UNIT - 1

THE INDIAN FINANCIAL SYSTEM

The financial system consists of a variety of institutions, markets, and instruments that
are related in the manner shown in fig. 1.1. It provides the principal means by which
savings are transformed into investments. Given its role in the allocation of resources,
the efficient functioning of the financial system is of critical importance to a modern
economy.

While an understanding of the financial system is useful to all informed citizens, it is

particularly relevant to the financial manager. He negotiates loans from financial
institutions, raises resources in the financial markets, and invests surplus funds in
financial markets. In a very significant way he manages the interface between the firm
and its financial environment.
This unit aims at providing a basic understanding of the financial system, in particular
the Indian financial system. It is divided into six sections as follows:

Functions of the financial system

Financial instruments
Financial institutions
Financial markets
Equilibrium in financial markets
Growth and trends in the Indian financial system

FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system performs the following interrelated functions that are essential to a
modem economy:

It provides a payment system for the exchange of goods and services

It enables the pooling of funds for undertaking large scale enterprises
It provides a mechanism for spatial and temporal transfer of resources
It provides a way for managing uncertainty and controlling risk
It generates information that helps in coordinating decentralised decision
making
It helps in dealing with the problem of informational asymmetry.

Payment System: Depository financial intermediaries such as banks are the pivot of
the payment system. Credit card companies play a supplementary role. To realise the
importance of this function, simply look at the hardship and inconvenience caused when
the payment system breaks down.
Pooling of Funds: Modem business enterprises require large investments which are
often beyond the means of an individual or even of hundred of individuals. Mechanisms
like financial markets and financial intermediaries, which are an integral part of the
financial system, facilitate the pooling of household savings for financing business. If
you look at it from the other side, the financial system enables households to participate
in large indivisible enterprises.
Transfer of Resources: The financial system facilitates the transfer of economic
resources across time and space. As Robert Merton says:
"A well-developed, smooth-functioning financial system facilitates the efficient life-cycle
allocations of household consumption and the efficient allocation of physical capital to
its most-productive use in the business sector

"A well-developed, smooth-functioning capital market also makes possible the efficient
separation of ownership from management of the firm. This in turn makes feasible
efficient specialisation in production according to the principle of comparative
advantage."
Risk Management: A well-developed financial system offers a variety of instruments
that enable economic agents to pool, price, and exchange risk. It provides opportunities
for risk-pooling and risk-sharing for both household and business firms. As Robert
Merton says:
"It facilitates efficient life-cycle risk-bearing by households, and it allows for the
separation of the providers of working capital for real investments (i.e., in personnel,
plant, and equipment) from the providers of risk capital who bear the financial risk of
those investments.
The three basic methods for managing risk are: hedging, diversification, and insurance.
Hedging entails moving from a risky asset to a riskless asset. A forward contract, for
example, is a hedging device. Diversification involves pooling and sub-dividing risks.
While it does not eliminate the total risk, it redistributes it to diminish the risk faced by
each individual. Insurance enables the insured to retain the economic benefits of
ownership while laying off the possible losses. Of course, to do this a fee or insurance
premium has to be paid.
Price Information for Decentralised Decision Making: Apart from the manifest
function of facilitating individuals and businesses to trade in financial assets, financial
markets serve an important latent function as well. They provide formation that helps in
coordinating decentralised decision making. Robert Merton puts it thus:
"Interest rates and security prices are used by households or their agents in making
their consumptions-saving decisions and in choosing the portfolio allocations of their
wealth. These same prices provide important signals to managers of firms in their
selection of investment projects and financings."
Coping with Informational Asymmetry: When one party to a transaction has
information that the other does not have, informational asymmetry exists. This leads to
the problems of moral hazard and adverse selection2, which are broadly referred as
agency problems. In this connection Robert Merton remarks:
"Such problems can prevent efficient separation of ownership and management of
business firms (the principal-agent problem). They can also prevent borrowers and
lenders from entering into otherwise mutually advantageous transactions."
Financial intermediaries like bands and venture capital organisations can solve the
problem of informational asymmetry by handling sensitive information discreetly and
developing a reputation for profitable activity.
FINANCIAL INSTRUMENTS

Financial instruments, financial institutions, and financial markets are closely

interrelated and it is difficult to separate them. However, for pedagogic convenience we
discuss them one by one.
Financial instruments range from the common (coins, currency notes, demand deposits,
corporate debentures, gilt-edged securities, and equity shares) to the more exotic
(futures and options). Financial instruments may be viewed as financial assets and
financial liabilities.
Financial assets represent claims against the future income and wealth of others.
Financial liabilities, the counterparts of financial assets, represent promises to pay some
portion of prospective income and wealth to others. Financial assets and liabilities
emanate from the basic process of financing. They distribute the returns and risks of
economic activities to a variety of participants.
The important financial assets and liabilities, claims and promises, in our economy are
as follows:
Money: Money is issued by the Reserve Bank of India and to a minor extent by the
Ministry of Finance.
Demand Deposit: This is a promise to repay a given sum as and when demanded by
the holder. It may or may not carry interest with it.
Short-term Debt: This is a promise to repay a specified sum along with interest within
a period of one year.
Intermediate-term Debt: This is a promise to repay a specified-sum along with
interest within a period that exceeds one year but is less than five years.
Long-term Debt: This is a promise to pay a stream of interest over a long period of
time (ordinarily exceeding five years) and then repay the principal in a lumpsum or in
installments. (In exceptional cases the debt may be perpetual).
Equity Stock: This represents ownership capital. Equity shareholders have a residual
interest in the income and wealth of the company after all other claims are fulfilled.
In addition to the above, a modern financial system has many other financial contracts
like forwards, futures, swaps, options, insurance, and so on.
FINANCIAL INSTITUTIONS
The primary role of a financial institution is to serve as an intermediary between lenders
and borrowers. Financial institutions in the organised sector function under the overall
surveillance of the Reserve Bank of India. The structure of financial institutions in India
is depicted in Fig. 1.2.

Before we learn about the various financial institutions in India, let us understand the
rationale for financial institutions (or intermediaries).
Rationale for Financial Institutions
What is the rationale for financial institutions? Put differently, what are the benefits to
individual investors when they invest indirectly through financial institutions rather
than directly in operating companies? It seems that there are several advantages:
Diversification: The pool of funds mobilised by a financial institution is invested in a
broadly diversified portfolio of financial assets (stocks, bonds, money market
instruments, and loans). Individual investors on scarcely achieve such diversification on
their own Remember that a diversified portfolio reduces risk.
Lower Transaction Costs: The average size of a transaction of a financial institution
is much higher than that of an individual investor. The transaction cost, in percentage
terms, tends to decrease as the transaction size increases. Hence, financial institutions,
compared to individual investors, incur lower transaction costs.
Economies of Scale: Buying and holding securities (or for that matter granting loans
and supervising them) calls for information gathering and processing and regular
monitoring. These functions entail cost. Financial institutions, thanks to their bigger
size and professional resources, enjoy economies of scale in performing these functions.
Hence they have a comparative advantage over individual investors.
Confidentiality: Companies seeking funds or the continuing support of existing
investors are required to disclose information that they like to keep confidential for
competitive reasons. They would feel more comfortable in dealing with few financial
institutions rather than numerous individual investors. Information shared with
financial institutions is generally kept confidential whereas information disclosed to
numerous individual investors falls in the domain of public knowledge.
Signaling: With greater professional expertise at their command, financial institutions
can pick up and interpret signals and cues provided by operating companies more
efficiently. Hence, they can offer better terms to operating companies which are likely to
gravitate to them. In this manner, financial institutions perform a signaling function for
the investing community.

Reserve Bank of India

The Reserve Bank of India (RBI) being the central banking authority is at the apex of the
Indian financial system. Established in 1935, it became a government-owned institution
from 1949 under the Reserve bank Act of 1948. Under this Act, the central government
is empowered to issue directions to the RBI, after consulting with the RBI governor. The
RBI performs the following traditional functions of the central banking authority: (i) It
formulates and implements monetary and credit policies (ii) It functions as the banker's
bank (iii) It manages the .liquidity reserves of the credit institutions and supervises their
operations (iv) It plays an important role in maintaining the exchange value of the
rupee. However, with the increased convertibility of the rupee, the importance of this
function is declining (v) It controls payments and receipts for international trade and
regulates other foreign exchange transactions.
In addition to the traditional functions of the central banking authority, the RBI
performs several functions aimed at developing the Indian financial system: (i) It seeks

to integrate the unorganised financial sector with the organised financial sector (ii) It
encourages the extension of the commercial banking system in the rural areas iii) It
influence the allocation of credit (iv) It supports innovation in cooperative banks (v) It
promotes the development of new institutions. For example, it set up the Unit Trust of
India (UTI), the Industrial Development Bank of India (IDBI), and the National Bank
for Agriculture and Rural Development (NABARD).
Commercial Banks
Commercial banks represent the most important institutions in the financial system.
The largest commercial Bank in India, the Stat Bank of India (SBI), was set up in 1955
when the Imperial Bank was nationalised and merged with some banks of the princely
states. In 1969, in one fell swoop, the fourteen largest privately-owned commercial
banks were nationalised. Subsequently, several other privately-owned commercial
banks were nationalised. As a result of these actions, public sector commercial banks,
which today are twenty-eight in number, virtually dominate the commercial banking
scene in the country.
The nationalisation and greater government control over the major banks was aimed at
(i) reducing the influence of business houses on banks, (ii) preventing misuse of the
resources of banks (iii) achieving a wider spread of bank credit (iv) directing a larger
flow of credit to priority sectors, and (v) making banks more effective instruments of
progress.
The changes in banking structure and control have resulted in (i) wider geographical
spread and deeper penetration of rural areas (ii) higher mobilisation of deposits (iii)
reallocation of bank credit to priority activities and (iv) lower operational autonomy for
bank management.
One of the major activities of the commercial banks is to provide working capital
advance to industry. In recent years, the RBI has been closely monitoring the credit
extended by commercial banks to industry, which traditionally relied heavily on
commercial banks and were the primary beneficiaries of the banking system. Several
committees-the Deheja Committee, the Tandon Committee, the Chore Committee, etc.
ere set up to look into the problem of working capital credit and to suggest remedial
measures. The major recommendations of these committees have been twofold;
reduction in bank credit to industry in relative terms and inculcation of a greater sense
of financial discipline in industrial borrowers. By and large, the RBI has accepted the
recommendations of these committees.
Developmental Financial Institutions
Since independence a number of developmental financial institutions have been set up
to primarily cater to the long-term financing needs of the industrial sector. An elaborate
structure of financial institutions' consisting of three all-India term-lending institutions
(Industrial Development Bank of India, Industrial Finance Corporation of India, and
Industrial Credit and Investment Corporation of India), State Financial Corporations,

and State Industrial and Development Corporations has come into being. Due to the
importance given to the small scale sector, the government established the Small
Industries Development Bank of India (SIDBI) in July 1989. It is a subsidiary of IDBI
and functions as the chief refinancing agency for the small scale sector.
The financial institutions have been fairly responsive to the growing and varied longterm financial requirements of industry. They have provided the bulk of long-term
industrial capital needs, particularly for new projects. They help in identifying
investment opportunities, encourage competent new entrepreneurs, lay emphasis on
development of backward regions, and support modernisation efforts. Their wideranging Activities may be divided under five broad categories: direct financing, indirect
financing, assistance financing, promotional work, and miscellaneous activities.
Insurance Companies
There are two insurance companies in India: the life Insurance Corporation (LIC) of
India and the General Insurance Corporation (GIC) of India (which is essentially a
holding company that has four fully-owned subsidiary companies in its fold). The life
Insurance Corporation of India, which provides life insurance, has massive resources at
its command due to two reasons: (i) insurance policies usually incorporate a substantial
element of savings, and (ii) insurance premiums are payable in advance. The
subsidiaries of the General Insurance Corporation of India, which are engaged in the
business of property insurance, too, have considerable resources with them because of
the advance collection of insurance premiums.
Other Public Sector Financial Institutions
There are a variety of other public sector financial institutions. A brief description of the
more important ones follows:
Post Office Savings Bank (POSB): Run by the Post and Telegraph Department on
behalf of the Ministry of Finance, Government of India, the POSB is operated through
the vast network of post offices. The POSB collects funds through various schemes like
savings bank accounts, recurring and cumulative time deposit schemes, Public
Provident Fund, and Indira Vikas Patras.
National Bank for Agriculture and Rural Development (NABARD): The apex
agricultural financing institution, BABARD channelises assistance through an elaborate
network of regional, state level, and field level institutions like the Regional Rural Banks
(RRB), the State Cooperative banks, and so on.
National Housing Bank (NHB): The apex agency for housing finance, NHB seeks
to promote an institutional framework for the supply of finance in the housing sector.
Mutual Funds

A mutual fund is a collective investment arrangement. In India three entities are central
to a mutual fund: the sponsor, the trust, and the asset management company. The
sponsor promotes the mutual fund. The mutual fund is organised as a trust4 (with a
board of trustees). It is, in a way, an umbrella organisation which floats various schemes
in which the investment public can participate. The asset management company,
organised as a separate joint stock company, manages the funds mobilised under
various schemes.
Mutual funds have recorded a very impressive growth in India in the last several years.
While there was only one mutual fund in India, viz., the Unit Trust of India, till 1986,
presently there are a number of mutual funds in both the public sector as well as the
private sector. Of course, Unit Trust of India, with its massive resources, continues to
dominate the mutual fund scene in India.
Non-Banking Financial Corporations
From the mid-eighties many non-banking financial corporations have come into being
in the public sector as well as the private sector-numerically, of course, most of them are
in the private sector. Some of the well known non-banking finance corporations are SBI
Capital Markets, Kotak Mahindra Finance, Sundaram Finance, and Infrastructure
Leasing and Finance Corporation.
Non Banking Financial Corporations engage in a variety of fund-based as well as nonfund based activities. The principal fund-based activities are leasing, hire purchase, and
bill discounting; the main non-fund based activities are issue management, corporate
advisory services, loan syndication, and FOREX advisory services.
FINANCIAL MARKETS
As against a real transaction that involves exchange of money for real goods or services,
a financial transaction involves creation or transfer of a financial asset. Here are some
examples of financial transactions: issue of equity stock by a company, purchase of
bonds in the secondary market, deposit off money in a bank account, transfer of funds
from a current account to a savings account. While this list can be easily extended, the
point of such examples is clear; financial transactions are very pervasive throughout the
economic system. Hence financial markets, which exist wherever financial transactions
occur, are equally pervasive.
Money Market
The money market deals in short-term debt, in contrast to the capital market which
deals in long-term debt and stock (equity and preference). A well-developed money
market (i) uses a broad range of financial instruments (treasury bills, bills of exchange,
etc.), (ii) channelises savings into productive investments (like working capital) (iii)
promotes financial mobility in the form of inter-sectoral flows of funds, and (iv)
facilitates the implementation of monetary policy by way of open market operations.

The money market in India, as in many other developing countries, is dichotomized into
the organised and unorganised segments. The principal intermediaries' in the organised
segment are the commercial and other banks. (In addition, there are the LIC, UTI,
Discount and Finance House of India Ltd., mutual funds, non-banking financial
companies, and cooperative societies which presently play a minor role). These
intermediaries lend funds on a short-term basis to create an active inter-bank call loan
market as part of the organised money market.
The Discount and Finance House of India Ltd., (DFHI), a financial house established as
a company under the Companies Act, 1956 provides liquidity to money market
instruments by creating a secondary market where they can be traded.
The salient features of the organised money market in India are:
1. A significant part of its operations, which is dominated by commercial banks, is
subject to tight control by the Reserve Bank of India which (a) regulates the interest rate
structure (on deposits as well as loans), reserve requirements, and sectoral allocation of
credit, and (b) provides support to the banks by lending to them on a short-term basis
and insuring the deposits made, by the public.
2. It is characterised by fairly rigid and complex rules which may prevent It from
meeting the needs of some borrowers even though funds may be available.
3. Overall, there used to be a paucity of loanable funds, mainly because of the low rate of
interest paid on deposits, but with the removal of the 10 per cent interest rate ceiling on
call loans, the situation has eased to some extent.
The principal participants in the unorganised money market are money-lenders,
indigenous bankers nidhis (mutual loan associations), and chit funds. They lend
primarily to borrowers who are not able to get credit from the organised money market.
The unorganised money market is characterised by informal procedures, flexible terms,
attractive rates of interest to depositors, and high rate of interest to borrowers.
The size of the unorganised money market is difficult to estimate, though it appears to
be fairly large. However, its importance relative to that of the organised money market
is declining. This is a welcome development from the point of view of the Reserve Bank
of India, because the existence of a large unorganised market frustrates its efforts to
control credit.
Capital Market (Corporate Securities)
The capital market is for financial assets that have long or indefinite maturity. When a
company wishes to raise capital by issuing securities, it goes to the primary market
which is the segment of the capital market where issuers exchange financial securities
for long-term funds. The primary market facilitates the formation of capital.

There are three ways in which a company may raise capital in the primary market:
public issue, rights issue, and private placement. Public issue, which involves sale of
securities to members of the public, is the most important mode of raising long-term
funds. Rights issue is the method of raising further capital from existing shareholders by
offering additional securities to them on a pre-emptive basis. Private placement is a way
of selling securities privately to a small group of investors.
The secondary market in India, where outstanding securities are traded, consists of the
stock exchanges recognised by the government. There are presently twenty one regional
exchanges (located at Bombay, Calcutta, Delhi Chennai and other cities) and two nationwide computerised exchanges, viz., the National Stock Exchange (NSE) and the Overthe-Counter Exchange of India (OTCEI).
The government has accorded powers to the Securities and Exchange Board of India
(SEBI), and autonomous body, to oversee the functioning of the securities market and
the operations of intermediaries like mutual funds and merchant bankers and to
prohibit insider trading.
Government Securities Market
Debt securities issued by the central government, state government semi-government
authorities, autonomous institutions like port trusts, electricity-hoards, all-India and
state-level financial institutions, and public sector enterprises are broadly referred to as
gilt-edged securities. Understandably, the market for gilt-edged securities is very large.
The salient features of the market for gilt-edged securities are:
1. Subscription to these securities is made almost wholly by commercial banks,
provident funds, and other institutional investors.
2. The secondary market is very narrow as institutional investors tend to retain these
securities until maturity.
3. Commercial banks hold a very substantial proportion of these securities to satisfy the
statutory liquidity ratio (SLR) requirement.
EQUILIBRIUM IN FINANCIAL MARKETS
The supply and demand for various commodities (such as aluminium) are cleared at
their respective equilibrium prices in real markets. Likewise, an equilibrium price clears
the market for loanable funds. Put differently, at the equilibrium price, the supply and
demand for loanable funds are matched. It is expressed as an interest rate-the amount
per rupee per annum that the lender gets and the borrower pays.
As Fig. 1.3 (a) shows, the supply schedule of loanable funds (Sf) has a positive slope,
implying that the lenders are willing to provide more funds as the interest rate rises. On
the other hand, the demand schedule for loanable funds (Df) has a negative slope,
implying that the borrowers are willing to borrow more funds as the interest rate falls.

Given the nature of these two schedules, the market for loanable funds will clear at, i.e.
the equilibrium rate of interest, and the amount of funds lent and borrowed will be
equal to OA.
Figure 1.3 (b) is the counterpart of Fig. 1.3 (a) in which the volume of securities
substitutes the loanable funds on the horizontal axis and the price per security replaces
the interest rate on the vertical axis. The demand schedule for securities (Ds) has a
negative slope, implying that the investors are willing to buy more securities as the price
falls. On the other hand, the supply schedule of securities (Ss) has a positive slope,
implying that the borrowers are prepared to offer more securities as the price rises.
Given the nature of these two schedules, the market for securities will clear at Pe, the
equilibrium price, and the amount of securities exchanged will be equal to OA. Note that
OA in Fig. 1.3 (a) and OA' in Fig. 1.3 (b) are equal, if the same unit of measurement is
used.
Suppose the supply schedule of loanable funds in Fig. 1.3(a) shifts rightward and
becomes Sf, implying that at each rate of interest, the amount of loanable funds supplied
increases. This results in a decrease in the equilibrium rate of interest from ic to ie and
an increase in the amount of loanable funds traded from OA to OB. The rightward shift
in the supply schedule of loanable funds is paralleled by a rightward shift, to the same
degree, in the demand schedule of securities (Ds to Ds) in Fig. 1.3(b). The leads to an
increase in the equilibrium price of securities from Pe to Pe along with an increase in the
amount the securities exchanged from A' to B.

Regulation of Interest Rates

In the previous discussion, we assumed that the interest rates are determined by the free
forces of demand and supply in financial markets. In India, however, the interest rates
in the organised sector have traditionally been almost wholly regulated. Despite some

deregulation in recent years, interest rates in India continue to be substantially

regulated. The key current regulations are as follows:

Interest rates on deposits with commercial banks are subject to a ceiling.

Interest rates chargeable by commercial banks are subject to floors.
Interest rates payable by companies on fixed deposit is subject to a ceiling.
Interest rates chargeable by developmental financial institution are subject to
floors.
Interest rates payable on small savings schemes are fixed by the government.

The interest rate policy of the government is designed to: (i) facilitate governmental
borrowing somewhat cheaply (ii) ensure stability in the macro-economic system (iii)
support certain activities through preferential lending rates, and (iv) mobilise
substantial savings. While some of these objectives may be laudable, critics of the
administered interest rate policy of the government argue, and quite rightly so, that
interest rates in India do not necessarily perform the role of allocating scarce resources
between alternative uses. This role is played largely by the government and its agencies.
As a result, there is scope for misallocation of resources.
Given the above backdrop of government policy, let us look at the structure of interest
rates. Table 1.1 shows how the short-term and long-term interest rates have evolved in
India. An analysis of the data given in this table reveals the following features of interest
rate behaviour in India.

1. There has been a general upward trend in the nominal interest rates. This perhaps
reflects higher inflation rates and scarcity of capital resources.

2. Interest rates on short-terms have been lower than those on long- term deposits. This
is in conformity with normal expectation because higher interest rates have to be offered
to induce investors to lend at longer maturities.
3. Term finance rates have been lower than working capital finance rates. This is
contrary to what one observes in freely functioning financial systems where longer
maturities generally carry higher interest rates.
GROWTH AND TRENDS IN THE INDIAN FINANCIAL SYSTEM
The Indian financial system experienced an impressive growth in the post-1950 era.
Financial Development Measures
The financial development of a country is commonly assessed in terms of the following
ratios:
Finance Ratio: Reflecting the relationship between financial development and
economic development, this ratio is defined as:

Financial Interrelations Ratio: An indicator which shows the relationship between

the financial system and the funding of investment, this ratio is measured as:

New Issue Ratio: Reflecting the extent to which the non-financial sector directly
finances investment, this ratio is defined as

Intermediation Ratio: A measure of the proportion of financial transactions which

occur through financial institutions, this ratio is expressed as

In the wake of the significant growth that has occurred in the Indian financial system,
the financial development measures improved substantially over the last forty five years.
This is evident from the following:

The trends in the financial development ratios suggest that: (i) financial flows are
increasing in relation to economic activity (ii) the financial system is increasingly
facilitating the transfer of funds from savings-surplus units to savings-deficit units, and
(iii) the role of financial intermediaries is expanding in the economy. Overall, one can
conclude that the Indian financial system is widening, deepening, maturing, and gaining
in sophistication.
Quality of Financial Development
The impressive growth of the financial system in terms of quantitative indicators has,
however, led to impairment of banks and financial institution. As P. J. Nayak observes:
"The maxim that credits institutions can grow only as fast as their resources, has
diverted attention to the growth of these institutions' liabilities, encouraged by a
Government of India vista of financial deepening, in which banks are encouraged to
transmit savings into investments. The imperative to raise the savings rate - more
explicitly that the financial savings rate - further spurred the growth of the institutions.
It is precisely, in such a strategy, however, that the seeds of retrogression have lain."
Echoing a somewhat similar view, L M Bhole says:
"The increasing politicization of lending institutions and credit programmes, and the
Government's gross interference in them has been progressively undermining the credit
discipline and increasing the financial distress in India."
Trends

The key trends discernible in the Indian financial system are as follows:

The statutory liquidity ratio applicable to commercial banks is being lowered.

The ambit of market-determined interest rates is increasing and correspondingly
the domain of administered interest rates is shrinking. This is accompanied by
greater volatility in interest rates.
Financial institutions like the Industrial Development Bank of India, which
traditionally had substantial access to cheaper SLR borrowing, have to now rely
more on the capital market.
In the regulation of financial markets and financial institutions, prudential
regulation and supervision (capital adequacy, disclosure, transparency, and so
on) are being emphasised and product and price controls are being done away
with.
The Indian financial system is getting gradually integrated with the world
financial system.
Financial innovation (introduction of new financial instruments or processes) is
gaining momentum. Options and futures are expected to be introduced in India.

QUESTIONS
1. What are the principal components of the financial system? Diagrammatically show
how they are related.
2. Discuss the functions of the financial system.
3. Describe briefly the important financial assets and liabilities.
4. What is the rationale of financial institutions?
5. What functions are performed by the Reserve Bank of India?
6. Discuss briefly the important financial institutions in India.
7. Write a short note on the money market in India.
8. What are the salient features of the gilt-edged securities market in India?
9. Describe the key regulations applicable to interest rates in India.
10. Define the important measures of financial development.
11. Discuss the key trends discernible in the Indian financial system.
REFERENCES
1. This section is based on Chapter 1 of the book - Cases in Financial Engineering by
Robert Merton et al., published by the Harvard Business School Press in 1994.

2. The nature of these problems may be illustrated with reference to insurance. A person
who has taken a fire insurance policy is likely to become somewhat negligent. This is the
moral hazard faced by the insurance company. A person who is more likely to
experience fire losses will be inclined to take fire insurance. This is the adverse selection
problem faced by the insurance company.
3. Note that the classification of debt into short term, intermediate term, and long term
categories on the basis of the period of maturity is quite arbitrary.
4. Except when it is set up under a statute as is the case of the Unit Trust of India
5. Or an exchange of goods for goods in a barter economy.
6. What is the difference between a money-lender and an indigenous banker? The
former neither accepts deposits nor deals in bills of exchange, whereas the latter accepts
deposits from public and discounts bundies (indigenous bills of exchange)
7. The inter-corporate deposit market may also be included as part of the unorganised
money market.
8. P.J. Nayak, The Reform of India's Financial System, Asian Development Bank:
Report.
9. L.M. Bhole, Financial Institutions and Markets, Tata McGraw-Hill Publishing
Company, New Delhi, 1992.

- End of Chapter UNIT - 2

CAPITAL MARKET AND MONEY MARKETS

CAPITAL MARKET
Introduction
An efficient capital market is an indispensable pre-requisite of economic development.
It is essentially an institution of a free economy.
In the literature on business finance, the expression capital market has been used in two
different senses:

a) In a broad sense, it refers to the complex of institutions, instruments and practices

which establish a link between the demand for, and the supply of, different types of
capital funds.
b) The securities market is one of these institutions. In a narrow sense, it means only the
securities market.
In a socialist or centrally planned economy, for example, in the Soviet Union, the
securities market need not exist. But in a mixed market-oriented economy, portion of
the monetary savings of households and institutions is channelled into productive
sectors private and public-through the securities market.
By the capital market is means the market for all the financial instruments, short-term
and long-term and for commercial, industrial and Government paper. Before the
industrial revolution, this paper was confined essentially to commercial paper and' often
related to the shipment of goods, though accommodation paper was also not unknown
at the time. In olden times, the princes found it far easier to finance their expenditure
either by borrowing from Jewish bankers, as in Europe or from Nagarseths, as in India,
or by debasing the currency, that is, by reducing the metal content of their coinage.
Fundamentally, the capital market is not different from any other market. The market
mechanism is essentially called for because of the fact that we have an exchange
economy with specialisation of functions. In the present-day world, to a considerable
extent, the people who initiate investment activity do not have funds for the purpose,
while there are people who save but who have no desire to utilise their savings directly
for investment activity in the sense of establishing a factory or any other business
enterprise. Hence there is a need for a market mechanism, which facilitates the transfer
of funds from those who have funds to those who need funds. The commodity that is
dealt with in the capital market is long-term money, that is, money which is either lent
for long periods or is invested more or less perpetually. A business enterprise requires
money for three purposes-for purchasing capital equipment and other fixed assets; for
holding stocks of raw materials and finished goods; and for making payments of wages,
etc. The first requirement is referred to as fixed capital or long-term capital and the
market for the provision of long-term funds is the capital market. The term capital
market thus refers to all the facilities and institution arrangements for the borrowing
and loaning of long-term funds. It is hardly necessary to add that the capital market has
nothing to do with capital goods. It is concerned with the raising of money capital.
Financial Institutions
The components of the financial system are:
i) Reserve bank of India, the apex Institution;
ii) The organised sector; and
iii) The unorganised sector.

