mutual Funds are relatively less expensive to invest compared to directly investing in capital markets. Large scale operation results in lower costs such as brokerage, custodial and other fees. (9) Transparency Investors will get regular information through periodical account statement. (10) Investors Protection All Mutual Funds are registered with Securities and Exchange Board of India (SEBI) and they function with the provision of strict regulations designed to protect the interests of investors. The operations of mutual funds are regularly monitored by SEBI. 5.4.2 Disadvantages of Mutual Fund No doubt mutual funds are good investment vehicles to over come the complex and unpredictable changes which takes place in the financial market. However, even mutual funds have some inherent disadvantages. (1) No Assured Returns Returns from Mutual Funds as a matter of fact depend on the securities and debt market. If the securities market is doing well then automatically the mutual funds industry will also do well. Thats why mutual fund companies always says mutual funds are subject to market risk. In addition, mutual funds are not insured or guaranteed by any government body unlike a bank deposit. There are strict norms for any fund that assures returns and it is now compulsory to establish that they have resources to back such assurances. (2) Restrictive Gains We know that risk is low in case of mutual funds, which causes low return. A fundamental concept is low risk and low return. (3) Expensive Cost incurred in operating mutual funds include advisory fees, trustee fees, agents commission, custodial fee and audit fees, transfer agent fees etc., from the Asset Management point of view. From the investor point of view there may be entry load and exit load. For Example if an investor invests say Rs 10,000 in a scheme that charges a 2% entry load (also called Front-end Load) at a net asset value of Rs 10 per unit, the public offer price will be calculated as follows:
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Like wise, if the investor wants to repurchase (redeem) the mutual fund there may be exit load (also called Back-end Load) assume for example 2% then investor will get only Rs 9.80 per unit.
(4) Poor Fund Management Due to lack of professional knowledge and experience of the fund manager some schemes are performing poorly and fund managers being unaccountable for poor results. (5) Excessive Diversification Excessive diversification of portfolio results in losing focus on securities of key segments. Moreover, too much concentration on blue chip securities which are high priced and which do not offer more than average return. (6) Switch over fees Generally funds impose a switch over fee or transaction cost as a charge on transfer of investment from one scheme to another within the same mutual fund company and also to switch over from one scheme to another within the same scheme. Types of Mutual Funds: Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class or classes of securities it can invest in. As we know that the concept of mutual fund is the portfolio management. Hence, in the process of diversification of risk the fund manager will invest the pooled money into various sectors. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the Indian Financial Market.
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5.5 TYPES OF MUTUAL FUNDS (1) Equity Funds Equity Funds are also called growth funds. The main objective of growth funds is capital appreciation over the medium to long term. They invest most of the corpus in equity shares with significant growth potential and they offer higher return to investors in the long run. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. They assume the risk associated with equity investments. There is no guarantee or assurance of returns. These schemes are usually close-ended and listed on stock exchanges. (2) Debt Funds Debt Funds are also called income funds. The main objective of income funds is to provide safety of investments and regular income to investors. Such funds invest only in debt instruments, and are good option for investors, averse to take risk associated with equities. Such funds invest predominantly in income bearing instruments like bonds, debentures, Gilt-funds and commercial paper and so on. The return as well as risk is lower in Debt Funds compared to equity funds. (3) Balanced Funds The main objective of Balanced Funds is to provide both capital appreciation and regular income. It means to say that balanced funds, whose investment portfolio includes both debt and equity. As a result, from the risk point of view, they fall somewhere between equity and debt funds so as the portfolio is balanced. Balanced funds are the ideal mutual fund vehicle for investors who prefer spreading their risk across various instruments. The Net Asset Value (NAV) of balanced funds is likely to be less volatile than the equity funds. Mutual Fund Schemes We can classify the mutual funds based on the objectives, functions and structure in the following categories.
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(1) Open-ended mutual funds An open ended mutual fund is a fund which continuously offers to sell and repurchase its units at NAV related prices. The fund itself buy back the units surrendered and is ready to sell new units. Open-end funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open ended mutual funds is invested in highly liquid securities, which enables the fund to raise money by selling securities at prices very close to those used for valuations. These open ended funds do not have fixed corpus fund which may increase or decrease depending upon the purchase or redemption of units by investors. (2) Close-ended Mutual Funds Close-ended mutual funds are those mutual funds which has fixed corpus fund and a stipulated maturity period ranging from 3 to 5 years. Primary example of such mutual fund is UTI Master Share. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed. The scheme remains open for a period not exceeding 45 days from the date of launch. The market price of the close-end funds is determined by supply and demand and not by net asset value. It is so because if an investor sells units directly to the fund, he cannot enter the fund again, as units bought back by the fund cannot be reissued. (3) Money Market Mutual Funds These funds invest in short term debt securities in the money market like certificate of deposits, commercial papers, government treasury bills and so on. The objective of such funds is high liquidity with low rate of return. In practice, companies use to invest in these funds to park their short-term funds as a part of their financial management. (4) Large Cap Funds and Mid Cap Funds Large Cap Funds are those mutual funds, which seek capital growth by investing primarily in the shares of large blue chip companies. These large cap funds can be named as growth funds. Generally companies with a market capitalisation in excess of Rs 1,000 crores are considered as large cap companies. Companies with a market capitalisation less than Rs 1,000 crores but more than Rs 500 crores generally considered Mid Cap companies. Mutual Fund companies investments into these companies are called large cap funds and Mid Cap Funds respectively. Of course there is no hard and fast rule to decide the large cap and Mid Cap. (5) Tax Saving Schemes To motivate the investors tax rebate scheme these mutual funds emerged. These schemes offer various options like income, growth or capital appreciation. Equity Linked
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Savings Schemes (ELSS) and pensions schemes can be quote as examples for tax saving schemes. (6) Load Funds and No Load Funds Load means a charge or commission at the time of purchase or sale of mutual funds. It means to say that each time we buy or sell units in the fund, a commission will be payable. Typically entry and exit loads range from 1% to 2%. It could be worth paying the load, if the fund has a good performance track record. No Load Fund do not charge a commission at the time of purchase or sale of units. That is, each time you buy or sell units in the fund, no commission will be payable. (7) Gilt Funds Gilt Funds means which deal exclusively in government securities. Reserve Bank of India in fact encouraged setting up of gilt funds with a view to create a wider investor base for government securities. (8) Index Schemes Index Schemes means that attempt to replicate the performance of particular index such as the Bombay Stock Exchange (BSE) Sensex or the National Stock Exchange -50 (NSE-50). An index fund is a mutual fund which invests in securities in the index on which it is based namely BSE Sensex or NSE-50. (10) Sectoral Schemes Sectoral funds means the funds invest in specific core sectors like energy, telecommunications, Information Technology, Construction, Transportation, and Financial Services. (11) Exchange Traded Funds (ETFs) Exchange Traded Funds are index funds listed on stock exchanges and trade like individual stocks on the stock exchanges. The investment objective of an ETF is to achieve the same return as a particular market index. The ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. (12) Fund of Funds Fund of Funds means a mutual fund that invests in other mutual funds. It means to say that a Mutual fund company invests in a number of different securities on combination of equity and debt of other mutual funds. Fund of Funds are designed to achieve greater diversification than traditional mutual funds.
