Professional Documents
Culture Documents
Version : 2.1
Date : 04-August-2005
TABLE OF CONTENTS
1 1.BFS CONCEPTS.................................................................................................................................4
2 1.1. THE CONCEPT OF MONEY.......................................................................................................5
3 1.2.FINANCIAL INSTRUMENTS.....................................................................................................13
4 1.3.FINANCIAL MARKETS..............................................................................................................24
5 2.BANKING..........................................................................................................................................33
6 2.1.INTRODUCTION TO BANKING...............................................................................................34
7 2.2.RETAIL BANKING......................................................................................................................42
8 2.3.CONSUMER LENDING...............................................................................................................56
9 2.4.COMMERCIAL AND WHOLESALE BANKING....................................................................70
Functions of the Treasury Manager......................................................................................................79
Bifurcation of All major markets (Equities, Bond, FX, Derivatives)....................................................84
Treasury applications segments & vendors..........................................................................................85
Some of the offerings in Cash Management Services are - .................................................................87
Payment / Disbursement Offerings........................................................................................................87
Collections Services...............................................................................................................................87
10 2.5.CARDS AND PAYMENTS.........................................................................................................105
11 2.6.INVESTMENT MANAGEMENT .............................................................................................117
12 2.7.INVESTMENT BANKING AND BROKERAGE....................................................................138
13 2.8.RISK MANAGEMENT...............................................................................................................154
14 2.9.CUSTODY AND CLEARING....................................................................................................162
1.1.1Market Constituents.....................................................................................................................164
1.1.2Securities Market.........................................................................................................................166
1.1.3Trade Initiation............................................................................................................................167
1.1.4Order Management.....................................................................................................................167
1.1.5Trade Execution...........................................................................................................................169
1.1.6Trade Enrichment........................................................................................................................170
1.1.7Trade Validation..........................................................................................................................170
1.1.8Trade Clearing............................................................................................................................170
1.1.9Trade Affirmation/Confirmation.................................................................................................172
1.1.10Trade Settlement Failure...........................................................................................................172
1.1.11Trade Settlement........................................................................................................................173
1.1.12Trade Accounting & Reconciliation..........................................................................................174
Trade accounting and Reconciliation is the internal control process used by custodians to manage
trade transactions. In this process, the custodian determines that the customer’s account has the
necessary securities on hand to deliver for sales, that the customer’s account has adequate cash or
forecasted cash for purchases. It maintains the records of trades internally and tries to match it with
outside world. It tries to match the positions by comparing positions of trades (Open and settled
both).....................................................................................................................................................174
1.1.13Risks associated with Trading & Settlement.............................................................................174
1.1.14Work Flows Of Trading and Settlement....................................................................................174
1.1.15Corporate Actions.....................................................................................................................178
1.1.16Income Processing ....................................................................................................................178
1.1.17Proxy Voting..............................................................................................................................179
1.1.18Tax Processing..........................................................................................................................180
15 2.10.CORPORATE SERVICES.......................................................................................................182
16 3.RECENT DEVELOPMENTS.......................................................................................................188
17 4.GLOSSARY.....................................................................................................................................200
18 5.REFERENCES................................................................................................................................208
1. BFS CONCEPTS
Simple interest
Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: P
is the Principal or the initial amount you are initially borrowing or depositing, to earn or charge
interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% interest on a beginning value of $100, the first year they would
get:
0.05*$100 = $5
If they continued to receive 5% interest on the original $100 amount, over five years the growth in
their investment would look like this:
Year 1: (5% of $100 = $5) + $100 = $105
Compound interest
With compound interest, interest is calculated not only on the beginning interest, but on any
interest accumulated with the initial principal in the meantime. Compound interest =
[P*(1+r/100)^t – P], where: P is the Principal or the initial amount you are initially borrowing or
depositing, to earn or charge interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% compound interest on a beginning value of $100, the first year
they would get the same thing as if they were receiving simple interest on the $100, or $5. The
second year, though, their interest would be calculated on the beginning amount in year 2, which
would be $105. So their interest would be:
.05 x $105 = $5.25
If this were to continue for 5 years, the growth in the investment would look like this:
Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00
INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For example, if
Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/(1+I) kgs. Of
groceries next year, where I refers to the rate of inflation beyond today.
Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply
and other market conditions hold), next year, you can only buy 5/(1.05) worth of groceries.
Inflation results in a decrease in the value of money over time. The link between the interest
rates, nominal and real, and inflation enables you to identify this impact.
Nominal Interest
Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if
counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal
rate of interest is 10%. This, as you see, includes the inflation rate.
Example
You’ve lent out 100 rupees, at 10%, for one year. On maturity, you get a profit, so you think, of 10
rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation!
Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year
ago, and it is less by the inflation rate. Thus the real interest you earned is less than 10%.
Example
like Present value and future value, we need to understand the basic concepts of simple and
compound interest described above.
Future Value
Future Value is the value that a sum of money invested at compound interest will have after a
specified period.
The formula for Future Value is:
FV = PV*(1 + i)n
Where:
FV : Future Value at the end of n time periods
PV : Beginning value OR Present Value
i : Interest rate per unit time period
n : Number of time periods
Example
If one were to receive 5% per annum compounded interest on $100 for five years,
FV = $100*(1.05)5 = $127.63
Intra-year compounding
If a cash flow is compounded more frequently than annually, then intra-year compounding is
being used. To adjust for intra-year compounding, an interest rate per compounding period must
be found as well as the total number of compounding periods.
The interest rate per compounding period is found by taking the annual rate and dividing it by the
number of times per year the cash flows are compounded. The total number of compounding
periods is found by multiplying the number of years by the number of times per year cash flows
are compounded.
Example
Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold it
for five years.,
Present value
Present Value is the current value of a future cash flow or of a series of future cash flows. It is
computed by the process of discounting the future cash flows at a predetermined rate of interest.
If $10,000 were to be received in a year, the present value of the amount would not be $10,000
because we do not have it in our hand now, in the present. To find the present value of the future
$10,000, we need to find out how much we would have to invest today in order to receive that
$10,000 in the future. To calculate present value, or the amount that we would have to invest
today, we must subtract the (hypothetical) accumulated interest from the $10,000. To achieve
this, we can discount the future amount ($10,000) by the interest rate for the period. The future
value equation given above can be rearranged to give the Present Value equation:
PV = FV / (1+I)^n
In the above example, if interest rate is 5%, the present value of the $10,000 which we will
receive after one year, would be:
PV = 10,000/(1+0.05) = $ 9,523.81
Example
An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of the
year. The after-tax net cash flows at the end of each year are forecast as follows:
Assume that the required rate of return for similar investments is 15.00%.
NPV = - 50000 + 9000/(1+0.15)^1 + 8500/(1+0.15)^2 + ….. +51000/(1+0.15)^10 = $612.96
Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:
• Increases with increase in future cash inflows for a given initial outlay
• Decreases with increase in initial outlay for a given set of future cash
inflows
• Decreases with increase in required rate of return
In the previous example, the IRR is that value of required rate of return that makes the NPV
equals zero.
IRR = r, where
NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/(1+r)^10 = $0.00
IRR can be calculated using trial and error methods by using various values for r or using the IRR
formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at
which the project/investment becomes viable.
FINANCIAL INSTRUMENTS
RAISING CAPITAL
Corporations need capital to finance business operations. They raise money by issuing Securities
in the form of Equity and Debt. Equity represents ownership of the company and takes the form of
stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is
also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the
extent of a company’s leverage.
Investors choose between debt and equity securities based on their investment objectives.
Income is the main objective for a debt investor. This income is paid in the form of Interest,
usually as semi-annual payments. Capital Appreciation (the increase in the value of a security
over time) is only a secondary consideration for debt investors. Conversely, equity investors are
primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is
received in the form of Dividends.
Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It
also means that if the company ceases to do business and liquidate its assets, that the debt
holders have a senior claim to those assets.
SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a creditor
relationship with a corporation or government agency (a bond), or rights to ownership (an option).
Financial instruments can be classified into:
• Debt
• Equity
• Hybrids
• Derivatives
DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are
all examples of debt.
Bond
An investor loans money to an entity (company or government) that needs funds for a specified
period of time at a specified interest rate. In exchange for the money, the entity will issue a
certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date
(maturity date). Interest on bonds is usually paid every six months (semiannually).
Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only
and Fully Registered Bonds.
Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These
bonds are Unregistered because the owner’s name does not appear on the bond, and there is no
record of who is entitled to receive the interest payments. Attached to the bond are Coupons. The
bearer clips the coupons every six months and presents these coupons to the paying agent to
receive their interest. Then, at the bond’s Maturity, the bearer presents the bond with the last
coupon attached to the paying agent, and receives their principal and last interest payment.
Bonds that are registered as to principal only have the owner’s name on the bond certificate, but
since the interest is not registered these bonds still have coupons attached.
Bonds that are issued today are most likely to be issued fully registered as to both interest and
principal. The transfer agent now sends interest payments to owners of record on the interest
Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and
the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,
Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customer’s
Confirmation serves as proof of ownership.
Example
• IBM can issue 10 year bonds with a coupon of 5.5%.
• Priceline can issue similar 10 year bonds at 8%
• The difference in coupon is due to their credit rating!
The principal or par or Face amount of the bond is what the investor has loaned to the issuer. The
relative "safety" of the principal depends on the issuer’s credit rating and the type of bond that
was issued.
Corporate bond
A bond issued by a corporation. Corporations generally issue three types of bonds: Secured
Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.
All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond.
In contrast, unsecured bonds are backed by the general assets of the corporation only. There are
three basic types of Secured Bonds:
Mortgage Bonds are secured by real estate owned by the issuer
Equipment Trust Certificates are secured by equipment owned and used in the issuers business
Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (usually U.S. Government
securities)
Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they
are the first to be paid principal or interest and are thus the safest of an issuer’s securities.
Unsecured Bonds include debentures and subordinated debentures. Debentures have a general
creditor status and will be paid only after all secured creditors have been satisfied. Subordinated
debentures have a subordinate creditor status and will be paid after all senior and general
creditors have first been satisfied.
Case Study
• Enron set up power plant at Dabhol, India
• The cost of the project (Phase 1) was USD 920 Million
• Funding
o Equity USD 285 mio
o Bank of America/ABN Amro USD 150 mio
o IDBI & Indian Banks USD 95 mio
o US Govt – OPIC USD 100 mio
o US Exim Bank USD 290 mio
• Enron US declared bankruptcy in 2002
• Enron India’s assets are mortgaged to various banks as above.
• Due to interest payments and depreciation, assets are worth considerably less than
USD 920 mio.
• Who will get their money back? And how much?
Treasury Securities
Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to
pay off maturing debt and raise the cash needed to run the federal government. When an investor
buys one of these securities, he/she is lending money to the U.S. government.
Treasury bills are short-term obligations issued for one year or less. They are sold at a discount
from face value and don't pay interest before maturity. The interest is the difference between the
purchase price of the bill and the amount that is paid to the investor at maturity (face value) or at
the time of sale prior to maturity.
Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual
interest payments. Treasury notes have a term of more than one year, but not more than 10
years.