The RBI is the centre-piece of the financial system and, by virtue of its being a central
bank of the country, it is a banker to the Government, banks and other financial
institutions. Its link is traditionally with the short-term market, although it has various
connections with the long-term market by virtue of its promotional and developmental
relationships.
Financial institutions are usually classified as banking institutions and non-banking
financial intermediaries. Banks can advance credit by creating claims against
themselves, whereas non-banking financial intermediaries can lend only of the
resources placed at their disposal by the ultimate savers. R.S. Sayers brings out the
distinction between the banking financial intermediaries and non-banking financial
intermediaries by stating that the former are the creators of credit, and the latter, the
purveyors of credit.
Classified by the nature of their activities, financial institutions fall broadly under the
following heads:
i) Carry institutions, which earn their income from carrying their assets. These are
commercial banks, co-operative banks and development finance companies.
ii) Turnover institutions, which are intermediaries earning their income by buying and
selling financial assets. These are investment companies and mutual trust companies.
iii) Brokerage institutions which do not carry nor purchase and sell on their own
account, but act simply as agents for the buyers and sellers of financial assets. For
example brokers' firms in the stock exchange and money exchange.
In less developed countries (LDCs), there is a need for a sound financial infrastructure
comprising diverse financial institutions and assets for promoting development.
Financial institutions raise the level of savings by motivating ideal funds and allocating
scarce capital more efficiently among various alternative investments.
They discharge the function by ensuring that ho worthwhile project suffers for want of
funds. They have a developmental function, too, for they promote the spirit of enterprise
and risk-taking by encouraging managerial and entrepreneurial talent, in the economy.
They have a technology function, for they offer technical consultancy services to
entrepreneurs.
They have a resource-shifting function, for they provide for the special needs of
particular geographical areas or certain segments of the economy. Specialised financing
institutions help in the process of shifting resources away from certain sectors to others
and encourage activities on the basis of national priorities.
Long-term financial institutions are primary and secondary. Primary financial
institutions raise the bulk of their resources from original savers, viz., households,
business, etc, for example, the Unit Trust of India and the life Insurance Corporation.

The former raises funds by the sale of units and the latter byway of insurance premiums.
Secondary institutions depend for the bulk of their resources on primary institutions,
banks, and the Government, the Industrial Finance Corporations, the SFCs, etc. Their
main function is to purchase primary securities from ultimate lenders.
Non-banking Financial Intermediaries
The phrase Non-Banking Financial Intermediaries (NBFIs) covers a very wide field of
institutions, ranging from development banks or insurance companies to fairly simple
institutions like mutual savings societies.
An NBFI is a generic term in economic literature and refers to financial institutions
whose liabilities are not accepted or used as a means of payment (or money) in the
settlement of debts.
The main difference between banks and NBFIs arise out of the difference in the nature
of their liabilities. However, this criterion of distinguishing NBFIs from banks is not
adequate, because all the liabilities of banks cannot be used as means of payment.
Because of the difficulty of distinguishing banks from the NBFIs, some of the NBFIs are
referred to as near-banks. The important NBFIs in India include hire-purchase finance
institutions, investment companies, chit funds, loan and finance companies, and nidhis.
The importance of financial intermediaries in the economy is derived from the
convenience they provide for savers and borrowers in their capacity as repositories of
savings and as lending institutions. They play a significant role in the progress of the
economy by influencing savings and investment. The place of NBFIs in the economy
depends on whether they perform functions which cannot be efficiently performed by
banks.
Capital Market - A Constituent of Financial Market
The financial market is a collective term encompassing the various markets which
provide long-term funds. It may be classified under two major groups, the first group
comprising the money market and the discount market, which are intimately and
inseparably linked together, and the second group comprising the capital market and
the securities market, which are closely inter-connected. Besides these two groups of
markets, there is the foreign exchange market which deals in foreign currencies.
The financial markets, too, are classified into capital market and money market, and
primary markets and secondary markets. This classification is based on the
understanding that there is no essential difference between the capital and money
markets, for both perform the same function of transferring resources to producers, and
the purchasing power is the commodity traded by them. The conventional distinction
between the two is based on the differences in the period of maturity of the financial
assets issued in these markets. While the capital market deals in long-term funds, the
money market deals in short-term funds. This distinction was also made in the earlier
classification. In practice, however, it is not always possible to demarcate different

institutions as belonging to one or the other of these markets, for there is a considerable
overlap between the two. Commercial banks, both as borrowers and lenders, belong to
both the markets. Primary markets are those in which the ultimate savers and investors
participate; and the securities purchased and sold. They are known as primary
securities. In practice, this is strictly no longer true because with the growth of the Unit
Trust and investment in industrial securities by other financial institutions, there are
now Intermediaries between the ultimate savers and investors in this market as well.
The new issues market is the best example of a primary market. The transactions on the
secondary markets do not result in the availability of fresh capital to the producers, who
deal in securities that have already been issued. The level of development in secondary
markets, however, determines the growth and efficiency of the primary markets. Stock
exchanges are the best examples of secondary markets.
It is clear, therefore, that it is difficult to attempt any rigid classification of financial
markets.
Having highlighted the basic ideas underlying the various components of the financial
market, it will be appropriate to discuss the following constituents of the financial
market.
i) The money market;
ii) The bill market (discount market);
iii) The new issue market (marketing of capital issues);
iv) Securities market;
v) Gilt-edged market;
vi) The capital market

Money Market
A line of demarcation between the money market and the capital market is fast tending
to be thin partly because of a change in the concept of liquidity and partly because of the
preponderance of fixed deposits in commercial banks which take an increasing part in
long-term investments. The essential feature of the money market lies in the supply of
short-term funds to business enterprises and to the members of the discount markets.
The main source of these funds is, really speaking, the commercial banks, which are
assisted by other agencies and supported by the Central Bank of the country, that is, the
Reserve Bank of India. When commercial banks desire to increase their cash balances,
the Reserve Bank of India enters the money market as the lender of the last resort. We
have discussed .the money market in greater detail separately.
Bill Market
The business of the discount market involves dealings in bills of exchange and the
supply of funds from different discount houses and bill brokers. For the supply of funds,
members of the discount markets often depend upon the money market. As a result, the
activities of the members of these two markets overlap to a considerable extent. We have
discussed the bill market in greater detail separately.
New Issue Market

The new issue market brings in new or fresh capital. It constitutes the primary market,
and has a unique and unrivalled importance in the financial market. The new issue
market is an integral part of the capital market of a country, and together with the stock
exchange, constitutes its securities market. The organic development of the society as
well as the scope for higher productive capacity and social welfare depend upon the
efficiency of this market. It has tremendous importance in the national economy
because of the fact that it is the vehicle through which forces affecting employment and
real income make themselves felt.
In regard to the raising of funds from the new issue market, while the larger companies
are well catered for, the smaller companies are less comfortably situated. In the United
Kingdom, the difficulties of the latter in regard to the raising of funds were brought to
public attention by the famous Macmillan Committees report making proposal for
dealing with the gap in the capital market which consisted of lack of provision for the
supply to smaller and medium-sized firms, of long-term capital in amounts too small for
a public issue. That this gap has been bridged in the UK, is evident from the Report of
the Radcliffe Committee (1959), in which it has been stated: One of the lines along
which efforts have been made to deal with his problem has been to develop facilities for
smaller issues, especially by private placing with institutional investors. Most of this
business is nowadays being handled by the issuing house.
The MacMillan Gap exists not merely in the UK. It exists as well in the USA. In India,
too, the small concern has always been the problem child of the new issue market. Small
businesses seeking capital are often confronted with difficulties which the better known
companies do not share. Investors are hesitant to entrust their saving to companies of
small size. Their reluctance to purchase securities of small enterprises is attributable to
several causes.
First, the average investor, in choosing an investment medium, is inclined towards a
business of which he has some previous knowledge. When a company is national in
scope, when its products are well known to the public, and when information
concerning its operations is available from financial manuals and other sources, its
securities are accepted by investors more readily than the securities of a concern known
only in its immediate locality.
Second, an important consideration in the minds of the average investors is
marketability. Wide distribution and a large number of security-holders are essential for
a broad market, and these are not offered by the securities of a small corporation.
Third, a small company may be quite vulnerable to unexpected happenings,
technological changes, competitive conditions and seasonal and cyclical factors. A
seasonal enterprise of substantial size, with strong banking connections, adequate
reserves and extensive technical resources is better equipped to meet emergencies than
one which has not achieved its full measure of growth. That is why the average investor
prefers a large company; it offers him a more stable vehicle for investment. The stock
exchange, though technically a secondary market, has been discussed elaborately, since
it has assumed tremendous significance in the complex industrial

Securities Market
Securities markets facilitate the buying and selling of stocks, bonds, and other types of
securities. In the United States, securities markets include organised stock exchanges or
organised bond exchanges, the over-the-counter market and the money market.
The securities market has two important segments:
a) The new issue market dealing in the securities of newly incorporated firms (initial
issues), and the newly issued securities of old companies (further issues) and of the
Government.
b) The secondary market dealing in already issued securities (industrial and
Government), and comprising official stock exchanges and unofficial over- the-counter
and kerb markets.
Most transactions in the new issue market (i.e., those relating to issues for new money
purposes as distinct from those for refunding purposes, or representing a mere legal
transformation of a private company into a public one) result in a net increase in the
mobilised savings of the community for productive investment. The secondary market
barely helps this market to function smoothly by conferring liquidity upon the newly
issued securities, which is a pre-requisite for making them attractive to potential buyers
in future. In other words, the secondary market facilitates the growth of new issues
while the new issue market facilitates the growth of the economy by facilitating the
collection of savings and the transfer of these saving to fund-users. From this, however,
one cannot jump to the conclusion that the securities market is one of the necessary
requirements for growth in a mixed market-type economy, for Japan has registered the
highest growth-rate in this century (higher than that of the Soviet Union) even without
possessing a securities market worth the name.
The factors which determine the role of the securities market vary between countries
and periods. But they include:
a) The importance of the corporate sector in the economy;
b) The average size of corporate enterprise;
c) The willingness of public companies to raise finance by selling securities;
d) The hold of monopoly over the private company sector;
e) The attitude of the Government to market borrowings as a source of funds vis--vis
other sources;
f) Legal codes and safeguards for the protection of investors in securities; and
g) The existence of facilities for the marketing of securities.

Gilt-edged Market
The securities market, in so far as the Government debt is concerned, is known as the
gilt-edged market. These securities relate to those issued by the Central and State
Governments. Local bodies, municipalities, improvement trusts, Port Trusts and other
public bodies. In view of the greater confidence of the public in the Government, these
securities carry less risk. All the marketable loans of these bodies are officially listed on
the recognised stock exchanges as soon as they are issued. The return on financial
investments is related to risk, maturity and a number of other factors. The yields are
higher on private securities than on Government securities because of the greater risks
involved in the former.
MONEY MARKET
Introduction
J.S.G. Wilson defines the money market as a centre in which financial institutions
congregate for the purpose of dealing impersonally in monetary assets. It is a wide term
and brings within its scope of a variety of transactions, instruments and institutions. Its
components are the call money market and the bill market. It is a centre where the
borrowers and lenders of money and near-money assets are brought together. A money
market functions primarily as an aid to banks and financial institutions so that they may
utilise their surplus funds. The short-term Government securities market is also a part
of the money market. It may also cover a group of markets for various types of money
assets characterised by relative liquidity or nearness to money. Such assets may be
called money, treasury bills, bills of exchange, etc. Although there are various centres of
money markets as Bombay, Calcutta, Chennai etc., they are not separate, independent
markets but are interlinked and related. In a true sense of free and perfect competition,
there should be only one price for each category of money assets, which would result
from sales and purchase dealing on a purely impersonal basis and through the operation
of blind economic forces.
The money market provides facilities for a quick and dependable transfer of short-term
debt instruments which finance the needs of business, Government, agriculture and
consumers.
At around the time the Reserve Bank was established, the unorganised money market
was the most important money market accounting for 90 percent of the transactions.
Since then, its importance in overall terms has fallen considerably. Yet for sectors like
agriculture, retail trade, small borrowers and small-scale industry, this market
continues to be an important source of finance.
The money market may be defined as the centre for dealings in capital assets of a shortterm character. In the money market a bid is made for short-term surplus investible
funds at the disposal of financial and other institutions and individuals by borrowers,
who include individuals, institutions and the Government. It meets the short-term
requirements of borrowers and provides liquidity to the lenders.

The Central Bank occupies a strategic position in the money market. It is the key
constituent of the money market, for it is the residual source of supply of funds. The
money market can obtain funds from the Central Bank in two ways - either by
borrowings or by sale of securities. Here, the Central Government comes into contact
with the financial sectors of the economy as a whole, and by varying liquidity in the
market by open market operations and by regulating the excess; it influences the cost
and availability of credit. A well-developed money market, therefore, contributes to an
effective implementation of the monetary policy.
The Indian Money Market exhibits a mixture of the characteristics of a developed
money market. On the one hand, there is the call loan market between banks, and on the
other, there is the absence of a bill market. It is characterised by the seasonal ebb- andflow demand for credit. The demand for credit is low or there is a slack season for it
from May to October, banks then accumulate surplus funds. The floating of new issues
of Government loans is generally done during the first half of the slack season in the
hope that the seasonality will be reduced with the growth of the Indian economy and the
money market.
The money market in India consists of two sectors, viz., the organised sector and the
unorganised sector. Higher rates of interests prevail in the unorganised sector The
organised market comprises primarily the Reserve Bank, the State Bank of India, the
Life Insurance Corporation, the General Insurance Corporation and the Unit Trust of
India. The unorganised market is largely made up of indigenous bankers and non- bank
intermediaries such as chit funds. In this market, there is no clear demarcation between
short-term and long-term finance, not even between the purposes of finance, for there is
usually nothing on a hundi, which is but an indigenous bill of exchange, to indicate
whether it is a genuine trade bill or whether it only provides financial accommodation.
By and large, these bills are accommodation bills. With a substantial improvement in
the geographical coverage of the organised banking sector and increase in the flow of
bank finance to small borrowers, the role of unorganised sector in providing finance for
trade, etc., has greatly diminished.
Characteristics of Money Markets
i) The essential characteristics of developed money market are integrated structures
between sub-markets, free flow of funds as between sub-markets or segments of the
same sub-market, a high degree of specialisation with regard to dealings in instruments
by various institutions, and a single price for each of the instruments traded.
ii) An important aspect of the Indian money market is the seasonality in the demand for
funds following agricultural operations.
iii) The Indian money market is characterised by insulation from the foreign money
markets because of the operation of strict exchange controls in the economy whereby all
inflows or outflows of funds are subject to the RBFs control.

iv) There is a dichotomy in the organised and unorganised markets. Unlike a developed
money market, the Indian money market in the organised sector is insulated from the
foreign money markets abroad because of the prevailing exchange controls in India, and
the absence of a free inflow and outflow of funds. The core of the Indian money market
is the inter-bank call money market, where the lenders and borrowers are mostly the
banks. In addition, the UTI and the LIC enter this market as suppliers. The funds dealt
with are the over-night money or money up to a fortnight.
v) There is no true market for bills, commercial or treasury, nor is there any acceptance
business. Most of the bills are not genuine trade pills. Treasury bills are sold on tap by
the RBI on behalf of the Government, and the main buyers are commercial banks.
vi) The money market structure suffers from the narrowness of the market for
Government and semi-Government securities. There is little scope for using open
market operations in Government securities to control credit. The i Reserve Bank's
operations in this sphere have, therefore been directed mainly at ensuring orderly
conditions in the Government securities market in order that there is a reasonable
allocation of the available resources between the Central Government, the State
Governments and the various oilier borrowers in the public sector, on the one hand, and
between the Government Sector arid the rest of the economy on the other.
vii) In the structure of the money market in India, it may be mentioned that stock
brokers are a part of it, for they borrow finance to carry out stock market transactions
and carry-over business. Some of the badla financiers borrow from commercial and cooperative banks to supplement their own resources for stock market operations. Limits
are sanctioned for these operators and brokers by the commercial banks.

Sub-Markets
The call money market in India and Pakistan and the federal funds market in the USA
are examples of a sub-market dealing with near-cash. The demand comes from banks
that fall short of reserves for a very short time and the supply comes from those who
have excess reserves. In India, this is called the inter-bank call market, wherein funds
are borrowed overnight for book adjustments by the banks which fall short of the
statutory reserve requirements. Brokers put through these transactions between banks
or the banks may choose to deal directly among themselves.
In the inter-bank market in India, in addition to all banks, foreign and Indian non-bank
institutions also operate, mostly as lenders. The RBI is the apex body for these
institutions and act as the lender of the last resort to the market. In the interbank
market, foreign banks are the main borrowers because, by the nature of their
operations, they finance trade and operate in the market mostly with a narrow cash
base.
Call Money Market
The market for short-term finance is call money. The call money market is that part of
the national money market where day-to-day surplus funds, mostly of the banks, are
traded in. The loans lent in this market are short-term loans, their maturity varying

from a day to a fortnight. As these loans are repayable on demand and at the option of
either the lender or the borrower, they are highly liquid, their liquidity being exceeded
only by cash. The call money market has developed in the USA as well as in the UK.
However, in India, there are no separate short-term call money markets. S.K. Muranjan
has pointed out that call loans in India are given:
a) To be bill market;
b) For the purpose of dealing in the bullion markets and stock exchanges;
c) For deals between banks; and
d) Frequently to individuals of high financial status in Bombay for ordinary trade
purposes in order to save the interest on cash credits and overdrafts.
The core of the organised segment of the Indian money market is the inter-bank call
money market. This is a most sensitive sector of the money market. During the 1960's
and early 1970's banks had substantial recourse to the Reserve Bank for
accommodation. However, in recent years, with the operation of the tight monetary
policy of restraining expansion in money supply, the Reserve Bank does not grant
accommodation to banks in the normal course.
Treasury Bills
Treasury bills constitute a separate segment of the market. These are of three months'
duration, issued on tap by the RBI (at one time both by tap and auction) on behalf of the
government for financing the latter's expenditure. In addition, there are treasury deposit
receipts of six to twelve months' duration. Mostly banks, UTI, LIC, etc., contribute to
these bills in addition to Government departments or agencies with surplus funds.
There is no true market, in treasury bills, for there are no further dealings in them.
A treasury bill is a particular kind of financial bill or a promissory note put out by the
Government of the country. A bill which does not arise from any genuine transaction in
goods is called a financial bill. Although State Governments also issued treasury bills
until 1950, it was only the Central Government which had been selling treasury bills.
Although treasury bills are not liquid in the sense in which genuine trade bills are, the
degree of their liquidity is greater than that of trade bills. If one had to arrange shortterm financial instruments on the basis of their liquidity, the arrangement would be
cash, call loans, treasury bills and commercial bills-in that order. Treasury bills are
highly liquid because there cannot be a better guarantee of repayment than the one
given by the Government and because the central bank of the country - that is, the
Reserve Bank of India - is always willing to purchase or discount them. As treasury trills
are claims against the Government, unlike ordinary trade bills, they do not require any
grading or further endorsement or acceptance.
The treasury bills which are in vogue in India are of two types-ordinary and ad hoc. The
former are issued to the public and the Reserve bank of India to enable the Government

to meet its needs for supplementary short-term finance. The latter are created in favor
of the Reserve Bank of India in order to serve two purposes. First, they replenish
Government cash balances. The finance raised by the Central Government through
these bills can be regarded as a counterpart of "ways and means advances made by the
Reserve Bank of India to the State Governments. Second, they provide the medium for
the employment of temporary surpluses of State Governments, semi-Government
departments and foreign Central Banks. They, therefore, facilitate the elimination of
undesirable fluctuations in the discount rate which would result if State Governments
were to compete with regular investors in the treasury bills issued to the public.
Participation Certificates
The Participation certificate is defined as an instrument whereby a bank can sell to a
third party (transferee) a part of a loan made by th6 bank to a client (borrower). It
represents a beneficial interest in a pool of agency loans or mortgages. It is a formal
credit instrument carrying a contractual interest obligation on a specified principal
amount. A participation certificate is a form of deposit because the institutions lending
to banks do not participate in the risk of lending and participate only nominally in
security. Banks issue participation certificates against the working capital advances
granted to industrial concerns. Any bank wanting to issue participation certificates has
to obtain the prior approval of the Reserve Bank of India for its participation in the
scheme of participation certificates. When this scheme was introduced in 1970-71, only a
few banjos were allowed to participate in it; but now all scheduled commercial banks
were allowed to participate in it; but now all scheduled commercial banks can do so. The
participation certificates serve the important purpose of mobilising funds among the
financial institutions and thereby of reducing their need to approach the Reserve bank
of India for refinance. They are an avenue for investment of floating funds, that is, funds
awaiting eventual investment. On the other hand, they help deficit institutions to
overcome a temporary shortfall in resources.
In a sense, therefore, the market for participation certificates is an extension of the call
money market. It also serves as a useful adjunct to the bill market. In terms of the
period of maturity, participation certificates are very close to commercial bills. As an
extension of the call money market, these certificates can potentially undermine the
monetary discipline which the Reserve bank of India may want to impose on banks from
time to time.
The maturity period of participation certificates varied between 30 days and 180 days.
This new credit instrument was well received by banks and financial institutions, as is
evident from the fact that the outstanding amount of participation certificates increased
from Rs.15 crores in 1971 to Rs.445 crores in 1979. The recourse to participating
certificates by banks on a sizable scale created difficulties in monetary management. The
Reserve Bank of India, therefore, introduced certain changes in the participation
certificate scheme with effect from July 27, 1979. Banks were instructed not to treat
participating certificates as contingent liabilities and to exclude the amount of
participating certificates from their total advances. They were also directed to treat the

amount of participating certificates as deposits and subject to SLR and CPR

requirements.
Provident Fund
Provident fund contributions are a form of compulsory saving which are made available
to the Government through investment in its securities. Until the passing of the
Employees' Provident Fund Act, 1952, provident fund contributions were voluntary. By
this enactment of 1952, provident fund contributions were made compulsory; and the
act is applicable to factories and establishments, employing 50 workers or more. It was
subsequently extended to all establishment employing 20 persons or more.
Provident funds constitute the savings of individuals with a salaried income, although
with the starting of the public provident fund scheme recently, it is now possible for
non-salaried individuals to save in this form. Savings in provident funds are contractual
obligation; and the major motives behind savings in this form are not to earn income or
to seek capital growth. The growth of provident, fund has been tremendous, and the
volume of savings of the household sector in the form of provident funds has increased
from Rs.19 crores in 1950-51 to Rs. 1,172 crores in 1976-77. Several factors have
contributed to the growth of provident funds in India. These are:
i. The adoption of statutory measures to make provident fund compulsory for industrial
and other establishments.
ii. The increase in the number of establishments covered by the statutory provisions.
iii. The expansion in the industrial and service sector of the economy and the
consequent increase in the number of salary earners.
iv. The introduction of the public provident fund scheme.
v. The provision of tax benefits for the savers.
vi. The increase in the minimum rates of contribution by the employees and employers.
vii. The increase in the level of money incomes in the economy.
Small Savings
Just as provident funds supplement the resources of the Governments, small savings are
a source of capital receipts of the Centre and States, for there is a scheme for sharing the
receipts of some of the categories of small savings between the Centre and the States.
These small savings do not directly contribute to the funds of the capital market; but
they are available for the development programmes of the Government. But for these
receipts, the borrowings of the government from the market would be larger. These
receipts also form part of the funds debt of the Government.

Next to commercial banks, small savings organisations mobilise the largest volume of
savings, followed by co-operative banks and the Unit Trust of India. In a country like
India, where small savers predominate and are dispersed over a vast geographical area
in a multitude of villages, the work of small savings organisations assumes significance
in quantitative and qualitative terms. The small savings schemes, which are
administered by post offices, have reached the largest number of villages in India. From
time to time, various promotional measures have been taken to mobilise them under the
various schemes. Full-time authorised agents have been appointed for the collection of
small savings. Limits for raising of tax-free savings have been raised; and a large
number of post office savings banks have become special members of local clearing
houses, etc. As a result of these efforts oil the part of the Government, the corresponding
volume of outstanding small savings collections rose from Rs.337 crores in 1950-51 to
Rs.2,227 crores in 1970-71 and to Rs.l1,781 crores in 1982-83. Although in absolute
terms, the growth of savings was good in the mobilisation of the total national savings or
household savings, the growth is not encouraging and does not come up to the
expectations of the Government.
Marketable Debt
The marketable debt of the Centre and States is issued to the public in the form of loans
every year. These are shown as a part of the capital receipts in their budgets. Rupee
loans are issued in the form of stock certificates. Promissory notes are entries in the
open General Ledger Account maintained by the RBI for institutional investors.
India has had the tradition of borrowing for public purposes continuously for a period of
at Least 200 years. The outstanding public debt, including the debt carrying the
guarantee of the Central Government or the State Governments, is very large by world
standards, whether considered absolutely or as a percentage of the country's GNP.
SERVICES OF COMMERCIAL BANKS
Commercial banks like all other financial institutions perform the major function of
providing a link between those who have surplus funds (savers) and who are in need of
funds (borrowers) thereby reaching or removing a variety of risks and minimizing the
cost of the transactions between those two units.
Savers are called surplus units and investors or borrowers are called deficit units. A
bank is thus a financial institution where people (households) or institutions keep their
income or saving in various forms such as current deposits, offering deposits and fixed
or term deposits. These deposits are used either as the medium of exchange or settling
transactions or as a store of value for safe keeping and future use. Entrepreneurs and
other deficit units, on the other hand, borrow funds from a bank in various forms such
as overdrafts, cash credits, etc. to enable them to purchase goods and services as inputs
or to acquire assets for production purposes ahead of their ability to pay. Hence banks
are both repositories of community's savings and purveyors of credit. Thus funds
(savings) flow from surplus units to deficit units through banks and other financial
institutions to bridge the gap between income and expenditure flow. In other words, the

primary task of any financial institution is to mobilise savings and provide such
resources for investment. In this sense, the essential activity of a bank is to convert the
raw materials of savings (funds) into outputs of loans and advances. Banks also receive
money for transfer and encash debts.