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(13) Off-shore Funds Off-shore Funds are those funds which attract foreign capital for investment in the country of the issuing company. They are also called cross border funds which lead to increase in foreign currency and foreign exchange reserves. Such funds invest in securities of foreign companies with the Reserve Bank of India permission. The first Off-shore fund in India namely The India Fund was launched by the Unit Trust of India in the year 1986. (14) Real Estate Mutual Funds (REMFs) Real Estate funds generally are classified as close ended mutual funds which invest predominantly in real estate and properties. These funds allow retail investors a chance to participate in the booming real estate business. (15) Gold Exchange Traded Fund Securities and Exchange Board of India granted permission in the year 2006, to introduce the Gold Exchange Traded Fund (GETF) schemes by mutual funds. These funds are permitted to invest into Gold, Gold related instruments. In India, investment in gold is a preferred avenue, hence GETFs should be aimed at gold investors who can diversify the portfolio and increase their income. (16) Systematic Investment Plans (SIPs) Under the systematic investment plan investors are allowed to invest in the equity and equity oriented mutual fund schemes a fixed sum of money periodically. This scheme gives higher returns if the investor has a long term investment plan. 5.6 NET ASSET VALUE The performance of a particular scheme of a mutual fund is denoted by Net Asset Value. Therefore, the net asset value of the fund is the cumulative market value of the assets of the fund net of its liabilities. As per the Association of Mutual Funds in India (AMFI), Net Asset Value (NAV) is the market value of the assets of the scheme minus its liabilities. Per unit of NAV is the net asset value of the scheme divided by the number of units outstanding on the valuation date. NAV can be calculated as follows
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For example: If the market value of the securities of a mutual fund scheme is Rs 400 lacs and the mutual fund has issued 20 lacs units of Rs 10 each to the investors, then the NAV per unit of the fund is Rs 20. The Net Asset Value is required to be disclosed by the mutual funds on a regular basis namely daily or weekly depending up on the type of scheme. There are following running expenses are charged directly to the scheme which affects its Net Present Value. They are selling and distribution expenses, Brokerage charges, Registration charges, Audit fees, Custodian fees, Cost of Advertisement and investor communication. We can visualize some expenses which are affecting the Net Present Value (NAV). They are penalties and interest for violation of rules and regulations, General administrative expenses not for any particular scheme, depreciation on fixed assets and so on. 5.7 SEBI (MUTUAL FUND) REGULATIONS, 1996 Mutual Fund institutional set up Institutional Set up of the Mutual fund can be described as a set up in the form of a trust, which has Sponsor, Trustees, Asset Management Company (AMC), and Custodian. Thus why, our elders use to say put not your trust in money, put your money in trust.
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Sponsors: As per definition of SEBI (Mutual Fund) Regulations sponsor means any person who, acting alone or in combination with another body corporate, establishes a mutual fund. The sponsor of a mutual fund is akin to the promoter of a company as he gets the fund registered with the SEBI. The registration will be granted by the SEBI only on fulfillment of the following conditions. (a) Sound Track Record: The sponsor should have a sound track record and general reputation of fairness and integrity in all his business transactions. For the purposes of this clause sound track record shall mean the sponsor should:
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1. be carrying on business in financial services for a period of not less than five years; and 2. The net worth is positive in all the immediately preceding five years; and 3. the net worth in the immediately preceding year is more than the capital contribution of the sponsor in the asset management company; and 4. the sponsor has profits after providing for depreciation, interest and tax in three out of the immediately preceding five years, including the fifth year. (b) SEBI approval for existing Mutual Fund: in the case of an existing mutual fund, such fund is in the form of a trust and the trust deed has been approved by the Board. (c) Sponsors Contribution: the sponsor has contributed or contributes at least 40% to the net worth of the asset management company: Provided that any person who holds 40% or more of the net worth of an asset management company shall be deemed to be a sponsor and will be required to fulfill the eligibility criteria specified in these regulations. (d) Persons Employed by the Sponsors: the sponsor or any of its directors or the principal officer to be employed by the mutual fund should not have been guilty of fraud or has not been convicted of an offence involving moral turpitude or has not been found guilty of any economic offence. (e) Appointment of Trustees, AMC and Custodians: Sponsors has to take care the activities like appointment of trustees to act as trustees for the mutual fund in accordance with the provisions of the regulations; appointment of asset management company (AMC) to manage the mutual fund and operate the scheme of such funds in accordance with the provisions of these regulations; appointment of a custodian in order to keep custody of the securities and carry out the custodian activities as may be authorized by the trustees. Trustees As per the definition of SEBI (Mutual Fund) Regulations trustees mean the Board of Trustees or the Trustee Company who hold the property of the Mutual Fund in trust for the benefit of the unit-holders. The trustees have the power of superintendence and control over the asset management company. They monitor the performance and compliance of regulations by the mutual fund. A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908), executed by the sponsor in favour of the trustees named in such an instrument.
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Contents of trust deed 1. The trust deed shall contain such clauses as are mentioned in the Third Schedule and such other clauses which are necessary for safeguarding the interests of the unitholders. 2. No trust deed shall contain a clause which has the effect of (i) limiting or extinguishing the obligations and liabilities of the trust in relation to any mutual fund or the unitholders; or (ii) indemnifying the trustees or the asset management company for loss or damage caused to the unitholders by their acts of negligence or acts of commission or omission. Rights and obligations of the trustees 1. The trustees and the asset management company shall with the prior approval of the Board enter into an investment management agreement. 2. The investment management agreement shall contain such clauses as are mentioned in the Fourth Schedule and such other clauses as are necessary for the purpose of making investments. 3. The trustees shall have a right to obtain from the asset management company such Information as is considered necessary by the trustees. 4. The trustees shall ensure before the launch of any scheme that the asset management Company, has, a. systems in place for its back office, dealing room and accounting; b. appointed all key personnel including fund manager(s) for the scheme(s) and submitted their bio-data which shall contain the educational qualifications, past experience in the securities market with the trustees, within 15 days of their appointment; c. appointed auditors to audit its accounts; d. appointed a compliance officer who shall be responsible for monitoring the compliance of the Act, rules and regulations, notifications, guidelines, instructions, etc., issued by the Board or the Central Government and for redressal of investors grievances; e. appointed registrars and laid down parameters for their supervision; f. prepared a compliance manual and designed internal control mechanisms including internal audit systems;
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g. specified norms for empanelment of brokers and marketing agents. The compliance officer appointed under clause (d) of sub-regulation (4) shall immediately and independently report to the Board any non-compliance observed by him.