Treasury bonds are issued by the U.S. Government. These are considered safe investments
because they are backed by the taxing authority of the U.S. government, and the interest on
Treasury bonds is not subject to state income tax. T-bonds have maturities greater than ten
years, while notes and bills have lower maturities. Individually, they sometimes are called "T-
bills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at
prevailing market prices.
Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not
marketable and the owner of a Savings Bond cannot transfer his security to someone else.
corporate bonds will offer a higher return than a government bond. It is important for investors to
research a bond just as they would a stock or mutual fund. The bond rating will help in
deciphering the default risk.
Commercial paper
An unsecured, short-term loan issued by a corporation, typically for financing accounts receivable
and inventories. It is usually issued at a discount to face value, reflecting prevailing market
interest rates. It is issued in the form of promissory notes, and sold by financial organizations as
an alternative to borrowing from banks or other institutions. The paper is usually sold to other
companies which invest in short-term money market instruments.
Since commercial paper maturities don't exceed nine months and proceeds typically are used
only for current transactions, the notes are exempt from registration as securities with the United
States Securities and Exchange Commission. Financial companies account for nearly 75 percent
of the commercial paper outstanding in the market.
There are two methods of marketing commercial paper. The issuer can sell the paper directly to
the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer
market for commercial paper involves large securities firms and subsidiaries of bank holding
companies. Direct issuers of commercial paper usually are financial companies which have
frequent and sizable borrowing needs, and find it more economical to place paper without the use
of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. This
savings compensates for the cost of maintaining a permanent sales staff to market the paper.
Interest rates on commercial paper often are lower than bank lending rates, and the differential,
when large enough, provides an advantage which makes issuing commercial paper an attractive
alternative to bank credit.
Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less
than 30 days. Paper usually is issued in denominations of $100,000 or more, although some
companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the
CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, bank
lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the
market.
Investors in the commercial paper market include private pension funds, money market mutual
funds, governmental units, bank trust departments, foreign banks and investment companies.
There is limited secondary market activity in commercial paper, since issuers can closely match
the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or
issuer usually will buy back the paper prior to maturity.
EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the
funds contributed by the owners (the stockholders) plus the retained earnings (or losses).
Common stock
Common stock represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of the
stock traded in the markets today is common. An individual with a majority shareholding or
controlling interest controls a company's decisions and can appoint anyone he/she wishes to the
board of directors or to the management team.
Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public
Offering (IPO). Before shares can be offered, or sold to the general public, they must first be
registered with the Securities and Exchange Commission (SEC). Once the shares have been
sold to investors, the shareholders are usually free to sell or trade their stock shares in the
Secondary Markets (such as the New York Stock Exchange – NYSE). From time to time, the
Issuer may choose to repurchase the stock they previously issued. Such repurchased stock
shares are referred to as Treasury Stock, and the shares that remain trading in the secondary
market are referred to as Shares Outstanding. Treasury Stock does not have voting rights and is
not entitled to any declared dividends. Corporations may use Treasury Stock to pay a stock
dividend, to offer to employees.
Stock Terminology
Public Offering Price (POP) – The price at which shares are offered to the public in a Primary
Offering. This price is fixed and must be maintained when Underwriters sell to customers.
Current Market Price – The price determined by Supply and Demand in the Secondary Markets.
Book Value – The theoretical liquidation value of a stock based on the company's Balance Sheet.
Par Value – An arbitrary price used to account for the shares in the firm’s balance sheet. This
value is meaningless for common shareholders, but is important to owners of Preferred Stock.
Example
When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ in
June 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split
twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current
Market Price stood at $46.26. However, if the stock-splits are taken into consideration the
actual market price would stand at 6 times the Current Market Price at whopping $253.56!!
Preferred Stock
Preference shares carry a stated dividend and they do not usually have voting rights. Preferred
shareholders have priority over common stockholders on earnings and assets in the event of
liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par
(always assumed to be $100) or a dollar amount.
Although preferred stock is equity and represents ownership, preferred stock investors are
primarily seeking income. The market price of income seeking securities (such as preferred stock
and debt securities) fluctuates as market interest rates change. Price and yield are inversely
related.
There are several different types of preferred stock including Straight, Cumulative, Convertible,
Callable, Participating and Variable. With straight preferred, the preference is for the current
year’s dividend only. Cumulative preferred is senior to straight preferred and has a first
preference for any dividends missed in previous periods.
Convertible preferred stock can be converted into shares of common stock either at a fixed
price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used
as a means for a risky company to obtain capital when neither debt nor equity works. It offers
considerable opportunity for capital appreciation.
Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.
Utilities represent the best example of nonconvertible preferred stock issuers.
HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.
Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of shares of
stock after a specified number of days. However, till the time of conversion the bonds continue to
pay coupons.
Case Study
Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond aggregating to
$100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue
was just 4% which was much lower than what it would have to pay if it raised the money in
India, where it is based out of. The company would use this money to pay-back existing loans
borrowed at much higher interest rates.
• Why doesn’t every company raise money abroad if it has to pay lower interest rates? Will
there is
• Will there be any effect on existing Tata Motors share-holders due to the convertible
issue? If ‘Yes’, when will this be?
Warrants
Warrants are call options – variants of equity. They are usually offered as bonus or sweetener,
attached to another security and sold as a Unit. For example, a company is planning to issue
bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so
they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire
worthless.
DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, foreign exchange, commodity or any other
item. For example, if the settlement price of a derivative is based on the stock price, which
changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence
derivative risks and positions must be monitored constantly.
Forward contract
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain
future time for a certain price. No cash is exchanged when the contract is entered into.
Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Index futures are all futures contracts where the underlying is the
stock index and helps a trader to take a view on the market as a whole.
Hedging involves protecting an existing asset position from future adverse price movements. In
order to hedge a position, a market player needs to take an equal and opposite position in the
futures market to the one held in the cash market.
Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can
earn risk less profits. When markets are imperfect, buying in one market and simultaneously
selling in other market gives risk less profit. Arbitrageurs are always in the look out for such
imperfections.
Options
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares
of the underlying security at a specific price on or before a specific date. There are two kinds of
options: Call Options and Put Options.
Call Options are options to buy a stock at a specific price on or before a certain date. Call
options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option premium, secures the investor the right to buy that certain stock at a specified
price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the
option premium. For call options, the option is said to be in-the-money if the share price is above
the strike price.
Example
The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24 th, 2003
expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would
mean that to break-even the person buying the Call Option on the Infosys stock, the stock
price would have to cross Rs.5290 as of Dec 24th, 2003!!
Put Options are options to sell a stock at a specific price on or before a certain date. With a Put
Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor
can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no
need to use the insurance, and the only cost is the premium. A put option is in-the-money when
the share price is below the strike price. The amount by which an option is in-the-money is
referred to as intrinsic value.
The primary function of listed options is to allow investors ways to manage risk. Their price is
determined by factors like the underlying stock price, strike price, time remaining until expiration
(time value), and volatility. Because of all these factors, determining the premium of an option is
complicated.
Types of Options
There are two main types of options:
• American options can be exercised at any time between the date of
purchase and the expiration date. Most exchange-traded options are
of this type.
Long-Term Options are options with holding period of one or more years, and they are called
LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and
manage risk or even speculate, they are virtually identical to regular options. LEAPS, however,
provide these opportunities for much longer periods of time. LEAPS are available on most widely-
held issues.
Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-
standard options are called exotic options, which either are variations on the payoff profiles of the
plain vanilla options or are wholly different products with "optionality" embedded in them.
Open Interest is the number of options contracts that are open; these are contracts that have not
expired nor been exercised.
Swaps
Swaps are the exchange of cash flows or one security for another to change the maturity (bonds)
or quality of issues (stocks or bonds), or because investment objectives have changed. For
example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the lower rates.
Currency Swap involves the exchange of principal and interest in one currency for the same in
another currency.
Forward Swap agreements are created through the synthesis of two different swaps, differing in
Case Study
duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes
swaps• don't
The perfectly
Worldmatch
Banktheborrows
needs offunds
investors wishing to hedge
internationally andcertain
loansrisks.
thoseFor funds
example,
to if
an investor wants to hedge for a five-year duration beginning one year from today,
developing countries. It charges its borrowers a cost plus rate and hence needs they can enter
into both a one-year and six-year swap, creating the forward swap that meets the requirements
to borrow at the lowest cost.
for their portfolio.
• In 1981 the US interest rate was at 17 percent, an extremely high rate due to
Swaptions - An option to enter
the anti-inflation tight into an interest
monetary rate swap.
policy of theTheFed.
contract
In gives
WesttheGermany
buyer the option
the
to execute an interest rate swap on a future date, thereby locking in financing costs at a specified
corresponding rate was 12 percent and Switzerland 8 percent.
fixed rate of interest. The seller of the swaption, usually a commercial or investment bank,
• the
assumes IBMrisk
enjoyed a very
of interest good reputation
rate changes, in Switzerland,
in exchange for payment ofperceived as one of the
a swap premium.
best managed US companies. In contrast, the World Bank suffered from bad
image since it had used several times the Swiss market to finance risky third
world countries. Hence, World Bank had to pay an extra 20 basis points (0.2%)
compared to IBM
• In addition, the problem for the World Bank was that the Swiss government
imposed a limit on the amount World Bank could borrow in Switzerland. The
World Bank had borrowed its allowed limit in Switzerland and West Germany
• At the same time, the World Bank, with an AAA rating, was a well established
name in the US and could get a lower financing rate (compared to IBM) in the US
Dollar bond market because of the backing of the US, German, Japanese and
other governments. It would have to pay the Treasury rate + 40 basis points.
• IBM had large amounts of Swiss franc and German deutsche mark debt and
thus had debt payments to pay in Swiss francs and deutsche marks.
• World Bank borrowed dollars in the U.S. market and swapped the dollar
repayment obligation with IBM in exchange for taking over IBM's SFR and DEM
loans.
• It became very advantageous for IBM and the World Bank to borrow in the
Business - IT Model – Cards v1.091 Page 23 of 209
market in which their comparative advantage was the greatest and swap their
respective fixed-rate funding.
Foundation Course in Banking
FINANCIAL MARKETS
Secondary markets
Secondary Market is a place where primary market instruments, once issued, are bought and
sold. An investor may wish to sell the financial asset and encash the investment after some time
or the investor may wish to invest more, buy more of the same asset instead, the decision
influenced by a variety of possible reasons. They provide the investor with an easy way to buy or
sell.
CAPITAL MARKETS
For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely
important. Capital markets have following functions:
1. Channeling funds from “savings pool” to “investment pool” - channeling funds from “those
who have money” to “those who need funds for business purpose”.
2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell financial
assets or instruments. Capital markets achieve this in a number of ways and it is particularly
important for institutional investors who trade in large quantities. Illiquid markets do not allow
them to trade large quantities because the orders may simply not get executed completely or
may cause drastic fluctuations in price.
3. Providing multitude of investment options to investors – this is important because the risk
profile, investment criteria and preferences may differ for each investor. Unless there are
many investment options, the capital markets may fail to attract them, thus affecting the
supply of capital.