Though the above functions of the bank appear to be simple, it was considered in the
past that the process of saving (thrift) was desirable (good) and the process of borrowing
(debt) was undesirable (bad) but a proper examination of both the processes reveals
that rising volume of debt (credit) is a corollary of rising volume of savings, which is
generated from the utilisation of debts. In other words, without debts an economy
would not grow, i.e. without debt there would be large capital formation, income
generation and savings, though banks do not themselves create wealth with the help of
debt. Therefore, what has to be watched in the economy is not the size of debt by itself
but to watch whether the size is manageable or otherwise. In other words, size of debt
has to be compared with income generated and repayment capacity of borrowing units.
The activities of saving and lending make it possible for the economic units to use
existing resources (money) more efficiently, that is, these activities discuss the demand
for stock money (currency). In other words, since outside money (currency) is scarce
deficit units try to economise its uses with the help of credits-trade credit, bank credit
etc.
Commercial banks in India perform most of the activities for their customers. The range
of services offered differs from bank to bank, depending mainly on the size and type of
banks. However, acceptance of deposits from the public and provision of credit, form
the mainstay of the banking business in India.
1) Customers Services,
2) Granting of Credit to Borrowers, and

3) Ancillary Services

Customer Services
i) The Teller System. One of the important measures for reducing the waiting time of
customers at the counter is adoption of the teller system. A few Indian commercial
banks have already introduced the teller system.
The Teller System is the method of encashing cheques/drafts in order to cut down
waiting time at the counter and thereby build their image as efficient enterprises. Under
this system the person makes the payment at the counter. The "teller" performs the two
functions-of passing cheques and paying cash. This reduces considerably the time
required for encashment of cheques. The teller also receives deposits up to a certain
amount. The value of any one cheque which can be encashed at a teller counter is
limited,
ii) Collection of Outstation Cheques, Bills and other instruments. Banks collect
outstation cheques and bills. Very often delay is involved in collection. The main reason
for the delay is due more time being taken in transit, long procedures for handling and
in receipt and dispatch of the instruments.
iii) Remittances. Instruments for transfer of funds through banks are mainly drafts, mail
transfers, telegraphic transfers and travellers cheques of which drafts are by far the most
common.
iv) Inter-bank Credit Transfer System. The inter-bank transactions relating to the
drawing of drafts, collection of bills and encashment of traveller's cheques are governed
by the reciprocal arrangements entered into by various banks with each other.
Granting of Credit to Borrowers
Banks grant credit advances and loans to customers. It is often observed that the
process of grant of credit comprises a lengthy procedure comprising filling in the
application form by the borrower, scrutiny of particulars furnished by him, assessment
of credit-worthiness, sanction of limits either by branch agent or higher authorities and
follow-up action on advances after they have been availed of by the borrower. There is a
great need for simplification of procedures and operating methods particularly with a
view to facilitating timely grant and adequate credit to priority sectors and small
borrowers.
Ancillary Services
Section 6 (1) of the banking Regulation Act, 1949, gives a list of permissible activities for
banks which include, in addition to raising deposits and the grant of secured and
unsecured advances, various ancillary services.

i. The borrowing, raising or taking up of money, lending or advancing of money either

upon or without security;
ii. The drawing, making, accepting, discounting, buying, selling, collecting and dealing
in bills of exchange, promissory notes, hundis, coupons, drafts, bills of lading, railway
receipts, warrants, debentures, certificates, scrips and other instruments and securities
whether transferable or not;
iii. The granting and issuing of letters or credit, traveller's cheques and circular notes;
iv. The buying, selling and dealing in bullion and species;
v. The buying and selling of foreign exchange including foreign bank notes;
vi. The acquiring, holding, issuing on commission, under-writing and dealing in stocks,
funds, shares, debenture stock, bonds, obligations, securities and investments of all
kinds;
vii. The purchasing and selling of bonds, scrips or other forms of securities on behalf of
constituents or others, negotiating of loans and advances;
viii. The receiving of all kinds of bonds or valuables, on deposit or for safe custody or
otherwise;
ix. The providing of safe deposit vaults;
x. The collecting and transmitting of money and securities;
xi. Acting as agents for any Government or local authority or any other person or
persons;
xii. The carrying on of agency business of any description including the clearing and
forwarding of goods, giving of receipts and discharges and otherwise acting as an
attorney on behalf of customers, but excluding the business of a managing agent or
secretary and treasurer of a company;
xiii. Contracting for public and private loans .and negotiating and issuing the same;
xiv. The effecting, insuring, guaranteeing, underwriting, participating in managing and
carrying of any issue - public or private, of State, municipal or other loans or of shares,
stocks, debentures, or debenture stock of any company, corporation or association and
the lending of money for the purpose of any such issue;
xv. Carrying on and transacting every kind of guarantee and indemnity business;
xvi. Managing, selling and realising any property which may come into the possession of
the company in satisfaction or part satisfaction of any of its claims;

xvii. Acquiring and holding and generally dealing with any property or any right, title or
interest in any such property which may form the security or part of the security for any
loans or advances or which may be connected with any such security;
xviii. Undertaking and executing trusts;
xix. Undertaking the administration of estates as executor, trustee or otherwise.
The business of a bank may be classified into two broad groups-funds activity,
comprising deposits and advances and other activity, which would include all other
services like remittances cheques and bills collection, foreign exchange dealings, etc.
Funds activity accounts for 65% of total servicing cost (41% for deposits and 24% for
advances). Among other activities, remittances and bills account for 21%, foreign
exchange for 4% and other activities including Government business handled by the
State Bank group for the balance of 10%. It is noteworthy that between 1970 and 1976,
there has been a sizeable increase in the share of advances in total banking costs, while
the share of deposits has remained virtually unchanged. The share of remittances, bills
and other activities has declined.
With the accent on deposit mobilisation and grant of credit to weaker sectors of society
during recent years, banks have introduced a number of new schemes. Besides these,
banks have also introduced certain services such as credit cards, gift cheques,
emergency vouchers, and participation certificates for the convenience of customers.
ROLE OF COMMERCIAL BANKS IN INDUSTRIAL FINANCE
In this country, banking is not a new occupation. We have a record of banking which
goes back at least 2,500 years, if not more. But in this long history of banking, till about
30 years back, banking had very little to do with industry. Going through our ancient
chronicles, whether the Arthashastra or the Buddhist Jatakas or the Jain Chronicles,
one does not see much connection between banking and industry, though there are
plenty of linkages between bankers and trade, between bankers and the State.
Most of the time, bankers, whether in India or in Europe, have been concerned with the
financing of trade, with the remittance of funds and with the putting out of their own
resources to make them available to those who needed them. The idea of mobilising
resources from others in order to place them in the hands of a large number of people is
a new concept. Bankers have to lend out of their deposits. Any other source of funds is
temporary or transient. It is not meant to be a genuine source of funds; it is not a
resource in the real sense. That the bankers have had to finance the Government since
the dawn of recorded history has parallels as of now, because a large part of banking
resources goes into the financing of the Government. Since the late sixties, there has
been an unrivalled and unprecedented expansion in banking accompanied by a massive
diversification of activities. During the last few years, there has been a much greater
involvement of bankers in social and economic development.

The commercial bank is the most important financial institution. In financing day-today transactions of the business world, it enables all other financial institutions to
function and contribute directly to their activities. The commercial banking structure is
the core of the modern financial systems. Every commercially and industrially advanced
nation today has its commercial banking system adapted to its own needs. There is no
phase of the economy in such nations, whether it be personal, corporate, or Government
economic activity which is not touched directly or indirectly by the commercial banking
system. Modem commercial banking has often been described as "department store
banking", as it is equipped to perform practically and service which its customers
require. There are two broad problems which any bank can solve satisfactorily. One
involves operational management and the other financial management. Operational
management concerns those operations through which direct contact with customers
results. Moreover, financial management is the testing ground for the sagacity of the
management of commercial banks.
There are two principal areas in which financial management is brought into play. The
first of these is lending operations which deal with customer loans and short-term openmarket paper. Lending operations are the heart of modern commercial banking.
Loans may be classified according to the types of borrowers, type of business maturity,
security or in any other manner. The banker is anxious to lend, if he can obtain security.
He may give loan, if the borrower obtains a satisfactory endorser or consignor who acts
as the security for the principal obligor. The banker may require inventory or security
such as warehouse receipts or field warehouse receipts. He may require the assignment
of title to new equipment purchased or a chattel mortgage. One means of securing a loan
is by negotiable securities of the Government or listed or unlisted securities. Accounts
receivable or cash value of life insurance policies are also pledged. However, it must be
noted that all loans cannot be secured; banks must have a good earning asset portfolio,
because loans and investments make up the principal means whereby the banks derive
money income. If the assets accumulated in the lending process are good, the bank is
strong, but if these are "weak", the bank is weak. Banks have special staff or service
departments. Large banks have departments for internal audit, internal analysis of
operations, planning and systems, personnel, equipment and supplies, etc.
Questions
1. How would you explain the importance of an efficient capital market as an
indispensable pre-requisite of economic development?
2. "Fundamentally the capital market is not different from any other market" Comment.
3. Why is a capital market described as a constituent of the financial market?
4. Discuss the services of modern commercial banks.

5. Discuss elaborately the role and the progress of commercial banks in the industrial
financing of this country.
6. Discuss various types and characteristics of Money Market.

- End of Chapter UNIT - 3

LEASING - AN INNOVATIVE SOURCE OF FINANCE

All over the world new strides have been reached in the discipline of financial service to
accelerate the pace of the industrialisation and economic development. For example in
the United State and Western countries, billions of dollars can be mobilized for large
projects by means of corporate securities, loans, commercial papers, mutual funds,
venture capital, etc., in a short period of time. In India too, there has been a remarkable
growth and diversification in the financial services. Growth of Leasing
Leasing is the fastest growing method of financing. At one time the business of lending
was in the hands of the banks, but businessmen often did not find bank borrowing
procedures satisfactory for many reasons. So when leasing as a form of finance came
along with its many advantages, it quickly found a highly profitable segment in the
financial market. Leasing is a magic solution for the finance-starved corporate sector,
the ultimate panacea for a development model that emphasizes modernisation and
diversification. The most convenient method of financing that offers several advantages
on both sides of the table, to the lender and the borrower. Leasing has taken a foothold
in India. It is perhaps the only industry that has done remarkably well in a short period
since the concept of leasing entered this country in 1973. The first leasing company in
India, incidentally known as First Leasing Company, took shape in that year. Since then
many other leasing companies have been formed and several companies have diversified
into leasing. Perhaps no other industry has created so much enthusiasm. Today the
country has 300 odd leasing companies, and the industry is going strong.
Leasing has established itself as one of the most important means of financing capital
assets because of the major advantages. Leasing companies provide 100 percent of the
cost of the equipment, thus conserving for the lessees its cash in an advantageous way
which most forms of financing will not achieve. A lease is a medium term facility and is
usually required by the lessee, whereas hire purchase periods tend to be shorter as do
the traditional forms of bank loans. With the increasing sophistication of modern
equipment, the cost tends to be much higher than historically so, and by raising the
exact amount by way of lease finance, the equipment should generate profit along with
the rentals needed to meet the contractual requirements. A lease is a revenue expense
and therefore, the lessee can offset the rentals against taxable income.

The rental pattern of leases can be tailored to accommodate the cash flow situation of
the lessee, thus making it possible to budget exactly for the payment of the rentals in
line with the company" cash flow generation. A leasing contract is viewed as a single
transaction outside the normal balance sheet of a company. The leased assets belong to
the lessor and are not available to the general creditors of the company. Moreover, the
liability arising out of leasing is not of capital nature but a kind of revenue applicable to
meet the rentals as they all due. Lease finance is particularly useful to those companies
which have strained capital situation but good funds flow and growth prospects. In
addition to over 300 companies, recently banks have also entered in leasing business
because leasing is a better means of deploying funds on attractive terms. There is
regular rental cash flow and built-in security.
Recently, leasing as a means of financing large capital expenditure has broken new
grounds. For example, in the acquisition of its new 747-300 Combi-aircraft, Air India
has used lease financing technique, which has enabled the corporation to conserve
foreign exchange of Rs.1.74 crores per annum. Further, the infrastructure leasing and
financial services limited (ILFSL) is trying to coordinate financial package from several
domestic financial institutions as well as global bodies like World Bank, the
Commonwealth Development Corporation and the Asian Development Bank for
financing major infrastructural projects. In India, where the capital formation is very
slow and availability of funds is also limited, entrepreneurs can gainfully utilise leasing
for setting up of new industries, expansion, diversification as well as modernisation of
their projects.
Role of Leasing
Leasing is the fastest growing method of financing. At one time the business of lending
was in the hands of the banks, but businessmen often did not find bank borrowing
procedures satisfactory for many reasons. So when leasing as a form of finance came
along with its many advantages, it quickly found a highly profitable segment in the
financial market. The market for leasing opportunities has grown fantastically. It is
estimated that the potential for leasing in India ranges from Rs. 1,000 crores to Rs.
1,500 crores a year where as the 300 odd leasing companies currently in operation are
servicing only Rs.650 crores to Rs.850 crores, i.e., only 35% of the potential. With such
potential, well-known business houses have also entered the leasing business. Today the
most visible companies in the field are Sundaram Finance, Motor & General Finance
Limited, Swadeshi Finance, Nagarjuna Finance, Mazda Leasing, Mid-West Leasing
Limited and SRF Finance Limited.
The role of leasing companies in the Indian economy is considerable and it is quite the
best thing that happened to Indian industry. By its very nature, money put into leasing
moves at its very faster velocity and investors can expect excellent returns from
investments in leasing shares. Leasing is a magic solution for the finance-starved
corporate sector.
Lease finance has a vital role to play in India in the coming years. "Leasing offers a
convenient means of diversification and modernisation of the Indian industry and is

particularly advantageous to small and medium scale industries who have a low capital
base and are unable to approach the capital market for raising funds." Various market
surveys in the country had indicated sizeable potential for leasing business.
There is a virtual hunger for finance in the Indian industry and the nearly 300 leasing
companies with paid up capital of Rs.300 crores, can hardly satisfy even a part of the
demand of the private sector industries. Notwithstanding the recent entry of banks and
financial institutions into leasing business, the demand for funds will be much more
than the supply. The seventh five year plan envisages a total investment of Rs.3,20,000
crores, of which Rs. 1,40,000 crores will be in the private sector. However, there will be
a shortfall of over Rs. 17,000 crores in the private sector and Rs.30,000 crores in the
public sector. This shortfall requires to be met through various funding agencies in the
private sector including lease financing. The Government therefore has insisted that the
corporate sector should tap the capital market directly to raise funds for financing its
expansion and diversification plans. Shortages of funds, procedural delays, and
stringent market conditions as far as institutional finance is concerned, have created a
resource gap which has to be filled by leasing companies.
With the growth and sophistication in trade, commerce and industry, better and. newer
financial services are indispensable. In India, to a great extent, such services are
concentrated in development of the financial institutions, nationalised banks and
Government agencies. As such, innovations and efficiency is comparatively low. It is
now desirable to involve the reputed private merchant bankers to provide a new thrust
to the growth of financial services. Financial services is the growth area of the future and
there is a huge potential waiting to be tapped. Top-guns in Indian industry are training
this sight as a new growth area: financial services.
"Venture Capital" is defined as long-term funds in equity or semi-equity form to finance
hi-technology projects involving high risk and yet having a strong potential of high
profitability. The venture capital companies developed in the US and spread to a
number of other industrialised countries like Japan. It is a fact that every venture
involves a high mortality risk and long gestation period and, therefore, venture
capitalists have to prepare substantial management inputs and in the early stages of the
project implementation. But once the project reaches the stage of profitability, the
venture capitalists can sell their equity interest at high premium in the capital market,
and earn substantial profits which can be redeployed in new ventures. The Industrial
Financial Corporation of India (IFCI) has set up the Risk Capital and Technology
Finance Corporation (RCTC) to take technology from the laboratory to the commercial
stage. Financial assistance under the scheme is provided for importation and adaptation
of technology to suit Indian conditions.
It is suggested that in line with guidelines for venture capital, the Government should
also enact suitable legislation for the operation of mutual funds. At present, in the
absence of any specific law applicable to mutual funds, these are being constituted in
various legal forms. In most of the advanced countries, where the mutual fund industry
is well established, there are special laws governing mutual funds. It will be in fitness of
things now to introduce an appropriate legal framework to govern these funds to ensure

their smooth functioning and safeguarding the interests of investors. Unless suitable
checks are imposed investors may be taken for a ride as happened in case of chit-fund
companies.
The role of leasing companies in the Indian economy is considerable and it is quite the
best thing that happened to Indian industry. By its very nature, money put into leasing
moves at its very fastest velocity and investors can expect excellent returns from
investments in leasing shares. As in investment, leasing shares initially have quickly
moved up to blue chip status. However, in 2 years, over 300 leasing companies have
entered the market. This alone indicates the vitality, health and potential growth of this
young business.
LEASE FINANCING - PROBLEMS AND PROSPECTS
In this paper, an attempt is made to analyse the problems and prospects of leasing
companies. The study is based on the field investigation covering 18 selected leasing
companies established in twin cities of Hyderabad and Secunderabad.
Equipment leasing has received increasing attention in the western countries over the
last two decades and in India during the last half decade. Equipment Leasing in India
has completed a decade and a half of development through it emerged in the early
seventies. There was a mushroom growth of institutions offering leasing services
following the initial success of leasing business in India.
Leasing business that has done remarkably well in a short period registered declining
trend during the last few years. This has evoked considerable interest in the researcher
to make a detailed analysis regarding problems and prospects of leasing business.
At the outset, let me discuss the importance and growth of leasing business in India.
Lease financing has been a welcome development as it has widened the capital market.
It is now recognised as a legitimate and an important method of financing of capital
goods and therefore, should be regarded as an alternative or an additional source of
finance for industrial growth.
There are several types of lease agreements. However, lease contracts can broadly be
classified into two main types, viz., financial lease and operating lease.
The lease period usually corresponds to the economic life of the asset and may be split
into the primary and the secondary lease period. Lease agreement is non- cancellable
during the primary lease period. The lessor recovers the entire cost of the asset as well
as his profit during the primary lease period. The secondary lease period covers the
balance of the life of the asset at a nominal rental. The scrap then reverts back to the
lessor.
Growth of Leasing Business

Modern leasing which began in the United States in the early 1950s, spread to European
countries and Japan in the early 1960s, and to the rest of the world during the 1970s.By
the early eighties, equipment leasing has gained strong foothold in Asia.
The concept of equipment leasing was introduced in the early 1970s in India. The first
leasing company, incidentally known as "First Leasing Company of India Ltd." was
established in 1973 in Madras. In 1979 one more leasing company - the "20th Century
Leasing Company - came into the leasing market. The success of the above two leasing
companies has attracted many others into the leasing industry. The number of leasing
companies grew to 60 in 1982, 150 in 1983 and to more than 500 in 1985.
But there are now less than 100 active companies engaged in leasing business and they
account for almost 85% of the total leasing business. It may be noted here that thought
the number of leasing companies has been showing declining trend the volume of
business has increased.
According to the Annual Reports of Equipment Leasing Association, India (ELAI) the
cumulative leases transacted by member companies is estimated to exceed Rs.700
crores as on 31-3-1989 against Rs.500 crores as on 31-3-1988. The business transacted
by the members during 1988-1989 exceeded Rs.200 crores as against Rs.150 crores
during the year 1987-1988. It may be pointed out that the business transacted by the
members accounted for over 80% of the total leasing business in the private sector in
India.
Problems of Leasing Companies
Lease financing has made rapid strides in many western countries and in Japan.
However, in India, many of the leasing companies are in trouble owing to lack of funds
and other legal constraints. As a large number of laws - such as Income Tax Act, Sales
Tax Act etc., affect the leasing, the leasing business in India has undergone a
phenomenal change during the last few years.
There were nearly 500 leasing companies in existence around 1985, but difficulties in
funding, levy of sales tax, compulsory minimum tax on book profits, etc., caused the
disappearance of many companies from the leasing field. Over 300 leasing companies
have either become dormant today or diversified into related and unrelated activities.
The reasons attributed to this debacle are highlighted hereunder.
Private sector leasing companies have already received a set-back because of the acute
competition from public sector leasing companies of financial institutions and
commercial banks. Financial Institutions like Industrial Credit and Investment
Corporation of India (ICICI) and Industrial Finance Corporation of India (IFCI) are
actively involved in leasing. These institutions have already become powerful forces. The
ICICI and IFCI have sanctioned and disbursed amounts to the extent of Rs.2000
millions. More and more government institutions are entering the field.

Commercial Banks like SBICAP and CANBANK which are already in the field, have done
the business to the extent of Rs. 1000 millions and many others viz., Punjab National
bank, Bank of Baroda, Bank of India, etc., have also been entering the field of leasing
through subsidiaries and this has added to the difficulties of private sector leasing
companies in expanding their activities.
Most of the leasing companies depend on bank borrowings at 16 to 18 per cent interest
which make the lease more expensive. On the other hand those banks, which have set up
or are thinking of setting up their own leasing subsidiaries, are reluctant to provide
funds to private sector companies.
Most of the leasing companies suffer from lack of qualified trained personnel. A true
professional leasing company would be able to provide an attractive lease package to
suit the specific requirements of a lessee. Since the lease financing is highly technical in
nature, the leasing companies need to have professional expertise.
Prospects of Leasing Business
Despite several problems, the leasing industry has come to stay and has a promising
future in India.
In developing economies like India, the existing commercial banks and financial
institutions were not in a position to meet the total demand by the corporate industries.
As such there is a wide gap between the demand for and supply of funds. Leasing
companies bridges this gap.
Most of the core industries which need heavy capital outlays like steel, coal, energy, etc.,
are in the government sector. These industries are now exploring the leasing route.
Their requirements would be in the nature of "big ticket" leases and would obviously
necessitate a consortium arrangement.
Financial institutions are intensifying their efforts to expand their activities. With their
larger resources and lower cost of funds, they have been able to captures, major share of
leasing business from the market.
Recently, Industrial Finance Corporation of India heads a consortium which has leased
Rs. 110 crores of equipment to Reliance Industries Limited's plant at Patalganga,
Maharashtra. The ICICI has given a "DORNIER" 14 seater aircraft on lease to UB group,
Bangalore. It costs around Rs. 14 cores.
The cumulative leases transacted by the members of Equipment Leasing. Association is
estimated to exceed Rs.700 crores, as on 31-3-1989. This share is over 80% of the total
leasing business transacted in India in the private sector.
It is certain that the banks and financial institutions have had a wide network and
financial muscle, but they may not be enough to match the private sector leasing
industry in providing services. Private sector leasing companies can tackle and even

forestall this competition by adopting new market segments such as more efficient
personalised service to the end users, leasing of consumer durables, etc. Moreover, the
entry of institutions and banks would bring the fittest to survive, market stability and
growth to the leasing business.
Conclusion
The government created suitable environment at the beginning for facilitating the
growth of lease financing in India by ensuring low cost of capital for the leasing
companies.
Leasing companies played a more positive role in the economy by mobilizing more and
more funds efficiently and cheaply. At the time of the leasing business receiving
momentum, the government introduced some laws which inhibited the growth of
leasing companies. These laws affected the leasing business and caused trouble for the
leasing companies.
However, of late, the government recognised the problems of leasing companies and
brought some changes in laws. For instance, recently the Motor Vehicles Act has been
amended and the amended Act provides for incorporating the interest of the lesser in
the Registration Certificate.
The financial institutions and banks on the one hand and the private sector lessors on
the other have to play very useful joint role to promote leasing business.
LEASE FINANCING - ACCOUNTING AND TAXATION ASPECTS
Types of Leases
Lease contract are of various types. The most important of these are Financial and
Operating leases. Where the lease effectively transfers substantially all of the risks and
benefits of ownership of the leased property from the lessor to the lessee, it should be
classified as a Financial Lease. Where, substantially, all the risks remain with the lessor,
the lease is designated as operating lease.
The financial lease is of non-cancellable type, wherein the lease is generally for long
period of time or substantially the whole of the economic life of the asset, and the total
lease rentals recovered around 90 to 95 per cent of the cost of the asset. Such leases are
cancellable only.
a) upon occurrence of some remote contingency,
b) with the permission of the lessor
In most cases, a lease agreement contains a clause which regulates the cancellation
aspects of the agreement and defines the circumstances under which the lease may be
terminated.

Accounting of Lease Finance

Because of the inherent advantages of lease finance in industry many countries have
introduced legislation to regulate its growth. Also a fair degree of standardization has
been achieved in many countries in respect of accounting practices related to lease
businesses. However, in India, there is no specific law governing lease transactions.
In Finance Lease Method, the transaction is capitalised, wherein the lessor substitutes
the present value of the future lease receivables for the leased out assets. The lessee in
turn recognises the present value of the lease payment as liability and the corresponding
figure as the leased asset. Expenditure for the lessor is only financial and administrative
expenses. The Institute of Chartered Accountants of India has issued a Guidance Note
on Accounting for Leases'. The relevant paras on the accounting for leases in the books
of the lessor and lessee are reproduced below.
Finance Lease
Assets leased under finance lease should be disclosed as "Assets given on lease" under
the head "Fixed Assets" in the balance sheet of the lessor. The classification of Assets
given on lease' should correspond to that adopted in respect of other fixed assets.
Lease rentals (those received and those due but not received) under a finance lease
should be shown separately under Gross Income' in the profit and loss account of the
relevant period.
It is appropriate that against the lease rental, a matching annual charge is made to the
profit and loss account. This annual lease charge should represent recovery of the net
investments/fair value of the leased asset over the lease term. The said charge should be
calculated by deducting the finance income for the period (as per para 12 below) from
the lease rental for that period. This annual lease charge would comprise (i) minimum
statutory depreciation (e.g., as per the Companies Act, 1956), and (ii) lease equalisation
charge, where the annual lease charge is more than the minimum statutory
depreciation. However, where annual lease charge is less than minimum statutory
depreciation a lease equalisation credit would arise In this regard, the following
accounting entries disclosures should be made:
a) A separate Lease Equalisation Account should be opened with a corresponding debit
or credit to Lease Terminal Adjustment Account, as the case may be.
b) Lease Equalisation Account should be transferred every year to the Profit and Loss
Account and disclosed separately as a deduction from/addition to gross value of lease
rentals shown under the head "Gross Income".
c) Statutory depreciation should be shown separately in the Profit and Loss Account.
d) Credit balance standing in Lease Terminal Adjustment Accountant at the end of the
year should be shown under the head 'Current Liabilities'. Similarly, debit balance

standing in Lease Terminal Adjustment Account at the end of the year, should be shown
under the head 'Current Assets', since it is of the nature of an expenditure the value of
which is to be received in future. At the end of the lease term, the balance standing in
Lease Terminal Adjustment Account should be transferred to leased asset account and
should be disclosed as recommended in (d) above,
e) Accumulated statutory depreciation should be deducted from the original cost of the
leased asset in the balance sheet of the lessor. However in the last year of the lease term,
the balance in the Lease Terminal Adjustment Account should be shown as a deduction
from the book value of the asset arrived at, as stated earlier.
The method of income measurement suggested in this paragraph, is in consonance with
the inherent nature of a finance lease.
The Finance income for the period should be calculated by applying the interest rate
implicit in the lease to the net investment in the lease during the relevant period This
method would ensure recognition of net income in respect of a finance lease at a
constant periodic rate of return on the lessor's net investment outstanding in the lease
However, some lessors use a simpler method for calculating the finance income for each
of the periods comprising the lease term by apportioning the total finance income from
the lease in the ratio of minimum lease payments outstanding during each of the
respective periods comprising the lease term. (The total finance income from the lease is
the difference receivable over the lease term and the fair value of the leased asset at the
inception of the lease). It is, however, clarified that where this method is used, overdue
lease rentals, i.e., lease rentals fall due but not collected should not be taken into
account for determining the amount of minimum lease payments outstanding during
each of the respective periods comprising the lease term.
Net investment in the lease may often be equal to the capital cost/fair value of the asset
at the inception of the lease. However, as per the definition, net investment is the
difference between the gross investment in the lease (i.e., the aggregate of the minimum
lease payments from the standpoint of the lessor and any residual value accruing to the
lessor) and the unearned finance income (i.e. the difference between the lessor's gross
investment in the lease and its present value).
Initial direct cost, such as commission and legal fees, often incurred by lessors in
negotiating and arranging the lease should normally be expensed in the year m which
they are incurred. Similarly, income on account of lease e.g., management fees, should
be realised in the year in which they accrue.
Operating Leases
A lease is classified as an operating lease if it does not secure for the lessor the recovery
of his capital outlay plus a return on the funds invested during the lease term. Therefore,
the asset should be treated by the lessor as a fixed asset and rentals receivable should be
included in income over the lease term.

Costs, including depreciation, incurred in earning the rental income should be charged
to income. Rental income should normally be recognised on a systematic basis which is
representative of the time pattern of the earnings process contained in the lease. In
many cases, recognition of rental income on a straight line basis over the lease term
would be representative of the time pattern.
A leased asset for an operating lease should be depreciated on a basis consistent with the
lessor's normal depreciation policy for similar assets.
Initial direct costs incurred by lessors in negotiations and arranging the lease should be
expensed in the year in which they are incurred.
Accounting for Leases in the Books of a Lessee Finance Leases
A lessee should disclose assets taken under a finance lease by way of a note to the
accounts, disclosing, inter alia, the future obligations of the lessee as per the agreement.
Lease rentals should be accounted for on accrual basis over the lease term so as to
recognise an appropriate charge in this respect in the profit and loss account, with a
separate disclosure thereof. The appropriate charge should be worked out with reference
to the terms of the lease agreement, type of the asset, proportion of the lease period to
the life of the asset as per the technical/commercial evaluation and such other
considerations. The excess of lease rentals paid over the amount accrued, in respect
thereof, should be treated as prepaid lease rental and vice versa.
Operating Lease
Lease rentals should be accounted for on accrual basis over the lease term so as to
recognise an appropriate charge in this respect in the profit and loss account with a
separate disclosure thereof. In other words, aggregate of the lease rentals payable over
the lease term should, unless, another systematic basis is more representative of the
time pattern, be spread over the term on straight line basis, irrespective of the payment
schedule as per the terms and conditions of the lease. The excess of lease rentals paid
over the amount accrued, in respect thereof, should be treated as prepaid lease rental
and vice versa.
Guidance Note Issued by I.C.A.I. and I.A.S.-17
The Research Committee of the Institute of Chartered Accountants of India has issued
the guidance note on Accounting for leases keeping in the present tax position.
Accordingly, the lessors are allowed to capitalise on the asset given on finance leasing.
However, the accounting treatment related to the determination of net profits in the
profit and loss account have been recommended so as to arrive at the same net profit as
per International Accounting Standards 17 (IAS-17) on "Accounting for Leases. In IAS17 a finance lease transaction is treated as a pure financing transaction only and
therefore it is recommended in the standard that the leased asset should be capitalised
in the books of the lessee as his asset, since, in substance it belongs to the lessee.