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5. The trustees shall ensure that an asset management company has been diligent in empanelling the brokers, in monitoring securities transactions with brokers and avoiding undue concentration of business with any broker. 6. The trustees shall ensure that the asset management company has not given any undue or unfair advantage to any associates or dealt with any of the associates of the asset management company in any manner detrimental to interest of the unitholders. 7. The trustees shall ensure that the transactions entered into by the asset management company are in accordance with these regulations and the scheme. 8. The trustees shall ensure that the asset management company has been managing the mutual fund schemes independently of other activities and have taken adequate steps to ensure that the interest of investors of one scheme are not being compromised with those of any other scheme or of other activities of the asset management company. 9. The trustees shall ensure that all the activities of the asset management company are in accordance with the provisions of these regulations. 10. Where the trustees have reason to believe that the conduct of business of the mutual fund is not in accordance with these regulations and the scheme they shall forthwith take such remedial steps as are necessary by them and shall immediately inform the Board of the violation and the action taken by them. 11. Each trustee shall file the details of his transactions of dealing in securities with the Mutual Fund on a quarterly basis. 12. The trustees shall be accountable for, and be the custodian of, the funds and property of the respective schemes and shall hold the same in trust for the benefit of the unitholders in accordance with these regulations and the provisions of trust deed. 13. The trustees shall take steps to ensure that the transactions of the mutual fund are in accordance with the provisions of the trust deed. 14. The trustees shall be responsible for the calculation of any income due to be paid to the mutual fund and also of any income received in the mutual fund for the holders of the units of any scheme in accordance with these regulations and the trust deed. 15. The trustees shall obtain the consent of the unitholders a. Whenever required to do so by the Board in the interest of the unitholders; or b. Whenever required to do so on the requisition made by three-fourths of the unitholdersof any scheme; or c. When the majority of the trustees decide to wind up or prematurely redeem the units. 16. The trustees shall ensure that no change in the fundamental attributes of any scheme or the trust or fees and expenses payable or any other change which would modify the scheme and affects the interest of unitholders, shall be carried out unless, a. a written communication about the proposed change is sent to each unitholder andan advertisement is given in one English daily newspaper having nationwide circulation as well as in a newspaper published in the
language of region where theHead Office of the mutual fund is situated; and b. the unitholders are given an option to exit at the prevailing Net Asset Value without any exit load. 17 The trustees shall call for the details of transactions in securities by the key personnel of the asset management company in his own name or on behalf of the asset management company and shall report to the Board, as and when required. 18 The trustees shall quarterly review all transactions carried out between the mutual funds, asset management company and its associates. 19 The trustees shall 22[quarterly] review the networth of the asset management company and in case of any shortfall, ensure that the asset management company make up for the shortfall as per clause (f) of sub-regulation (1) of regulation 21. 20 The trustees shall periodically review all service contracts such as custody arrangements, transfer agency of the securities and satisfy itself that such contracts are executed in the interest of the unitholders. 21 The trustees shall ensure that there is no conflict of interest between the manner of deployment of its net worth by the asset management company and the interest of the unitholders. 22 The trustees shall periodically review the investor complaints received and the redressal of the same by the asset management company. 23 The trustees shall abide by the Code of Conduct as specified in the Fifth Schedule. 24 The trustees shall furnish to the Board on a half-yearly basis, a. a report on the activities of the mutual fund; b. a certificate stating that the trustees have satisfied themselves that there have been no instances of self-dealing or front running by any of the trustees, directors and key personnel of the asset management company; c. a certificate to the effect that the asset management company has been managing the schemes independently of any other activities and in case any activities of the nature referred to in sub-regulation (2) of regulation 24 have been undertaken by the asset management company and has taken adequate steps to ensure that the interests of the unitholders are protected. 25 The independent trustees referred to in sub-regulation (5) of regulation 16 shall give their comments on the report received from the asset management company Disqualification from being appointed as trustees No person shall be eligible to be appointed as a trustee unless a. he is a person of ability, integrity and standing; and b. has not been found guilty of moral turpitude; and c. has not been convicted of any economic offence or violation of any securities laws;
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d. No asset management company and no director (including independent director), officer or employee of an asset management company shall be eligible to be appointed as a trustee of any mutual fund. e. No person who is appointed as a trustee of a mutual fund shall be eligible to be appointed as a trustee of any other mutual fund: Provided that any mutual fund which is not in compliance with sub-regulation (3) or (4) as at the commencement of the Securities and Exchange Board of India (Mutual Funds) (Fifth Amendment) Regulations, 2006 shall ensure compliance therewith within three months from such commencement f. Two-thirds of the trustees shall be independent persons and shall not be associated with the sponsors or be associated with them in any manner whatsoever. 5.8 ASSET MANAGEMENT COMPANY As per the definition of the SEBI (Mutual Fund) Regulations asset management company means a company formed and registered under the Companies Act, 1956 (1 of 1956) and approved as such by the SEBI under its regulations. Every mutual fund is required to have an Asset Management Company and should enter into an agreement with the trustees of the mutual fund to formulate schemes, raise money against units, invest the funds in accrued securities and after meeting the permissible costs as per norms, distribute income to the share holders of the fund. Appointment of an asset management company 1. The sponsor or, if so authorised by the trust deed, the trustee, shall appoint an asset management company, which has been approved by the Board under subregulation (2) of regulation 21. 2. The appointment of an asset management company can be terminated by majority of the trustees or by seventy-five per cent of the unitholders of the scheme. 3. Any change in the appointment of the asset management company shall be subject to prior approval of the Board and the unitholders. Eligibility criteria for appointment of asset management company For grant of approval of the asset management company the applicant has to fulfil the following : a. in case the asset management company is an existing asset management company it has a sound track record, general reputation and fairness in transactions. Explanation : For the purpose of this clause sound track record shall mean the net worth and the profitability of the asset management company; b. the directors of the asset management company are persons having adequate professional experience in finance and financial services related field and not found
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c.
d.
e. f.
guilty of moral turpitude or convicted of any economic offence or violation of any securities laws; the key personnel of the asset management company 26[have not been found guilty of moral turpitude or convicted of economic offence or violation of securities laws for any asset management company or mutual fund or any intermediary registration has been suspended or cancelled at any time by the Board; the board of directors of such asset management company has at least fifty per cent directors, who are not associate of, or associated in any manner with, the sponsor or any of its subsidiaries or the trustees; the Chairman of the asset management company is not a trustee of any mutual fund; the asset management company has a networth of not less than rupees ten crores :
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Provided that an asset management company already granted approval under the provisions of Securities and Exchange Board of India (Mutual Funds) Regulations, 1993 shall within a period of twelve months from the date of notification of these regulations increase its networth to rupees ten crores : Provided further that the period specified in the first proviso may be extended in appropriate cases by the Board up to three years for reasons to be recorded in writing: Provided further that no new schemes shall be allowed to be launched or managed by such asset management company till the networth has been raised to rupees ten crores. Explanation : For the purposes of this clause, networth means the aggregate of the paid up capital and free reserves of the asset management company after deducting therefrom miscellaneous expenditure to the extent not written off or adjusted or deferred revenue expenditure, intangible assets and accumulated losses. The Board may, after considering an application with reference to the matters specified in sub-regulation (1), grant approval to the asset management company. Terms and conditions to be complied with The approval granted under sub-regulation (2) of regulation 21 shall be subject to the following conditions, namely: a. any director of the asset management company shall not hold the office of the director in another asset management company unless such person is an independent director referred to in clause (d) of sub-regulation (1) of regulation 21 and approval of the Board of asset management company of which such person is a director, has been obtained; b. the asset management company shall forthwith inform the Board of any material change in the information or particulars previously furnished, which have a bearing on the approval granted by it;
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c. No appointment of a director of an asset management company shall be made without prior approval of the trustees; d. The asset management company undertakes to comply with these regulations; e. no change in the controlling interest of the asset management company shall be made unless, i. ii. prior approval of the trustees and the Board is obtained;
a written communication about the proposed change is sent to each unitholder and an advertisement is given in one English daily newspaper having nationwide circulation and in a newspaper published in the language of the region where the Head Office of the mutual fund is situated; and a. the unitholders are given an option to exit on the prevailing Net Asset Value without any exit load; b. The asset management company shall furnish such information and documents to the trustees as and when required by the trustees. Asset Management Company and its obligations as per SEBI (Mutual Fund) Regulations 1. The asset management company shall take all reasonable steps and exercise due diligence to ensure that the investment of funds pertaining to any scheme is not contrary to the provisions of these regulations and the trust deed. 2. The asset management company shall exercise due diligence and care in all its investment decisions as would be exercised by other persons engaged in the same business. 3. The asset management company shall be responsible for the acts of commission or omission by its employees or the persons whose services have been procured by the asset management company. 4. The asset management company shall submit to the trustees quarterly reports of each year on its activities and the compliance with these regulations. 5. The trustees at the request of the asset management company may terminate the assignment of the asset management company at any time. Provided that such termination shall become effective only after the trustees have accepted the termination of assignment and communicated their decision in writing to the asset management company. 6. Notwithstanding anything contained in any contract or agreement or termination, the asset management company or its directors or other officers shall not be absolved of liability to the mutual fund for their acts of commission or omission, while holding such position or office. 7. The Chief Executive Officer (whatever his designation may be) of the asset management company shall ensure that the mutual fund complies with all the provisions of these regulations and the guidelines or circulars issued in relation thereto from time to time and that the investments made by the fund managers are
in the interest of the unit holders and shall also be responsible for the overall risk management function of the mutual fund. 8. The fund managers (whatever the designation may be) shall ensure that the funds of the schemes are invested to achieve the objectives of the scheme and in the interest of the unit holders. 9. An asset management company shall not through any broker associated with the sponsor, purchase or sell securities, which is average of 5 per cent or more of the aggregate purchases and sale of securities made by the mutual fund in all its schemes Provided that for the purpose of this sub-regulation, the aggregate purchase and sale of securities shall exclude sale and distribution of units issued by the mutual fund : Provided further that the aforesaid limit of 5 per cent shall apply for a block of any three months. An asset management company shall not purchase or sell securities through any broker [other than a broker referred to in clause (a) of sub-regulation (7)] which is average of 5 per cent or more of the aggregate purchases and sale of securities made by the mutual fund in all its schemes, unless the asset management company has recorded in writing the justification for exceeding the limit of 5 per cent and reports of all such investments are sent to the trustees on a quarterly basis: Provided that the aforesaid limit shall apply for a block of three months. 10. An asset management company shall not utilise the services of the sponsor or any of its associates, employees or their relatives, for the purpose of any securities transaction and distribution and sale of securities : Provided that an asset management company may utilise such services if disclosure to that effect is made to the unitholders and the brokerage or commission paid is also disclosed in the half-yearly annual accounts of the mutual fund : Provided further that the mutual funds shall disclose at the time of declaring half yearly and yearly results : i. any underwriting obligations undertaken by the schemes of the mutual funds with respect to issue of securities associate companies, ii. devolvement, if any, iii. subscription by the schemes in the issues lead managed by associate companies, iv. subscription to any issue of equity or debt on private placement basis where the sponsor or its associate companies have acted as arranger or manager.