4. Providing efficient price discovery mechanism – efficient because the price is determined by
the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers in
the market at any point. So the market price can be considered as a fair price for that
instrument.
STOCK MARKETS
Stock markets are the best known among all financial markets because of large participation of
the “retail investors”. The important stock exchanges are as follows:
• New York Stock Exchange (NYSE)
• National Association of Securities Dealers Automated Quotations
(NASDAQ)
• London Stock Exchange (LSE)
• Bombay Stock Exchange (BSE),
• National Stock Exchange of India (NSE)
Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares
that are traded on that particular exchange. Exchanges then follow a mechanism to automatically
match these trades based on the quoted price, time, quantity, and the order type, thus resulting in
trades. The market information is transparent and available real-time to all, making the trading
efficient and reliable.
Earlier, before the proliferation of computers and networks, the trading usually took place in an
area called a “Trading Ring” or a “Pit” where all brokers would shout their quotes and find the
“counter-party”. The trading ring is now replaced in most exchanges by advanced computerized
and networked systems that allow online trading, so the members can log in from anywhere to
carry out trading. For example, BOLT of BSE and SuperDOT of NYSE.
BOND MARKETS
As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in exchanges, most
of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations between
dealers. Lately there have been efforts to create computer-based market place for certain type of
bonds.
If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on the
direction of interest rates change. Remember, bond pays interest at a fixed coupon rate
determined at the time of issue, irrespective of the prevailing market interest rate. Market interest
rates are benchmark interest rates, such as Treasury bill rates, which are subject to change
because of various factors such as inflation, monetary policy change, etc. So when the prevailing
market interest rates change, price of the bond (and not the coupon) adjusts, so that the effective
yield for a buyer at the time (if the bond is held to maturity) matches the market interest rate on
other bonds of equal tenure and credit rating (risk).
So when the market interest rates go up, prices of bonds fall and vice-versa. Thus, since price of
bonds changes when market interest rate changes, all bonds have an interest rate risk. If the
market interest rates shoot up, then the bond price is affected negatively and an investor who
bought the bond at a high price (when interest rates were low) stands to lose money or at least
makes lesser returns than expected, unless the bond is held to maturity.
Example
Bond Price calculation can be summed by an easy formula:
where B represents the price of the bond and CFk represents the kth cash flow which is made
up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon
payment and the Principal.
• What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate
(i) is 10% and the Coupon payments are Rs.5 annually?
• Would the bond price increase/decrease if the coupon is reduced? What would be happen
to bond price if the interest rates came down?
Participants
Only authorized foreign exchange dealers can participate in the foreign exchange market. Any
individual or company, who needs to sell or buy foreign currency, does so through an authorized
dealer. Currency trading is conducted in the over-the-counter (OTC) market.
profitability of investments made by foreign companies in that country. Regulators try to ensure
that the fluctuations are not caused by any factor other than the market forces.
Example
The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange
rates to ensure that the importers/exporters are not hurt due to any exchange rate
fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world,
maintains a long-standing reputation of sharp increases in short-term volatilities.
MONEY MARKET
Money market is for short term financial instruments, usually a day to less than a year. The most
common instrument is a “repo”, short for repurchase agreement. A repo is a contract in which the
seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price.
Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also
considered as money market instruments.
Since the tenure of the money market instruments is very short, they are generally considered
safe. In fact they are also called cash instruments. Repos especially, since they are backed by a
Govt. security, are considered virtually the safest instrument. Therefore the interest rates on
repos are the lowest among all financial instruments.
Money market instruments are typically used by banks, institutions and companies to park extra
cash for a short period or to meet the regulatory reserve requirements. For short-term cash
requirements, money market instruments are the best way to borrow.
Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, the
minimum investment in bond and money markets runs into hundreds of thousands of Rupees or
Dollars. Hence the money market participants are mostly banks, institutions, companies and the
central bank. There are no formal exchanges for money market instruments and most of the
trading takes place using proprietary systems or shared trading platforms connecting the
participants.
Typically the government designates one or more agencies as regulator(s) and supervisor(s) for
the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the
US has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules
and norms for each activity and each category of participant. For example,
• Eligibility norms for a company to be allowed to issue stock or bonds,
• Rules regarding the amount of information that must be made
available to prospective investors,
• Rules regarding the issue process,
• Rules regarding periodic declaration of financial statements, etc.
Regulators also monitor the capital market activity continuously to ensure that any breach of laws
or rules does not go unnoticed. To help this function, all members and issuers have to submit
certain periodic reports to the regulator disclosing all relevant details on the transactions
undertaken.
Trading Systems
The volume of transactions in capital markets demands advanced systems to ensure speed and
reliability. Due to proliferation of Internet technology, the trading systems are also now accessible
online allowing even more participants from any part of the world to transact, helping to increase
efficiency and liquidity. The trading systems can be divided into front-end order entry and back-
end order processing systems.
Order entry systems also offer functions such as order tracking, calculation of profit and loss
based on real-time price movements and various tools to calculate and display risk to the value of
investments due to price movement and other factors.
Back-office systems validate orders, route them to the exchange(s), receive messages and
notifications from the exchanges, interface with external agencies such as clearing firm, generate
management, investor and compliance reports, keep track of member account balances etc.
Exchange systems
The core exchange system is the trading platform that accepts orders from members, displays
the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as
possible and sends status messages and trade notifications to the parties involved in each trade.
In addition, exchanges need systems to monitor the transactions, generate reports on
transactions, keep track of member accounts, etc.
Accounting Systems
The accounting systems take care of present value calculations, profit & loss etc.- of investments
and funds and not the financial accounts of the firms.
SUMMARY
• Financial markets facilitate financial transactions, i.e. exchange of
financial assets such stocks, bonds, etc.
• Financial markets bring buyers and sellers in a financial instrument
together, thus reducing transaction costs, channeling funds,
improving liquidity and provide a transparent price discovery
mechanism.
• Each financial market is segmented into a Primary market, where
new instruments are issued and a Secondary market, where the
previously issued instruments are bought and sold by investors.
• Stock markets, bond markets, money markets, foreign exchange
markets and derivatives markets are prominent examples of financial
markets.
• Shares (stock) of a company are issued and traded in the stock
markets.
• Bond markets are where bonds such as treasury bonds, treasury
notes, corporate bonds, etc. are traded.
• Money markets, like bonds markets, are also fixed income markets.
Instruments traded in money markets have very short tenure.
• Foreign exchange markets trade in currencies.
• Derivatives markets trade derivatives, which are complex financial
instruments, whose returns are based upon the returns from some
other financial asset called as the underlying asset.
• Price of any financial instrument depends basically on demand and
supply, which in turn depend upon multiple different factors for
different markets.
• Each financial instrument has a differing level of inherent risk
associated with it. Money market instruments are considered the
safest due to their very short tenure.
• Regulators play a very important role in the development and viability
of financial markets. Regulators try to ensure that the markets
function in a smooth, transparent manner, that there is sufficient and
timely disclosure of information, that the interest of small investors is
not compromised by the large investors, and so on, which is critical
for overall vibrancy, efficiency and growth of the market and the
economy.
2. BANKING
INTRODUCTION TO BANKING
WHAT IS A BANK?
The term ‘Bank’ is used generically to refer to any financial institution that is licensed to accept
deposits and issue credit through loans.
Banks are the backbone of any economy, as all monetary transactions end up touching banks.
The main functions of banks are to:
• Channelize Savings
• Provide credit facilities to borrower
• Provide investment avenues to investors
• Facilitate the trade and commerce dealings
• Provide financial backbone to support economic growth of the
country
• Minimize Cash Transactions
• Provide Services
• Ensuring that sufficient funds are available for long term investment
to businesses as well as government, without causing inflation to rise
• Providing certain financial services to the government, the public,
financial institutions, and foreign official institutions
• Monitoring the foreign currency assets and liabilities and monitoring
the inflow and outflow of foreign currency
UNIVERSAL BANKING
The universal banking concept permits banks to provide commercial bank services, as well as
investment bank services at the same time.
Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities
businesses in US. That act was intended to address the perceived causes of bank failures during
the Great Depression of 1929.
Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear
that promoting stability and best practices cannot be done through artificially separating these
business areas. Over the years, banks and securities firms have been forced to find various
loopholes in the Glass-Steagall barriers. The restrictions undermined the ability of American
banks to compete with the other global banks which were not covered by such legislation.
Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to
offer a full range of commercial and investment banking services to their customers.
Example
In the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s restrictions,
the investment and commercial banking industries witnessed an abundance of commercial
banking firms making forays into the I-banking world. The mania reached a height in the
spring of 1998. In 1998, NationsBank bought Montgomery Securities, Société Génerale
bought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of
America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought
Bankers Trust (which had bought Alex. Brown months before), and Citigroup was created in a
merger of Travelers Insurance and Citibank.
While some commercial banks have chosen to add I-banking capabilities through acquisitions,
some have tried to build their own investment banking business. J.P. Morgan stands as the
best example of a commercial bank that has entered the I-banking world through internal
growth. J.P. Morgan actually used to be both a securities firm and a commercial bank until
federal regulators forced the company to separate the divisions. The split resulted in J.P.
Morgan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan
has slowly and steadily clawed its way back into the securities business, and Morgan Stanley
has merged with Dean Witter to create one of the biggest I-banks on the Street.
SUMMARY
• Banks are an integral part of any economy channelizing savings from
lenders to borrowers
• Bank deposits are low risk investments
• The Central bank is the “Bankers’ Bank” and it regulates other banks
in an economy.
• Central banks define a nation’s monetary policy
• A bank makes a profit by investing or lending money that is earning a
higher rate of interest than it pays to its depositors.
• A bank is required to keep a certain amount of "cash reserves" by
regulation to maintain liquidity, i.e. to ensure that the banking system
does not face a cash crunch due to higher withdrawals, which can
lead to panic among investors and a run on a bank.
• Banks create a “Money Multiplier” effect
• Banks are generally organized as corporate banking, investment
banking, retail banking, and private banking functions.
Universal banks provide commercial banking as well as investment
bank services under one roof
RETAIL BANKING
RETAIL SERVICE
Banking Accounts
Banking account can classified as below based on their features, cost and usefulness.
Checking Accounts
• Quick, convenient and, frequent-access to the money.
• Checks are used to withdraw money, pay bills, purchasing, transfer
money to another accounts and many other common usage.
• Some banks pay interest while many do not.
• Institutions may impose fees on checking accounts, besides a
charge for the checks ordered. Any combination of the following
three ways can be used by the banks:
o Flat fee regardless of the balance maintained or number of transactions.
o Additional fee if average balance goes down below a specified amount.
o A fee for every transaction conducted.
Savings Account
• Allows making withdrawals, but checks writing facility is not there.
• Number of withdrawals or transfers one can make on the account
each month is limited.
• Passbook savings – The pass book must be presented when you
make deposits and withdrawals
• Statement savings – Institution regularly mails a statement that
shows withdrawals and deposits for the account.
• Institutions may assess various fees on savings accounts, such as
minimum balance fees.