Accordingly, depreciation is charged by the lessee in his books of account. The lessor is
required to show the aggregate of lease rentals receivable, over the outstanding lease
period as a receivable. Consequently, he is entitled for depreciation charges in his books
of account. The profit and loss account of the lessor is credited with the finance income
(the interest income) which is his true income keeping in view the true nature of thefinance lease. It can be seen that there is a major difference in the procedure for
accounting for lease transactions as recommended in the Guidance Note issued by the
Research Committee of the I.C.A.I. and the Accounting for lease transactions in the
International Accounting Standards. Thus, the Guidance Note is only an interim
measure keeping in view the present tax position in the country;
Taxation of Lease Transactions
The present practice by the lessor in India is to capitalise the asset leased out on finance
lease and show the same in their books of account. Accordingly, the entire amount of the
periodic lease rental comprising of principal and interest components pertaining to the
period is recognised in the relevant profit and loss account as revenue. The
corresponding debit is made by way of the depreciation charge as per schedule 14 of
Companies Act, 1956. The lessor is obliged to disclose the asset given on finance lease as
their own asset, even though they have only a financial interest in the leased asset.
Since, the assets are shown in the Balance Sheet of the lessor, the entire lease rentals are
shown as the revenue from the lease transactions.
The Central Board of Direct Taxes has issued a circular with respect to the Depreciation
of assets in Hire Purchase agreements, wherein, various conditions subject to which
depreciation charges on assets acquired under Hire Purchase agreements are
prescribed. It is suggested that, keeping in view the true nature of finance lease wherein
the interest of the lessor is recognised only as the financier and not owner of the asset, a
similar circular be issued in respect of the admissibility of the depreciation allowance to
the lessee instead of the lessor. This is to pave the way for a sound accounting practice as
recommended in the International Accounting Standard No. 17.
ILLUSTRATIONS
Investment decisions are taken by industry round the year for a variety of reasons.
Capital expenditure is incurred by industrial units usually in respect of the following
areas:

Assets being acquired under a legal obligation. Pollution control devices, canteen,
crche, safety equipments under Labour Legislations,
Normal addition to fixed assets,
In the context of expansion and diversification, new technology absorption,
modernisation, replacement of worn out assets etc.
Community development projects like township, school, hospital, roads, street
lighting, public park etc., and
Special exigencies like balancing equipments, DG Set etc.

It is common to use the investment appraisal techniques or the Cost Benefit Analysis for
evaluating normal commercial capital expenditure. However, these techniques cannot
be applied for all the above areas because the decision to spend on fixed assets is not
necessarily a commercial one, but is influenced by certain other considerations.
When the capital expenditure decision is to be taken, generally, a decision on Means of
Financing has to be finalized. Such decision is very much influenced by the capital
structure of the organization, financial/operating leverages, funds position, and
availability and source of funds, debt equity situation etc. Out of the sources under
borrowed capital, lease financing is one such source, having its origin only few years
ago, in this country.
Let us examine with reference to practical situations, the following 2 issues from the
Lessees view point:
a) For whom is the Lease Financing beneficial?
b) When should an industrial Unit opt for Lease Financing? For this purpose, the
following data is assumed:

8. Financing Options
a) Own Funds

b) Institutional Loans at 15% Interest repayable in 5 years

c) Lease financing with i) Lease Management Fee - 2% (one-time payment)
ii) Lease Rental at Rs. 22.50 per thousand plus 4% S.T. on Lease Rental for 60
months
9. Company Taxation is 52.5%. Ignore Investment Allowance.
Now, depending upon the funds position, both the above companies will have to choose
from one of the following financing options:
(a) Own Funds

(b) Term Loans

(c) Lease Financing

Any financing decision ultimately has to bear in mind the impact of such decision on the
earning per share after tax. Keeping this in mind, let us evaluate the above options for
the 2 companies during the life span of the asset to be procured.

The summarized position of Earnings per Share after tax of the 2 companies under the
3 financing options is below:

Certain clear conclusions emerge from the above results. These are:
1. Earnings per share is influenced by the Capital Structure of a Company. There is high
Capital gearing for Company A, while it is the other way round for Company B.
Shareholders of Companies with highly geared Capital always stand to gain, in terms of
earnings per share, when the going is good.
2. Financing from own funds gives the highest earning per share for both Companies,
but the rate of earning is high for a low-equity, high Term Loan Company.
3. Under the Term Loan and Lease Financing as alternative Sources of Funds, the
earnings per share is slightly better with the lease financing option for both Companies.
This is because the total outgo on Lease Rentals, Lease Management Fee and S.T. on
Rentals are slightly less than the total of Depreciation and Interest on Term Loan. As
stated elsewhere, thanks to the keen competition among lease financing companies, the
lessor passes on a part of his benefits of depreciation and tax benefits to the lessee, while
fixing the lease rental.
4. Thus, for any profit making company, with a debt equity Ratio of 2:1 or above, Lease
financing is strongly advocated for the following reasons:
a) It does not make dent on the liquidity position.
b) It truly meets the borrowing criteria in terms of cost, convenience and control.
c) No Margin Money is needed and no encumbrances on existing fixed assets are
insisted.
d) It is all the more welcome, if there is a liquidity crunch, in the borrowing company.
e) It increases the lessee's capacity to borrow, at the same time, permitting him to make
alternative use of available funds.
5. A few points, which a lessee should guard against, by suitable arrangement/
agreement with the lessor, are:

a) Protection against supplier's warranties for the equipment.

b) Insulation against risks of obsolescence.
c) Safeguard against deprivation of usage rights for any minor non-observance of lease
covenants.
6. What will happen to a loss making company, if it wishes to go in for lease-financing?
The answer is not far to seek. There will be no tax on net profits, to the extent of losses
sustained from existing operations or cumulative past losses. In fact, lease financing is
an ideal source of finance for such company, as it may already have a liquidity crisis and
an-eroded/encumbered asset base. The big question, however, is, which Lease financing
company will come forward to provide finance to such company with its poor showing in
the past?
7. This paper has dealt the subject essentially on the Return on Investment approach.
There are a few people, who do the evaluation on the Net present Value Method with
D.C.F. computations, which finally compares the cash outflows to the Company under
the 3 financing options in terms of present values. But the question is - is an investment
decision, an expenditure decision or a decision centering on returns to the owners? If
the latter view point is right, the ROI approach seems more logical.
Questions
1. Discuss the advantages and disadvantages of leasing.
2. Explain the different kinds of leasing.
3. Explain the structure of leasing industry in India.
4. What are the problems of leasing in India?

- End of Chapter UNIT- IV

MUTUAL FUNDS

Introduction
In recent years the Government has announced a number of policy initiatives, towards
liberalisation in industrial and financial sectors. One of the significant policies has been
for the development of new financial instruments like commercial paper (CPs) and

Certificate of Deposits (CDs). These new instruments are expected to impart greater
competitiveness, flexibility and efficiency, to the financial sector. The development of
various MFs is a part of response to this new favourable environment, the world over
amongst various instruments. MFs have proved to be the single most catalytic
instrument in generating momentous growth in the capital market. In India too, in the
past couple of years, since banks were allowed to undertake this activity, MFs have come
up in a big way. For instance, a MF or unit trust is an open-end investment institution.
Sometimes, closed-end funds may also be set up for specific schemes with predetermined period of their duration and conditions governing their investment. The
investing public is fully aware of the practices and performance of each of these
investment institutions. The constitution and composition of the Managers and their
functions are governed by the appropriate legislation and convention.
Concept of MFs
The concept of MF is new to the capital market but not to the International capital
world. The origin of MFs can be traced to the U.K. in the 19th century which spread to
the United States in the beginning of 20th century. Subsequently, hundreds of MFs have
been developed and extended to Latin America, Far East and Europe.
MFs are basically a trust which mobilises savings from the people and invests them in a
mix of corporate and Government Securities. The fund comprises equal units
/shares/certificates and the public invests its savings in them depending on the
quantum of resources available with individuals. The fund uses these savings for
investment in debenture issues and equity shares of various companies. The resulting
funds are distributed amongst the fund owners. It offers the individual, advantages of
reasonable dividend and capital appreciation coupled with safety and liquidity.
Mode of Operation
The MF operators actively manage the portfolio of securities and earn income through
dividend, interest and capital gains which is eventually passed on to MF shareholders.
Thus, by investing in a MF, an individual gets the benefits of diversified portfolio
handled by specialists. As MFs are only interested in investments, and not in the
management companies they typically restrict their investment to about 5% of its
capital. Investors also get a wide choice through various schemes which offer different
profiles of liquidity and returns commensurate with investors perceptions and needs.
Indian Scenario
MFs are not new in India though the terms came to be popular only recently. Unit Trust
of India (UTI), the country's largest MF has been in operation for the past 30 years.
With its country-wide network of 387 offices and 80000 strong agency force and
innovative schemes tailored to meet the requirements of almost every investor's needs,
it has been successful in attracting over 300 lakh investors and generate investible funds
of over Rs.50,000crores as on 31.3.93. The launching of master shares in September

1986 has been an important land mark. When the UTI was established in India, it
differed from its counterparts in other countries in four respects.
i) The UTI is the first institution of its kind in the public sector.
ii) It combines the functions of management and trustees in one body, viz., the board of
trustees, unlike in other countries where the investment manager and trustees are two
separate entities.
iii) Its original capital of Rs.5crores was provided by the Reserve Bank of India, State
Bank of India and the Life Insurance Corporation of India and other banks and financial
institutions.
iv) There are important tax concessions which are specially attractive for investors from
small and medium income groups.
TYPES OF MFS
On the Basis of Execution and Operation
MFs can be classified into 2 broad categories, viz.
a) Open-ended MFs
b) Closed-ended MFs
Open-ended MFs function on deposit and withdrawal basis. They accept new deposits at
any time. The investor is credited with shares on the books of the company and receives
regular statements with regard to the value of holdings in the fund. No stock certificate
is issued and the investor deals with the company floating MFs while making deposits or
withdrawals. Unit Scheme 1964, of UTI, ULIP, Children's Growth Fund, Canara Bank's
Can Guilt and Cancigo are a few examples of open-end MFs.
Close-ended funds raise all their capital at one point of time. So the close ended MFs
have fixed authorised capital which can be enlarged through rights issue. A fixed
number of shares are issued and the ownership is represented by a stock certificate. If
these funds are listed in the stock exchange, the shares can be bought and sold freely.
The capital base will not change. UTI's Master share, LIC's Dhanshree, Can bank's Can
share, Can stock etc., are examples of closed ended MFs.
ON THE BASIS OF OWNERSHIP
Public Sector MFs
In India, the MFs have not only come to stay but many financial experts believe that the
nineties will be the decade of MFs. Though it was in 1964, that the first MF emerged in
the country, it took another 23 years before the second one took shape. After the calm

there was a storm as institution after institution viewed with each other in mopping up
the funds from the investing public through mutual funds. In the last 5 years, SBI, BOI,
Indian Bank, Punjab National Bank, Canara Bank, LIC, GIC have all launched MFs.

(i) Entry of Banks in the MFs Business: In India MFs business was made lawful
for a banking company to engage-in from June 1987 only. The entry of SBI MF closely
followed by Can Bank MF added new dimensions to the MFs business in India. Schemes
after schemes launched by these banks, have been very well received by the investing
public. Among the non-bank financial institutions, LIC entered MFs business in 1986
and ICICI, and GIC also.
(ii) Money Market MF: In April 1992, the Government announced the setting up of
Money Market. MFs (MMMFs) with the purpose of bringing money market instruments
within the reach of individuals. RBI has recently issued guidelines for setting up money
market MFs. The MMMFs will be set up by scheduled commercial banks and financial
institutions. They can invest only in specified short-term institutions. They can invest
only in specified short-term money market instruments, viz., Certificate of Deposits
(CDs), Commercial Papers (CPs), 182 days treasury bills and can lend in call and short
notice. The shares/units of MMMFs would be issued only to individuals. In this respect,
they will differ from UTI and other MFs who have been mobilising the savings of the
middle classes (and also of others including companies) investment in equities in the
capital market.
(iii) Off-shore MFs: The floating of off-shore MFs is an excellent way of bringing
overseas funds into the country. The Corpus of these off-shore funds is raised abroad
and brought into India for portfolio investments. These funds have to be content with
both current risk (namely, exchange depreciation) and country risk (like disintegration
of Yugoslavia) for the global investor. UTI has floated off-shore funds, viz., India fund
and India growth fund.
Private Sector MFs
Viewing the growth of MFs in Indian Capital Market, the private sector has been
enthusiastic to secure permission to launch their own MFs. Dr. Man Mohan Singh in his
1991 budget speech announced that the Government has decided to further promote the
development of MFs by throwing the floor open to the private and joint sector. As a
result the Union Finance Ministry on February 14, 1992 allowed the private sector to
float MFs in the market. They are required to function under the direct superintendence
of the SEBI. At present, over 100 companies have applied for permission to set-up

private MFs. The SEBI has outlined the broad framework of the authorisation process
and selection criteria for these funds. Media reports named the authorization process
and selection criteria for these funds. Media reports named the Tatas RPG Group,
Escorts, 20th Century, City Bank, ANZ Grindlays, Standard Chartered and a list of other
companies' names who have sent their applications. In fact, Citi Bank, is not only
planning to establish MFs but also thinking of bringing some international pension and
investment funds to the Indian Market.
ON THE BASIS OF INVESTMENT PATTERN AND YIELD

Advantage of MFs
MFs offer the following advantages to both the investors as well as to the economy as a
whole.
To Investors
Reduced Risk: MF provides small investors access to reduced investment risk
resulting from diversification, economies of Scale in transaction cost and professional
financial management.
Diversified Investment: Small investors participate in larger basket of securities and
share the benefits of efficiently managed portfolio by experts and are free from keeping
record of share certificate, of various companies, tax rules etc.
Botheration Free Investment: Investors get freedom from emotional stress
involved in buying or selling securities, MFs relieve them from such stress as it is
managed by professional experts who act scientifically with right innings in buying and
selling for their clients.

Revolving type of Investment: Automatic re-investment of dividends and capital

gains provides relief to the members of MFs.
Selection and timings of Investment: Expertise in stock selection and timing is
made available to investors so that invested funds generate higher returns to them.
Wide Investment Opportunities: Availability of wider investment opportunities
that create an increased level of liquidity for the fund holders become possible because
of package of more liquid securities in the portfolio of MFs. These securities could be
converted into cash without any loss of time.
Investment Care: Care for securities is available through MF of the investors
relieving them of various rules and regulations.
The above advantages are only illustrative and not exhaustive as there is scope for more
to be added to the list in the light of individuals own experience(s). Nevertheless MFs
bring a wide variety of securities within the reach of the investors with free liquidity at
maximum gains and minimum risks involved in the portfolio investments.
To the Economy
Mobilisation of savings of the people and channelising them into productive
investments, contributing to the developments of capital market, providing the much
needed finance for the industrial and economic development of the country are the
ultimate advantages of MFs to the economy.
Rural and Semi-urban Areas Remain Untapped
Firstly it is to be noted that the subscribers to MFs have for the most part been rich who
have invested therein for purposes other than the benefits accruing to investment in
stock markets. It is perhaps for this reason that investors belonging to the middle class
in rural and semi-urban areas have virtually ignored the magnum and the
canstock/canshare. Generally speaking the response from the rural and semi- urban
areas is extremely poor.
Advertisement War
For once the Indian investor is treated in a better manner, far from running after the
MFs, he is now being wooed by them, so much so that a vital war has broken out
between at least two of them. It is common experience that the MFs advertise "assured
returns" particularly when things had reached a point where every new scheme that
entered the market felt obliged to offer a return half a percentage point higher than the
previous scheme.
Misrepresentation in Ads

Fund managers are surprised that no one has still questioned the UTIMF advertisement
claiming 18% returns, when UTI sells its 64 scheme units for over Rs. 19.00 and claims
to pay 18% on the Rs.10 price of the unit SBI claims include yearly returns and the
market appreciation making the claim preposterous.
Flow of Funds from Agriculture to Industry
When MFs offer a return of 12 to 13.5% depending on the general economic scene which
is evidently higher than 10% return on fixed deposit from any commercial bank, there is
a flow of funds from fixed deposits to MFs. To maintain the status quo, the RBI would
have to pump in more money which should trigger off inflationary forces. This would
cause distortions by disturbing the equilibrium in both the goods and money markets,
which is not desirable.
Wide Fluctuation in Share Prices
The emergence of MFs with large resources at their disposal, has been a source of
strength to the stock market as over a period there will be a steady absorption of floating
stocks-with the likelihood of more MFs coming into being, it may become necessary to
have specified norms for trading though any rigidity in procedures may have a stifling
effect of the operations of Funds and on the spread of the habit of investment in units,
magnums or shares of MFs.
Transfer of Portfolio
Purchases by MFs are not limited to the respective schemes for which they have mopped
up funds. Large purchase by one also has the potential of pre-empting the others from
making way in the over-heated market. Market sources say that the authorities both in
Delhi and Dalai Street act to check the situation.
Guidelines
With the establishment of (SEBI) Securities and Exchange Board of India, Guidelines
are issued in the recent years for the effective functioning of the MFs and for giving
more protection to small investors. MFs shall be operated only by separately established
Asset Management Companies. AMCs which are already existing should have a sound
track record, general reputation and fairness in all their business transactions.
The Government will have to enact a 'Mutual Fund Act' to regulate the industry in the
interest of investors, and the promoting banks and institutions.
Conclusion
The fast acceptance of MFs in our financial market reveals the existing demand for such
a profitable and relatively safe instruments. Thus once, MFs gain credibility and faith
among the common man, they are going to be very significant force in the financial
sector. So far MFs are urban oriented. It has further been seen that a significant share of

existing funds come from corporate sector due to the fiscal reliefs available to them. The
urban bias of MFs is also seen from the fact that though total bank deposit have not
been affected by growth of MFs, urban and metropolitan centres have witnessed some
declaration. Thus the banking system has a positive advantage in the form of a large
country wide branch network to tap the hitherto neglected rural areas. While one feels
happy that the commercial banks have gone in a big way in the sphere of MF business
one would like to sound a note of caution that our banks should exercise some
safeguards like not sidelining their normal banking operations, remaining competitive
in the business by having a specialised staff.
Questions
1. Define a mutual fund and describe the various schemes that can be offered by it.
2. "Mutual funds provide stability to share prices, safety to investors and resources to
prospective entrepreneurs". Discuss.
3. What rights and facilities are available to an investor of mutual funds? What factors
should be considered before selecting a mutual fund?
4. Discuss the present state of the mutual funds in India and outline the causes for their
slow growth.

-End Of ChapterUNIT - V
MERCHANT BANKING

Merchant bank is defined as a kind of financial institution that provides a variety of

services, including investment banking, management of customer's securities,
portfolios, insurance, acceptance of bills, etc.
Merchant banks are neither merchants nor are they necessarily banks. Merchant
banking originated through the entering of London merchants in financing of foreign
trade through acceptance of bills. Later the merchants also assisted the governments of
undeveloped countries in raising long-term funds through floatation of bonds in the
London market and obtaining their quotation on the London Stock Exchange. Over a
period merchant banks extended their activities to domestic business of syndication of
short-term and long-term finance, underwriting of new issues, acting as registrars and
share transfer agents, debenture trustees, portfolio managers, negotiating agents for
mergers and take-overs etc.

The post-war period has witnessed the rapid growth of merchant banking through the
innovation of instruments such as "Euro-Dollars" and the growth of various financial
centres like Singapore, Hong Kong, Bahamas and more recently Bahrain, Kuwait,
Dubai, etc.
Growth in India:
Merchant banking in India is of recent origin. It has its beginning in India in 1967, when
Grindlays Bank established a division, followed by Citibank in 1970 (it has now ceased
to provide merchant banking services) and State Bank of India in 1972. Later on the
ICICI set up their merchant banking division followed by a few other banks like
Syndicate Bank, Bank of India, Bank of Baroda, Chartered Bank, Mercantile Bank, etc.
Some leading brokers have also entered the field.
The merchant banks, as they have developed in our country, could be broadly classified
into three categories. The first category comprises the divisions of commercial banks;
the second category consists of national and state level financial corporations like ICICI,
SICOM. The third category includes leading broker firms who have extended their
activities into merchant banking like H.L, Consultancy & Management Services
(FICOM), Champalal Investments and Financial Consultancy Company (CIFCO), J.M.
Financial and Investment Consultancy Services, DSP Financial Consultancy, etc. A
closer look at the work of these merchant banks indicates that the whole gamut of
merchant banking activities is hardly covered by any of these agencies. They operate
more like issue houses than full-fledge merchant banks. For many of these merchant
banking firms, there was an extension of broking services rendered earlier.
Services rendered
The services rendered by merchant banks can be examined under the following
important heads:
Issues Management: The public visibility of merchant banking has been largely
confined to management of issue of corporate securities by newly floated companies,
existing companies, and foreign companies for complying with the provisions of FERA.
The types of services under this head include obtaining consent/acknowledgement from
SEBI for issue of capital, preparation of prospectus, tying up arrangement of
underwriting, appointment of brokers and bankers to the issues, press publicity,
compliance of stock exchange listing requirements, etc.
Credit Syndication: Merchant banks undertake preparation of project files, loan
application for financial assistance on behalf of promoters from various financial
institutions for term loan, working capital finance from commercial banks for new
projects, etc. Finance for the projects abroad is also arranged by merchant bankers.
Government Consents: Merchant batiks guide promoters in the matter of rules,
regulations, capital goods clearance, import clearance, etc.

Arranging Fixed Deposits: The companies are also helped by merchant banks to
raise finance by way of public finance. In this connection, they provide not only the
required guidance but also act as brokers for the mobilization of public deposits.
Management of new accounts of deposits is also undertaken.
Portfolio Management: It includes advising on investment in government securities
to trusts, charitable institutions, companies regarding their investment in compliance
with the provisions of various Acts. Merchant banks have undertaken purchase and sale
of securities and management of individual investment portfolio of investors.
Other Services: Merchant banks provide corporate counselling and advisory services
on mergers, acquisition, and reorganization. Some of them also help in taking up cost
audit and recruitment of executives.
Role of the Merchant Banker
It makes a fascinating review if one goes into the details of the service provided by the
merchant banker. The initial spade work in the form of feasibility studies, market
surveys; advice on project location, size of the unit, the inherent profitability of the
venture; the necessary legal formalities to be complied with; obtaining the consent of
relevant authorities, and a host of other aspects form die very foundation of any
enterprises. All these complex functions are much beyond the capacity of small and
medium sectors to undertake in an effective manner. In fact, even large units find
difficulty in fulfilling all these requirements. The merchant banking services help in the
completion of these tasks. Having participated at the foundation stage, the merchant
banker helps at the state of operations. Here guidance in the matters like the capitalmix, management of public issuer, arrangement of credit, investment counselling,
drafting of necessary documents, and many other connected aspects are all effectively
handled by the merchant banker
The merchant banker also plays a rehabilitation role at the time of acquisition, merger,
take-over, or amalgamation. He feels the pulse of the capital market by keeping a close
vigil on the events happening in the stock exchange.
Qualities Required for Rendering Services
The principal qualities which should be a hallmark of a successful merchant banker are:
(i) expertise, and (ii) ability to build up the requisite bank-client relationship.
Entrepreneurs approach merchant bankers on the assumption that they know much
more and are competent to render advice and guidance. Therefore, merchant bankers
have to equip themselves with knowledge and information about the various aspectslegal, technical, financial and economic-involved in setting up an industrial enterprise.
Besides, they should be familiar with the analytical aspects and criteria applied in
evaluating the viability and profitability of projects. Expertise combined with experience
can go a long way to make a successful merchant banker. Secondly, integrity and
maintenance of high professional standards are necessary as they form the very
foundation on which business is built. The highly confidential nature of the work

involved, advice sought and given, the need of having an objective and impartial
approach contribute to the essentiality of this quality. Finally, as regards bank-client at
relationship, the client expects complete identification of the merchant banker with the
project assignment. The merchant banker should be a comrade-in-arms sitting on the
same side of the table and reducing the anxiety of the client. He should inspire trust and
confidence. It has been said that while commercial banks live on their deposits,
merchant banks live on their wits.
Scope of Merchant Banking in India
As the merchant banking is an essential function in project counselling and credit
syndication/management, it acts as a catalyst in the process of floating project ideas into
industrial ventures. The functions of merchant banking have to expand a lot. The scope
is extremely wide. Merchant banking to-day is a protective and promoting force to
entrepreneurs, corporate sector and investors. The role can be enlarged both in
domestic and international market. The operations have to expand both horizontally
and vertically so that merchant banking can evolve itself into a powerful subsidiary
organ of the parent organization.
The setting up of a separate merchant banking division by leading share brokers,
commercial banks and other reported financial institutions is a very encouraging
development. The growing popularity of the services of the merchant banker is a clear
indication of the vast scope that lies ahead. In the context of the massive investment that
is envisaged in the various sectors of the economy and industry in particular, merchant
banking expertise is likely to be in a much greater demand in the coming years.
India has built up a wide base of industrial structure. With acceleration of the process of
industrialisation, the demand both for financial and other services rendered by
merchant banking institutions and required by the industrial sector will grow.
a) The growing emphasis on development of industries like fertilizers, petro-chemicals,
and electronics which are highly sophisticated and complex in character will require
specialised services.
b) The policy of decentralisation and encouragement of small and medium industries
will involve the problem of providing technical and financial advice to these industries.
c) With the changing emphasis in lending policies of organised credit institutions from
security to credit-worthiness of the business, corporate enterprises will require the
services of a financial intermediary in. respect of project appraisal, financial
management, etc.
d) The elimination of managing agency which used to offer its services to companies
under its management for securing financial resources has created a vacuum which
needs to be filled.

e) The middle sector industries which did not have the benefit of the services of
established industrial houses will continue to feel the need for such services.
f) There is a definite possibility of Indian enterprise investing in joint ventures abroad.
These may raise certain problems which have not so far been faced by Indian industries.
Keeping in mind the above requirements, the need for merchant banking institution can
be examined in the correct perspective. The questions which require examination are
whether such institutions are required in India and, if so, what should be their functions
and the best form of their organisation. There is also the question whether the financial
community consisting of commercial banks and term-lending institutions will be able to
offer their services. Commercial banks have only recently begun to acquire experience of
project lending. The term-lending financial institutions are mainly object oriented,
being concerned with financing the new projects or existing ones. These institutions
have acquired considerable experience of the problems involved but they have hardly
any personnel or time for assisting or guiding entrepreneurs in preparing their projects.
The merchant banking institutions are required to render the following services to
Indian companies and to Indian joint ventures abroad. On the basis of the examination
of the project, the institutions should design and negotiate a financial package which
would meet the specific type of terms of financing needed by the clients. In appropriate
cases, they may also agree to guarantee loans obtained by the company. They should
also offer various services involved in the syndication of projects like assisting in the
reorganisation of companies, negotiation about mergers, making feasibility studies of a
project and giving advice on rules and regulations of the stock exchange. The proposed
institutions will be particularly useful in medium size units which find it very difficult to
float their issues in the market. Merchant banking institutions should offer investment,
management and advisory services, particularly to medium and small savers. With the
exception of a few firms of brokers registered with the stock exchanges, there is
practically no investment advisory service in India. There are thousands of persons in
the medium income group who are unable to manage their funds. It may be mentioned
that some of the commercial banks used to maintain accounts on behalf of big clients
like princes and zamindars, and made investments on behalf of these persons. The
proposed institution may agree to maintain accounts, say of Rs. 10,000 and above and
invest funds on behalf of their individual clients. They should also be able to manage
provident fund, pension fund, and trusts of various types.
Another area in which the services of merchant banking institutions can be used is in
respect of acceptance and credit discounting function. The need for such services
particularly arises where the bill market is developed. In due course, after the bill
market is sufficiently developed in India and the proposed merchant banking
institutions acquire the necessary expertise, they may also enter the acceptance-and
discounting business.
Merchant Banking and SEBI

Today with 160 merchant banks authorised by Securities & Exchange Board of India
(SEBI), merchant bankers have acquired the status of being amongst the most crucial
and important intermediaries in the capital market, being closely related to the issue of
securities to the public so as to provide a broad framework for regulating merchant
banking activities the government issued guidelines in April 1990 and the SEBI
(Merchant Bankers) Rules were published by the Ministry of Finance in December 1992.
The Securities and Exchange Board of India has been entrusted with the responsibility
of administering the guidelines. SEBI, therefore, becomes the body to authorise
merchant bankers and oversee their activities to ensure that those authorized have the
necessary expertise, financial standing and discharge their responsibilities with a high
degree of professional integrity and responsibility.
The guidelines would be suitably modified from time to time depending on the need and
SEBI would dissipate the necessary information. SEBI has also issued guidelines to
merchant bankers on the authorised activities and said authorisation would have to be
taken from SEBI in a prescribed format.
SEBI categories for merchant bankers. Merchant bankers can be registered with SEBI
under four categories:
Category-I
Capital adequacy requirement is Rs.l crore. Merchant bankers in this category can (I)
carry on any activity of the issue management, which will inter alia consist of
preparation of prospers and other information relating to the issue, determining
financial structure, tie-up of financiers and final allotment and refund of the
subscription; and (ii) act as adviser, consultant, manager, underwriter, portfolio
manager;
Category-II
Capital adequacy requirement is Rs.50 lakhs. Merchant bankers of this category can act
as adviser, consultant, co-manager, portfolio manager, and underwriter.;
Category-III
Capital adequacy requirement is Rs.20 lakhs. Merchant bankers of this category can act
as underwriter, adviser, and consultant to an issue;
Category-IV
There is no capital adequacy requirement. They can act only as adviser or consultant to
an issue.
Appointment of lead merchant bankers

All issues should be managed by at least one merchant banker functioning as a lead
merchant banker. However, in case of an issue of offer of rights if the amount of the
issue of the body corporate does not exceed Rs.50 lakhs, the appointment of a lead
merchant banker is not essential. The number of lead merchant bankers may not exceed
in case of any issue of:

Responsibilities of lead managers: No lead manager shall agree to manage or be

associated with any issue unless his responsibilities relating to issue mainly those of
disclosures, allotment and refund re clearly defined, allocated and determined and a
statement specifying such responsibilities is furnished to SEBI at least one month before
the opening of the issue for subscription. No lead merchant banker shall agree to
manage the issue made by any body corporate, if such body corporate is an associate of
the lead merchant banker. A lead merchant banker shall not be associated with any
issue if a merchant banker who is not holding a certificate is associated with the issue.
Due diligence certificate: The lead merchant banker, who is responsible for
verification of the contents of a Prospectus or the Lette4r of Offer in respect of an issue
and the reasonableness of the views expressed therein, shall submit to SEBI at least two
weeks prior to the opening of the issue for subscription, a due diligence certificate on the
prescribed Form C.
Continuance of association of lead manager with an issue: The lead manager
undertaking the responsibility for refunds or allotment of securities in respect of any
issue shall continue to be associated with the issue till the subscribers have received the
share or debenture certificates or refund or excess application money.
Acquisition of shares prohibited: No merchant banker or any of its directors,
partner or manager or principal officer shall either on their respective accounts or
through their associates or relatives enter into any transaction in securities of bodies
corporate on the basis of unpublished price sensitive information obtained by them
during the course of any professional assignment either from the clients or otherwise.
Every merchant banker shall submit to SEBI complete particulars of any transaction for
acquisition of securities of anybody corporate, whose issue is being managed by that
merchant banker, within fifteen days from the date of entering into such transaction.