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11. The asset management company shall file with the trustees the details of transactions in securities by the key personnel of the asset management company in their own name or on behalf of the asset management company and shall also report to the Board, as and when required by the Board. 12. In case the asset management company enters into any securities transactions with any of its associates a report to that effect shall be sent to the trustees at its next meeting. 13. In case any company has invested more than 5 per cent of the net asset value of a scheme, the investment made by that scheme or by any other scheme of the same mutual fund in that company or its subsidiaries shall be brought to the notice of the trustees by the asset management company and be disclosed in the half-yearly and annual accounts of the respective schemes with justification for such investment [provided the latter investment has been made within one year of the date of the former investment calculated on either side] 14. The asset management company shall file with the trustees and the Board a. detailed bio-data of all its directors along with their interest in other companies within fifteen days of their appointment; b. any change in the interests of directors every six months; and c. a quarterly report to the trustees giving details and adequate justification about the purchase and sale of the securities of the group companies of the sponsor or the asset management company, as the case may be, by the mutual fund during the said quarter. 15. Each director of the asset management company shall file the details of his transactions of dealing in securities with the trustees on a quarterly basis in accordance with guidelines issued by the Board. 16. The asset management company shall not appoint any person as key personnel who has been found guilty of any economic offence or involved in violation of securities laws. 17. The asset management company shall appoint registrars and share transfer agents who are registered with the Board : Provided if the work relating to the transfer of units is processed in-house, the charges at competitive market rates may be debited to the scheme and for rates higher than the competitive market rates, prior approval of the trustees shall be obtained and reasons for charging higher rates shall be disclosed in the annual accounts. 18. The asset management company shall abide by the Code of Conduct as specified in the Fifth Schedule. Custodian As per the definition of the SEBI (Mutual Fund) Regulations custodian means a person who has been granted a certificate of registration to carry on the business of custodian of securities under the Securities and Exchange Board of India (Custodian of Securities) Regulations, 1996.
Appointment of custodian 1. The mutual fund shall appoint a Custodian to carry out the custodial services for the schemes of the fund and sent intimation of the same to the Board within fifteen days of the appointment of the Custodian; in case of a gold exchange traded fund scheme, the assets of the scheme being gold or gold related instruments may be kept in custody of a bank which is registered as a custodian with the Board. 2. No custodian in which the sponsor or its associates hold 50 per cent or more of the voting rights of the share capital of the custodian or where 50 per cent or more of the directors of the custodian represent the interest of the sponsor or its associates shall act as custodian for a mutual fund constituted by the same sponsor or any of its associates or subsidiary company. Agreement with custodian The mutual fund shall enter into a custodian agreement with the custodian, which shall contain the clauses which are necessary for the efficient and orderly conduct of the affairs of the custodian: Provided that the agreement, the service contract, terms and appointment of the custodian shall be entered into with the prior approval of the trustees. 5.9 SEBI (MUTUAL FUND) REGULATIONS, 1996 General Obligations: Some of the general obligations as per the SEBI (Mutual Fund) Regulations, 1996 reproduced below. (1) Proper books of account and records, etc. Every asset management company for each scheme shall keep and maintain proper books of account, records and documents, for each scheme so as to explain its transactions and to disclose at any point of time the financial position of each scheme and in particular give a true and fair view of the state of affairs of the fund and intimate to the Board the place where such books of account, records and documents are maintained. Every asset management company shall maintain and preserve for a period of Eight years its books of account, records and documents. (2) Restrictions on issue expenses All expenses should be clearly identified and appropriated in the individual schemes. The Asset Management Company may charge the mutual fund with investment and advisory fees which are fully disclosed in the offer document subject to the following namely:
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i. One and a quarter of one per cent of the weekly average net assets outstanding in each accounting year for the scheme concerned, as long as the net assets do not exceed Rs. 100 crores, and ii. One per cent of the excess amount over Rs. 100 crores, where net assets so calculated exceed Rs. 100 crores. For schemes launched on a no load basis, the asset management company shall be entitled to collect an additional management fee not exceeding 1% of the weekly average net assets outstanding in each financial year. In addition to the above, recurring expenses including: i. marketing and selling expenses including agents commission, if any ; ii. brokerage and transaction cost ; iii. registrar services for transfer of units sold or redeemed ; iv. fees and expenses of trustees ; v. audit fees ; vi. custodian fees ; vii. costs related to investor communication ; viii. costs of fund transfer from location to location ; ix. costs of providing account statements and dividend/redemption cheques and warrants ; x. Insurance premium paid by the fund; xi. Winding up costs for terminating a fund or a scheme; xii. Costs of statutory advertisements (xii.a) In case of a gold exchange traded fund scheme, recurring expenses incurred towards storage and handling of gold; (xii.b) In case of a capital oriented scheme, rating fees; and (xiii) Such other costs as may be approved by the Board. The total expenses of the scheme excluding issue or redemption expenses, whether initially borne by the mutual fund or by the asset management company, but including the investment management and advisory fee shall be subject to the following limits : i. On the first Rs. 100 crores of the average weekly net assets 2.5%; ii. On the next Rs. 300 crores of the average weekly net assets 2.25%; iii. On the next Rs. 300 crores of the average weekly net assets 2.0%; iv. On the balance of the assets 1.75%: Provided that such recurring expenses shall be lesser by at least 0.25% of the weekly average net assets outstanding in each financial year in respect of a scheme investing in bonds: Provided further that in case of a fund of funds scheme, the total expenses of the scheme including the management fees shall not exceed 0.75% of the daily or weekly average net
160
assets, depending upon whether the NAV of the scheme is calculated on daily or weekly basis. Any expenditure in excess of the limits specified in sub-regulation (6) shall be borne by the asset management company or by the trustee or sponsors. (3) Declaration of dividends: A mutual fund may declare dividends in accordance with the offer document and subject to such Guidelines as may be specified by the Board. (4) Despatch of warrants and proceeds: Every mutual fund and asset management company shall, a. despatch to the unitholders the dividend warrants within 30 days of the declaration of the dividend; b. despatch the redemption or repurchase proceeds within 10 working days from the date of redemption or repurchase; c .in the event of failure to despatch the redemption or repurchase proceeds within the period specified in sub-clause (b), the asset management company shall be liable to pay interest to the unitholders at such rate as may be specified by the Board for the period of such delay; d. otwithstanding payment of such interest to the unit-holders under sub-clause (c),the asset management company may be liable for penalty for failure to despatch the redemption or repurchase proceeds within the stipulated time. (5) Annual Report: Every mutual fund or the asset management company shall prepare in respect of each financial year an annual report and annual statement of accounts of the schemes and the fund as specified in Eleventh Schedule. (6) Auditors report: Every mutual fund shall have the annual statement of accounts audited by an auditor who is not in any way associated with the auditor of the asset management company. Explanation: For the purposes of this sub-regulation and regulation 66 auditor means a person who is qualified to audit the accounts of a company under section 224 of the Companies Act, 1956 (1 of 1956). An auditor shall be appointed by the trustees. The auditor shall forward his report to the trustees and such report shall form part of the Annual Report of the mutual fund. The auditors report shall comprise the following: i. Auditor has obtained all information and explanations which, to the best of his knowledge and belief, were necessary for the purpose of the audit ;
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ii the balance sheet and the revenue account give a fair and true view of the scheme, state of affairs and surplus or deficit in the Fund for the accounting period to which the Balance Sheet or, as the case may be, the Revenue Account relates ; iii. the statement of account has been prepared in accordance with accounting policies and standards as specified in the Ninth Schedule. (7) Annual Report to the investors: The scheme wise Annual Report of a mutual fund or an abridged summary thereof shall be mailed to all unitholders as soon as may be but not later than six months from the date of closure of the relevant accounting year. The Annual Report and abridged summary thereof shall contain details as specified in the Eleventh Schedule and such other details as are necessary for the purpose of providing a true and fair view of the operations of the mutual fund: Provided that the abridged scheme wise annual report mailed to unitholders need not contain full portfolio disclosure but must contain details on group company investments such as the name of the company, the amount of investment made in each company of the group by each scheme and the aggregate investments made by all schemes in the group companies of the sponsor. (8) Notice before inspection and investigation: Without prejudice to the provisions of regulation 55, the Board shall have the power to appoint an auditor to inspect or investigate, as the case may be, into the books of account or the affairs of the mutual fund, trustee or asset management company: Provided that the Auditor so appointed shall have the same powers of the inspecting officer as stated in regulation 61 and the obligation of the mutual fund, asset management company, trustee, and their respective employees in regulation 63, shall be applicable to the investigation under this regulation. (9) Show cause notice and order: On receipt of the report from the enquiry officer, the Board shall consider the same and issue to the mutual fund, trustees or Asset Management Company, a show-cause notice. The mutual fund, asset management company or trustee, shall within fourteen days of the date of the receipt of the show-cause notice, send a reply to the Board. The Board, after considering the reply of the mutual fund, trustees or asset management company, if any, shall as soon as possible pass such order as it deems fit. The Board shall send to the mutual fund, trustees, or Asset Management Company, a copy of the order made under regulations.