Time Deposits (Certificates of Deposit)
Branch Banking
o Sales and customer service Operations - Tasks, such as new account opening,
account maintenance and product sales
Teller Operations
• Teller functionality
o Cash advances
o Consumer /mortgage loan payments
o Currency and coin orders
o Deposits, including commercial deposits
o Fee collection
o Foreign currency exchange
o Payments
o Stop payments
o Transfers
o Wire transfers
o Withdrawals
ATM Systems
Shared/Regional National/International
Proprietary Systems
Systems Systems
Money Transfer
• Cheques/Checks
o Bearer Checks
o Account Payee Checks
o Travelers’ Checks
o Bankers Checks
• Debit Cards
• Demand Drafts
• Automated Clearing House (ACH)
• Standing Instructions
• Electronic Transfer
ELECTRONIC BANKING
Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic
technology as a substitute for checks and other paper transactions. EFTs are initiated through
devices like ATM cards or codes that let one to access your account. Many financial institutions
use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose. 7
The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
transactions. The Act does not cover “stored value” cards like prepaid telephone cards, mass
transit passes, and some gift cards. These "stored-value" cards, as well as transactions using
them, may not be covered by the EFT Act.
Direct Deposit
Customers can authorize specific deposits, such as paychecks and Social Security checks, to
their account on a regular basis.
Pay-by-Phone Systems
They let customers call their financial institution with instructions to pay certain bills or to transfer
funds between accounts. For such transactions, customers need to have an explicit agreement
with their banks.
7
Excerpted from Federal Trade Commission website http://www.ftc.gov
Point-of-Sale Transfers
Customers can pay for their purchases with a debit card, which also may also double up as the
ATM card. Debit card purchase transfers money - fairly quickly - from the customer’s bank
account to the store's account. So the customer should have the required funds in his/her account
before the use of debit card.
EFT REGULATIONS
Disclosures
The documents (usually fine print) supplied by the issuer of the “access device” cover the legal
rights and responsibilities regarding an EFT account. Before using EFT services, the institution
must tell the customer the following information:
• A summary of customer’s liability for unauthorized transfers.
• The telephone number and address of the person to be notified in
the event of an unauthorized transfer, a list of the institution's
"business days", and the number of days to report suspected
unauthorized transfers.
• The type of transfers, fees for transfers, and any limits on the
frequency and dollar amount of transfers.
• A summary of right to receive documentation of transfers, to stop
payment on a pre-authorized transfer, and the procedures to follow
to stop payment.
• Procedures to report an error on a receipt for an EFT or periodic
statement and to request more information about a transfer listed on
the statement, and the number of days to report.
• A summary of the institution's liability if it fails to make or stop certain
transactions.
• Circumstances under which the institution will disclose information to
third parties concerning customer’s account.
• Charges for using ATMs where the customer does not have an
account.
No terminal receipts would be issued for regularly occurring electronic payments that are pre-
authorized, like insurance premiums, mortgages, or utility bills. Instead, these transfers will
appear on your periodic statement.
Customers are also entitled to a periodic statement for each statement cycle in which an
electronic transfer is made. The statement must show the amount of any transfer, the date of
credit or debit to their account, the type of transfer and type of account(s) to or from which funds
were transferred, and the address and telephone number for inquiries.
Errors
Customers have 60 days from the date a statement is received to notify errors to the bank. The
best way is to notify the financial institution by way of a certified letter, return receipt requested.
Under US federal law, the institution has no obligation to conduct an investigation if the customer
missed out the 60-day deadline.
The financial institution has 10 business days to investigate the error. The institution has to
communicate the results of its investigation within three business days after completion and must
correct the error within one business day after detecting the error. If the institution needs more
time, it may take up to 45 days to complete the investigation - but only if the money in dispute is
returned to the customer’s account with due notification of the credit. At the end of the
investigation, if no error has been found, the institution may take the money back after sending a
written explanation.
Introduction
Electronic Billing Presentation and Payment (EBPP) is the use of electronic means, such as email
or a short message, for rending a bill.
Advantages
The advantage of EBPP over traditional means is primarily the savings to the operator in terms of
the cost to produce, distribute, and collect bills.
EBPP may be used in lieu of a standard paper bill as a means to reduce operational costs. Some
operators may view EBPP as an alternative to prepay as some operators view prepay service
strictly as an alternative to traditional billing, but it usually has most value as an alternative
mechanism for billing post-paid customers. However, EBPP can also be used simply as an
informational tool to inform the customer of charges levied against the account.
EBPP is an efficient mechanism to bill or inform third parties of charges. For example, the father
of a son in college may want to know how much the child is spending on mobile phone service
prior to the bill becoming to high.
Some EBPP systems require software for payment while others require only standard browser
software for accesses a web site for secure payment. Alternatively, the billing arrangement can
be made in advance for funds to be automatically debited from a customer’s account with a
financial institution. However, the more attractive model for most will be to have control over when
the bill is actually paid, rather than have it be paid at a predetermined date.
Future of EBPP
FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and more than 9,000 on-line and off-line depository institutions and thus
plays a key role in US payments mechanism. The system is available on-line depository
institutions with computers or terminals that communicate directly with the Fedwire network.
These users originate over 99 percent of total funds transfers. The remaining customers have off-
line access to Fedwire for a limited number of transactions.
Fedwire transfers U.S. government and agency securities in book-entry form. It plays a significant
role in the conduct of monetary policy and the government securities market by increasing the
efficiency of Federal Reserve open market operations and helping to keep the market for
government securities liquid.
Depository institutions use Fedwire mainly to move balances to correspondent banks and to send
funds to other institutions on behalf of customers. Transfers on behalf of bank customers include
funds used in the purchase or sale of government securities, deposits, and other large, time-
sensitive payments.
Fedwire and CHIPS, a private-sector funds transfer network specializing in international
transactions, handle most large-dollar transfers. In 2000, some 108 million funds transfers with a
total value of $380 trillion were made over Fedwire -- an average of $3.5 million per transaction.
All Fedwire transfers are completed on the day they are initiated, generally in a matter of minutes.
They are guaranteed to be final by the Fed as soon as the receiving institution is notified of the
credit to its account.
Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks.
However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required the
pricing of Fed services, including funds and securities transfers, and gave nonmember depository
institutions direct access to the transfer system. To encourage private-sector competition, the law
requires the Fed's fees to reflect the full cost of providing the services, including an implicit cost
for capital and profitability.
In addition to Fedwire, the Federal Reserve Banks provide net settlement services for participants
in private-sector payments systems, such as check clearing houses, automated clearing house
associations (ACH), and private electronic funds transfer systems that normally process a large
number of transactions among member institutions. Net settlement involves posting net debit
and net credit entries provided by such organizations to the accounts that the appropriate
depository institutions maintain at the Federal Reserve.
An automated clearing house processes and delivers electronic debit and credit payments among
participants.
SUMMARY
•Retail banking is banking services provided for individuals. Common
services include –
o Branch Banking
o Customer Care
o Teller Services
o Deposit and Loan Products
o Online Banking
o Financial Advisory
• ATM banking has become increasingly popular over the last few
decades
• There are many types of Banking Accounts
o Checking Accounts
o Money Market Deposit Accounts
o Savings Account
o Time Deposits (Certificates of Deposit)
o Basic or No Frill Banking Accounts
• Electronic banking, also known as electronic fund transfer (EFT),
uses computer and electronic technology as a substitute for checks
and other paper transactions.
• EFT’s are initiated through devices like ATM cards or codes that let
one to access your account. Many financial institutions use ATM or
debit cards and Personal Identification Numbers (PINs) for this
purpose.
• The federal Electronic Fund Transfer Act (EFT Act) covers most (not
all) electronic customer transactions.
• EFT offers the following services to the customers:
o Automated Teller Machines (ATMs)
o Direct Deposit
o Direct Debits/Electronic Bills Presentment
o Pay-by-Phone Systems
o Personal Computer Banking
o Point-of-Sale Transfers
o Electronic Check Conversion
• EBPP is an upcoming mode of transaction involving the use of
electronic means, such as email or a short message, for rending a
bill.
• FedWire is an electronic transfer system developed and maintained
by the Federal Reserve System. The system connects Federal
Reserve Banks and Branches, the Treasury and other government
agencies, and depository institutions and thus plays a key role in US
payments mechanism
• Clearing House Interbank Payment System (CHIPS) is a private
sector funds transfer network mainly for international transactions.
CHIPS transfers are settled on a net basis at the end of the day,
RETAIL LENDING
Retail Lending is one of the most important functions performed by a bank. It encompasses the
following:
• Personal loans, consumer loans
• Asset based loans - auto loans, home loans
• Open ended loans
• Lease, Hire Purchase
• Credit cards
Open ended loan allow the borrower to borrow additional amount subject to the maximum amount
less then a set value.
• Similar to overdraft facilities provided by banks.
• Interest is calculated on the daily outstanding balance.
• Usually a card (similar to a Credit Card) is issued by the lending
institution.
• The lending institution has tie-ups with various merchant
establishments.
• Also allow you to withdraw Cash.
• Important Terms;
c. Limit (L) – max outstanding allowed
d. Margin (M) – percentage of limit that can be drawn
e. Asset value (AV) – value of underlying asset
f. Drawing Power (DP) - lower of L and (1-M)*AV
• Example:
Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000
Lease
• Two main types – operating, financial
• The Financier owns the asset.
• Depreciation is claimed by the financier.
• Tax deduction can be claimed for the full value of the rental paid.
• Financier takes care of maintenance, insurance etc.
Hire Purchase
• The asset is owned by the financier.
Interest Rates
Fixed Rate of Interest
The rate of interest applicable is guaranteed not to change during the fixed rate period. Borrower
& bank protected from adverse interest rate movements.
Collateral
An asset than can be repossessed by the lender if the borrower defaults. They are of the
following types
• Primary (same asset for which finance is taken)
• Secondary (asset backing the loan different)
Charge Types
• Pledge – gold, bank has possession
• Hypothecation – vehicle, borrower has possession
• Lien – against bank deposits
• Assignment – insurance policies, rights get transferred to bank
• Shares - periodic drawing power calculation
• Mortgage – immovable property
MORTGAGES
A loan secured by the collateral of some specified real estate property that obliges the borrower
to make a predetermined series of payments. If the borrower doesn’t keep up the loan
repayments, the lender can repossess the real estate property and sell it in order to get the
money back.
The rate of interest applicable is lower than personal loans and comparable to other asset based
loans.
To compare the cost of different Mortgages deals one should look at the APR – Annual
Percentage Rates. All firms that quote an APR must calculate it in a standard way, so one can
compare like with like. The APR for a loan is a single figure, which takes into account:
• The amount of interest you are charged
Kinds of Mortgages
Mortgages can be classified based on the interest rates deals:
Standard variable The payments go up and down as the mortgage rate changes.
rate
The payments are set at a certain level for a set period of time – for
example, one year, two years, or five years. At the end of the period,
Fixed interest rate
one is usually charged the lender’s standard variable rate (or
sometimes a new fixed rate is offered).
The payments are variable, but they are set at less than that lender’s
Discounted interest
going rate for a fixed period of time. At the end of the period, one is
rate
charged the lender’s standard variable rate.