Code of Conduct for merchant bankers: SEBI has laid down a comprehensive
code of conduct for merchant bankers, a merchant banker in the conduct of his business
shall observe high standard of integrity and fairness in all his dealings with his clients
and other merchant bankers. He shall render at all times high standards of service,
exercise due diligence, ensure proper care and exercise independent professional
judgment. He shall not make any statement or become privy to any act, practice or
unfair competition, which is likely to be harmful to the interests of other merchant
bankers. He shall not make any exaggerated statement, whether oral or written, to the
client about the qualification or the capability to render certain services or his
achievements in regard to services rendered to other clients.
A merchant banker shall not divulge to other clients, press or any other party any
confidential information about his client, which has come to his knowledge and shall not
deal in securities of any client company without making disclosure to SEBI and also to
the Board of Directors or the client company.
A merchant banker shall endeavour to ensure that (a) the investors are provided with
true and adequate information without making any misguiding or exaggerated claims
and are made aware of attendant risks before any investment decision is taken by them;
(b) copies of prospectus, memorandum and related literature are made available to the
investors; (c) adequate steps are taken for fair allotment of securities and refund of
application money without delay; (d) complaints from investors are adequately dealt
with.
The merchant bankers shall not generally and particularly in respect of any securities be
party to creation of false market, price rigging or manipulation, passing of price
sensitive information to brokers, members of stock exchanges and other players in the
capital market or take any other action which is unethical or unfair to the investors.
Critical Appraisal of Merchant Banks
We can have critical assessment of the functioning of the firms of merchant bankers
operating in our country during the last five years.
Organisational structure: An inherent weakness of our merchant bankers becomes
apparent when one observes the web-like structure of most merchant banking firms.
Some of them have gone public and got a stock exchange listing. Apparently they have
no links with their parent bodies but in essence they are just extended family business
and are extremely closely held.
Personalised business: Merchant banking in India is still based on personalized
business contacts. There is a drive towards professionalism. Each merchant banking
house boasts of professional talent. Some of them have drawn young talent from
management schools and accounting firms but still these merchant banking houses
require a professionalised profile in the coming years.

Dominance of inter-corporate deposit business: Inter-corporate deposits, in the

recent past, became a regular feature of the many merchants especially since the windfalls on booking advances that Lohia Machines and Bajaj Auto garnered. DSP was
estimated to be doing inter-corporate loan business of Rs.100 crores per annum. J.M.,
the other big merchant banker, accounted for an equal share of the market. The total
lack of any regulatory mechanism created substantial instability, The existence of
certain unhealthy practices in the inter-corporate lending market could also be solved by
merchant bankers evolving a code of conduct.
Neglected portfolio management activity: Many merchant bankers made tall
claims regarding the organisation of portfolio business. But this activity has mostly
remained ill-organised and undeveloped. Only J.M. developed this to some extent by
setting up its own research and analysis wing with files relating to 600 companies
borrowed from their stock broking firm. This firm put most of its data on computer to
aid the analysis and decision-making process. DSP also considered the idea of portfolio
management of investors but with not much success. FICOM, however, discontinued the
services because it found them become too cumbersome. Other merchant banking
houses have got a similar sad tale to tell.
Lacking entrepreneurial approach: Many merchant bankers have not shown
much entrepreneurial ability. Their phenomenal growth has really coincided with a
period in which a lot of money was lying around probably in banking deposits. What
they have succeeded in doing is to draw existing investors' preference in favour of one
instrument against the other. They have not succeeded in broad-basing the corporate
sector's search for funds by channelising rural funds into productive investment.
Overselling of new issues: Merchant bankers have more often than not been guilty
of over-doing in pushing the sale of new issues. They would be appreciated much more if
they looked upon their role as that of an impartial adviser rather than merely looking to
their own and their clients' gains. A credibility gap has been created in the minds of the
investing public regarding their usefulness.
Lack of responsibility to lenders: Merchant banker, the primary agents of their
clients, have a responsibility to lenders. There have been cases where misleading
information to financial institutions was provided. By adopting short-cuts they failed to
appreciate the Importance of creating an atmosphere of trust and goodwill with lending
institutions.
Wasteful expenditure: Merchant bankers have been accused of being spend-thrifts
at the expense of the shareholders of client companies, Disproportionate amount is
spent on advertisements and conferences and the company gets saddled with the bills.
Cost consciousness has been the biggest casualty in their operation.
Merchant banks have got a bright future to stay and grow. They have to take corrective
action to put their house in order and look to a future of growth in size and stature. As
long as capital markets grow, they grow.

Non-Banking Finance Companies

In India, there are over 3750 firms registered as non-banking finance companies
(NBFCs). But all of them are not active. Many are shelf companies belonging to
corporate groups. Those that are registered with the Reserve Bank of India amount to
over 450 companies. This figure does not take into account the various nidhis or mutual
benefit funds and numerous chit funds
NBFCs have no defined purpose like banks and financial institutions. Some of them are
product-based, offering services like car and truck finance, loans for consumer durables.
Others have flourished because of increased disintermediation in the financial markets.
Yet others, like nidhis, emerged because they provided an additional source for
deploying savings, long before the equity fever gripped the country. Some started to
exploit the inefficiency in die existing system and stepped in to provide services for
which there was demand. Corporate houses too have been responsible, to some extent,
for the mushrooming of NBFCs, as finance companies gave them an additional channel
for leveraging.
Liberalisation from 1992 gave a fillip to NBFCs. As the artificial segmentation of savings
and the pre-emption of it by state-owned financial sector slowly dismantled, these
companies tasted freedom for the first time. Now NBFCs have added other dimensions
to their wide portfolios, by promoting banks, mutual funds and consumer finance
companies. Till the current liquidity crunch began, non-bank finance companies were
on a perfect batting pitch and were posting impressive scores.
The ongoing liquidity crunch has disturbed the pitch. There are major mismatches in
the asset and liability profiles of most finance companies. Those without a diverse
resource base and dependence on banks, financial institutions and the inter-corporate
market for the bulk of their funds are already in trouble. On the asset side, the prices of
financial assets (both stock and bonds) have slumped, as the interest rates rise and the
share, price index falls. They are unable to exit from many of their investments.
Moreover, the competition is also becoming fiercer with the4 arrival of strong
international players and increased efficiency of the nationalised banking sector, which
is fast claiming market shares lost in the eighties. Against banks they lose out in terms of
cost of resources. Furthermore, banks are beginning to enforce a strict end-use
monitoring policy to ensure that money is not used for any other purpose where bank
finance can be available. Against the new international players, NBFCs face two- fold
problem. One is the former's financial muscle, and the other is their access to new
product technology.
Challenge before NBFCs: Many NBFCs tried to assume the role of financial
supermarket primarily starting as a bill-discounting outfit, gradually forayed into
merchant banking, car finance, broking and even leasing. Now there is realisation that
product delivery is the key to success and one cannot do everything in the same
company. The management cannot cope with generalist and specialist function
simultaneously. The root of the problems currently faced by the NBFCs can be traced to
their evolutionary process. They were primarily developed to take advantage of gaps in

the financial system. Leasing, the bill market, car and truck financethere was a
demand in all these products and the NBFCs stepped in to fill the breach left by the
state-owned sector. The most significant expansion occurred after 1990. When the
credit squeeze was on, the NBFCs suddenly saw their bills portfolio soar as corporates
were desperate for funds, credit from the banking sector having virtually stopped. The
booming capital market also gave them another avenue for profits. The car finance
boom occurred simultaneously. Inevitably, the success created a herd mentality and
every corporate wanted an active finance company in its group. Further, having a
finance company allowed groups to raise additional funds from the capital market.
Survival of NBFCs: There are a variety of views on the matter of survival of NBFCs.
While some tend to see the future as one of super-specialisation and product-based
competition, others feel that it is best to be present in most segments because segmentspecific players will find it harder to survive in a market that is not free and deregulated.
One matter where there is more of a consensus is the shape of the market. Most agree
that the market will be a three-tiered one. There will be the top 10 or 15 who will be able
to survive and prosper. The second category will consist of players who will always try to
break into the big league but will be unsuccessful as they have not yet reached the
critical mass. It is from this segment that the casualities will occur. The third segment
will be the niche players who would simply concentrate on a particular sub-segment in
the business. Insufficient resources is one reason why NBFCs will be force to specialise.
Specialisation is, however, not all that new. One of the most successful finance
companies in the country, Madras-based Sundaram Finance has always been one to
stick to knitting, which is, truck finance. Others like Apple Industries are now trying to
focus on their car finance business, where they are a market leader. The feeling that is
more widespread is that if a NBFC has to survive, it has to have a clear business strategy
lined up.
Resource mobilisation: Finance companies have done well to mobilise deposits,
despite having to operate in a market where rates are regulated and tenures dictated.
Using personalised collection services and a few extra incentives under the table, they
have been able to collect large sums of money. Pressure to obtain more of their funds
from this route is mounting as bank finance and institutional money begin to dry up.
The financial institutions like LIC, GIC, UTI have stopped subscribing to debentures
issued by NBFCs. With banks and FIs making a focussed foray into leasing, refinance for
leases is also hard to come by.
The only sources of funds for NBFCs for asset financing are fixed deposits and/or
shareholder moneys. As collecting money from shareholders at any premium is only a
fantasy, given the current market conditions and poor valuation enjoyed by finance
firms, FDs remain the sole option. Little wonder then that finance firms have been
trespassing the RBI guidelines regarding payment of brokerage on deposits with some
impunity. Most NBFCs flout RBI norms on incentives on FDs. NBFCs are allowed to
access deposits, unsecured borrowings upto 10 times their net owned funds, though few
exceed their debt-equity ratio of 6 : 1. But accessing too much of borrowings affects the
capital adequacy of the companies and also pushes up the weighted average cost of

working funds. Fixed deposits only exist because of market imperfections. In three
years, it is suggested that an ICICI or an IDBI debenture, which is as liquid as an FD, is a
better proposition.
Finance companies are eligible for bank finance only as a percentage of their total
exposure in fund-based activities. In case a finance company which is involved in
equipment leasing and hire purchase activity has not less than 75 per cent of its assets in
equipment leasing and hire purchase and 75 per cent of its gross income is from these
two types of activities, it is entitled to three times the net owned funds (NOF) of the
company. Other equipment leasing and hire purchase companies are eligible for bank
finance up to two times of their NOF.
Asset liability mismatch: The biggest problem faced by finance companies is that of
asset liability mismatches. Many firms find themselves in trouble after having funded
long-term assets like bought-out deals through essentially short-term sources like fixed
deposits or inter-corporate deposits. FDs are good if matching assets can be found. Car
loans and truck loans are an ideal match as the repayment period matches with an FD
(fixed deposit).
As asset risks are not the same, it becomes important to carefully construct the profile of
assets. The best credit risk is one where there is an earning asset which can be
repossessed. Car and truck loans belong to this category. Plant and machinery and
consumer finance are the worst asset risks. It is difficult to repossess plant and
machinery as NBFCs have little pull over manufacturing companies. As for consumer
finance, it is worst possible source of unsecured lending. For assets where exist is not
assured, many finance companies are stuck with assets like shares, bonds and real estate
which they cannot sell without booking losses. Finance companies will have to use their
net worth for this financing. Even activities like underwriting require firms to have a
high net worth to pay up if an issue fails.
Shifting focus to fee-based activities: Currently NBFCs are planning to shift focus
from fund-based activities towards fee-based business. This change has been spurred by
the fact that while on the one hand, fund-based income is not adequate for growth, or
die other hand, there fund-based income is not adequate for growth, on the other hand,
there is going to be a greater paucity of funds available with these companies.
Further, with credit from banks and financial institutions becoming increasingly hard to
come by, there will be an increased emphasis on fee-based income from activities like
ICD broking, promoter funding and lease broking. Some of the larger companies like
Lloyds Finance arid playing an active role in the area of advisory services, like helping
the foreign institutional investor (FII) place his funds in India. Apart from acting as
advisors, some of these companies will also be entering the area of securitization.
Possibility of mergers and take-overs: While some finance companies may
quietly perish and never be heard of again, like the leasing companies of the eighties, the
world of NBFCs will not be the same again, There is bound to be some consolidation but
take over may not be as widespread as predict. There may be some instances of local

players merging to gain critical mass. This could prove to be a hurdle for the bigger
players as market sentiment may turn against them as many smaller companies have
raised significant sums from the primary market.
The first to perish will be those promoted by every other industrial group in the country.
Lacking in focused strategies, these firms will cease to do business and become shelf
companies again. Probably the only industrial group-promoted-finance companies to
survive will be those that use their finance company mainly as a sales aid like Ashok
Leyland Finance or the upcoming Maruti venture with GE and HDFC. Only by becoming
a member of NSE or a category I merchant banker, finance firms will not be able to
survive.
International tie-ups: A foreign partner can help in a number of ways: access to new
technology for designing new products, systems and procedures which help streamline
credit appraisal, additional source to access funds and, lastly, help improve personnel
skills. But the need for a foreign partner will vary from business to business. Investment
banking, for instance, is perceived as an area where global tie-ups are a must if a firm
has to compete with international banks. With the SBI Caps-Lehman Brothers tie-up in
March 1996 all the top five players-Kotak, ICICI, DSP, JM-have some sort of alliance
with an international bank. These tie-ups allow these merchant banks to offer their
corporate clients an exhaustive array of capital-raising services in the domestic and
international market.
Questions
1. Distinguish between commercial bank and merchant bank
2. 'The scope for merchant banking is great in India'. Discuss
3. Explain the services of merchant bankers.
4. Explain in detail the "pre-issue management".
5. Discuss the guidelines for merchant bankers issued by SEBI.

-End Of ChapterUNIT - VI
OTHER FINANCIAL SERVICES

I. HIRE PURCHASE

Hire purchase is a method of selling goods. In a hire purchase transaction, the goods are
let out on hire by a finance company (creditor) to the hire purchase customer (hirer).
The buyer is required to pay an agreed amount in periodical instalments during a given
period. The ownership of the property remains with the creditor and passes on to the
hirer on the payment of last instalment.
FEATURES OF HIRE PURCHASE AGREEMENT
1. Under hire purchase system, the buyer takes possession of goods immediately and
agrees to pay the total hire purchase price in instalments.
2. Each instalment is treated as hire charge.
3. The ownership of the goods passes from buyer to seller on the payment of the last
instalment.
4. In case the buyer makes any default in the payment of any instalment the seller has
the right to repossess the goods from the buyer and forfeit the amount already received
treating it as hire charge.
5. The hirer has the right to terminate the agreement at any time before the property
passes. That is, he has the option to return the goods in which case he need not pay
instalments falling due thereafter. However, he cannot recover the sums already paid as
such sums legally represent hire charge on the goods in question.
LEGAL POSITION
The Hire Purchase Act, 1972 defines a hire purchase agreement 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 agreement under which:
i) Possession of goods is delivered by the owner thereof to a person on condition that
such person pays the agreed amount in periodical instalment.
ii) The property in goods is to pass to such person on the payment of the last of such
instalments, and
iii) Such person has a right to terminate the agreement at any time before the property
so passes.
HIRE PURCHASE AND CREDIT SALE
Higher purchase transaction is different from credit sale.
In case of actual sale, the title in the property, i.e., ownership and possession is
transferred to the purchase simultaneously. In hire purchase, the ownership remains
with the seller until the last instalment is paid.

HIRE PURCHASE AND INSTALMENT SALE

Hire purchase transaction is different from instalment system. In case of instalment
system it is not only the possession of goods but also the ownership of goods which is
transferred to the buyer immediately at the time of agreement. Further, when the buyer
stops payment of dues, the seller has no right to repossess the goods. He has the only
right to sue the buyer for the non-payment of price. The buyer has no option to
terminate the agreement by returning the goods but has the right of disposing of the
goods in any manner as he likes. Any loss of goods should be borne only by the buyer as
risk lies with the ownership.
HIRE PURCHASE AND LEASING
Hire purchase is also different from leasing.
1. In a contract of lease, the ownership rests with the lessor throughout and the
lessee (hirer) has no option to purchase the goods.
2. Leasing is a method of financing business assets whereas hire purchase is a
method of financing both business assets and consumer articles.
3. In leasing, depreciation and investment allowance cannot be claimed by the
lessee. In hire purchase, depreciation and investment allowance can be claimed
by the hirer.
4. The entire lease rental is tax deductible expense. Only the interest component of
the hire purchase instalment is tax deductible.
5. The lessee, not being the owner of the asset, does not enjoy the salvage value of
the asset. The hirer, in hire purchase, being the owner of the asset, enjoys salvage
value of the asset.
6. Lessee is not required to make any deposit whereas 20% deposit is required in
hire purchase.
7. With lease, we rent and with hire purchase we buy the goods.
ORIGIN AND DEVELOPMENT
The growth and development of hire purchase system can be traced back to the advent
of industrial development in U.K., Henry Moore, a Bishogate piano-maker introduced
the system of hire purchase in 1846 in U.K. Cowperwait & Sons, a furniture dealer
introduced the hire purchase system in U.S.A. in 1807. The Singer Manufacturing
Company started selling sewing machine under hire purchase agreement. The idea was
developed by wagon companies which were formed to finance the purchase of wagons
by collieries. The wagon companies bought the wagons and then let them out to
collieries under hire purchase agreement.
All early hire purchase transactions were financed by manufacturers or dealers
themselves. Subsequently, independent finance houses came into existence to offer hire
purchase of a wide variety of consumer articles, automobiles and industrial machinery
on hire purchase.

In India, hire purchase finance started only after I world war. However, it was only after
II world war that its growth assumed visible dimension. The concept of hire purchase
was not quite popular in the pre-independence period though a few were endeavouring
to increase the volume of their business with the provision of extending credit to
intending buyers. With the increase in economic activity, many Non-banking Finance
Companies entered the scene in the fifties and sixties.
The pioneers in the field were Commercial Credit Corporation Limited, Motor and
General Finance Limited and Investment Supply Limited. These companies were set up
predominantly to finance road transport sector. The volume of hire purchase business
was around Rs.635 crores in 1987-88, out of which automobiles accounted for 55 per
cent. To-day about 25 per cent of sale of commercial vehicles is accounted by hire
purchase. It is estimated by the Federation of Hire Purchase Association that the stockon-hire of hire purchase companies comprising corporate and non-corporate entities
would be approximately Rs.3000 crores now.
In addition to commercial vehicle, purchase of consumer articles like household
appliances, air conditioners, refrigerators, office furniture and equipment is financed
through hire purchase. In recent years, the consumer durable goods market is
experiencing an unprecedented boom. The growing Indian middle class - 100 to 150
million, growing at a rate of 20 per cent per annum and their willingness to mortgage
the future for to-days enjoyment have led to spectacular growth in hire purchase
business.
The institutions engaged in the hire purchase business in organised sector include
commercial banks, co-operative banks, State Finance Corporations, National Small
Industries Corporation and 1200 Non-banking Finance Companies and in the
unorganised sector they comprise a large number of partnership firms and individuals.
National Small Industries Corporation supplies machinery to small scale industry under
hire purchase. The Industrial Development Bank of India indirectly participates in
financing hire purchase business by way of rediscounting nuance bills/promotes arising
out of sale of indigenous machinery on hire purchase basis. The Industrial Credit and
Investment Corporation also has a discounting scheme of usance bills under hire
purchase scheme.
BANKS AND HIRE PURCHASE BUSINESS
Through a recent notification issued on 7.9.1990 under clause (O) of Sub Section (1) of
Section 6 of the Banking Regulation Act, 1949, the Government of India has permitted
banks to engage in 'hire-purchase' business. Though the statutory framework now
enables the banks to carry on hire purchase business, and to set up subsidiaries for
undertaking such business, the Reserve Bank of India is of the view that in the public
interest and in the interest of banking policy, the following guidelines should be made
applicable to banks so far as hire-purchase business is concerned:

i) For the present, banks shall not themselves undertake directly (i.e., departmental)
the business of hire-purchases.
ii) Banks which have set up subsidiaries (i.e., a company in which it holds not less than
51% of the shares) for the business of equipment leasing, merchant banking, etc., may
undertake the hire-purchase business either through such a subsidiary or through a
separate subsidiary. Other banks may set up subsidiaries to transact hire purchase
business either exclusively or together with the business of equipment leasing. Banks
desirous of undertaking hire-purchase business through an existing or new subsidiary as
above, will require prior approval of the Reserve Bank of India.
iii) An existing bank subsidiary that may hereafter transact hire-purchase business or a
new subsidiary set up to transact such business, as provided in clause (ii) above, shall
not engage itself in the financing of other companies or concerns engaged in hirepurchase business.
iv) Investment of a bank in the shares of its subsidiary set up for undertaking
equipment leasing and/or hire-purchase business, together with investment of the bank
in shares of other companies carrying on equipment leasing and/or hire purchase
business, shall not in the aggregate exceed 10 per cent of the paid-up capital and
reserves of the bank.
v) While banks may invest in shares of other hire-purchase companies within the limits
specified in Section 19 (2) of the Banking Regulation Act, 1949 with the Reserve Bank's
prior approval they shall not act as promoters of such companies.
vi) Any application to be made to the Controller of Capital Issue in connection with the
setting up of a new subsidiary or for subsequent issue of capital shall need prior
clearance from the Reserve Bank of India.
vii) Banks setting up a subsidiary for the purpose of carrying hire-purchase business or
through the existing subsidiaries should furnish such information in such form and at
such time as the Reserve Bank may require from time to time.
BANK CREDIT FOR HIRE-PURCHASE BUSINESS
The subsidiary of commercial bank may lend either to the dealer or to intermediary who
has already financed articles sold by the dealer to the hirer under hire-purchase
contract. While considering proposals from dealers or hire-purchase financing
companies, the bank subsidiary has to take extra precautions, looking to the particular
nature of transaction under hire-purchase contract.
When offered this type of business, the bank subsidiary would make an assessment of
the standing and financial position of the dealer or of the hire-purchase company, and
take into consideration the principles of good lending and carry out the procedure
indicated below:

Customer
When approached for hire purchase facility, the bank subsidiary should take care to
make the assessment of the standing and financial position of the business customer.
Purpose
The type of goods being used to finance in the hire-purchase transactions is of great
importance. In the event of default, the bank may reconsider repossessing the goods and
selling them to clear the advance. Thus, if the goods can be readily sold elsewhere (e.g.
relatively new car), then these agreements are better security than those for (say)
cameras which will have a lower resale value.
Amount
Bank subsidiaries taking up hire-purchase business would do well to discourage small
individual loans. In order to ensure proper servicing and monitoring, it is also essential
to a have floor limit on the amount of individual hire-purchase transactions. While it
may be about Rs.50,000 for automobile sector, it may be about Rs. 10,000 for consumer
durables.
Period
The facility will normally be extended over two to three years.
Repayment
Repayment is spread evenly, or as agreed, over the loan period. The repayment should
be adaptable to the hirers needs. The repayment can usually be tailor made to suit the
income generated from the use of asset so that it is self-financing. Sometime, repayment
holidays can be allowed and repayment is delayed until the asset is operational or
producing profit. To ensure timely recovery in the case of car, two-wheeler, and
consumer durable financing, it would be preferable to have institutional tie-ups with
employers/employees cooperative societies for which eligibility criteria can be laid
down.
Security
Hire purchase advance is against hypothecation of equipment/ mortgage and pledge of
hundis/promotes and lodgements of hire-purchase agreements. The bank subsidiary
will ask the borrower to complete the banks form of security to charge the security
under an equitable/hypothecation charge. If the borrower is a limited company which is
not of sufficient strength to allow equitable/hypothecation facility and if suitable
security is not available, it is normal to obtain a debenture over the assets of the
company, under which a floating charge is obtained.