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(10) Effect of suspension or cancellation of certificate of registration On and from the date of the suspension of the certificate or the approval, as the case may be, the mutual fund, trustees or asset management company, shall cease to carry on any activity as a mutual fund, trustee or asset management company, during the period of suspension, and shall be subject to the directions of the Board with regard to any records, documents, or securities that may be in its custody or control, relating to its activities as mutual fund, trustees or asset management company. (11) Action against intermediaries The Board may initiate action for suspension or cancellation of registration of an intermediary holding a certificate of registration under section 12 of the Act who fails to exercise due diligence or to comply with the obligations under these regulations; Provided that no such certificate of registration shall be suspended or cancelled unless the procedure specified in regulations applicable to such intermediary is complied with. Illustration 1: A mutual fund that had a net asset value of Rs 10 at the beginning of month -t made income and capital gain distribution of Re 0.05 and Re 0.04 per share respectively during the month, and then ended the month with a net asset value of Rs 10.03. Calculate monthly return. Answer: Monthly Return on the Mutual Fund = r
NOTES
(NAVt - NAV t-1) + Income at the timet + Capital Gain r = NAV t-1 (Rs 10.03 Rs 10.00) + Re 0.05 + Re 0.04 = = 0.012 Rs 10.00 = 1.20% per month or 14.40% per annum Illustration 2: The unit price of TSS Scheme of a mutual fund is Rs 10. The public offer price of the unit is Rs10.204 and the redemption price Rs 9.80. Calculate (i) Front end load and (ii) Back end Load. Answer: (i) Calculation of Front-end Load Public offer price = Net Asset Value 1 Front-end load
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10.204
10 1 Front-end load = = 10 0.204 / 10.204 = Rs 0.01999 or 2%
10.204 (1 Front-end load) Front end load (ii) Calculation of back end load
Redemption price =
Net Asset Value 1- back end load 10 1- Back end load = = 10 0.20 / 9.80 = 2.04%
9.80
9.80 (1 - Back end load) Back end load
Illustration 3: Mr. A has invested in three Mutual Fund schemes as per detailed below: Date of investment Amount of investment Net Asset Value at entry date Dividend received up to 31.03.2004 NAV as at 31.03.2004 01.12.2003 Rs 50,000 Rs 10.50 Rs 950 Rs 10.40 01.01.2004 Rs 1,00,000 Rs 10 Rs 1,500 Rs 10.10 01.03.2004 Rs 50,000 Rs 10 Rs Nil Rs 9.80
Required; what is the effective yield on per annum basis in respect of each of the three schemes to Mr. A up to 31.03.2004. Answer: MF X Rs 50,000 4,761.905 10.40 49,523.81
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Investment No. of units Unit NAV on 31.3.2004 Total NAV on 31.03.2004
MF Y Rs 1,00,000 10,000 10.10 1,01,000
MF Z Rs 50,000 5,000 9.80 49,000
Increase or (decrease) of NAV Dividend Received Total yield Number of days Effective yield per annum
(476.19) 950 473.81 122 2.835%
1,000 1,500 2,500 91 10.027%
(1,000) Nil (1,000) 31 (24%)
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5.10 MUTUAL FUNDS AND CREDIT RATING Credit rating has occupied vital place in the modern and developed financial markets. The issuer of long term source of fund, long term debt, debentures, bonds, fixed deposit and commercial paper, including mutual funds need to have the credit rating not only to get reliability from the others but also to fulfill the legal requirements such as SEBI and RBI. The Benefits of credit rating to the mutual funds For the Investor, the Ratings: Facilitate informed investment decision making Provide independent and reliable opinion on: the relative credit quality of the portfolio the quality of the Funds management and operations Help meet specific investment objectives For the Intermediaries, the Ratings help to: Provide informed advice to investors Offer products matching the specific return-risk preferences of investors Enhance the marketability of various schemes Differentiate (using the ICRA Rating) the various Schemes from other Rated/ non-Rated Schemes
For the Fund Sponsors/AMCs, the Ratings: Provide an assessment made by an independent agency Serve as a marketing tool to differentiate a scheme from other available schemes Help meet investors rating requirements Provide for benchmarking of performance
ICRA Mutual Fund Credit Risk Ratings: Scale and Definitions ICRAs LongTerm Debt Fund Credit Risk Rating Scale: This scale is used to rate the underlying credit risk of debt funds portfolio on the long term rating scale
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Notes: For the rating categories mfAA through to mfC the sign of + (plus) or - (minus) may be appended to the rating symbols to indicate their relative position within the rating categories concerned. Thus, the rating of mfAA+ is one notch higher than mfAA, while mfAA- is one notch lower than mfAA. ICRAs Short-Term debt fund Credit Risk Rating Scale: This scale applies to debt funds with weighted average maturity up to one year. Such funds would generally include liquid funds and cash funds. Benchmark maturity for this scale is 12 months.