The payments go up and down as the mortgage rate changes but are
guaranteed not to go above a set level (the ‘cap’) during the period of
the deal.
Capped rate
Sometimes, they cannot fall below a set minimum level either (the
‘collar’ or ‘floor’). At the end of the period, one is charged the lender’s
standard variable rate.
Repayment Methods
Repayment mortgage
• Monthly payments over the agreed number of years (Called the
mortgage ‘term’) goes partly towards the interest and partly towards
the principal.
• If all the monthly payments agreed with the lender are made, the
whole loan will be repaid by the end of the term.
• Monthly payments could increase if interest rates rise.
Interest-only mortgage
• The monthly payments to the lender cover only the interest on the
loan. They do not pay off any amount one has borrowed.
• One usually makes separate payments into a savings scheme each
month to build up a lump sum, which is then used to pay off the
whole amount one has borrowed, in one go at the end of the
mortgage term or sooner.
• This involves some investment risk in building up a sum of money to
repay the loan.
• It is one’s responsibility to save enough money to repay the loan at
the end of its term.
Endowment mortgage
AUTO LOANS
Auto Loans is basically lending to the individual customers for a two or four wheeler or their
personal use. The following section describes the multiple mechanisms by which the financing for
auto loans is normally done.
STUDENT LOANS
Student Loans are Loans availed by eligible students to pursue graduate and post graduate
studies in US Schools/Colleges/Universities. These loans are usually provided by banks, Credit
Unions and other financial institutions which are guaranteed by state sponsored Guarantors
Types of Student Loans
Students Loans offered can be categorized broadly into two types:
SUMMARY
• The loans given to retail customer come under Consumer Lending.
There are four major types of Consumer Lending –
o Personal loans
o Mortgages
o Auto Loans
o Student Loans
• Personal loans normally have the highest interest rates charge while
mortgages have the lowest.
• Retail lending cycle includes -
o Loan application management and processing
o Loan repayments and termination
o Delinquencies identification and collections
CORPORATE LENDING
CORPORATE LENDING
Corporate Lending refers to various forms of loans extended by banks to corporate bodies like
proprietorship, partnership, private limited companies or public limited companies. Banks lend to
such entities on the strength of their balance sheet and business cash flows. Corporate loans are
provided by banks for various purposes like new projects, capacity expansion or plant
modernization, daily cash flow requirements (working capital) etc. Depending on the nature of the
requirement, loans may be long-term or short-term in nature.
Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate
defaults on payment of principal or interest on the loan, the bank can take possession of the
security and sell off the same to meet principal or interest payment on the loan. Security is usually
in the form of land, buildings, plant and machinery, physical stock of the raw material, goods for
sale etc.
Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if
also payable on the committed amount of the loan. Also, in most cases, the corporate would have
to pay a certain amount as processing fees for the loan. This would cover the bank’s overhead
costs in the loan process.
Credit enhancements
Credit enhancement is a mechanism used to increase the original rating of a loan for a corporate.
Credit enhancements can be in the form of pledge of shares, cash collateral, corporate or bank
guarantees etc.
Example:
A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the
loan rating and thus reduce interest payable on the loan, the promoters pledges their share
holding in the company with the bank. Thus, whenever there is a default on repayment of the
loan, the bank has the right to sell the shares in the market. Based on the historic volatility of the
shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan to
BBB+.
TYPES OF LOANS
Term loans
These loans can either be short term loans or long term loans.
Long-term loans are extended for purposes like new projects, capacity expansion or plant
modernization. These loans are usually repayable over a 2-7 year period after an initial
moratorium period (period during which loan repayments are not required) to help the corporate
complete implementation of the project before revenue generation takes place.
Example
On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding
their IT modernization project across the nation. The loan is repayable in 16 quarterly
installments starting April 15, 2005, after an initial moratorium of 4 quarters. The interest
payable would be LIBOR+0.5% payable quarterly. The loans would be secured by AT&T
equipment at their HQ, worth USD 300 mn.
Short term loans are extended usually for meeting working capital requirements. The loans can
be repayable in various tenures starting from a week to as long as 1 year. The loans are either
repayable in fixed installments or in one bullet installment at the end of the period. In some cases,
short term loans are backed by promissory notes which are legal instruments that guarantee
payment of a certain amount on a specified due date.
Corporate bonds
Corporate bonds are used for the same purpose as term loans, but the loan is backed by a
transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who
receives the right to get payments from the corporate. Bonds are rated depending on the rating of
the corporate and depending on the rating, the market demands varying amounts of interest. A
certain class of bonds called junk bonds is issued by corporates with very low credit ratings and
carries very high rates of interest.
Working Capital
For any business, there would be current assets in the form of cash, receivables, raw material
inventory, goods for sale inventory etc while there would be current liabilities in the form of
payables and other short term liabilities. Part of the current assets would be funded through
current liabilities while the rest would have to be funded through a mixture of short term and long
term loans. As per norms, 25% of the working capital gap would have to be funded by long term
sources like equity or term loans while the rest 75% can be funded through short term loans and
overdraft limits.
Banks conduct a detailed assessment of the current assets and liabilities for a corporate and
arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include
only receivables which are less than 6 months old. Also within the specified limit, banks keep
reviewing the current asset and current liability position of a company to arrive at the drawing
power for each month. Corporates are allowed to borrow up to the working capital limit or the
drawing power, whichever is lower.
Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of the
business. The bank makes available a certain sum of money for a period of time (say, USD 20.0
million for a period of 1 year). There would be a separate account called the overdraft account
created to monitor withdrawals under this loan. Whenever the corporate has a deficit in its main
business account, it can draw money from the overdraft account (up to the limit of USD 20.0
million). It can also put back money in the overdraft account as and when they have surpluses in
the business account. Interest is calculated by the bank on the various end-of-day deficits in the
overdraft account and is usually payable by the corporate at the end of every month.
Lines of credit
These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw
the loan as and when required within the validity period and repay the loan after a certain period
(repayment period). Interest is either repayable in certain intervals or in one bullet installment at
the end of the repayment period. In many cases, the lines of credit are of a revolving nature. The
same is explained via the example provided below:
Example
Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within
the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative
outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with
interest at the end of 30 days from the date of borrowal. Since AT&T can thus ‘revolve’ the limit
any number of times within the specified limit and validity period, these are called revolving lines
of credit.
Bill discounting
Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial
instrument by which one party promises to pay the other party a certain amount of money on a
specified due date. This is transferable and the final holder of the bill holds the right to receive the
payment from the concerned party. The corporate would have bills of exchange which are drawn
on their dealers, which entitle the corporate to receive certain amounts of money from the dealer
after a pre-defined credit period. The corporate can then transfer the bill to the bank and get a
discounted amount upfront. The bank collects the interest on the bill amount for the specified
period upfront in this process called bill discounting. On the due date, the bank collects the
payment from the concerned party directly.
Commercial Paper
Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows
money from banks for short periods of time. A CP binds the corporate to make a payment equal
to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like
a short term unsecured loan. However, a CP is tradable in the market – the bank can sell the CP
to a third party. For this reason, banks charge lesser interest on CPs than normal short term
loans. However, since CPs are unsecured and are to be tradable in the market, banks provide CP
lending to only highly rated corporates.
Leasing
Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment,
or other fixed assets on behalf of the corporate and grants use of the same for a specified time to
the corporate in exchange for payment, usually in the form of rent. The owner of the leased
property is called the lessor, the user the lessee. Lease payments (which include principal and
interest payments usually) can be shown by corporates as operating expenses and hence leases
are used by some corporates as a substitute for loans to get better tax benefits.
Example
Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from
future monthly sale of oil explored from its specified offshore rig. In this case, there would be a
mechanism to ensure that money from monthly sale of oil explored from the specified rig for the
period of the loan would be used to service payment of interest and principal of the loan to
Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices and
ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch Shell.
Loan commitments are generally classified as accrual and recorded off-balance sheet.
CREDIT DERIVATIVES
Credit derivatives are financial contracts that transfer credit risk from one party to another,
facilitating greater efficiency in the pricing and distribution of credit risk among market players.
Example
The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer
whereby he will make periodic payments to the dealer in exchange for a lump sum payment in the
event of default by XYZ Corp. during the term of the derivatives contract. As a result of such a
contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer. In
market parlance, the corporate bond investor in this example is the buyer of protection, the dealer
is the protection seller, and the issuer of the corporate bond is called the reference entity.
Credit derivatives can be used to create positions that can otherwise not easily be established in
the cash market. For instance, consider an investor who has a negative view on the future
prospects of a given corporation. One strategy for such an investor would be to short the bonds
issued by the corporation, but the corporate repo market for taking short positions in corporates is
not well developed. Instead, the investor can buy protection by way of credit default swap. If the
corporation defaults, the investor is able to buy the defaulted debt for its recovery value in the
open market and sell it to its credit derivatives counterparty for its face value.
Banks use credit derivatives both to diversify their credit risk exposures and to free up capital
from regulatory constraints. As an example, consider a bank that wants to diminish its exposure
to a given client, but does not want to incur the costs of transferring loans made to that client to
another bank. The bank can, without having to notify its client, buy protection against default by
the client in the credit derivatives market: Even though the loans remain on the bank's books, the
associated credit risk has been transferred to the bank's counterparty in the credit derivative
Example
contract.
The above example can also be used to illustrate banks' usage of credit derivatives to reduce
Let us visualize a bank, say Bank A which has specialized itself in lending to the office
their regulatory capital requirements. Under current Basle standards, for a corporate borrower,
equipment segment. Out of experience of years, this bank has acquired a specialized
the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve.
knowledge of the equipment industry. There is another bank, Bank B, which is, say,
However, if its credit derivatives counterparty happens to be a bank located in an OECD country,
specialized in the cotton textiles industry. Both these banks are specialized in their own
and the bank can demonstrate that the credit risk associated with the loans has been effectively
segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in the
transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to
office equipment segment and bank B is focused on the textiles segment. Understandably,
1.6 percent.
both the banks should diversify their portfolios to be safer.
One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say
textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office
equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know
enough of the textiles segment as bank A does not know anything of the office equipment
segment.
Here, credit derivatives offer an easy solution: both the banks, without transferring their
Business or
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portfolio concentration, could buy into the risks of each of 209
other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a fee.
Both continue to hold their portfolios, but both are now diversified. Both have diversified their
Foundation Course in Banking
TREASURY SERVICES
The Treasury Services department is concerned with managing the financial risks of the
bank. Hence, the treasurer's job is to understand the nature of these risks, the way they interact
with the business, and to minimize or to offset them. In many cases, the treasury services
department also provides cash management solutions for customers of the bank. The Treasury
services department of a bank performs the following functions:
• Managing the cash position of the bank, managing liquidity and
associated risks
• Forex services: provides forex services to corporates, enters in to
deals with multiple counterparties to maintain a risk-managed
position for the bank.
• Risk management services: provides risk management products like
swaps, options etc to corporates and enters in to multiple deals with
various counterparties to maintain a risk-managed position for the
bank.
• Conducts research on various market factors, monitors interest rate
and economic scenario etc
• Cash Management services for corporates – managing collections
and payments
Typically, the treasury has a front office desk which enters in to trades (in forex, money markets,
equity, treasury securities etc) with various market participants and a middle office/back office
desk which monitors positions and provides operational support.