In necessary, the bank subsidiary will ask the hirer to furnish a guarantor of means and
the bank would in such a case insist that the guarantor should also accept the hundis. It
is a practice with some banks to insist for insurance policy to indemnity the bank against
the default of the hirer. The premiums will be charged to the hirer.
In view of the cost and difficulty of the repossession of the security of a fast depreciating
asset, the customer's ability to repay is vital and no reliance is placed on security.
Monitoring and Control
The bank needs to exercise control over the on-going situation. A periodical certificate
should be obtained from the finance company at the monthly intervals, stating the total
amount of outstanding but excluding those hire-purchase agreements which have
become in arrears and are, therefore, suspects. One or two months in arrears may be
acceptable but more than that suggest that the particular hirer is in permanent default.
The bank will keep a running total of these amounts, returning agreements which have
become lapsed to their customers.
II. DISCOUNTING, FACTORING AND FORFAITING
In India, the financial services sector is developing at a faster rate so as to meet the
emerging needs of the economy. Many innovative schemes have been introduced by this
sector and one such area wherein it has been introduced is book debt financing.
Financial institutions try to extend their financial assistance to a larger cross-section of
the trading community through book debt financing. A kind of book debt financing is
already practised in India by the commercial banks. It is nothing but bill financing. This
type of financing is done either by way of direct purchase of bills of customers or
discounting them.
DISCOUNTING
Generally, a trade bill arises out of a genuine credit trade transaction. The supplier of
goods draws a bill on the purchaser for the invoice price of the goods sold on credit. It is
drawn for a short period of 3 to 6 months and in some cases for 9 months. The buyer of
goods accepts the same and binds himself liable to pay the amount on the due date. In
such a case, the supplier of goods has to wait for the expiry of the bill to get back the cost
of the goods sold. It involves locking up of his working capital which is very much
needed for the smooth running of the business or for carrying on the normal production
process. It is where the commercial banks enter into as a financier.
The commercial banks provide immediate cash by discounting genuine trade bills. They
deduct a certain charge as discount charge from the amount of the bill and the balance is
credited to the customer's account and thus, the customer is able to enjoy credit
facilities against the discounting of bills. Of course, this discount charges include
interest for the unexpired period of the bill plus some service charges. Bill financing is
the most liquid one from the banker's point of view since, in times of emergencies, they
can take those bills to the Reserve Bank of India for rediscounting purposes. In fact, it

was viewed primarily as a scheme of accommodation for banks. Now, the situation is
completely changed. To-day it is viewed as a kind of loan backed by the security of bills.
Bill financing is superior to the conventional and traditional system of cash credit in
many ways.
i) First of all, it offers high liquidity, in the sense, funds could be recycled promptly and
quickly through rediscounting.
ii) It offers quick and high yield. The banker gets income in the form of discount charges
at the time of discounting the bills.
iii) Again, there is every opportunity to earn the spread between the rates of discount
and rediscount.
iv) Moreover, bills drawn by business people would never be dishonoured and they are
not subject to any fluctuations in their values.
v) Cumbersome procedures to create the security and the positive obligations to
maintain it are comparatively very fewer.
vi) Even if the bill is dishonoured, there is a simple legal remedy. The banker has to
simply note and protest the bill and debit the customer's account. Bills are always drawn
with recourse and hence, all the parties on the instrument are liable till the bill is finally
discharged.
vii) Above all, these bills would be very much useful as a base for the maintenance of
reserve requirements like CRR and SLR.
It is for these reasons, the Reserve Bank of India has been trying its best to develop a
good bill market in India. The Reserve Bank of India introduced a Bill Market Scheme as
early as 1952 itself and thereafter, with some modifications. It has lowered the effective
rate of interest on bill finance by 1% below the cash credit rate. Despite many efforts of
the Reserve Bank of India to promote and develop a good bill market, bill financing
forms barely 5% of the total credit extended by banks. The latest step of the Reserve
Bank of India to promote the bill market is the launching of the factoring service
organisations.
FACTORING
As such a lot of working capital is tied up in the form of trade debts. Distribution of
collection especially for the small-scale and medium-scale companies is the biggest
problem. The average collection period has been on the increase. Delays in collection
process in turn lead to liquidity problems and consequently to delay in production and
supplies. The peculiar situation in India is that a number of small scale units are
catering to the requirements of a single large buyer. This large buyer is always known for
his procrastination in paying his small suppliers. The crux of the problem is hot so much

the failure to pay altogether as the failure to pay on time. As a result, the interest cost of
financing book debts is quite heavy. This increase in cost of capital reduces profit and
competitiveness of a company particularly the small ones in the market. Ultimately, the
small unit may become even sick. To overcome this situation, the factoring service has
been conceived.
MEANING
The word factor has been derived from the Latin word Facere which means to make
or to do. In other words, it means to get things done. According to the Webster
Dictionary Factor is an agent, as a banking or insurance company, engaged in financing
the operations of certain companies or in financing wholesale or retail trade sales,
through the purchase of account receivables. As the dictionary rightly points out,
factoring is nothing but financing through purchase of account receivables.
Thus, factoring is a method of financing whereby a company sells its trade debts at a
discount to a financial institution. In other words, factoring is a continuous arrangement
between a financial institution, (namely the factor) and a company (namely the client)
which sells goods and services to trade customers on credit. As per this arrangement,
the factor purchases the clients trade debts including accounts receivables either with
or without recourse to the client, and thus, exercises control over the credit extended to
the customers and administers the sales ledger of his client. The client is immediately
paid 80 per cent of the trade debts taken over and when the trade customers repay their
dues, the factor will make the remaining 20 per cent payment. To put it in a laymans
language, a factor is an agent who collects the dues of his client for a certain fee.
MODUS OPERANDI
A factor provides finance to his client upto a certain percentage of the unpaid invoices
which represent the sale of goods or services to approved customers. The modus
operandi of the factoring scheme is as follows:
i) There should be a factoring arrangement (invoice purchasing arrangement) between
the client (which sells goods and services to trade customers on credit) and the factor,
which is the financing organization.
ii) Whenever the client sells goods to trade customers on credit, he prepares invoices in
the usual way.
iii) The goods are sent to the buyers without raising a bill of exchange but accompanied
by an invoice.
iv) The debts due by the purchaser to the client is assigned to the factor by advising the
trade customers, to pay the amount due to the client, to the factor.

v) The client hands over the invoices to the factor under cover of a schedule of offer
along with the copies of invoices and receipted delivery challans or copies of R/R or
L/R.
vi) The factor makes an immediate payment up to 80% of the assigned invoices And the
balance 20% will be paid on realization of the debt.
TERMS AND CONDITIONS
The existence of an agreement between the factor and the client is central to the
function of factoring. The main terms and conditions generally included in a factoring
agreement are the following:
i) Assignment of debt in favour of the factor,
ii) Selling limits for the client,
iii) Conditions within which the factor will have recourse to the client in case of nonpayment by the trade customer,
iv) Circumstances under which the factor will have recourse in case of non-payment.
v) Details regarding the payment to the factor for his services, say for instance, as a
certain percentage on turnover,
vi) Interest to be allowed to the factor on the accounts where credit has been sanctioned
to the supplier, and
vii) Limit of any overdraft facility and the rate of interest to be charged by the factor.
FUNCTIONS
As stated earlier the term factoring' simply refers to the process of selling trade debts of
a company to a financial institution. But, in practice, it is more than that. Factoring
involves the following functions:
i) Purchase and collection of debts.
ii) Sales ledger management.
iii) Credit investigation and undertaking of credit risk.
iv) Provision of finance against debts.
v) Rendering consultancy services.
Purchase and Collection of Debts

Factoring envisages the sale of trade debts to the factor by the company, i.e., the client.
It is where factoring differs from discounting. Under discounting, the financier simply
discounts the debts backed by account receivables of the client. He does so as an agent
of the client. But, under factoring, the factor purchases the entire trade debts and thus,
he becomes a holder for value and not an agent. Once the debts are purchased by the
factor, collection of those debts becomes his duty automatically.
Sales Ledger Management
Sales ledger management function is a very important one in factoring. Once the
factoring relationship is established, it becomes the factor's responsibility to take care of
all the functions relating to the maintenance of sales ledger. The factor has to credit the
customer's account whenever payment is received, send monthly statements to the
customers and to maintain liaison with the client and the customer to resolve all
possible disputes. He has to inform the client about the balances in the account, the
overdue period, the financial standing of the customers, etc. Thus, the factor takes up
the work of monthly sales analysis, overdue invoice analysis and credit analysis.
Credit Investigation and Undertaking of Credit Risk
The factor has to monitor the financial position of the customer carefully, since, he
assumes the risk of default in payment by customers due to their financial inability to
pay. This assumption of credit risk is one of the most important functions which the
factor accepts. Hence, before accepting the risk, he must be fully aware of the financial
viability of the customer, his past financial performance record, his future ability, his
honesty and integrity in the business world etc. For this purpose, the factor also
undertakes credit investigation work.
Provision of Finance
After the finalisation of the agreement and sale of goods by the client, the factor
provides 80% of the credit sales as prepayment to the client. Hence, the client can go
ahead with his business plans or production schedule without any interruption. This
payment is generally made without any recourse to the client. That is, in the event of
non-payment, the factor has to bear the loss of payment.
Rendering Consultancy Services
Apart from the above, the factor also provides management services to the client. He
informs the client about the additional business opportunities available, the changing
business and financial profiles of the customers, the likelihood of coming recession etc.
TYPES OF FACTORING
The type of factoring services varies on the basis of the nature of transactions between
the client and the factor, the nature and volume of client's business, the nature of
factor's security etc. In general, the factoring Vs. ices can be classified as follows:

i) Full service factoring or without recourse factoring

ii) With Recourse Factoring
iii) Maturity Factoring
iv) Bulk Factoring
v) Invoice Factoring
vi) Agency Factoring
vii) International Factoring
Full Service Factoring
Under this type, a factor provides all kinds of services discussed above. Thus, a factor
provides finance, administers the sales ledger, collects the debts at his risk and renders
consultancy service. This type of factoring is a standard one. If the debtors fail to repay
the debts, the entire responsibility falls on the shoulders of the factor since he assumes
the credit risk also. He cannot pass on this responsibility to his client and, hence, this
type of factoring is also called Without Recourse Factoring.
With Recourse Factoring
As the very name suggests, under this type, the factor does not assume the credit risk. In
other words, if the debtors do not repay their dues in time and if their debts are
outstanding beyond a fixed period, say 60 to 90 days from the due date, such debts are
automatically assigned back tp the client. The client has to take up the work of collection
of overdue account by himself. If the client wants the factor to go on with the collection
work of overdue accounts, the client has to pay extra charge called Refactoring Charges.
Maturity Factoring
Under this type, the factor does not provide immediate cash payment to the client at the
time of assignment of debts. He undertakes to pay cash as and when collections are
made from the debtors. The entire amount collected less the factoring fees is paid to the
client immediately. Hence it is also called 'Collection Factoring'. In fact, under this type,
no financing is involved. But, all other services are available.
Bulk Factoring
Under this type, the factor provides finance after disclosing the fact of assignment of
debts to the debtors concerned. This type of factoring is resorted to when the factor is
not fully satisfied with the financial condition of the client. The work relating to sales
ledger administration, credit control, collection work etc., has to be done by the client

himself. Since the notification has been made, the factor simply collects the debts on
behalf of the client. This is otherwise called Disclosed Factoring.
Invoice Discounting
Under this type, the factor simply provides finance against invoices without undertaking
any other functions. All works connected with sales administration, collection of dues
etc. have to be done by the client himself. The debtors are not at all notified and hence
they are not aware of the financing arrangement. This type of factoring is very
confidential in nature and hence it is called 'Confidential Invoice Discounting' or
'Undisclosed Factoring'.
Agency Factoring
The word agency has no meaning as far as factoring is concerned. Under this type, the
factor and the client share the work between themselves as follows:
i) The client has to look after the sales ledger administration and collection work, and
ii) The factor has to provide finance and assume the credit risk.
International Factoring
Under this type, the services of a factor in a domestic business are simply extended to
international business. Factoring is done purely on the basis of the invoice prepared by
the exporter. Thus, the exporter is able to get immediate cash to the extent of 80% of the
export invoice under international factoring. International factoring is facilitated with
the help of export factors.
FACTORING vs. DISCOUNTING
Factoring differs from discounting in many respects. They are:
i) Factoring is a broader term covering the entire trade debts of a client whereas
discounting covers only those trade debts which are backed by Accounts receivables.
ii) Under factoring, the factor purchases the trade debt and thus becomes a holder for
value. But, under discounting the financier acts simply as an agent of his customer and
he does not become the owner. In other words, discounting is a kind of advance against
bills whereas factoring is an outright purchase of trade debts.
iii) The factor may extend credit without any recourse to the client in the event of nonpayment by customers. But, discounting is always made with recourse to the client.
iv) Account receivables under discount are subject to rediscounting whereas it is not
possible under factoring.

v) Factoring involves purchase and collection of debts, management of sales ledger,

assumption of credit risk, provision of finance and rendering of consultancy services.
But, discounting involves simply the provision of finance alone.
vi) Bill discounting finance is a specific one in the sense that it is based on an individual
bill arising out of an individual transaction only. On the other hand, factoring is based
on the whole turnover' i.e., a bulk finance is provided against a number of unpaid
invoices.
vii) Bill financing through discounting requires registration of charges with the
Registrar of Companies. In fact, factoring does not require such registration.
viii) Discounting is always a kind of in-balance sheet financing". That is, both the
amount of receivables-and bank credit are shown in the balance sheet itself due to its
with recourse nature. But, factoring is always "off-balance sheet financing.
COST OF FACTORING
The cost of factoring comprises of two aspects namely finance charges and service fees.
Since the factor provides 80% of the invoice as credit, he levies finance charges. This
charge is normally the same interest rates which are in vogue in the banking system.
Factoring is a cheap source because the interest is charged only on the amount actually
provided to the client as repayment of his supplies. Apart from this financial charge, a
service charge is also levied. This service fees is charged in proportion to the gross value
of the invoice factored based on sales volume, number of invoices, work involved in
collections etc. Generally, the factor charges a service fee on the total turnover of the
bills. It is around 1%. If the bills get paid earlier, service charges could be reduced
pending upon the volume of work involved.
BENEFITS
Factoring offers a number of benefits to the clients. Some of the important benefits are:
Financial Service
Many of the manufacturers and traders find their working capital being locked up in the
form of trade debts. This has been a great handicap to the small and medium scale
manufacturers because they have to wait for 3 months to 9 months to realise their debts.
In the meantime, the business may suffer due to want of funds. In fact, many business
concerns fail more as a result of inadequate cash flow than anything else. The key to
successful working capital management lies in the ability of an enterprise to convert
sales into cash flow and the speed at which it is done. The major benefit of the factoring
service is that the clients will be able to convert their trade debts into cash up to 80%
immediately as soon as the credit sales are over. They need not wait for months together
to get cash for recycling.

Another major advantage is that there are no constraints by way of fixed limits as in the
case of cash credit or O.D. As sales grow, the financial assistance also grows and both
are directly proportional to each other:
The greatest advantage is that factoring assures immediate cash flow. When the cash
position improves, the client is able to make his-purchases on cash basis and thus, he
can avail of cash discount facilities also.
Collection Service
Collection of debts is another problematic area for many concerns. It is found that over
60% of the total sales of the SSI sector and over 50% of total sales of the medium and
large scale sector are made on "On Account Terms of Payment" i.e. credit sales. It means
that collection of debts becomes an important internal credit management and it
requires more and more time. So, industrialists cannot concentrate on production.
Delay in collection process often leads to delay in production and supplies. Moreover,
the interest cost of financing book debts is also on the increase. Ultimately, it affects the
profitability of the company. Now, this collection work is completely taken up by the
factoring organisation, leaving the client to concentrate on production alone. This is an
important service rendered by a factor to his client. The cost of collection is also cut
down as a result of the professional expertise of a factor;
'Credit risk' Service
In the absence of a factor, the entice credit risk has to be borne by the client himself. Bad
debts eat away the profit of a concern and in some cases, it may lead to the closure of a
business. But, once the factoring relationship is established, the client need not bother
about the loss due to bad debts. The factor assumes the risk of default in payment by
customers and thus, the client is assured of complete realization of his book debts. Even
if the customer fails to pay the debt, it becomes the responsibility of the factor to pay
that amount to the client. It is the greatest advantage of factoring.
Provision of Expertise 'Sales Ledger Management' Service
Administration of sales ledger is purely an accounting function which can be performed
efficiently only by a few. In fact, the success of any organisation depends upon the
efficiency with which the sales ledger is managed. It requires a specialized knowledge
which the client may not possess. But, the client can receive services like maintenance of
accounting records, monthly sales analysis, overdue invoice analysis and customer
payment statement from the factor. Besides, he maintains contact with customers to
ensure that they repay their dues promptly. Thus, it becomes the factor's responsibility
to take care of all the functions relating to the maintenance of sales ledger. Thus,
factoring offers an excellent credit control for the client.
Consultancy Service

Factors are professionals in offering management services like consultancy. They collect
information regarding the credit worthiness of the customers of their clients, ascertain
their track record, quality of portfolio turnover, average size of inventory etc., and pass
on the same to their clients, It helps the clients avoid poor quality and risky customers.
They also advise their clients on important financial matters. Generally, no time is
available to the client for investigating his customer's credit standing. Now, the factor
takes up this work on behalf of his client.
Economy in Servicing
Factors are able to render very economic service to their clients because their overhead
cost is spread over a number of clients. Moreover, their service charges are also
reasonable. Factoring is a cheap source of finance to the client because the interest rate
is charged only oh the amount actually provided to the client, say, for instance, 80% of
his total invoices and not on the total amount of the invoices. Thus, clients are able to
get factoring services at economic rates.
Miscellaneous Services
Generally, factors are able to computerise their operations fully. So they are able to
render prompt service at reasonable rates. They spend more on M.I.S. analysis. They
also build bigger credit library of debtors by means of collecting information about new
debtors. Thus, improved cash flow through realization of trade debts by factoring,
efficient follow up of collections, computerized sales ledger maintenance and the
competitive rates are the main benefits of factoring.
FACTORING IN INDIA
In India, the idea of providing factoring services was first thought of by the vaghul
working Group. It had recommended that banks and private non-banking financial
companies should be encouraged to provide factoring services with a view to helping the
industrialists and traders to tide over their financial crunch arising out of delays in the
realization of their book debts. The RBI subsequently constituted a study group in
January 1988 under the chairmanship of Mr. C.S. Kalyanasundaram, former Managing
Director of the SBI, to examine the feasibility of starting factoring services. On the
recommendation of the committee, the Banking Regulations Act was amended in July
1990 with a view to enabling commercial banks to take up factoring services by forming
separate subsidiaries.
In the public interest and in the interest of banking policy, the RBI is of the view that:
i) The banks should not directly undertake the business of factoring.
ii) The banks may set up separate subsidiaries or invest in factoring companies jointly
with other banks.

iii) A factoring subsidiary or a joint venture factoring company may undertake the
factoring business. But, they should not finance other factoring companies.
iv) The banks can invest in the shares of factoring companies not exceeding 10% of the
paid up capital and reserves of the bank concerned.
But, recently in February, 1994, the RBI has permitted all banks to enter into factoring
business departmentally. Perhaps, this step would have been taken with a view to giving
further impetus to the factoring system. Since factoring requires special skills and
infrastructure, the RBI has further stipulated that:
i) Factoring activities should be treated on par with loans and advances and should
accordingly be given risk weight of 100 per cent for calculation of capital to risk asset
ratio.
ii) A banks exposure shall not exceed 25% of the banks capital funds to an individual
borrower and 50% to a group of borrowers. Factoring would also be covered within the
above exposure ceiling along with equipment leasing and hire purchase finance.
iii) Factoring services should be provided only in respect of those invoices which
represent genuine trade transactions.
In India, the factoring service was first started by the State Bank of India in association
with the Small Industries Development Bank of India, Union Bank of India, State Bank
of Sourashtra and State Bank of Indore. The pioneering factoring company founded by
the SBI is called "SBI - Factors and Commercial Services Pvt. Ltd. (SBI FACS). It was
started in July 1991 with a subscribed capital of Rs.25 crores. It has been allotted the
Western Zone comprising of Maharashtra, Gujarat, Goa, Madhya Pradesh, the Union
territories of Dadra, Nagar Haveli, Daman and Diu. Similarly, the RBI has allotted the
Southern Region to the Canara Bank, the Northern Region to the Punjab National Bank
and the Eastern Region to the Allahabad Bank for providing necessary factoring services
to the clients of those regions This zonal restriction has been removed by the RBI in
1993. In the South, Canara Bank has already established Can Factors Ltd. Now, these
two factoring companies can operate in the centres outside their given zones. Besides
the above, some non-banking companies also have made a bid for entering into
factoring services. Thus, factoring service has got a very bright future in India due to its
superiority over other forms of financing.
INTERNATIONAL FACTORING
Generally factoring services are very popular for domestic business. They are gradually
entering into export business also.
Just as domestic suppliers, the exporters also find that there is a considerable delay in
receiving payments from the importers. As a result, they are hard pressed for money to
ensure their profitability as well as to maintain and expand their export business. In this

situation, international factoring comes really handy to them to find the required
resources.
Definition
The International Institute for the Unification of Private Law in 1988 has defined
international factoring as follows:
"Factoring means an arrangement between a factor and his client which includes at least
two of the following services to be provided by the factor: (i) Finance, (ii) Maintenance
of Accounts, (iii) Collection of debts, and (iv) Protection against Credit Risks.
As the definition points out, the services of a factor in a domestic business are simply
extended to international trade. However, the functioning of this scheme is different
depending upon the type of export factoring and the arrangement made by the exporter
and the factor.
Types of Export Factoring
Generally, in the absence of factoring, all export finance businesses are backed by
Letters of Credit. But, factoring relates purely to 'Open Account Transactions' with no
promissory notes and collaterals. Factoring is done entirely on the basis of the invoice
prepared by the exporter and so it is purely an "invoice-based export, finance"
technique.
In an international factoring transaction, there are four parties namely:
i) The exporter who is taking the place of a client in a domestic transaction.
ii) The importer who is taking the role of a customer in a domestic transaction.
iii) Export Factor (EF) and
iv) Import Factor (IF)
The exporter (client) and the factor enter into an agreement for export factoring Which
may take any one of the following types.
i) Two factor system
ii) Single factor system
iii) Direct Export factor system
iv) Director Import factor system
Two Factor System

There are two factors under this system one in the exporters country and the other in
the importers country. When the exporter wants to do business with some importer or
importers, he approaches the factor in his country and informs him of his business
proposals, the likely size of the business, the number of invoice likely to be raised, the
value of the consignment and the currency involved.
This export factor in turn informs the same to his counter-part, i.e., import factor in the
importing country. The import factor makes enquiries regarding the financial position
of the importer and his dealings and, if satisfied, he conveys the message to the export
factor. He also indicates the limit for factoring and his commission for undertaking this
work. Then, the export factor contracts the exporter and conveys the positive findings
and his readiness to cover the credit risk through factoring. If the rates are acceptable to
the exporter, he signs an agreement with the export factor.
Once this factoring relationship is established, the exporter sends the goods to the
importer along with the invoice with a condition that the payments should be made to
the import factor. Two copies of the invoices are sent to the export factor along with a
notification that the debts have been assigned to the import factor. At this stage, the
export factor makes payment immediately to the extent of 80% of the invoice amount to
the exporter.
Therefore, the export factor informs the import factor about the financial deal by
sending a copy of the invoice. Now, it becomes the responsibility of the import factor to
monitor and maintain the account and take all possible efforts to collect the amount at
the due date. When the amount is collected, it is sent to the export factor. In case of any
default, the import factor has to pay the amount to the export factor from his own
sources.
When the amount is realised from the import factor, the export factor pays the balance
of 20% of the invoice amount to the exporter. The cost of factoring is debited to the
exporter's account and the commission due to the import factor is also sent. Thus, the
financial dealing has to be carried out with the help of two factors and hence it is called
Two factor system'.
Single Factor System
Under this system also, two factoring companies, as stated earlier, are involved.
However, the responsibility of making the payment, maintenance of books of accounts,
its administration etc., initially rests with the export factor. But, just to cover the credit
risk, the export factor enters into an agreement with the import factor to collect the debt
from the importer, in case the export fact is not able to realise the amount. If such a
contingency arises, the export factor has to assign the debt in favour of the import
factor. Thus, the import factor is called upon to assist the export factor only during the
times of difficulties in realising the debt Otherwise, the export factor himself will do all
the work. So, it is called 'Single factor system.
Direct Export Factor System

Under this system, there is a factoring agreement directly between die exporter and the
export factor and no other party is involved. The entire export credit risk, the
administration of the account, the advance payments etc., have to be done only by the
export factor. Hence, it is called 'direct export factor system'.
Direct Import Factor System
It is just the opposite of direct export factor system. Here, the agreement is between the
exporter and the import factor in the importer's country. The import factor assumes all
responsibilities for the collection of the debt, from the importer.
FACTORING IN OTHER COUNTRIES
In European countries, factoring organisations have an option to finance both domestic
and export business. The tough business conditions and continued recession across
Europe have affected the factoring business of late. Hence, some factoring organisations
had to wind up their business in the U.K. as well as in the U.S.A. Again, there has been
merger of factoring companies. Now, more than 700 factoring companies are operating
in some forty countries. Nine out of ten of the world's strongest banks now have their
own foothold in the factoring industry.
In the U.S.A. the Fuji Bank's Chicago based Heller financial has taken over the CIT
Group factoring. It has become the biggest U.S. factor. Similarly BNY Financial acquired
BT Factors in 1990. Again, Citizen's and Southern Commercial acquired the Security
Pacific in 1989 and it is now called 'National bank Commercial'. In all, there were l7 big
factors and the total U.S. factoring business volume was more than $51 billion in 1991.
In the U.S.A. the factoring organisations specialise in financing the apparel business
which accounts for nearly 75% of the total volume of factoring business.
Italy occupies the first portion in terms of factoring business volume, followed by the
U.S.A The U.K occupies the third position. In Japan, the first specialised factoring
company was established only in 1972 when Sanwa Bank started the Sanwa Business
Credit Co. The special feature of the Japanese factoring business is that they focus on
hunting of promissory notes in contrast to cash financing of accounts receivables.
Factoring is also becoming popular in North America, Asia, Singapore, Malaysia and
South Korea It is said that factoring in Singapore and Malaysia is growing at a faster rate
of 40% a year.
On the whole, the export factoring business does not occupy a major share. There is a
global network of large factoring companies at Amsterdam called Factors Chain
International (FCI). As per the data released by the Factors Chain International the total
turnover in factoring business worldwide during 1991 was $260 billion, of which the
export factoring turnover was only 6%.

However, export factoring is popular in countries like Germany, Belgium and

Netherlands where the export factoring business accounts for nearly 30% of the total
factoring business. In India also, the ECGC is thinking of introducing such a scheme in
the near future. The latest country to take up the business of factoring is China, which is
giving importance to export factoring.

The factoring turnovers of some selected countries are given in Table-2.

Edifactoring
To assist international factoring, the FCI has developed a special communication system
for its members called Electronic Data Interchange factoring. This is mainly to speed up
the business communications so that factoring becomes more effective. Edifactoring
facilitates paperless trading. The sellers and debtors can exchange their
communications relating to purchase order, invoice, payment etc., through EDIFACT
message. Thus, factoring can be done efficiently and speedily.
There is a good scope for factoring business in India, however, to succeed in the
business, the factor has to take into account the following:
i) A factor has to adopt credit appraisal skills of a very high order.
ii) He has to develop a very strong MIS on the basis of day-to-day transactions of
debtors.
iii) He should follow an efficient monitoring mechanism for receivables and debtors.
iv) He should computerise all his operations, maintain incisive record of collection
experience and build a good credit library of debtors.
v) Above all, he must pay attention to the commercial viability of the deal, and the
balanced book of assets of his client.
vi) He must ascertain whether his client is a mar of high integrity and his debtors
command good respect in the financial mark
FORFAITING

Forfaiting is another source of financing against receivables like factoring. This source is
mostly employed to help an exporter for financing goods exported on a medium term
deferred basis.
The term 'a forfeit is a French word denoting to give something' or 'give up one's rights'
or 'relinguish rights to something'. In fact, under forfaiting scheme, the exporter gives
up his right to receive payments in future under an export bill for immediate cash
payments by the forfaitor. This right to receive payment on the due date passes on to the
forfaitor, since, the exporter has already surrendered his right to the forfaitor. Thus, the
exporter is able to get 100% of the amount of the bill minus discount charge
immediately and get the benefits of cash sale. Thus, it is a unique medium which can
convert a credit sale into a cash sale for an exporter. The entire responsibility of
recovering the amount from the importer rests with the forfaitor. Forfaiting is done
without any recourse to the exporter i.e., in case the importer makes a default, the
forfaitor cannot go back to the exporter for the recovery of the money.
DEFINITION
Forfaiting has been defined as "the non-recourse purchase by a bank or any other
financial institution, of receivables arising from an export of goods and services".
FACTORING vs. FORFAITING
Both factoring and forfaiting are used as tools of financing. But, there are some
differences:
i) Factoring is always used as a tool for short term financing whereas forfeiting is for
medium term financing at a fixed rate of interest.
ii) Factoring is generally employed to finance both the domestic and export business.
But, forfaiting is invariably employed in export business only.
iii) The central theme of factoring is the purchase of the invoice of the client whereas it
is only the purchase of the export bill under forfaiting.
iv) Factoring is much broader in the sense it includes the administration of the sales
ledger, assumption of credit risk, recovery of debts and rendering of consultancy
services. On the other hand forfaiting mainly concentrates on financial aspect only and
that too in respect of a particular export bill.
v) Under factoring, the client is able to get only 80% of the total invoice as credit
facility whereas the 100% of the value of the export bill (of course deducting service
charges) is given as credit under forfeiting.
vi) Forfaiting is done without recourse to the client whereas it may or may not be so
under factoring.

vii) The bills under forfeiting may be held by the forfaitor till the due date or they can be
sold in the secondary market or to any investor for cash. Such a possibility does not exist
under factoring.
viii) Forfaiting is a specific one in the sense that it is based on a single export bill arising
out of an individual transaction only. But, factoring is based on the whole turnover,
i.e., a bulk finance is provided against a number of unpaid invoices.
Working of Forfaiting
In a forfeiting transaction, the exporter is the client and the financial institution is
called the forfaitor and the importer is the debtor. When an exporter intends to export
goods and services, he approaches a forfaitor and gives him the full details of his likely
export dealing such as the name of the importer, the country to which he belongs, the
currency in which the export of goods would be invoiced, the price of the goods and
services etc. He discusses with him the terms and conditions of finance. If it is
acceptable, a sale contract is signed between the exporter and the importer on condition
that the payment should be made by the importer to the forfaitor.
As usual, bills or promissory notes are signed by the importer. Such notes are
guaranteed by the importers bank and forwarded to the exporters bank. Generally,
such notes would be released to the exporter only against shipping documents. When
goods are exported, the shipping documents are handed over to the exporters bank. The
exporters bank, then forwards the shipping documents to the importers bank after
releasing the notes/bills to the exporter. These documents finally reach the hands of the
importer through his bank.
Thereafter, the exporter takes these notes to the forfaitor who purchases them and gives
ready cash after deducting discount charges.
Cost of Forfaiting
The cost of forfeiting finance is always at a fixed rate of interest which is usually
included in the face value of the bills or notes. Of course, it varies depending upon the
arrangements duration, credit worthiness of the party, the country where the importer is
staying, the denomination of the currency in which the export deal is to be done and the
overall political, economic and monetary conditions prevailing in the importers
country. Since the forfaitor has to assume currency fluctuation risk, interest rate
fluctuation risk and the countrys risk, he charges a fee and obviously it varies according
to the risk factor involved in the deal.
Benefits of Forfaiting
(i) Profitable and Liquid: From the forfaitors' point of view, it is very advantageous
because he not only gets immediate income in the form of discount charges, but also,
can sell them in the secondary market or to any investor for cash.