NOTES
Notes: For the short-term fund ratings of mfA1 through to mfA4, the sign of + (plus) may be appended to the rating symbols to indicate their relatively stronger position within the rating categories concerned. Thus, the rating of mfA2+ is one notch higher than mfA2. 5.11 INSURANCE 5.11.1 Introduction Insurance basically are two types one is life insurance and other one is general insurance. Under Life Insurance policy the insurance covers the life o the insured up to the policy amounts. In other words in case of death of the policy holder, the nominee of the insured could get the policy value. Life insurance policy also facilitate for payment of the policy value either at maturity or by installments at an agreed bonus to the policy holder. General Insurance means insurance other than the life insurance. As per the definition of the Insurance Act General Insurance Business as fire, marine or miscellaneous insurance
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business whether carried on singly or in combination with one or more of them. For example general insurance can be viewed as exchange risk insurance, motor vehicle insurance, burglary insurance and workmen compensation insurance and so on. History of the Insurance Companies in India: The Indian Life Assurance Companies Act, 1912 was the first statutory measure to regulate life business in India. In 1928, the Indian Insurance Companies Act was enacted to enable the Government to collect statistical information about both life and non-life business transacted in India by Indian and foreign insurers including provident insurance societies. In 1938, with a view to protecting the interest of the Insurance public, the earlier legislation was consolidated and amended by the Insurance Act, 1938 with comprehensive provisions for effective control over the activities of insurers. There was large number of insurance companies and level of operations and unfair trade practices during the period 1950s. Therefore, the Government of India decided to nationalize insurance business in the same year. The Life Insurance Corporation of India (LIC) was formed by the Government of India in the in the year 1956 by an Ordinance. The LIC absorbed 154 Indian, 16 non-Indian insurers as also 75 provident societies. Till the year 1990 the LIC was the only player in the life insurance business. This sector is reopened to the private sector in the year 2000 based on the R N Malhotra (the former insurance secretary and the RBI governor) committee report. The General Insurance came to India as a legacy of British occupation. The general insurance company was established in India for the first time in the year 1850 in Calcutta by the British. In the year 1972 General Insurance Business (Nationalisation) Act, 1972 was brought by the government of India. The General Insurance Corporation is not meant to offer returns but is a protection against contingencies like accidents, illness, fire, burglary etc. The General Insurance Corporation has four subsidiaries namely (i) The National Insurance Company Limited (ii) New India Assurance Company Limited (iii) Oriental Insurance Company and (iv) United India Insurance Company Limited. In the year 1993, the committee under the chairmanship of R N Malhotra was strongly recommended the need of regulations for the insurance business. In this process the Insurance Regulatory and Development Authority (IRDA) Act, 1999 was enacted by parliament in the fiftieth year of the Republic of India to provide for the establishment of an authority to protect the interest of holders of insurance policies. At present the Indian Insurance industry is governed by the Insurance Act, 1978, the General Insurance Business (Nationalisation) Act, 1972, Life Insurance Corporation Act, 1956 apart from the IRDA regulations.
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The IRDA was incorporated as a statutory body with the objectives which includes promotion of competition so as to enhance customer satisfaction through increased consumer choice and lower premiums, while ensuring the financial security of the insurance market. The IRDA opened up the market in August 2000 with the invitation for application for registrations. Foreign companies were allowed ownership of up to 26%. The Authority has the power to frame regulations under Section 114A of the Insurance Act, 1938 and framed various regulations ranging from registration of companies for carrying on insurance business to protection of policyholders interests. In December, 2000, the subsidiaries of the General Insurance Corporation of India were restructured as independent companies and at the same time GIC was converted into a national re-insurer. Parliament passed a bill de-linking the four subsidiaries from GIC in July, 2002. At present there are 15 general insurance companies including the Export Credit Guarantee Corporation (ECGC), and Agriculture Insurance Corporation of India and 16 life insurance companies operating in the country. 5.11.2 Life Insurance Businesses in India There are 15 private sector companies and one in public sector was registered with the IRDA up to the year ending 2006. They are as follows; 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. Life Insurance Corporation of India Birla Sun-life Insurance Company Limited Bajaj Allianz Life Insurance Company Limited HDFC Standard Life Insurance Company Limited ICICI Prudential Life Insurance Company Limited ING Vysya Life Insurance Company Limited Max New York Life Insurance Company Limited Metlife India Insurance Company Pvt. Limited Kotak Mahindra Old Mutual Life Insurance Limited SBI Life Insurance Company Limited TATAAIG Life Insurance Company Limited Reliance Life Insurance Company Limited Aviva Life Insurance Company India Pvt. Ltd Sahara India Life Insurance Company Limited Sriram Life Insurance Company Limited Bharti AXA Life Insurance Company Limited.
NOTES
We have various types of life insurance products with which insurance companies are dealing with, namely Endowment Plan, Money back Policies, Whole-life policy, Term Insurance policy, Unit-linked Insurance polices and Group Insurance policies. These life insurance products are occupying the major market share in terms of resource mobilization.
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As per the report of the IRDA till October 2006 the market share of Life Insurance Players are as follows
We have the following advantages in case of Life Insurance Business: a. Financial protection to the insured family against unpredictable events. b. Income tax benefit under section 80C up to Rs 1,00,000 at present c. It provides a very good source of income for the individuals who retired from the services due to age factor d. Insurance business helps us by providing certain periodic financial needs, either for childs education or marriage etc. 5.11.3 Type of products under Life Insurance Business: As we said in the above we have following broad types of insurance policies for the investors according to their interest and choice to choose for investment. (1) Endowment Policy: Endowment policy means the sum assured together with bonus is payable on the date of maturity or in the event of death of the insured, whichever is earlier. This is popular product mobilizes considerable market because it provides us long term savings facility with risk coverage. (2) Money back Policy: Money-back policy means the sum assured is returned as lum-sum after defined period of intervals. In this policy the policy holder receives a fixed sum at fixed intervals during the term of the policy and at the end of the maturity. This policy is also popular because it meets the needs of short term finance requirements of the investors.
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(3) Whole-life Policy: Whole-life policy means the policy holder goes on paying the premium through out his life and on account of his death, the money is handed over to his family. This policy is not success due to non fulfillment of either short term or long term needs of the insured in addition to heavy premium. (4) Term Insurance Policy: Term insurance policy means the policy holder goes on paying the premium for the defined period of time with very low premium and the sum assured is payable only if the policy holder dies within the policy term. If the policy holder survives, he is not entitled to any payment on maturity. (5) Unit Linked Insurance policy: Unit linked insurance policies means a part of the premium is invested in a fund and the return is linked to the performance of the fund. These are like mutual funds when we pay the premium, the insurance company after deducting some charges, invests the net amount in stock market instruments. These are NAV based insurance policies few of them cover the risk few of the non risk coverage policies. For Example recently the LIC of India launched the two Unit Linked Insurance policies one is Profit Plus and Market Plus, former one cover the insurance and later one is non risk coverage policy. (6) Group Insurance Policy: Group insurance polices are generally taken by the corporate to cover the risk of the life of their employees. Group gratuity and superannuation plans are come under this category. These are popular polices in India because of lower premium and group gratuity and superannuation plans are compulsory as a result of statutory compliance. General Insurance Business Basically the general insurance business is to provide the short term coverage of insurance risk usually for a period of 12 months. Since general insurance is non-life insurance it covers the following types of insurance namely a. Fire Insurance b. Motor Vehicle Insurance c. Marine Insurance and d. Miscellaneous insurance. The six public sector general insurance companies namely the Oriental Insurance Company Limited, The New India Assurance Company Limited, The National Insurance Company Limited and the United India Insurance Company Limited in addition to ECGC
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and Agriculture Insurance Company of India catering the services to cover the risk of fire, motor vehicles, marine and miscellaneous risk. Private sector companies also participate in general insurance business as helping hand to the insured. We have the following general insurance companies under private sector to provide the non-life insurance in India. 1. 2. 3. 4. 5. 6. 7. 8. 9. The Royal Sundaram Alliance Insurance Company Limited The Reliance General Insurance Company Limited IFFCO Tokio General Insurance Company Limited TATA AIG General Insurance Company Limited Bajaj Alianz General Insurance Company Limited ICICI Lombard General Insurance Company Limited Cholamandalam General Insurance Company Limited HDFC Chubb General Insurance Company Limited Star Health and Allied Insurance Company Limited
5.11.4 Types of general insurance policies: (1) Fire Insurance Policies: Fire Insurance policy can be described as an agreement whereby one party, for a consideration, undertakes to indemnify the other party up to an agreed amount against financial loss of goods or property which the latter may suffer because of fire. Fire insurance generally covers the building or flat, plant and machinery, furniture and fixtures, loss of profit and so on. Fire insurance policy is a comprehensive policy which covers loss on account of fire, earthquake, riots floods, strikes, and malicious intent etc. Owner of the premises are only allowed to take this type of policy, a tenant if not allowed to insure the rental premises, however he is allowed to insure the contents of the premises. (2) Motor Vehicle Insurance: Motor vehicle insurance covers generally two types of risks one is the risk of damage by an accident or loss by theft and other one is the risk of liability arising from an injury or death of any person in an accident caused by a vehicle, commonly known as Third party Insurance. Therefore as per the Indian Motor Vehicles Act the owner of the vehicle is compulsorily required to get third party insurance. (3) Marine Insurance: Marine Insurance is one of the oldest insurance. It means the insurance company or the underwriter agrees to indemnify the owner of a ship or cargo against risks which are incidental to marine adventure such as sinking or burning of the ship and its contents, stranding of the ship, collision of ship, jettison etc.