Most large investment banks provide Treasury Services to their clients. Treasury domain
includes
• Fixed Income : An investment that provides a return in the form of
fixed periodic payments and eventual return of principle at maturity.
Unlike a variable-income security where payments change based on
some underlying measure, such as short-term interest rates, fixed-
income securities payments are known in advance.
• Money Markets : The money market is a subsection of the fixed
income market. The difference between the money market and the
fixed income market is that the money market specializes in very
short-term debt securities (debt that matures in less than one year).
Money market investments are also called cash investments
because of their short maturities. Some of the popular money
market instruments include Certificates of Deposit (CD), Commercial
Paper (CP), Treasury Bills (T-Bills)
• Foreign Exchange : The market for buying and selling of currencies
is called the Foreign Exchange market (FX ). It is a 24 hour non-stop
market. Some of the major Currency traded include – The US
Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great
Britain Pound (GBP), The Swiss Frank (CHF). FX rates express the
value of one currency in terms of another currency. They involve
o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of
currency.
o The terms currency - the currency used to express the price of the commodity, in
varying amounts of
o Interest rate – Risk due to volatility of interest rates. A bank may have borrowed at
floating rates of interest and lent at fixed rate of interest and the interest rates moves up
o Currency – Risk due to volatility in exchange rates. A bank may have its payment
obligations in a currency say USD and the rate to purchase the said currency goes up
• Commodity – Risk due to volatility in commodity prices. A bank may
have an obligation to deliver a commodity in the future and the price
of the commodity moves up
• Cash Management Services - CMS is a service provided by banks to
its corporate clients for a fee to reduce the float on collections and to
ease the bulk payment transactions of the client. The three elements
of CMS are:
o Receivables Management –Helps the company to manage collection of its sale proceeds
from remote upcountry regions
o Payables Management – Helps the company to manage its payments to its regular
suppliers without keeping numerous bank accounts for various locations and then
reconciles them periodically in a highly manual / paper-based environment
o Liquidity Management – Helps the company by ensuring direct and instant access to its
bank accounts. It should not happen that a company has excess funds in one bank
account and it needs to pay through another bank account where there are no funds
• Managing Liquidity & Interest Rate risks
o Asset Liability Management – A bank’s assets and liabilities need to necessarily match.
If they don’t the bank may have liquidity problems which would endanger its solvency.
The long term assets should not be financed by short term sources of funds. The bank
would not be able to serve its lenders if the timings of its inflows do not match its
outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find out
mismatches and take corrective actions
Example
For simplicity, assume interest rates are annually compounded and all interest accumulates to the
maturity of the respective obligations. The net transaction appears profitable—the bank is earning
a 20 basis point spread—but it entails considerable risk.
At the end of one year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. Assume interest rates are at 4.00% at the end of the first year.
• The Bank will now have to pay a higher rate of interest (4.00%) on the new financing than the
fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying
4.00% on its financing.
The problem in this simple example was caused by a maturity mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to asset-
liability mismatches are small or trivial. However, in a period of volatile interest rates, the
mismatches would become serious.
The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks
have ALM committees comprised of senior managers to address the risk. Techniques for
assessing asset-liability risk came to include gap analysis, duration analysis and scenario
analysis. Gap analysis looks at amount of assets and liabilities in various maturity buckets
while Duration analysis looks at weighted average maturity of cash flows to compare
assets and liabilities. Since liquidity management is closely linked to asset-liability
management, assessment and management of liquidity risk is also a function of ALM
departments and ALM committees. ALM strategies often include securitization, which allows firms
to directly address asset-liability risk by removing assets or liabilities from their balance sheets.
This not only eliminates asset-liability risk; it also frees up the balance sheet for new business.
• Yield curve risk: Yield curve risk arises when unanticipated shifts of
the yield curve (a plot of investment yields against maturity periods)
have adverse effects on a bank's income or underlying economic
value. Yield curves can shift parallel or change in steepness, posing
different risks. For instance, the underlying economic value of a long
position in 10-year government bonds hedged by a short position in
5-year government notes could decline sharply if the yield curve
steepens, even if the position is hedged against parallel movements
in the yield curve.
Foreign exchange is essentially about exchanging one currency for another. Forex rates between
two currencies at any point of time are influenced by a variety of factors like state of the economy,
interest rates & inflation rate, exchange rate systems (fixed/floating), temporary demand-supply
mismatches, foreign trade position etc.
Foreign exchange exposures for a financial entity arise from many different activities. A company
which borrows money in a foreign currency is at risk when the local currency depreciates vis-à-vis
the foreign currency. An exporter who sells its product in foreign currency has the risk that if the
value of that foreign currency falls then the revenues in the exporter's home currency will be
lower. An importer who buys goods priced in foreign currency has the risk that the foreign
currency will appreciate thereby making the cost in local currency greater than expected.
Generally the aim of foreign exchange risk management is to stabilise the cash flows and reduce
uncertainty from financial forecasts.
Since a bank is usually a counter party to the above transactions, it faces similar forex Risk when
the reverse happens.
Basics of forex
Currencies are quoted in one of the two ways:
• Direct Quotation (1 USD = INR 45.26) &
• Indirect Quotation (INR 100 = USD 2.21).
‘Direct’ or ‘Indirect’ are always vis-à-vis the US dollar perceptive. In practice, all currencies except
the British Pound are quoted in the direct quotation method. Since rates for all currencies are
quoted vis-à-vis the US dollar, cross currency rates (example: INR/Euro) would be obtained by
combining the two primary currency quotes vis-à-vis the US dollar.
Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase US dollars
against home currency in case of direct quotes) and the ask rate (rate at which the bank will sell
US dollars against home currency in case of direct quotes). The bid rate will always be lesser
than the ask rate to cover for operational charges and profit margins of the banks. Examples are:
• INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred
to as one ‘pip’)
• EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count,
referred to as one ‘pip’)
While the derived cross currency rate would be:
INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51
Foreign currency deals in a particular currency necessary have to be settled in the home nation of
the currency. Hence, banks taking part in international transactions need to maintain accounts in
various countries to enable transacting in those currencies. These accounts are of multiple types:
• Nostro (Our/my account with you): Current account maintained by
one bank with another bank abroad in the latter’s home currency
• Vostro (Their account with me/us): Current account maintained in the
home currency by one bank in the name of another bank based
abroad
Typically, banks have vostro/nostro accounts with multiple foreign banks.
The most basics tools of forex risk management are 'spot' and 'forward' contracts. These are
contracts between end users and financial institutions that specify the terms of an exchange of
two currencies. In any forex contract there are a number of variables that need to be agreed upon
and they are:
• The currencies to be bought and sold - in every contract there are
two currencies the one that is bought and the one that is sold
• The amount of currency to be bought or sold
• The date at which the contract matures
• The rate at which the exchange of currencies will occur
The exchange rates advertised either in the newspapers (and that mentioned above) or on the
various information services assume a deal with a maturity of two business days ahead - a deal
done on this basis is called a spot deal. In a spot transaction the currency that is bought will be
receivable in two days whilst the currency that is sold will be payable in two days. This applies to
all major currencies with the exception of the Canadian Dollar.
Most market participants want to exchange the currencies at a time other than two days in
advance but would like to know the rate of exchange now. This is done through a forward
contract to exchange the currencies at a specified exchange rate at a specified date. In
determining the rate of exchange in six months time there are two components:
• the current spot rate
• the forward rate adjustment
The spot rate is simply the current market rate as determined by supply and demand. The
forward rate adjustment is a slightly more complicated calculation that involves the interest rates
of the currencies involved.
Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest
rate), with interest rates adjusted for the period of the forward rate. The concept behind this
equation is that if you defer the value date of a spot transaction each party will have the funds
that they would have paid to invest. The difference between a forex spot rate and the forward rate
for a particular tenure is called the forward premium for that tenure. Currencies can have forward
premiums or forward discounts vis-à-vis the US dollar.
Forex risk can also be covered through forex future contracts. Futures are exactly similar to
forwards, except for the fact that these deals are brokered through an exchange, non-
customizable (only standard deals available) and hence, not prone to counter-party risk.
CASH MANAGEMENT
Cash Management Service (CMS) is a service provided by banks to its clients for a fee to
reduce the float on collections and to ease the bulk payment transactions of the client. Large
Corporations like GM or Ford need to manage cash well since they have:
• Payments to multiple parties at various locations – Payments need to
be made to suppliers across the country. Typically these have
suppliers across the country to reduce dependence on one or a few
suppliers
• Collections from multiple parties at various locations - How does a
company collect its sale proceeds from remote upcountry regions?
• Multiple banking accounts at various locations
o Ensure local deficits and surpluses are managed – A corporate may be paying its
employees salaries out of one bank account whereas it may be banking its receivables in
another bank account another location leading to surpluses and deficits in their bank
accounts
o Ensure net surplus is invested properly – If a corporate is unable to identify surpluses, a
corporate may risk keeping money idle leading to loss of interest income if it does not
prudently invest its net surpluses leading to
o Reduce operational costs associated with payments & collections – A CMS would help
optimize wasted operational cost on payments and collections
• Cash Management solutions help corporations:
o Devise an effective account & investment strategy to manage surpluses and deficits –
Pooling, Netting, Zero-balance structures
o Automate collections and payments process flows
o Outsource collections and payments administration & reconciliation
Example
Consider a consumer goods company in Mid-west US, with dealerships spread through 12 states.
The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio, Michigan,
Illinois and Texas. The company transports goods to the 4 depots which serves the respective
local dealers and in some cases dealers in neighboring states. All the depots are treated as
independent cost centers, with sales from respective regions and salaries and general expenses
for these regions marked to the depot concerned. Collections from dealers in various locations
are managed by local sales teams, one team for each state. The company wants to:
• Ensure daily monitoring of collections from various states
• Sweep all local collections daily to a central bank account at Michigan
• Ensure that local accounts do not remain in debit when the central account is in credit.
• Provide facility for temporary intra-day overdraft for the local accounts
• Ensure that surplus money in the central account is invested in an optimal fashion while
allowing sufficient liquidity
• All payments from local accounts above $10,000 require an approval from the CFO sitting in
Michigan
This is a typical case where the company needs the services of a bank to manage its cash
collections and payments. The company needs both cash management facilities and MIS of
collections and payments that can allow it to track revenue and expenses in the manner required.
Companies rarely fail because they are insolvent. They do fail because they are illiquid.
Companies must focus on precise working capital management as a critical component of
treasury strategy. Companies require:
• rich information, to parallel the company’s cash flow cycle
• global cash concentration, through pooling mechanisms
• automated internal funding mechanisms for deficit positions
• Investment options to match individual profiles for liquidity, risk and
return.