(ii) Simple and Flexible: It is also beneficial to the exporter. All the benefits that are
available to a client under-factoring are automatically available under forfaiting also.
However, the greatest advantage is its simplicity and flexibility. It can be adopted to any
export transaction and the exact structure of finance can also be determined according
to the needs of the exporter, importer and the forfaitor.
(iii) Avoids Export Credit Risks: The exporter is completely free from many export
credit risks that may arise due to the possibility of interest rate fluctuations or exchange
rates fluctuations or any political upheaval that may affect the collection of bills.
Forfaiting acts as an insurance against all these risks.
(iv) Avoids Export Credit Insurance: In the absence of forfaiting the exporter has
to go for export credit insurance. It is very costly and at the same time it involves very
cumbersome procedures. Hence, if an exporter goes for forfaiting, he need not purchase
any export credit insurance.
(v) Confidential and Speedy: International trade transactions can be carried out
very quickly through a forfaitor. It does not involve much documentary procedures.
Above all, it is very confidential. The speed and confidentiality with which deals are
made are very beneficial for both the parties namely the exporter and the importer. No
banking relationship with the forfaitor is necessary, since, it is a onetime transaction
only.
(vi) Suitable to all kinds of Export Deal: It is suitable to any kind of goods whether capital goods exports or commodity exports. Any export deal can be subject to
forfaiting.
(vii) Cent per cent Finance: The exporter is able to convert his deferred transaction
into cash transaction through a forfaitor. He is able to get 100 per cent finance against
export receivables.
(viii) Fixed Rate Finance: Forfaiting provides finance always at a fixed rate only.
So, there is no need to enter into any hedging transactions to protect against interest
rate and exchange rate risks.
DRAWBACKS
(i) Non-availability for Short and Long Periods: Forfaiting is highly suitable to
only medium term deferred payments. Forfaitors do not come forward to undertake
forfait financing for long periods, since, it involves much credit risks. Similarly, it cannot
be used for availing short term credit or contracts involving small amounts because they
do not give rise to any bills or notes. Hence, exporters who require short term and long
term credit have to seek some other alternative source.
(ii) Non-availability for Financially Weak Countries: Similarly, forfaitors
generally do not come forward to undertake any forfait financing deal involving an
importer from a financially weak country. Generally, the forfaitor has a full grasp of the

financial and political situation prevailing in different countries, and hence, he would
not accept a deal if the importer stays in a risky country. In exceptional cases, it can be
undertaken at a higher price.
(iii) Dominance of Western Currencies: In International forfaiting, transactions
are dominated in leading western currencies like Dollar, Pound Sterling, Deutsche Mark
and French and Swiss Francs. Hence, our trade contracts have to be in foreign
currencies rather than in Indian rupees.
(iv) Difficulty in Procuring International bank's Guarantee: Forfaitors do not
normally finance an export deal unless it is supported by an unconditional and
irrevocable guarantee from an international bank known to the forfaitor. Generally, it is
the duty of the exporter to procure a guarantee of this kind and it is a stupendous task
for an exporter to do so.
Forfaiting in India
Forfaiting, as a source of finance, has gained substantial momentum abroad. Though it
had its origin in 'Zurich', it has been well established in all the financial centres of the
world. Some of the important forfaiting centres are London, Zurich, HongKong
Singapore and Frankfurt. It has become a popular source of finance among Europeans.
In India, forfaiting is slowly emerging as a new product in the liberalised financial
market. It was approved by the Union Government only in January, 1994. The existing
schemes available for exporters like concessional finance by commercial banks,
insurance cover against export credit risks by ECGC etc. are available mainly to large
and well established exporters. In this context, forfaiting may be a real boon to the
small, as well as, new exporters.
In India, forfaiting is done by the EXIM Bank. The minimum value of a forfaiting
transaction is Rs.5,00,000/-. A special form of promote/Bill has to be used for forfaiting
of transactions. An Indian exporter who wants to avail of this service has to approach
the EXIM bank through his bank. The EXIM Bank would obtain the forfaiting quotation
from the forfaiting agency abroad. Based on this, the exporter would work out his price
to be quoted to the importer. If the importer accepts the price and the payment terms,
the contract would be finalised and executed. The exporter would then get cash through
forfaiting arrangements for which he has to enter into a separate contract with the
forfaitor through the EXIM bank.
However, in order to encourage forfaiting finance business, it is necessary to designate
export contracts in leading international currencies. In the wake of economic
liberalisation and opening of our economy to the global market, there are good
prospects for forfaiting business in India. To promote forfaiting business, it is essential
that we should dominate our trade contracts in foreign currencies rather than in Indian
rupees. Now, since the rupees has gained strength, it is time for us to denominate our
trade obligations in foreign currencies so that the pace of forfaiting business may be
accelerated mainly to boost our export trade.

VENTURE CAPITAL
Venture capital is a growing business of recent origin in the area of industrial financing
in India. The various financial institutions set up in India to promote industries have
done commendable work. However, these institutions do not come up to the benefit of
risky ventures when they are undertaken by new or relatively unknown entrepreneurs.
They contend to give debt finance, mostly in the form of term loans to the promoters
and their functioning has been more systematic to that of commercial banks. The
financial institutions have devised schemes such as seed capital scheme, Risk capital
Fund etc., to help new entrepreneurs. However, to evaluate the projects and extend
financial assistance they follow the criteria such as safety, security, liquidity and
profitability and not potentiality. The capital market with its conventional financial
instruments/schemes does not come much to the benefit or risky ventures. New
institutions such as mutual funds, leasing and hire purchase company's have been
established as another source of finance to industries. These institutions also do not
mitigate the problems of new entrepreneurs who undertake risky and innovative
ventures.
India is poised for a technological revolution with the emergence of new breed of
entrepreneurs with required professional temperament and technical know-how. To
make the innovative technology of the entrepreneurs a successful business venture,
support in all respects and more particularly in the form of financial assistance is all the
more essential. This has necessitated the setting up of venture capital financing
Division/Companies during the latter part of eighties.
CONCEPT OF VENTURE CAPITAL
The term Venture Capital' is understood in many ways. In a narrow sense, it refers to,
investment in new and untried enterprises that are lacking a stable record of growth.
In a broader sense, venture capital refers to the commitment of capital as shareholding,
for the formulation and setting up of small firms specialising in new ideas or new
technologies. It is not merely an injection of funds into a new firm, it is a simultaneous
input of skill needed to set up the firm, design its marketing strategy and organise and
manage it. It is an association with successive stages of firm's development with
distinctive types of financing appropriate to each stage of development.
Meaning of Venture Capital
Venture capital is long term risk capital to finance high technology projects which
involve risk but at the same time has strong potential for growth. Venture capitalists
pool their resources including managerial abilities to assist new entrepreneurs in the
early years of the project. Once the project reaches the stage of profitability, they sell
their equity holdings at high premium.
Definition of a Venture Capital Company

A venture capital company is defined as "a financing institution which joins an

entrepreneur as a co-promoter in a project and shares the risks and rewards of the
enterprise".
Features of Venture Capital
Some of the features of venture capital financing are as under:
1. Venture capital is usually in the form of an equity participation. It may also take the
form of convertible debt or long term loan.
2. Investment is made only in high risk but high growth potential projects.
3. Venture capital is available only for commercialisation of new ideas or new
technologies and not for enterprises which are engaged in trading, brokerage, financial
services, agency, liaison work or research and development.
4. Venture capitalist joins the entrepreneur as a co-promoter in projects and share the
risks and rewards of the enterprise.
5. There is continuous involvement in business after making an investment by the
investor.
6. Once the venture has reached the full potential the venture capitalist disinvests his
holdings either to the promoters or in the market. The basic objective of investment is
not profit but capital appreciation at the time of disinvestment.
7. Venture capital is not just injection of money but also an input needed to set up the
firm, design its marketing strategy and organise and manage it.
8. Investment is usually made in small and medium scale enterprises.
Disinvest Mechanism
The objective of venture capitalist is to sell off the investment made by him at
substantial capital gains. The disinvestment options available in developed countries
are: (i) Prompter buy back (ii) Public issue (iii) Sale to other venture capital Funds (iv)
Sale in OTC market and (v) management buy outs.
In India, the most popular investment route is promoter's buy back. This permits the
ownership and control of the promoter intact.
The Risk Capital and Technology Finance Corporation, CAN - VCF etc., in India allow
promoters to buy back equity of their enterprise.
The public issue would be difficult and expensive since first generation entrepreneurs
are not known in the capital market. The option involves high transaction cost and also

less feasible for small ventures on account of high listing requirements of the stock
exchange.
The OTC Exchange in India has been set up in 1992. It is hoped that OTCEI would
provide disinvestment opportunities to venture capital firms.
The other investment options such as the management buyout or sale to other venture
capital fund are not considered appropriate in India.
Scope of Venture Capital
Venture capital may take various forms at different stages of the project. There are four
successive stages of development of a project viz., .development of a project idea;
implementation of the idea, commercial production and marketing and finally large
scale investment to exploit the economics of scale and achieve stability. Financial
institutions and banks usually start financing the project only at the second or third
stage but rarely from the first stage. But venture capitalists provide finance even from
the first stage of ideal formulation. The various stages in the financing of venture capital
are described below:
(1) Development of an Idea - Seed Finance: In the initial stage venture capitalists
provide seed capital for translating an idea into business proposition. At this stage
investigation is made in depth which normally takes a year or more.
(2) Implementation Stage - Start up Finance: When the firm is set up to
manufacture a product or provide a service, start-up finance is provided by the venture
capitalists. The first and second stage capital is used for full scale manufacturing and
further business growth.
(3) Fledging Stage - Additional Finance: In the third stage, the firm has made
some headway and entered the stage of manufacturing a product but faces teething
problems. It may not be able to generate adequate funds and so additional round of
financing is provided to develop the marketing infrastructure.
(4) Establishment Stage - Establishment Finance: At this stage the firm is
established in the market and expected to expand at a rapid pace. It needs further
financing for expansion and diversification so that it can reap economies of scale and
attain stability. At the end of the establishment stage, the firm is listed on the stock
exchange and at this point the venture capitalist disinvests their shareholdings through
available existing routes.
Before investing in small, new or young hi-tech enterprises, the venture capitalists look
for percentage of key success factors of a venture capital project. They prefer projects
that address these problems. An idea developed for these success factors has been
presented in Table-1.

Keys
VI - Absence of this factor constitutes an insurmountable obstacle for an institution to
develop venture capital activities in the country.
I - The presence of this factor constitutes a clear incentive to an institution for
developing venture capital activities in the country.
LI - The presence of this factor may influence favourably the decision of an institution ,
but does not constitute a decisive factor.
NI - Not important.

After assessing the viability of projects, the investors decide for what stage they should
provide venture capital so that it leads to greater capital appreciation.
All the above stages of finance involve varying degrees of risks and venture capital
industry, only after analysing such risks, invest in one or more. Hence they specialize in
one or more but rarely all.
IMPORTANCE OF VENTURE CAPITAL
Venture capital is of great practical value to every corporate enterprise in modern times.
Advantages to Investing Public
1. The investing public will be able to reduce risk significantly against unscrupulous
management, if the public invest in venture fund who in turn will invest in equity of new
business. With their expertise in the field and continuous involvement in the business
they would be able to stop malpractices by management.
2. Investors have no means to vouch for the reasonableness of the claims made by the
promoters about profitability of the business. The venture funds equipped with
necessary skills will be able to analyse the prospects of the business.
3. The investors do not have any means to ensure that the affairs of the business are
conducted prudently. The venture fund having representatives on the Board of Directors
of the company would overcome it.
Advantages to Promoters
1. The entrepreneur for the success of public issue is required to convince tens of
underwriters, brokers and thousand of investors but to obtain venture capital
assistance, he will be required to sell his idea to justify the officials of the venture fund.
2. Public issue of equity shares has to be preceded by a lot of efforts viz., necessary
statutory sanctions, underwriting and brokers arrangement publicity of issue etc. The
new entrepreneurs find it very difficult to make underwriting arrangement, as nobody
would take risk with them. All these arrangements require a great deal of effort. Venture
fund assistance would eliminate those efforts by leaving entrepreneur to concentrate
upon bread and butter activities of business.
3. Cost of public issues of equity share often range between 10 per cent to 15 per cent of
nominal value of issue of moderate size, which are often even higher for small issues.
The company is required, in addition to above, to incur recurring costs for maintenance
of share registry cell, stock exchange listing fee, expenditure on printing and posting of
annual reports etc. These items of expenditure can be ill afforded by the business when
it is new. Assistance from venture fund does not require such expenditure.
General

1. A developed venture capital institutional set up reduce the time lag between a
technological innovation and its commercial exploitation.
2. It helps in developing new processes/products in conducive atmosphere, free from
the dead weight of corporate bureaucracy, which helps in exploiting full potential.
3. Venture capital acts as a cushion to support business borrowings, as Bankers and
investors will not lend money with inadequate margin of equity capital.
4. Once venture capital funds start earning profits, it will be very easy for them to raise
resources from primary capital market in the form of equity and debts. Therefore, the
investors would be able to invest in new business through venture funds and, at the
same time, they can directly invest in existing business when venture fund disposes its
own holding. This mechanism will help to channelise investment in new high-tech
business or the existing sick business. These business will take-off with the help of
finance from venture funds and this would help in increasing productivity, better
capacity utilisation etc.
5. The economy with well-developed venture capital network induces the entry of large
number of technocrats in industry, helps in stabilising industries and in creating a new
set of trained technocrats to build and manage medium and large industries, resulting in
faster industrial development.
6. A venture capital firm serves as an intermediary between investors looking for high
returns for their money and entrepreneurs in search of needed capital for their startups.
7. It also paves the way for private sector to share the responsibility with public Sector.
ORIGIN
Venture capital as a new phenomenon originated in USA and developed spectacularly
worldwide since the second half of the seventies. American Research and Development
Corporation, founded by Gen.Doriot soon after the Second World War, is believed to
have heralded the institutionalisation of venture capital in the USA. Since then the
industry has developed in many other countries in Europe, North America and Asia. The
real development of VC took place in 1958. When the Business Administration Act was
passed by the US congress. In USA alone there are 800 venture capital firms managing
around $ 40 b of capital with annual accretions of between $ 1b and $5b. It is reported
that some of the present giants like Apple, Microsoft, xerox etc. are the beneficiaries of
venture capital.
UK occupies a second place after US in terms of investment in VC. The concept became
popular in late sixties in UK. The Government's Business Expansion Scheme which
permitted individuals to claim tax reliefs for investment in companies not listed in stock
exchange led to the success of VC in UK. The Charter House Development Limited is the
oldest venture capital company established in 1934 in UK. The Bank of England

established its venture capital company in late 40's. The U.K. witnessed a massive
growth of industry during 70's and 80's. During 1988 there were over 1000 venture
capital companies in UK which provided Rs.3700 crores to over 1500 firms.
The success of venture capital in these countries prompted other countries to design and
implement measures to promote venture capital and their total commitment have been
rising.
INITIATIVE IN INDIA
Indian tradition of VC for industry goes back more than 150 years when many of the
managing agency houses acted as venture capitalists providing both finance and
management skill to risky projects. It was the managing agency system through which
Tata Iron and Steels and Empress Mills were able to raise equity capital from the
investing public. The Tatas also initiated a managing agency house, named Investment
Corporation of India in 1937 which by acting as venture capitalist, successfully
promoted hi-tech enterprises such as CEAT tyres, Associated Bearings, National Rayon
etc. The early form of venture capital enabled the entrepreneurs to raise large amount of
funds and yet retain management control. After the abolition of managing agency
system, the public sector term lending institutions met a part of venture capital
requirements, through seed capital and risk capital for hi-tech industries which were not
able to meet promoters contribution. However, all these institutions supported only
proven and sound technology while technology development remained largely confined
to government labs and academic institutions. Many hi-tech industries, thus, found it
impossible to obtain financial assistance from banks and other financial institutions due
to unproven technology, conservative attitude, risk awareness and rigid security
parameters.
Venture capitals' growth in India passed through various stages. In 1973, R.S. Bhatt
Committee recommended formation of Rs.100 crore venture capital fund. The Seventh
Five Year Plan emphasised the need for developing a system of funding venture capital.
The Research and Development Cess Act was enacted in May 1986 which introduced
access of 5% on all payments made for purchase of technology from abroad. The levy
provides the source for the venture capital fund.
United Nations Development Programme in 1987 on behalf of government examined
the possibility of developing venture capital in private sector. Technology Policy
Implementation Committee in the same year also recommended the same provision.
Formalised venture capital took roots when venture capital guidelines were issued by
Comptroller of Capital Issues in November 1988.
GUIDELINES
The following are the guidelines issued by the Government of India:
1. The public sector financial institutions, State Bank of India, scheduled banks, foreign
banks and their subsidiaries are eligible for setting the venture capital funds with a

minimum size of Rs. 10 crore and a debt equity ratio of 1:15. If they desire to raise funds
from the public, promoters will be required to contribute a minimum of 40 per cent of
capital. Foreign equity upto 25 per cent subject to certain conditions would be
permitted. The guidelines provide for Non Resident Indian investment up to 74 per cent
on a repatriable basis and 25 per cent to 40 per cent on a non repatriable basis. It should
invest 60 per cent of its funds in venture capital activity. The balance amount can be
invested in new issue of any existing or new company in equity, cumulative convertible
preference shares, debentures, bonds or any other security approved by Controller of
Capital Issues.
2. The venture capital companies and venture capital funds can set up as joint venture
between stipulated agencies and non-institutional promoters but the equity holding of
such promoters should not exceed 20 per cent and should not be the largest single
holder.
3. Venture capital assistance should go to enterprises with a total investment of not
more than Rs. 10 crore.
4. The venture capital company (VCC)/Venture Capital Fund (VCF) should be managed
by professionals and should be independent of the parent organisation.
5. The VCC/VCF will not be allowed to undertake activities such as trading, broking,
money market operations, bills discounting, intercorporate lending. They will be
allowed to invest in leasing to the extent of 15 per cent of the total funds deployed. The
investment on revival of sick units will be treated as a part of venture capital activity.
6. Listing of VCCs/VCF can be according to the prescribed norms and underwriting of
issues at the promoter's discretion.
7. A person holding a position or full time chairman/president, chief executive,
managing director or executive director /whole time director in a company will not be
allowed to hold the same position simultaneously in the VCC/ VCF.
8. The venture Capital assistance should be extended to:
i) The enterprise having investment up to Rs. 10 crores in the project.
ii) The technology involved should be new and untried or it should incorporate
significant improvement over the existing technologies in India.
iii) The promoters should be new, professionally or technically qualified with
inadequate resources.
iv) The enterprise should be established in the company form employing
professionally qualified person for maintenance of accounts.

9. Share pricing at the time of disinvestment by a public issue or general sale offer by the
company or fund may be done subject to this being calculated an objective criteria and
the basis disclosed adequately to the public.
THE INDIAN SCENARIO
Methods of Venture Financing
Venture capital is available in three forms in India.
1. Equity
2. Conditional Loan
3. Income Note
Equity: All VCFs in India provide equity but generally their contribution does not
exceed 49% of the total equity capital. VCF's buy equity shares of an enterprise with an
intention to ultimately sell off to make capital gain.
Conditional Loan: A conditional loan is repayable in the form of royalty after the
project generate sales. No interest is paid on such loans. VCF's charge royalty ranging
between 2 and 15 per cent. Some VCF's give a choice to the entrepreneur to pay a high
interest rate instead of royalty on sales once the project becomes commercially sound.
Income Note: An Income Note combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales. Funds
are made available in the form of unsecured loans at 9 per cent per year during
development stage and 18.5 per cent after the development phase. In addition to
interest, royalty on sales could also be charged.
At present, several venture capital firms are incorporated in India and they are
promoted either by all India Financial institutions like IDBI, ICICI, IFCI, State level
financial institutions, public sector banks or promoted by foreign banks/private sector
or financial institutions like Indus venture capital funds. The present venture capital
players can be broadly classified into the following four categories:
Scope of Venture Capital
Companies Promoted by all India FIs
Venture Capital Division of IDBI.
Risk Capital and Technology Finance Corporation Ltd. (RCTC) (Subsidiary of IFCI)
Technology Development and Information Company of India Ltd. (TDICI), (promoted
by ICICI &UTI).

Companies Promoted by State Fl

Gujarat Venture Finance Ltd. (promoted by GUC).
Andhra Pradesh Industrial Development Corporation Venture Capital Ltd.. (promoted
by APIDC).
Companies Promoted by Banks
Can Bank Venture Capital Fund (promoted by Canfin and Canara Bank)
SBI Venture Capital Fund (promoted by SBI caps)
Indian Investment Fund (promoted by GHndlays Bank)
Infrastructure Leasing (promoted by Central bank of India).
Companies in Private Sector:
Indus Venture Capital Fund (promoted by Mafatlals & Hindustani Lever)
Credit Capital Venture Fund (India) Ltd.
20th Century Venture Capital Corporation Ltd.
Venture Capital Fund promoted by V.B. Desai & Co.
A brief account of major ingredients of Indian venture capital industry is presented
here.
IDBI Venture Capital Fund
The initial impetus was given by IDBF's Technology Division when venture capital fund
was set up in 1986 for encouraging commercial application of indigenously developed
technology and adopting imported technology for wider domestic applications.
The salient features of the scheme are:
1. Financial assistance under the scheme is available to projects whose requirements
range between Rs.5 lakhs and 2.5 crores. The promoters stake should be at least 10% for
the ventures below Rs.50 lakhs and 15% for those above Rs. 50 lakhs.
2. Assistance was extended in the form of unsecured loan involving minimum legal
formalities. Interest at a concessional rate of 9% is charged during technology
development and trial run production and 17% of the product is introduced in the
market.

3. The fund extends financial assistance to ventures such as leading computer softwares,
electronics, bio-technology, non-conventional energy food processing, medical
equipments etc.
4. If the project does not succeed, IDBI can insist on transfer of technology to some
other promoter designated by it on mutually agreed terms and conditions. It has
assisted 70 projects with a net sanction of Rs.46.80 crores up to March 1993.
The Risk Capital and Technology Finance Corporation
The Risk Capital and Technology Finance Corporation Ltd., (RCTC) the subsidiary of
IFCI provides venture capital through technology - finance and development scheme to
meet the specific needs of such technology development. The RCTC, apart from
providing assistance in the form of risk capital, is expected to finance high tech projects
in the form of venture capital for technology up gradation and development. The
assistance is provided in the form of short term conventional loan or interest free
conditional loans allowing profit and risk sharing with the project sponsors or equity
participation. Through its Technology Finance Development Scheme, it has assisted 23
projects committing funds of the order of Rs.13 crores and under venture capital fund
scheme, it has assisted 17 projects with a sanction of Rs.16 crores as on 31st March 1993.
Technology Development and Information Company of India LimitedTDICI-1988
The venture capital fund was jointly created by Industrial Credit and Investment
Corporation of India (ICICI) and Unit Trust of India (UTI) to finance projects of
professional technocrats in the small and medium size industries who take initiative in
designing and developing indigenous technology in the country. TDICP's first venture
capital fund of Rs.20 crores was subscribed equally by ICICI and UTI under the new
Venture Capital Unit Scheme I of UTL Under the scheme TDICI sanctioned financial
support of Rs.20 crores to 40 projects which include computer hardware, computer
integrated manufacturing system, tissue culture, chemicals, food and feed technology,
environmental engineering etc. The TDICPs second venture Fund of Rs.100 crores has
been contributed by UTI, ICICI, other financial institutions, banks, corporate sectors
etc. By 31, March 1993, TDICI had provided a cumulative financial assistance of
Rs.79.29 crore. TDICI has disbursed Rs.25.81 crores to 42 companies under scheme I
and Rs.79.29 crores to 79 companies under scheme II in a variety of industries such as
computers, electronics, bio-technology, medical, non-conventional energy etc. Many of
these projects are set up by first generation entrepreneurs.
i) TDICI invests in companies with attractive growth and earnings potential, with a
view to achieving long term capital gain. TDICI involves in seed, start-up, and growth
stage companies in a wide spectrum of industrial sub-sectors.
ii) The scheme seeks to assist technocrats involved in developing commercially viable
technologies or products, implementing indigenously developed yet untested

technologies on a commercial scale, and adapting innovative technologies for domestic

applications.
iii) The assistance per project may be up to Rs.2 crore in the form of equity and/ or
conditional loan (with flexible interest rates and repayment period).
iv) The equity in the project would be held for a period of 5-8 years and thereafter sold
to the promoter (at a mutually agreed price) or disposed in the secondary market.
v) During the development phase, the conditional loan would carry no interest; during
the post-development phase the interest rate on it would depend on the commercial
viability of the project.
Gujarat Venture Finance Ltd. (GUFL)
The Gujarat Industrial Investment Corporation promoted Gujarat Venture Finance Ltd.,
the first state level venture finance company to begin venture finance activities since
1990. It provides financial support to the ventures whose requirements range between
25 lakhs and 2 crore. GUFL provides finance through equity participation and quasi
equity instruments. The firms engaged in bio-technology, surgical instruments,
conservation of energy and good processing industries are covered by GUFL. Total
corpus of Rs.24 crores of the fund was co-financed by GIIC, IDBI, state level finance
corporations, some private corporate and the World Bank. GUFL has extended the net
sanctions of Rs. 10.67 crores to 12 projects up to March 1993.
Andhra Pradesh Industrial Development Corporations Venture Capital
Ltd. (APIDC - VCL)
The APID - VCL was launched in June 1990 with a fund of Rs. 13.50 crore of which
Rs.4.5 crore was contributed by the World Bank, Rs. 3 crore by IDBI and Rs. 1.5 crore
was committed by Andhra Bank. APIDC - VCL has a few proposal for venture capital
financing in the sphere of biotechnology and computer software applications. Assistance
to each venture is in the range of Rs.25 lakhs to Rs.l crore and does not exceed 49 per
cent of the total equity of a project. Assistance is normally in the form of equity but
depending on the circumstances loans may also be provided.
Canara Bank
Canara Bank has set up a venture capital fund called canbank venture capital fund worth
Rs.10 crore. It has sanctioned Rs.10 crore to 33 projects as on March 1992 in diverse
fields like chemicals, machines, food stuffs etc.
State Bank of India Capital Markets Ltd. (SBICAP)
The State Bank of India's subsidiary SBI Capital Markets Ltd. extend venture capital
assistance to technical entrepreneurs who have good technical ability but lack financial
strength. The support is by way of either direct subscription or by way of underwriting

support to the company. In any case direct participation will note be in excess of 49% of
the total paid up capital of the assisted unit. The projects in high priority, thrust areas
such as import substitute, high export potential, hi-tech options are preferred. The
equity holdings of assisted companies are generally disinvested in a period of three years
either by way of sale to public, sale in the OTC exchange of India, sale by private treaty
or by buy back arrangements with promoters or their nominees. SBICAPO as on
September 30, 1992 assisted 17 companies with investment of Rs.812 lakhs.
Indus Venture Capital Fund
Indus venture capital fund is one of the not worthy private sector venture companies. It
has been promoted with a starting corpus of Rs.21 crores contributed by several Indian
and international institutions and companies. Indus venture Management Limited has
been entrusted to manage the fund of Indus venture capital, fund. It provides equity and
management support to the firms. Financial assistance is given to those firms who
confine their commercial operations in areas of health care products, electronics and
computer technology. Investment strategy of the fund is not to invest more than 10% of
its corpus in one project and equity stake in a company may be up to 50%. The basic
objective is to earn capital gains through equity liquidation after a certain reasonable
time span.
The leading leasing company, 20th Century Finance Corporation has launched venture
capital fund worth Rs.20 crore to cater to the needs of small businessmen.
Credit Capital Venture Fund Limited
The first private sector venture capital fund called, Credit Capital Venture Fund Ltd.
(CVF) was set up by Credit Capital Corporation Limited (CVF) in April 1989 with an
authorised capital of Rs.10 lakhs. Rs. 6.5 crore was subscribed by International financial
agencies. The CVF went to public in January 1990 to raise Rs.3.5 crore. It provides
entrepreneurs who have ideas and ability, but no finance, with equity capital for new
greenfield projects. Its main thrust area would be export oriented industries and
technology oriented projects. The present portfolio of the fund consists of investment in
six units worth Rs.25 lakhs. CVF launched a new venture fund of Rs. 10 crore called The
Information Technology Fund to provide direct equity support to projects in the
technology information field.
Present Position
There were 20 venture capital companies in India both in private and public sector in
1994. These companies assisted 350 projects to the tune of R3.250 crores up to 1993-94.
The form of assistance in these projects are as follows:
Equity

62%

Convertible debenture

14%

Debt

24%

Out of the 350 projects assisted 62% belongs to new entrepreneurs.