We have the common sub- types of marine insurance which are as follows: Cargo insurance, Hull Insurance and Freight Insurance. Cargo insurance means it is type of insurance which covers risks to the cargo on the ship. The cargo on the ship is exposed to risk arising from any act of God, enemies, fire etc. Marine Hull Insurance means the ship is also exposed to the perils described in the cargo insurance. Therefore the owner of the ship may effect hull insurance to cover the risk arising from the act of God, enemies, fire etc. (4) Miscellaneous Insurance: In addition to the above general insurance there are a number of other insurance policies which cover various other types of risks which includes Fidelity insurance, Credit insurance, Workmens Compensation Insurance, Potential liability insurance and so on. Reinsurance Business Reinsurance plays a vital role in the insurance business. The services provided by the reinsurance company is almost same as provided by the insurance companies to their policy holders. In case of general insurance business the risk is huge due to their magnitude or nature, hence, one insurance company can not afford to cover entire risk for example aviation insurance. Therefore, the reinsurance business can be defined as an agreement between a ceding company and a reinsurer whereby the former agrees to cede and the latter agrees to accept a certain specified share of risk or liability upon terms and condition as set out in the agreement. A ceding company means the original insurance company which has accepted the risk and has agreed cede or pass on that risk to another insurance company or a reinsurance company. We further classify the reinsurance into two sub classification one is Facultative Reinsurance and other one is the Treaty Reinsurance. 5.11.5 Insurance Regulatory and Development Authority Act, 1999 The IRDA is the supreme body to regulate the entire insurance business in India. The Insurance Regulatory and Development Authority is empowered to issue the regulations, guidelines and clarifications along with the promotional and development role. The promotional and development role includes promoting competition so as to enhance customer satisfaction through increased consumer choice and lower premium, while ensuring the financial security of the insurance market. Duties, Powers and Functions of Authority. As per section 14 of the IRDA Act, 1999 relating to the duties, powers and functions of the authority is reproduced below.
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1.
Subject to the provisions of this Act and any other law for the time being in force, the Authority shall have the duty to regulate, promote and ensure orderly growth of the insurance business and re-insurance business. Without prejudice to the generality of the provisions contained in sub-section (1), the powers and functions of the Authority shall include, a. issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or cancel such registration; b. protection of the interests of the policy holders in matters concerning assigning of policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender value of policy and other terms and conditions of contracts of insurance; c. specifying requisite qualifications, code of conduct and practical training for intermediary or insurance intermediaries and agents; d. specifying the code of conduct for surveyors and loss assessors; e. promoting efficiency in the conduct of insurance business; f. promoting and regulating professional organisations connected with the insurance and re-insurance business; g. levying fees and other charges for carrying out the purposes of this Act; h. calling for information from, undertaking inspection of, conducting enquiries and investigations including audit of the insurers, intermediaries, insurance intermediaries and other organisations connected with the insurance business; i. control and regulation of the rates, advantages, terms and conditions that may be offered by insurers in respect of general insurance business not so controlled and regulated by the Tariff Advisory Committee under section 64U of the Insurance Act, 1938 (4 of 1938); specifying the form and manner in which books of account shall be maintained and statement of accounts shall be rendered by insurers and other insurance intermediaries; regulating investment of funds by insurance companies; regulating maintenance of margin of solvency;
2.
j.
k. 1.
m. adjudication of disputes between insurers and intermediaries or insurance intermediaries; n. o. supervising the functioning of the Tariff Advisory Committee; specifying the percentage of premium income of the insurer to finance schemes for promoting and regulating professional organizations referred to in clause (f);
p. q.
specifying the percentage of life insurance business and general insurance business to be undertaken by the insurer in the rural or social sector; and exercising such other powers as may be prescribed.
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Registration Procedure To carry insurance business in India should be registered with the IRDA. The registration procedure explained under Insurance Regulatory and Development Authority (Registration of Indian Insurance Companies) Regulations, 2000 is produced below: 1. An applicant desiring to carry on insurance business in India shall make a requisition for registration application in Form IRDA/R1. 2. Every requisition for registration application shall be accompanied by a. a certified copy of the memorandum of association and articles of association, where the applicant is a company and incorporated under Companies Act,1956 (1 of 1956); b. the name, address and the occupation of the directors and principal officer; c. a statement of the class of insurance business proposed to be carried on; d. a statement indicating the sources that will contribute the share capital required under section 6 of the Act; 3. An affidavit must be submitted by the principal officer of the insurer that the requirement of paid up capital of Rs 100 crore in case of insurance business and Rs 200 crore in case of general and reinsurance business have been complied with. 4. The insurance companies are required to deposit with the RBI, on behalf of the Government of India in cash or approved securities in case of Life Insurance business a sum equivalent to 1% of total gross premium not exceeding Rs 10 crore within India in any financial year, in case of general insurance business a sum equivalent to 3% of total gross premium not exceeding Rs 10 crore, within India in any financial year. 5. The fee of rupees fifty thousand for each class of business for registration shall be remitted by a bank draft issued by any scheduled bank in favour of the Insurance Regulatory and Development Authority payable at New Delhi. 6. A certificate from a practising chartered accountant or a practising company secretary certifying that all the requirements relating to registration fees, share capital, deposits, and other requirements of the Act have been complied with by the applicant; has to enclosed. 7. A certificate copy of the published prospectus if any and standard policy forms of the insurer and statements of the assured rates, advertisements, terms and conditions to be offered in connection with insurance policies, together with a certificate in
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connection with life business by an actuary that such rates or advantages or terms and conditions are workable and sound. 8. Any such other documents required by the IRDA need to be submitted. On submission of all the relevant documents the IRDA may register the applicant name and grant a certificate of registration. 5.12 SECURITISATION AND ASSETS RECONSTRUCTION COMPANIES For the past 10 years it is evident that Indian economy has faced many times financial crises. In most cases, crises arises mainly due to financial sector culminate into non-performing assets namely NPAs. A higher rate of NPAs in the banking system can severely affect the economy in many ways for any given country. In addition to the existing non-performing assets the banks tend to become risk averse in making new loans, particularly to small and medium sized companies. Thus large scale NPAs when left untouched, cause continued economic and financial degradation of the country. Non-Performing Asset: It means an asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. NPA can be defined as a credit facility or advance whose (i) interest and installment of principal remain overdue for more than 90 days in respect of a term loan, (ii) account remains out of order for more than 90 days in respect of an overdraft or cash credit, (iii) bill remains overdue for more than 90 days in case of bills purchased or discounted, (iv) interest and or installment of principal remain overdue for two harvest seasons but for a period not exceeding two half years in case of advances granted for agricultural purposes and (v) amount to be viewed remain overdue for more than 90 days in respect of other accounts. The Government of India came to know the importance of recovery of non-performing assets only when the Narasimhan Committee was highlighted this in the year 1997. The Narasimhan Committee report mentioned that an importance aspect of the continuing reform process was to reduce the high level of non-performing assets as means of banking sector reform. With this it was expected that with a combination of policy and institutional development, new NPAs in future could be lower, however our problem is with the huge backlog of existing NPAs. Of course, there is no doubt the higher rate of NPAs impinged severely on the banks performance and their profitability. The Report envisaged creation of an Asset Recovery Fund to take the NPAs off the lenders books at a discount.