Collections Services
• Collect funds around the globe – CMS provides accurate and timely
collection of receivables worldwide
• Funds are credited to the cash management account
o Local collections – Refer to collections from suppliers / debtors who issue local cheques
o Outstation collections - Refer to collections from customers not in the base location of
the corporation
Banks have responded to the call for evolved cash management concepts. Accelerating accounts
receivable and streamlining accounts payable via a single banking system interface provide the
stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash
management with liquidity and investment offerings. They do so by:
• developing optimal account structures
• applying cash concentration techniques like pooling and sweeping
• providing investment vehicles to maximize cash flows
• implementing foreign exchange and interest rate exposure netting
systems
• Establishing regional treasury and shared service centers.
The final objective of most of these cash management solutions is to effectively outsource the
corporate’s receivables and payables process and ensure the best possible liquidity and short
term investment management strategy. Moreover, increasingly, cash management (both
payments and collections) are moving over to a web-based environment where the corporate can
manage his receivables, payables and liquidity position online. In many cases, there is almost-
complete integration between the bank and the company’s supply chain/ERP system which
manages collection and payments data internally. Some of the common methods used for cash
management are described below.
Cheque Collections – Lock Box service
There are possibilities for optimizing and streamlining a company’s incoming payment flows. The
most common collection mechanism is a Cheques lock box service – a collecting service which
enables companies to collect and settle cheques locally (In a typical case, each of the corporate’s
debtors would send cheques along with accepted invoices to a designated post box, hence the
lock box name). Banks undertake to collect cheques at various pre-defined locations on behalf of
the customer, send them for clearing and credit the amount s to a specified customer account.
Once the cheques are collected by the bank through person, courier or delivered by the company
representative:
• the cheques are sorted and batched
• post dated cheques are kept for processing on the value date
• the image of the cheques and the remittance advices are captured
and sent to the corporate
• cheques are sent for clearing, if required
• realized cheques are tallied and amounts credited to the corporate’s
bank account
• the information on cheques collected is transmitted to the corporate
for electronic reconciliation
In enhanced versions of this facility, the bank manage the receivable books of the corporate -
managing collections, monitoring receivables ageing and providing reconciled collection reports
which can be directly uploaded to corporate information/supply chain systems.
account. Thus the participating accounts will not bear any credit or debit interest, and all balances
are concentrated in the central account enabling optimal management of your cash position.
Netting
Netting is the fundamental method for centralising and offsetting intra company and third party
payments. Netting not only significantly reduces payment flows and costs, but also provides
invaluable management information. Banks offer both domestic and cross-border netting
solutions.
Clearing services
Banks offer clearing services to other banks. In such cases, a bank with strong local branch
coverage offers to participate in clearing arrangements on behalf of other banks with no physical
presence at these locations. Also clubbed under correspondent banking services, this facility
primarily helps use the branch networks of various banks on a complimentary basis.
Asset Securitisation
Financial institutions and banks need to raise fresh capital to fund continuous asset growth and
portfolio management. This has become a major challenge for many financial institutions and
banks due to tough capital market conditions and other market related factors. Asset
securitisation can offer an alternative cost efficient financing tool, enabling them to better manage
liquidity and funding requirements.
Asset securitisation transactions have one basic concept: the identification and isolation of a
separable pool of assets that generate revenue streams independently from the originating entity.
The securities issued on these assets are then sold to investors who base their returns
exclusively on the underlying assets’ performance. The structure is illustrated below:
All these entities need not be present in every transaction. The number of entities depends on the
complexity of the transaction. An example would help understand the concept better.
Example
Bank of America (Originator) has 5000 home loans totaling more than $600 million. The individual
loans are of various credit profiles and various repayment periods. Bank of America is
constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to
‘sell’ about 2000 home loans totaling $200 million. The steps followed are shown below:
• Bank of America conducts an internal study of the portfolio and ascertains that the average
maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It
realizes that historically 10% of the total home loan owners default. So it would only realize
$180 million instead of $200 million.
• Bank of America wants to enhance the rating so that it can ‘sell’ the loans at a better price. It
decides to provide a cash security of $10 million (Credit enhancement) in the scenario of any
repayment default by home loan borrowers.
• Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking
into account the cash security provided rates it AA+.
• Bank of America ‘sells’ the pool of housing loans amounting to $200 million to a independent
firm, Plexus SPV Ltd.
• Backed by these home loan’s future cash flows, Plexus SPV Ltd. issues debt certificates for
$200 million to investors. Plexus pays back the investors the money from the repayments
done by the home loan borrowers.
• Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to
cover operational costs.
• From now on, all EMI repayments on these home loans made by retail investors would flow
through Plexus SPV Ltd and then reaches the investors.
The above example captures the gist of any securitisation transaction, but there are a lot of
structuring issues and legal and regulatory challenges involved in any such transaction.
Fannie Mae and Ginnie Mae are examples of institutions specializing in securitisation
transactions of mortgage loans for US banks. They help US banks in having enough fresh funds
for home loan disbursements.
RTGS is a system provides online settlement of payments between financial institutions. In this
system payment instructions between banks are processed and settled individually and
continuously throughout the day. This is in contrast to net settlements where payment instructions
are processed throughout the day but inter-bank settlement takes place only afterwards typically
at the end of the day. Participant banks will have to maintain a dedicated RTGS settlement
account with the central bank for outward and inward RTGS payments.
RTGS systems do not create credit risk for the receiving participant because they settle each
payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because participants need
sufficient liquidity to cover their outgoing payments.
TRADE FINANCE
The main objective of trade finance is to facilitate transactions. There are many financing options
available to facilitate international trade such as pre-shipment finance to produce or purchase a
product, and post-shipment finance of the receivables.
Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a portion
of the face value of a trade bill drawn by the exporter, accepted by the buyer and endorsed to the
Bank.
In competitive supply situations, favorable terms of payment often ensure that the order is
won. An exporter usually wants to get paid as quickly as possible and an importer will want to pay
as late as possible – preferably after they have sold the goods. Trade finance is often required to
bridge these two disparate objectives.
Question
Pre-shipment finance is liquidated only through realizations of export bills or amounts received
through export incentives. Pre shipment finance should not normally remain outstanding
beyond the original stipulated shipment date. In case it remains outstanding, can the non-
adjusted amount be then transferred as post shipment finance?
BILL OF LADING
A bill of lading or BOL is:
• A contract between a carrier and a shipper for the transportation of
goods.
• A receipt issued by a carrier to a shipper for goods received for
transportation.
• Evidence of title to the goods in case of a dispute.
The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind a
shipper even if it meant that the shipper's goods could be detained and sold by the sub-
contractor.
CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his representative,
performs ‘due diligence’ or a reasonable assessment of the risks posed by the potential buyer.
The sources of information include:
• Chambers of commerce, Business Bureaus or their equivalents
• Credit rating services such as TRW and Dun & Bradstreet which
have international affiliates
• Trade associations and trade promotion organizations
• Freight forwarders, brokers, and banks
• Direct references from the buyer
PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment method can be
selected. The most common payment methods are described below:
• Cash in advance
• Letter of credit
• Documentary collection
• Open account or credit
• Counter-trade or Barter
CASH IN ADVANCE
Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is
usually a wire transfer or a check. Although an international wire transfer is more expensive, it is
often preferred because it is speedy and does not bear the danger of the check not being
honored. The check can be at a disadvantage if the exchange rate has changed significantly by
the time it arrives, clears and is credited. On the other hand, the check can make it easier to shop
for a better exchange rate between different financial institutions.
For wire transfers the seller must provide clear routing instructions in writing to the buyer or the
buyer’s agent. These include:
• Full name, address, telephone, and telex of the seller’s bank
• Bank’s SWIFT and/or ABA numbers
• Seller’s full name, address, telephone, type of bank account, and
account number.
Features
• The LC serves to evenly distribute risk between buyer and seller.
The seller is assured of payment when the conditions of the LC are
met and the buyer is reasonably assured of receiving the goods
ordered. This is a common form of payment, especially when the
contracting parties are unfamiliar with each other.
• Since banks deal with documents and not with products, they must
pay an LC if the documents are presented by the seller in full
compliance with the terms, even if the buyer never receives the
goods. Goods lost during shipment or embargoed are some
examples. Iraq for example, never received goods that were shipped
before its embargo but the LCs had to be paid anyway.
Disadvantages
• If there are discrepancies in the timing, documents or other
requirements of the LC the buyer can reject the shipment. A rejected
shipment means that the seller must quickly find a new buyer,
The mechanism
Usually, four parties are involved in any transaction using an LC:
1. Buyer or Applicant
The buyer applies to his bank for the issuance of an LC. If the buyer does not have a credit
arrangement with this issuing bank then he must pay in cash or other negotiable securities.
2. Issuing bank
The issuing or applicant’s bank issues the LC in favor of the beneficiary (Seller) and routes
the document to the beneficiary’s bank. The applicant’s bank later verifies that all the terms,
conditions, and documents comply with the LC, and pays the seller through his bank.
3. Beneficiary’s bank
The seller’s or beneficiary’s bank verifies that the LC is authentic and notifies the beneficiary.
It, or another trusted bank, can act as an advising bank. The advising bank is used as a
trusted bridge between the applicant’s bank and the beneficiary’s bank when they do not
have an active relationship. It also forwards the beneficiary’s proof of performance and
documentation back to the issuing bank. However, the advising bank has no liability for
payment of the LC. The beneficiary, or his bank, can ask an advising bank to confirm the LC.
The confirming bank charges a fee to ensure that the beneficiary is paid when he is in
compliance with the terms and conditions of the LC.
4. Beneficiary or Seller
The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.
Example
An Asian Buyer from a Swedish Exporting company stated when he convinced the
Exporter to sell to them on open account terms. The Asian Buyer obtained 60 days credit,
which was to be calculated from the date of the invoice. The value of the order was USD
100, 000 and the goods were dispatched and invoiced by the Swedish Exporter on the 15th
July 2003.
The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on
the 21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700
as it resulted in his account being overdrawn by this amount for 68 days at 9% per annum.
Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have incurred a
further cost in canceling or rearranging the forward contract. Letters of Credit provide real and
tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course if
the Asian buyer had not paid at all they would have lost the whole USD 100,000
The standby LC is like a bank guarantee. It is not used as the primary payment method but as a
fail safe method or guarantee for long-term projects. This LC promises payment only if the buyer
fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should
the buyer default, the seller must then apply to the bank for payment - a relatively simple process
without complicated documentation. Since the standby LC can remain valid for years (Evergreen
Clause) it eliminates the cost of separate LCs for each transaction with a regular client.
Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank
to open his own LC to buy inputs necessary to fill his buyer’s order.
DOCUMENTARY COLLECTION
The seller sends a draft for payment with the related shipping documents through bank channels
to the buyer’s bank. The bank releases the documents to the buyer upon receipt of payment or
promise of payment. The banks involved in facilitating this collection process have no
responsibility to pay the seller should the buyer default unless the draft bears the aval (ad
valutem) of the buyer’s bank. It is generally safer for exporters to require that bills of lading be
“made out to shipper’s order and endorsed in blank” to allow them and the banks more flexible
control of the merchandise.
Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon
receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new
buyer or pay for return shipment. Documentary collections are viable only for ocean shipments,
as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document
whereas the comparable airway bill is not negotiable as an ownership title.