SUGGESTIONS FOR THE GROWTH OF VENTURE CAPITAL FUNDS
Venture capital industry is at the take off stage in India. It can play a catalytic role in the
development of entrepreneurship skill that remains unexploited among the young and
energetic technocrats and other professionally qualified talents. It can help promote new
technology and hi-tech industries, which involve high risk but promises attractive rate of
returns. In order to ensure success of venture capital in India, the following suggestions
are offered:
Exemption/Concession for Capital Gains
Capital gains law represents a hurdle to the success of venture capital financing. The
earnings of the funds depend primarily on the appreciation in stock values. Further, the
capital gains may arise only after 3 to 4 years of investment and that the projects, being
in new risky areas, may not even succeed. Capital gains by corporate bodies in India are
taxed at a much higher rate than gains of individual investors. Taking into account the
high investment risk and long gestation period this is a deterrent to the development of
VCFs.
The benefit of capital gains, under section 48 of the Act is not significant. Hence, it
would be advisable that all long term capital gains earned by VCCs should be exempted
from tax or subjected to concessional flat rate. Further, capital gains reinvested in new
ventures should also be exempted from tax. Section 52 (E) of the Act should be amended
to give effect to this.
Development of Stock Markets
Guidelines issued by finance ministry provides for the sale of investment by way of
public issue at the price to be decided on the basis of book value and earning capacity.
However, this method may not give the best available prices to venture fund as it will
not be able to consider the future growth potential of the invested company.
One of the major factor which contributed to the success of venture funds in the West is
development of secondary and tertiary stock markets. These markets do not have listing
requirements and are spread over all important cities and towns in the country. These
stock markets provide excellent disinvestment mechanism for venture funds. In India,
however, stock market is not developed beyond a few important cities.
Success of venture capital fund depends very much upon profitable disinvestment of the
capital contributed by it. In US and UK, secondary and tertiary markets helped in
accomplishing the above. However, in India, promotion of such markets is not feasible
in the prevailing circumstances as such laissez faire policy may attract persons with
ulterior motives in the business to the detriment of the general public. However, stock

market operation may be started at many more big cities where, say, the number of
stock exchanges can be increased to 50. Further, permission to transact in unlisted securities with suitable regulation will ensure firsthand contact between venture fund
and investors.
Fiscal Incentives
Fiscal incentives may be given in the form of lowering the rate of Income Tax. It can be
accomplished by:
i) Application of provisions applicable to non-corporate entities for taxing long term
capital gains.
ii) An allowance to funds similar to Section 80-CC of Income Tax Act, say 20 per cent of
the investment in new venture which can be allowed as deduction from the income.
Private Sector Participation
In US and UK where the economy is dominated by private sector, development of
venture fund market was possible due to very significant role played by private sector
which is often willing to put money in high risk business provided higher returns are
expected. The guidelines by finance ministry provide that non-institutional promoter's,
share in the capital of venture fund cannot exceed 20 per cent of total capital; further
they cannot be the single largest equity holders. The private sector, because of this
provision, may not like to promote venture fund business.
Promotion of venture funds by private sector, in addition to public financial institutions
and banks, is recommended as:
a) Private sector is in advantageous position as compared to financial institutions and
banks to provide managerial support to new ventures as leading industrial houses have
a pool of experienced professional managers in all fields of management viz., marketing,
production and finance.
b) The leading business houses will be able to raise funds from the investing public with
relative ease.
Review the Existing Laws
To-day's need is to review the constraints under various laws of the country and resolve
the issues that could come in the way of growth of the innovative mode of financing. The
initiative on the part of the Government in the direction would see rapid growth of a
new breed of venture capital assisted by entrepreneurs.
COMMERCIAL PAPER

During the 1980s a wave of financial liberalisation and innovation in financial

instruments swept the world. A basic feature of the many innovations is the trend
towards securitisation, i.e., raising money direct from the investors in the form of
negotiable securities as a substitute for bank credit. The companies found it cheaper to
borrow directly from public by way of short term paper. The cost of fund is cheaper for
the companies as it involved lower information and transaction cost. This also suits the
interest of many investors as it provides them with a wide spectrum of financial
instruments to choose from and in placing their funds at reasonably high rates of return.
Commercial paper is a new instrument used for financing working capital requirements
of corporate enterprises.
What is a Commercial Paper?
A commercial paper is an unsecured promissory note issued with a fixed maturity by a
company approved by RBI, negotiable by endorsement and delivery issued in bearer
form and issued at such discount on the face value as may be determined by the issuing
company.
Features of Commercial Paper
1. Commercial Paper is a short term money market instrument comprising usance
promissory note with a fixed maturity.
2. It is a certificate evidencing an unsecured corporate debt of short term maturity.
3. Commercial paper is issued at a discount to face value basis but it can also be issued
in interest bearing from.
4. The issuer promises to pay the buyer some fixed amount on some future period but
pledges no assets, only his liquidity and established earning power, to guarantee that
promise.
5. Commercial paper can be issued directly by a company to investors or through
banks/merchant bankers.
Advantages of Commercial Paper
Simplicity: The advantage of commercial paper lies in its simplicity. It involves hardly
any documentation between the issuer and investor.
Flexibility: The issuer can issue commercial paper with the maturities tailored to
match the cash flow of the company.
Diversification: A well rated company can diversify its source of finance from banks
to short term money markets at somewhat cheaper cost.

Easy to Raise Long Term Capital: The companies which are able to raise funds
through Commercial Paper become better known in the financial world and are thereby
placed in a more favourable position for raising such long term capital as they may, from
time to time, require. Thus there is an in-built incentive for companies to remain
financially strong.
High Returns: The Commercial paper provides investors with higher returns than
they could get from the banking system.
Movement of Funds: Commercial paper facilitates securitisation of loans resulting in
creation of a secondary market for the paper and efficient movement of funds providing
cash surplus to cash deficit entities.
Commercial Paper Market in Other Countries
The roots of commercial paper can be traced way back to the early nineteenth century
when the firms in the USA began selling open market paper as a substitute for bank loan
needed for short term requirements but it developed only in 1920s. The development of
consumer finance companies in the 1920s and the high cost of bank credit resulting
from the incidence of compulsory reserve requirements in the 1960s contributed to the
popularity of commercial paper in the USA. To-day, the US Commercial paper market is
the largest in the world. The outstanding amount at the end of 1990 in the US
Commercial paper market stood at $ 557.8 billion. The Commercial paper issue in the
US are exempted from Security Exchange Commission registration and from
requirement of issue of prospectus so long as proceeds are used to finance current
transactions and the paper's maturity is less than 270 days.
Most of the Commercial paper market in Europe is modelled on the lines of the US
market. In the U.K. the sterling Commercial Paper market was launched in May 1986. In
the UK, the borrower must be listed on the stock exchange and he must have net assets
of at least $ 50 million. However, rating by credit agencies is not required. The
maturities of Commercial paper must be between 7 and 364 days. The commercial paper
is exempted from stamp duty.
In France, commercial papers were thought of as a flexible alternative to bank loans.
The commercial paper was introduced in December 1985. Commercial paper can be
issued only by non-bank French companies and subsidiaries of foreign, companies. The
paper are in bearer form. It can be either issued by dealers or placed directly. The
maturity ranges from ten days to seven years. Rating by credit agencies is essential. To
protect investors, law contains fairly extensive disclosure requirements and requires
publication of regular financial statements by issuers. The outstanding amount at the
end of 1990 in France Commercial paper market was $ 31 billions.
The Canadian commercial paper market was launched in 1950s. The commercial paper
is generally used for terms of 30 days to 365 days although terms such as overnight are
available. The Commercial paper issued by Canadian companies is normally secured by

pledge of assets. The outstanding amount at the end of 1990 in the Canadian market was
$ 26.8-billions.
In Japan, the Yen Commercial paper market was opened in November 1987. The
commercial paper issues carry maturities from two weeks to nine months. Japan stands
second in the commercial paper market in the world with an outstanding amount of $
117.3 billions in 1990.
In 1980s many other countries launched commercial paper market, notably Sweden
(early 1980s) Spain (1982), Hongkong (1982 Singapore (1984) and Norway 1984).
Commercial Paper in India
In India, on the recommendations of the Vaghul Working Group, the RBI announced on
27th March that Commercial Paper will be introduced soon in Indian money market.
The recommendations of the Vaghul Working Group on introduction of Commercial
paper in Indian money market are as follows:
1. There is need to have limited introduction of commercial paper. It should be carefully
planned and the eligibility criteria for the issuer should be sufficiently rigorous to ensure
that the commercial paper market develops on healthy lines.
2. Initially, access to the Commercial paper market should be restricted to rated
companies having a net worth of Rs.5 crores and above with good divided payment
record.
3. The commercial paper market should function within the overall discipline of CAS.
The RBI would have to administer the entry on the market, the amount of each issue
and the total quantum that can be raised in a year.
4. No restriction be placed on the participants in the commercial paper market except
by way of minimum size of the note. The size of any single issue, should not be less than
Rs. 1 crore and the size of each lot should not be less than Rs. 5 lakhs.
5. Commercial paper should be excluded from the stipulations on unsecured advances
in the case of banks.
6. Commercial paper would not be tied to any specific transaction and the maturity
period may be 15 days and above but not exceeding six months, backed up if necessary
by a revolving underwriting facility of less than three years.
7. The issuing company should have a net worth of not less than Rs.5 crores, a debt
equity ratio of not more than 1.5, a current ratio of more than 1.33, a debt servicing ratio
closer to 2, and be listed on the stock exchange.
8. The interest rate on commercial paper would be market dominated and the paper
could be issued at a discount to face value or could be interest bearing.

9. Commercial paper should not be subject to stamp duty at the time of issue as well as
at the time of transfer by endorsement and delivery.
On the recommendations of the Vaghul Working Group, the RBI announced on 27th
March 1989 that Commercial paper will be introduced soon in Indian money market.
Detailed guidelines were issued in December 1989, through Non-banking companies
(Acceptance of Deposits through Commercial Paper) Direction, 1989 and finally the
Commercial papers were introduced in India from 1 January 1990.
RBI Guidelines on Commercial Paper Issue
The important guidelines are:
1. A company can issue commercial paper only if it has:
(i) a tangible net worth of not less than Rs. 10 crores as per the latest balance sheet,
(ii) minimum current ratio of 1.33 : 1,
(iii) a fund based working capital limit of Rs.25 crores or more and
(iv) a debt servicing ratio closer to 2,
(v) The company is listed on a stock exchange and
(vi) subject to CAS discipline
(vii) It is classified under Health code No. 1 by the financing banks;
(viii) The issuing company would need to obtain PI from CRISIL.
2. Commercial paper shall be issued in multiples of Rs.25 lakhs but the minimum
amount to be invested by a single investor shall be Rs. 1 crore.
3. The Commercial Paper shall be issued for a minimum maturity period of 3 months
and the maximum period of 6 months from the date of issue. There will be no grace
period on maturity.
4. The aggregate amount shall not exceed 20% of the issuer's fund based working
capital.
5. The commercial paper is issued in the form of usance promissory notes, negotiable by
endorsement and delivery. The rate of discount could be freely determined by the
issuing company. The issuing company has to bear all floatation cost including stamp
duty, dealers' fee and credit rating agency fee.

6. The issue of Commercial paper cannot be underwritten or co-opted in any manner.

However, commercial banks can provide standby facility for redemption of the paper on
the maturity date.
7. Investment in Commercial paper can be made by any person or banks or corporate
bodies registered or incorporated in India and unincorporated bodies too. Non resident
Indians can invest in Commercial paper on non-repatriation basis.
8. The companies issuing commercial paper would be required to ensure that the
relevant provisions of the various statutes such as companies Act 1956, the IT Act, 1961
and the Negotiable Instruments Act 1981 are complied with.
Procedure and Time Frame for Issue of Commercial Paper
1. Application to RBI through financing bank or leader of consortium bank for working
capital facilities together with a certificate from credit rating agency.
2. RBI to communicate in writing their decision on the amount of Commercial paper to
be issued to the leader bank.
3. Issue of Commercial paper to be completed within 2 weeks from the date of approval
of RBI through private placement.
4. The issue may be spread over 2 weeks on different dates but all such commercial
papers shall bear the same maturity date.
5. Issuing company to advice RBI through the bank/leader of the bank, the amount of
actual issue of commercial paper within 3 days of completion of the issue.
Implications of Commercial Paper
The issue of Commercial paper is an important step in disintermediation bringing a
large number of borrowers as well as investors in touch with each other, without the
intervention of the banking system as financial intermediary. The borrowers can get at
least 20% of their working capital requirements directly from market at rates which may
be more advantageous than borrowing through a bank. The first class borrowers have
the prestige of joining the elitist commercial paper club with the approval of CRISIL, the
banking system and the RBI. However, RBI has presently stipulated that the working
capital limits of the banks will be reduced to the extent of issue of Commercial paper.
Industrialists have already made a plea that the issue of commercial paper should be
outside the scheme of bank finance and other guidelines such as recommendation of
banks and approval of RBI should be waived. RBI has not accepted the plea at present as
commercial paper is a unsecured borrowing and not related to a trade transaction. The
main aim of the RI is to ensure that commercial paper develops a sound money market
instrument. So, in the initial stages emphasis should be on the quality rather than
quantity.

Implications on Bank
The impact of issue of commercial paper on commercial banks would be of two
dimensions. One is that the banks themselves can invest in commercial paper and show
this as short term investment. The second aspect is that the banks are likely to lose
interest on working capital loan which was hitherto being lent to the companies, which
have, now started borrowing through commercial paper.
Further, the larger companies might avail of the cheap funds available in the market
during the slack season worsening the bank's surplus fund position, but come to the
banking system for borrowing during the busy season when funds are costly. This would
mean the banks are the losers with a clear impact on profitability.
However, the banks stand to gain by charging higher interest rate on reinstated portion
especially if it is done during busy season and by way of service charges for providing
standby facilities and issuing and paying commission. Further, when large borrowers
are able to borrow directly from the market, banks will correspondingly be freed from
the pressure on resources.
Impact on the Economy
The process of disintermediation is taking place in the free economies all over the world.
With the introduction of CP, financial disintermediation has been gaining momentum in
the Indian economy. If CPs are allowed the free play, large companies as well as banks
would learn to operate in a competitive atmosphere with more efficiency. This would
result in greater excellence in the services of banks as well as management of finance by
companies.
Since the inception of CPs in India in January 1990 23 companies have issued CPs
worth Rs.419.4 crores till June 1991. There has been phenomenal progress in CP market
in recent years. The total issue amounted to Rs. 9,000 crores in June 1994.
Recent Trends
RBI has liberalised the terms of issues of CP from May 30, 1991. According to the
liberalised terms, proposal by eligible companies for the issues of CP would not require
approval of RBI. Such companies would have to submit the proposal to the financing
and which provided working capital either as a sole bank or as a leader of the
consortium. The bank, on being satisfied of the compliance of the norms would take the
proposal on record before the issue of Commercial paper.
RBI has further relaxed the rules in June 1992. The minimum working capital limit
required by a company to issue CP has been reduced to Rs.5 crores. The ceiling on
amount of which can be raised through CP has been raised to 75% of working capital. A
closely held company has also been permitted to borrow through CPs provided all the
criteria are met. The minimum rating required from CRISIL has been lowered to P2
from PI while minimum rating need from ICRA is A2 instead of Al.

According to the RBI monetary policy for the second half of 1994-95, the standby facility
by banks for CP has been abolished. When CPs are issued, banks will have to effect a
pro-rate reduction in the cash credit limit and it will be no longer necessary for banks to
restore the cash credit limit to meet the liability on maturity of CPs. This will impart a
measure of independence to CP as a money market instrument.
Future of Commercial Paper in India
Corporate enterprises requiring burgeoning funds to meet their expanding needs find it
easier and cheaper to raise funds from market by issuing commercial paper. Further, it
provides greater degree of flexibility in business finance to the issuing company in as
much as it can decide the quantum of CP and its maturity on the basis of its future cash
flows. CPs have made a good start but its future depends on a number of factors. The
structural rigidies such as rating requirements, timing of issue, terms of issue, maturity
range, denominational range, interest rate stand in the way of developing commercial
paper market. The removal of stringent conditions and imposing of such regulatory
measures justifiable to issuers, investors and dealers will improve the potentiality of CP
as a source of corporate financing.
Credit cards
Credit cards are an innovation in Banking. Every innovation is a new way of meeting an
old problem. Consumer credit is an age old problem which is met in an innovative way
through credit cards. Credit cards are a new means of extending credit by the card issuer
to the card holder. The issuer extends a credit facility, without normal formalities
involved in extending credit, to the card-holder. The card-holder draws money from the
issuer of the card or its agencies. Also he buys things or services from approved
merchant establishments using the card. The latter simply accept chargeslips signed by
the card-holder. Credit cards, made of high grade plastic or . plastic-like substance,
bears the names of the issuer and the card-holder, the number assigned to the latter,
details as to time and place validity, and in some cases the photo of the holder. Carrying
the card tantamounts to having cash. In India there are 14 credit card issuers, the latest
addition to the list of issuers being the 'Standard Chartered' Bank.
Parties
There are three parties - the card issuer, the card-holder and the seller of services and
products, for the card issuer, credit cards are an innovative means of increasing their
business income through admission fee, add-on fee, annual fee, services fee and interest
charged on card-holders. Commission on card sales received from business firms who
have booked credit-card sales is another income.
For the credit card-holders, credit cards are an innovative way to pay for the purchases.
They can go for instant purchases without checking their liquidity'. Instantly, they can
add their liquidity by drawing cash without bank accounts or without sufficient balances
in their accounts'. 24 hour Automatic Teller machines for cash drawals are also available
on select cards at select places. With a credit-card the card-holder feels rich even though

his bank accounts are drawn closely. Really sense of feeling assured is there. With credit
cards in pocket, emergencies are not felt so by card-holders. They exclude a sense of
confidence. Perhaps taking the cue of the above feeling, CANCARD tells, you won't
need anything else". To ensure that one feels assured, the AMERICAN EXPRESS CARD
tells "don't leave home without it."The best way to pay" is the slogan used by Citibank
Card Services. No doubt credit cards are a new means of consumer finance.
For the business establishments, accepting credit cards is an innovative form of doing
business with the upper and upper middle class. Surely these-business establishments
get the patronage of the burgeoning upper middle class. The commission they pay on
card sales is only a fraction of profits made, which otherwise they wouldn't have made.
Actually accepting credit cards adds to the prestige of the firms. An indirect publicity is
what they get. Even the Oberoi Bangalore advertises the preferred hotel of "the Master
Card, Bank of America and Visa. It pays to accept cards. The American express Bank
therefore projects that its credit card- is not plastic, it's prestige". The job of card-issuer
is to serve as a conduit between the client card-holders and the client merchant
establishment in effecting a transaction, payments being made to/ received by, as the
case may be, the card-issuer.
New Culture
Credit cards have created a new Consumer Culture. Barbarra Ehrenreich would tell, "the
paradox of Consumer Culture is that people are constantly faced with two sets of
contradictory messages. The more powerful is that projected by advertising which urges
people to buy, to indulge themselves. The other is do not spend, save and not indulge
yourself credit cards hold out the key to how one can "have the cake and eat it too". In
essence credit cards give an answer to the above paradox. You can indulge and save at
the same time. You buy on your card for which only a delayed payment is required. The
delayed payment for a purchase in essence is an investment. Sometimes cash drawals on
credit cards are used for making investments which otherwise might have slipped off
your hands. Credit cards thus create both consumption and investment cultures at the
same time. That is one's propensity to consume and invest are enhanced by credit cards.
Credit cards thus help create a new social, financial and business culture.
Types of Cards
The cards are of two types. These are (premium charge) cards the (pure) credit cards.
The (premium charge) cards or simply charge cards require the card holders to pay
every month the whole of sum due. The Diners Club, American Express, Cancards, etc.,
expect "their clients to clear balances every month. The (pure) credit cards like the Gold
and classic cards issued by Citibank, Hongkong Bank etc., give the card-holders the
option to pay a small sum and roll over the unpaid balances carrying an interest charge
at 2.5 per cent per month. Thus a real credit facility is enjoyed by these card-holders.
Many Issuers

There are many institutions issuing credit cards. Foreign banks like Citibank, Hongkong
Bank, ANZ Grindlays Bank, Standard and Chartered Bank and American Express,
Indian Banks like Andhra Bank, Bank of Baroda, Bank of India, Canara Bank, Central
Bank of India and State Bank of India issue credit cards. Mercard Limited, a nonbanking firm also issues credit card. Many of the foreign banks generally issue VISA,
MASTERCARD and DINERS CLUB cards.
Popularity of Cards issued by Foreign Banks
These foreign banks in India are city based, cater to the "creamy layer" of Indian society
mostly. Their customer profile is much different from those of their Indian counterparts.
Hence, the credit card issued by foreign banks enjoy higher popularity. Perhaps their
competition is in service, not in rates. Their fees, charges and interest are more than
that of the Indian counterparts. But due to wider acceptability of their cards, and swifter
service by them, their popularity is currently higher.
A Stir in the Card Market
Now Citibank, Hongkong Bank, Standchart Bank and American Express seem to have
generated heat in the card market. All lavishly spend on advertisement, but strategies
differ. Citibank is adopting an open door policy, whereas American Express adopts
selectivity route as it wants to enter in a small way. Hongkong Bank adopts a balanced
strategy. Hongkong Bank has rolled out a big media campaign too. The Goldmine
contest extending upto 15th January 1994 to popularise Visa and Master Cards is aptly
used by Hongkong Bank for promoting its Card business prospects. A media ad war is
thus going on.
Indian Banks in Card Business
Most Indian banks have entered the credit card business only recently. They concentrate
on the upper middle class- consumers. Among them, Andhra Bank was first to introduce
credit cards in Indian soils in 1981. About the same time Central Bank of India also
entered the credit card business. They are the innovators in the credit card business in
India.
Bank of Baroda's Cards, viz., Bobcard and Bob Card Exclusive are claimed to be much
popular. The annual fee for Bobcard is Rs. 100 and for the Bob Card Exclusive is
Rs.500/-. The Bob Card Exclusive gives a special privilege, i.e., Cash drawal upto Rs.
15,000/- for meeting medical emergencies. There are about 1.6 lakhs Bob card holders
now.
Bank of India issues India card. Besides this bank, Allahabad bank, Bank of
Maharashtra, Oriental Bank of Commerce, South Indian Bank Limited, Tamil Nadu
Mercantile Bank and United Western Bank also issues India Card with tie-up
arrangements with Bank of India. Like the Hongkong Bank Hyatt Regency Preferred
Gold card, Bank of India issues Taj Premium Cards with Exclusive collaboration with
the Taj group of hotels.

Canara Bank and Bank of Baroda though entered late in the late 80s, they made the card
culture spread among the middle class widely. Canara Bank has three types of cards Cancard for individuals and Business cards and Corporate cards for frequent travellers
for business purposes. Cancard is accepted by over 13500 business establishments in
India and Nepal. Cash withdrawal facility from over 9000 branches of Canara Bank and
correspondents banks is also available. Corporation Bank, Dena Bank, Indian Overseas
Bank, Karur Vysya Bank, Saraswat Co-operative Bank, Syndicate Bank and Union Bank
of India serve as correspondent banks and themselves issue cancards. Cancards are
available for a small annual fee of Rs.l25/= p.a. Free and automatic insurance covering
risk of accidental death upto Rs. 1,00,000/= is available to all card-holders with
nomination facility. Besides, insurance covers against accidents and medical expenses
for card-holders and their families are available at far cheaper premium rates. Canara
Bank also does a good deal of promotion of its card business. It volunteered to despatch
application forms to subscribers to its mutual fund schemes. Besides it does advertise
for its cards. Cancard has now a membership of around 1.6 lakhs. Cancard is one of the
popular cards.
State Bank of India and its associate banks issue State Bank Cards. State Bank cards
have certain unique features. The cards bear the photo of the holder. Card clients are
issued with special cheque leaves which are presented to merchant establishments for
card purchases. No commission is charged on the merchant establishment, on card
sales. Merchant establishments should be double happy on this score. There are two
cards from State Bank of India - State Bank Card (General) and State Bank Hi-Value
card. The former is issue for an annual fee of Rs.50 and the latter for Rs.250/=. Media
promotion is not conspicuous in the case of State Bank of India. Over 20,000 merchant
houses accept SBI credit cards.
Apart the banks, Mercard Limited, a Madras based firms owing alliance to Mercantile
Credit Corporation is making strides in the credit card business. Does purchasing
power mean a thick wad of notes or just a slim plastic card? Asks Mercard Limited. Its
credit card, Mercard, is valid in India and Nepal. Launched in 1987, over 7000 leading
hotels, shops and even hospitals accept Mercard. Like its banking counterparts, Mercard
also offers a range of benefits to its customer. Mercard is upto make its credit card a
'plastic money market'. Scaling new horizons, entering new arenas, and enhancing the
lifestyle of the proud owners of Mercard are the current pursuits of Mercard Limited. It
has also gone for a media blitzkreig. A quarter page ad in The Hindu on 17th and on
28th November mean that Mercard is very serious about promoting its business. The
business needs lot of funds. At present, Mercard Limited has floated on public issue of
shares to raise more equity capital.
General Benefits
Credit card boom is sighted in India. The card issuers want to rope in many card-clients.
Many benefits are now being offered to woo the deserving customers. Free Insurance
covering the risk of accidental death is a common feature. In case, the card is lost or
stolen, the liability of the card holder for any possible fraudulent use of card by others is
limited to a maximum of Rs.l000/-. Card replacement is speedily undertaken. Citibank

alerts that the lost or stolen cards can be replaced normally in 3 days of reporting of the
event. Additional cards at a special concessional fee for family members-spouse and one
adult child, are also issued on request. The emphasis by every card issuer is the value
for money. Sure, card-holders get Value for money'. Hence the current in the credit card
business.
Future
Surely credit cards are all set to make a definite impact on life-style of people. A boom in
the credit card business is quite expected. Merchant establishments should be enrolled
in large number to offer variety to card-users in the choice of shops to shops. About
40,000 establishments in India accept credit cards of one firm or the other. True some
merchant establishments do not align with the credit card business. They hopefully feel
enough is enough. Even some feel that credit card sales are a nuisance. Credit cards
benefit only customers and not us, say some merchants. This attitude does not seem to
be prudent. Incremental sales definitely result and that merchant establishment stand
to gain. Accepting credit cards is a competitive tool. Visa cards are accepted the World
over by 10 million shops, hotels, etc. Merchant firms should be forward looking and
come forward to accept credit cards. Regarding the credit card holding population, in
India their size is about 7 lakh persons. The tax paying people numbers 7 million in
India. Assuming these 8 million constitute the potential market, the present size is just
about 10%. The untapped market is very big. Sure with conscious promotion the
potential market can be turned into a reality. Credit cards are a credit to all: the issuer,
the user and acceptor-business-firms. Credit cards herald an era of innovative banking,
innovative shopping and innovative marketing.
QUESTIONS
1. Distinguish between hire purchase and instalment sale.
2. Distinguish between hire purchase and least.
3. Explain the features of hire purchase.
4. Distinguish between discounting and factoring.
5. What is factoring? Discuss its modus operandi.
6. Explain clearly the various functions involved in factoring.
7. Define Forfaiting. Is it similar to international facing?
8. What is international factoring? Who are the parties involved in it?
9. Discuss in detail the various services rendered by factoring intermediaries.
10. Critically assess the role of forfaiting as a source of financing.
11. Distinguish between factoring and forfaiting and state the scope for the
introduction of such services in India.
12. What is Venture Capital?
13. State the features of Venture Capital.
14. Explain the various stages of Venture capital financing.
15. Discuss the importance of Venture Capital.
16. Explain the guidelines for venture capital in India.
17. Explain the performance of various venture capital firms functioning in India.
18. Discuss the scope of Venture Capital in India.

19. What is a commercial paper?

20. What are the advantages of commercial paper?
21. State the RBI guidelines on commercial paper issue.

- End Of Chapter -