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Asset Reconstruction Company (ARC) is a company which is set up with the objective of taking over distressed assets (Non performing assets) from banks or financial institutions and to reconstruct or redress these assets to make those assets saleable. In this context the Narasimham Committee in its first report had suggested formation of Asset Reconstruction Companies (ARC) with a view to clean the balance sheet of banks. These Asset Reconstruction Companies are generally public or government owned companies. ARCs functions as debt aggregators and engage in acquisition of NPAs. Thus ARCs take away the distraction by isolating NPAs from the banking system and fucntion as Bad Bank. ARCs facilitate the banking system free from NPAs and allow to act as Good Bank. In fact the Government of India encourages transfer of assets to ARCs through creation of supportive environment. Therefore, ARCs will purchase the non performing assets from banks and financial institutions at a discount which will clear their balance sheets of sticky loans. NPAs can be assigned by banks and Financial Institutions. In turn these assets will be reconstructed or rebuilt and then sold in the market in various forms or recovered through securitization and reconstruction of enforcement of security. In this process the Government of India proactively initiated certain measures to control NPAs by setting up Debt Recovery Tribunals and Debt Appellate Tribunals under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993. To expedite the process of recovery from NPAs, the Government of India also set up the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. In India The Asset Reconstruction Company Limited, is the first ARC with an initial equity capital of Rs 10 Crore out of which ICICI bank, IDBI and SBI contribution is up to 24.50%, and balance to be shared by HDFC and UTI Bank. These ARCs will need to be registered with RBI before they take up any activity. The banks and financial institutions make their balance sheets cleaner after selling their impaired assets to ARCs and they also find time to develop their business. Asset Reconstruction Companies may be able to mix up their assets (ie. good and bad) in such manner to make them saleable. There is possibility of securitization resulting in funding of these assets through capital instruments. Securitisation is a process of transformation of illiquid asset into security which may be traded later in the open market. The Reserve Bank of India framed guidelines for Asset Reconstruction Companies, banks and financial institutions for transfer of assets to ARCs by defining prudential guidelines for ARCs and permitting Indian banks and financial institutions to participate in papers (certificates) issued by ARCs.
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5.12.1 Guidelines: Issued by the RBI has been reproduced which are in the nature of recommendatory (1) Acquisition of Financial Assets: a. The Asset Acquisition Policy shall provide that the transactions take place in a transparent manner and at a true price in a well informed market, and the transactions are executed at arms length in exercise of due diligence; The Policy so framed should provide for checks in the matter of acquiring assets from a single Bank/FI, own sponsors and any single entity upto a desirable level of ceiling so that possible departures from desirable practices are avoided; The percentage of financial assets to be acquired should be appropriately and objectively worked out keeping in view the fact that the percentage of ownership stake has a bearing on the speed with which security interest rights can be enforced in accordance with the provisions of the Ordinance; For easy and faster realisability, financial assets due from a single debtor to various banks / FIs may be considered for acquisition. Similarly, financial assets having linkages to the same collateral may be considered for acquisition to ensure relatively faster and easy realisation ; Both fund and non-fund based financial assets may be included in the list of assets for acquisition. Standard Assets likely to face distress prospectively may also be acquired ;Acquisition of funded assets should not include takeover of outstanding commitments, if any, of bank / FI to lend further. Terms of acquisition of security interest in non-fund transactions, should provide for the relative commitments to continue with bank/FI, till demand for funding arises; Loans not backed by proper documentation should be avoided;
b.
c.
d.
e.
f.
g.
h. The valuation process should be uniform for assets of same profile and a standard valuation method should be adopted to ensure that the valuation of the financial assets is done in scientific and objective manner. Valuation may be done internally and or by engaging an independent agency, depending upon the value of the assets. Ideally, valuation may be entrusted to an asset acquisition committee, which shall carry out the task in line with an Asset Acquisition Policy laid down by the Board in this regard; i. j. A record indicating therein the details of deviations made from the prescriptions of the Board in the matter of asset acquisition, pricing, etc. should be maintained; To ensure functioning of Securitisation Companies/ Reconstruction Companies on healthy lines, the operations and activities of such companies may be subjected to periodic audit and checks by internal / external agencies.
(2) Engagement of Outside Agency: Securitisation Companies/ Reconstruction Companies may engage the services of reputed specialised external agencies to handle the task of taking possession of secured assets in pursuance of its right to enforce security interest. (3) Sale Committee: It is desirable that the Sale Committee authorises in case of joint / consortium financing, the secured creditor with the highest outstanding, or more preferably, the Securitisation Company/ Reconstruction Company as the designated secured creditor to arrange for the sale of secured assets. (4) Issue of security receipts: i. The parties in question may finalize the price at which security receipt will be issued as per the mutually agreed terms and on assessment of the risks involved; ii. In cases where security receipts are issued involving transfer of risks to the full extent and rewards to a limited extent, there could be a possibility of sharing of surplus between the issuer and the investors; iii. The issuer may consider obtaining credit rating from any of recognized credit rating agencies. iv. The matters relating to charging of management fee by the Securitisation Company/ Reconstruction Company, for managing schemes floated by it, may be as per the mutually agreed terms. Summary A mutual fund is a group of investors operating through a fund manager to purchase a diverse portfolio of stocks or bonds. Mutual funds are highly cost efficient and very easy to invest in. One of the most advantageous factor in the mutual fund is, it reduce the risk by diversification and maximize the returns due to professional expertise of fund managers employed by it. Institutional Set up of the Mutual fund can be described as a set up in the form of a trust, which has Sponsor, Trustees, Asset Management Company (AMC), and Custodian. Thus why, our elders use to say put not your trust in money, put your money in trust.
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As per the definition of the SEBI (Mutual Fund) Regulations asset management company means a company formed and registered under the Companies Act, 1956 (1 of 1956) and approved as such by the SEBI under its regulations. Insurance basically are two types one is life insurance and other one is general insurance. Under Life Insurance policy the insurance covers the life o the insured up to the policy amounts. In other words in case of death of the policy holder, the nominee of the insured could get the policy value. Life insurance policy also facilitate for payment of the policy value either at maturity or by installments at an agreed bonus to the policy holder. General Insurance means insurance other than the life insurance. As per the definition of the Insurance Act General Insurance Business as fire, marine or miscellaneous insurance business whether carried on singly or in combination with one or more of them. For example general insurance can be viewed as exchange risk insurance, motor vehicle insurance, burglary insurance and workmen compensation insurance and so on. The Government of India came to know the importance of recovery of non-performing assets only when the Narasimhan Committee was highlighted this in the year 1997. The Narasimhan Committee report mentioned that an importance aspect of the continuing reform process was to reduce the high level of non-performing assets as means of banking sector reform. Asset Reconstruction Company (ARC) is a company which is set up with the objective of taking over distressed assets (Non performing assets) from banks or financial institutions and to reconstruct or redress these assets to make those assets saleable. In this context the Narasimham Committee in its first report had suggested formation of Asset Reconstruction Companies (ARC) with a view to clean the balance sheet of banks.
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Self Examination Questions: 1. 2. 3. 4. 5. 6. 7. Explain the various types of mutual funds available in the Indian Financial Market. Explain the advantages and disadvantages in case of investments in Mutual Funds Explain SEBI regulations with respect to mutual funds Explain the concept of insurance and types of insurance Please list out few points from the IRDA regulations with respect to insurance companies. What do you mean by securitisation? Explain the concept of Assets Reconstruction companies.
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MBA

DBA 1749 INDIAN FINANCIAL SYSTEM

III SEMESTER COURSE MATERIAL

Centre for Distance Education

Author Mr . Mahammad R af i Sy ed, AICWA Mr. Raf Syed,

Reviewer Dr . J . Gopu Dr. J.

Editorial Board Dr .T .V .Geetha Dr.T .T.V .V.Geetha

Dr .H.P eer u Mohamed Dr.H.P .H.Peer eeru

Dr .C . Chella ppan Dr.C .C. Chellappan

Dr .A.K annan r.A.K

Copyrights Reserved (For Private Circulation only) ii

Mr. Mahammad Rafi Syed Author

DBA 1749 INDIAN FINANCIAL SYSTEM

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139 140 140 141 141 143

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