Drafts
A draft (sometimes called a bill of exchange) is a written order by one party directing a second
party to pay a third party. Drafts are negotiable instruments that facilitate international payments
through respected intermediaries such as banks but do not involve the intermediaries in
guaranteeing performance. Such drafts offer more flexibility than LCs and are transferable from
one party to another. There are two basic types of drafts: sight drafts and time drafts.
Sight Draft
After making the shipment the seller sends a sight draft, through his bank to the buyer’s bank,
accompanied by agreed documentation such as the original bill of lading, invoice, certificate of
origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees it
and thereby receive the documentation that gives him ownership title to the goods that were
shipped. There are no guarantees made about the goods other than the information about
quantities, date of shipment, etc. which appears in the documentation. The buyer can refuse to
accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to a
destination without a buyer. There is no recourse with the banks since their responsibility ends
with the exchange of money for documents.
Example
HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied. Frequently,
trading partners will use a combination of payment methods. For example: the seller may require
that 50% payment be made in advance using a wire transfer and that the remaining 50% be
made by documentary collection and a sight draft.
OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one of the
most common methods of payment in international trade and many large companies will only buy
on open account. Payment is usually made by wire transfer or check. This can be a very risky
method for the seller, unless he has a long and favorable relationship with the buyer or the buyer
has an excellent credit rating. Still, there are no guarantees and collecting delinquent payments is
difficult and costly in foreign countries especially considering that this method utilizes few legally
binding documents. Contracts, invoices, and shipping documents will only be useful in securing
payment from a recalcitrant buyer when his country’s legal system recognizes them and allows
for reasonable settlement of such disputes.
Consignment
The consignment method requires that the seller ship the goods to the buyer, broker or distributor
but not receive payment until the goods are sold or transferred to another buyer. Sometimes even
the price is not pre-fixed and while the seller can verify market prices for the sale date or hire an
inspector to verify the standard and condition of the product, he ultimately has very little recourse.
Credit Card
Some banks offer buyers special lines of credit that are accessible via credit card to facilitate
even substantial purchases. It is convenient for both parties - but the seller should confirm the
bank charges and also bear in mind that the laws that govern domestic credit card transactions
differ from those govern international use.
Factoring
Factoring is a discounting method without recourse. It is an outright sale of export accounts
receivable to a third party, (the factor) who assumes the credit risk. The factor may be a factoring
house or a department of a bank. The advantage to the exporter is the removal of contingent
liabilities from its balance sheet, improved cash flow and elimination of bad debt risk.
Factoring is for short-term receivables (under 90 days) and is more related to receivables against
commodity sales.
Forfaiting
The exporter sells accounts receivables to a forfaiter on a “non-recourse discount” basis, and
the exporter effectively passes all risks associated with the foreign debt to the forfaiter. The
forfaiter may be a forfaiting house or a department of a bank. The benefits are same as factoring -
maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used in
short, medium and long-term contracts.
Forfaiting can be for receivables against which payments are due over a longer term, over 90
days and even up to 5 years.
Example
An Asian Importer wants to purchase machinery that he is unwilling or unable to pay for in
cash until that machinery begins to generate income.
At the same time, the exporter wants immediate payment in full in order to meet his on-going
business commitments
Forfaiting solution works as follows
1. Commercial contracts are negotiated subject to finance;
2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a series of
Promissory Notes or Bills of Exchange to be drawn in favour of the exporter which the
importer arranges to have guaranteed by his local bank;
3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount which
is then agreed;
4. The goods are shipped;
5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without recourse"
to the order of the discounting bank);
6. The discounting bank purchases the guaranteed notes or bills from the exporter at the
agreed rate.
Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his goods
and can pay for them in installments over time; and the forfaiter has title to an asset which
he may retain as an investment.
9
The above “International Payments Comparison Chart” is reproduced from US Department of
Agriculture website - www.ams.usda.gov/ Pub.
CREDIT CARDS
The U.S. payments industry has undergone a significant shift in recent years. Check usage is
declining while the adoption of electronic payment forms is growing. During calendar year 2003,
44.5 billion electronic payments were originated in the United States with a value of $27.4 trillion.
This represents a CAGR of 3.8% since 2000, which is twice the real GDP growth (1.9%).
Non-cash Payment instruments in the US can be classified as follows:
Check-based Payments
Until recently, checks were the most used payment instrument in the US. Towards the end of
2004, Cards-based payment instruments have overtaken them. Their popularity has been due to
their ease of use at the point of sale, for bill payments, and for person-to-person payments. The
latest development in this payment instrument is the introduction of Check 21 Act, which is
related to the truncation of checks to electronic form. A recent study by Federal Reserve indicates
that while checks paid decreased by over 5 billion from 2000 to 2003, the number of electronic
payment transactions increased by over 13 billion. It is estimated that before the end of the
decade credit cards and debit cards will individually exceed the number of paid checks.
Cards-based Payments
Debit
Debit cards enable the holder to make purchases and to charge those purchases directly to a
current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based)
or off-line (Signature-based). On-line debit cards have been available for several decades and
have seen tremendous growth since the early 1990’s. Off-line debit cards are a more recent
innovation and consumers are increasingly using them at merchant locations that accept
bankcards. Of all cards-based payments, debit has seen the highest growth.
ATM
Financial institutions issue ATM cards to consumers to provide on-line access to account
information and to allow consumers to make withdrawals and deposits at ATMs. Many financial
institutions now offer ATM cards that can also be used as debit cards for POS transactions at
participating retailers.
Credit
These include general-purpose credit cards and private-label credit cards (discussed later).
Compared to other electronic payment instruments, credit cards have shown a relatively
moderate growth since 2000.
Chip Cards
These cards have the capability to store funds electronically in an embedded chip, which updates
the funds available data as transactions are made. While Prepaid cards are best known for their
use as a gift card, they are increasingly used for payroll, incentives, insurance, refunds and other
purposes. Some stored value cards may also be smart cards if they contain an integrated
microchip. The integrated chip can store value and perform other functions, such as consumer
authentication, health care programs, government-funded benefits programs, transportation
services, etc. The chip might also contain consumer preferences and loyalty program information
for marketing purposes.
Automated Clearing House (ACH)
An ACH transaction is a batch-processed, value-dated electronic funds transfer between
originating and receiving financial institutions. ACH payments are used in a variety of payment
environments. Originally, consumers primarily used the ACH for paycheck direct deposit. Now,
they increasingly use the ACH for bill payments (often referred to as direct payments), corporate
payments (business-to-business), and government payments (e.g., tax refunds), and electronic
check presentment. There are two national ACH operators – Electronic Payment Networks, a
private processor with a 30% market share while the rest of the market is served by the Federal
Reserve Banks.
Emerging Payments
Online Bill Pay (EBPP, EIPP)
Online services that enable customers to receive, review, and execute payment of their bills over
the Internet.
Person-to-Person Payments (P2P)
On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an
electronically initiated transfer of value from one individual to another.
Internet Currencies / Digital Cash / e-Wallets
Similar to P2P payments, individuals can transfer electronic cash value to other individuals or
businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash
payment instruments for purchases at retailers’ Web sites or they can transfer cash to other
individuals through e-mail. Individuals use a credit card or signature-based debit card number to
pre-fund the Web certificate or electronic account, and recipients redeem the value with the
Issuer.
Electronic Benefits Transfer (EBT)
Electronic system that allows a recipient to authorize transfer of his/her government benefits from
a Federal account to a retailer account to pay for products received. EBT is currently used to
issue food stamps and other benefits in the US.
Generic Framework for Payment Instruments
The diagram below depicts the common model on which most payment systems are based..
FourCornerPaymentSystemModel
Payer Payee
Present Non -cashPayment instrument
Goods/ Services
Network
While the flow of funds, information, and data are different, in most cases, the set of participants
are similar. The initiator of the payment (payer) is typically a consumer and the recipient of the
payment (payee), typically a merchant. The payer and the payee are shown to have a
relationship with their respective financial institutions. The payment network routes the
transactions between the financial institutions
Credit Card Market Overview
Credit card activities in the US represent more than 25 billion individual transactions purchasing
$1.7 trillion dollars in products and services equaling more than 10% of GDP. There are 1.2 billion
credit cards (including store and gas credit cards) in circulation in the US held by over 160 million
individuals. The average household possesses 14.27 credit cards with an average household
credit balance of $9,450 in 200310. Credit card fees paid by consumers exceed $15 billion.
A Credit card is a type of a payment card product. A payment card product is a set of
entitlements. It allows the client to access the features the provider (e.g., financial institution)
attaches to the card.
A sample of possible payment card entitlements is shown below:
Access Convenience Affordability
Credit Worldwide acceptance Interest rate
Deposits 24 hour availability Fees
Merchants Portability Benefits
ATMs Monthly statements Payment terms
To create an actual payment card product, these entitlements are grouped together to appeal to a
target segment – consumer or business. A card is issued to a cardholder and usually displays
cardholder name, account number, expiration date, location acceptance logos (e.g.,
Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some
of the new cards contain chips that store information such as additional customer information and
stored value. A card usually is linked to some type of financial account (e.g., credit card to a credit
line and a debit card to a checking/savings account).
Credit Cards
A credit card indicates that the holder has been granted a line of credit enabling the cardholder to
make purchases and/or draw cash up to a pre-arranged amount. Interest is charged on the
amount of the unpaid credit balance and cardholders are often charged an annual user fee.
The dominant payment card types that are in use at this time in developed banking environments
are those employing the use of “magnetic stripe” technology. Part of the reason for this is the
relatively lower cost of Points-of-Sale (POS) terminals and the formation of well-established
specifications that allows these magnetic-stripe cards to be used in virtually any card-based POS
device worldwide. The production costs of the stripe card are also low. Additionally, administrative
support requirements are well developed.
However, smart cards, introduced a decade ago, are making significant inroads in some countries
where, in addition to, regulated pilots being undertaken some significant schemes are already in
place. These plastic cards, which are embedded with a computer chip, offer a number of
significant benefits to financial institutions, retailers, and cardholders—ranging from improved
security to a host of innovative new features.
But while smart card usage has been rapidly increasing thanks to a diverse set of applications
from wireless telephones to loyalty programs, the predicted mass migration of payment
applications from conventional magnetic-stripe cards to smart cards has not yet materialized. One
of the biggest hurdles, until now, has been the lack of universally accepted specifications for
smart card based payments; however, consensus on EMV (Europay / MasterCard / Visa)
specifications for smart cards is now set to change this situation and smart cards are poised to
challenge the 2+ billion magnetic-stripe cards in circulation around the globe.
Acquirer: Does business with merchants enabling them to accept credit cards. Acquirers buy
(acquire) the merchant's sales slips and credit the tickets' value to the merchant's account.
Acquirer’s key activities can be summarized as –
Due to high factors such as high volumes and low profit margins, most US banks have sold
their acquirer businesses to non-banking entities that specialize in this field. Following are the
Income and Expense sources in an Acquirer business –
Income:
Merchant discount (1–4% of transaction value)
Processing fees ($ 0.20 – $ 0.40 per transaction)
Monthly minimum fees
Customer service fees
POS Equipment sales/service
Expense:
Interchange fees paid to Issuer
ISO/MSP fees
Data processing & Communications expenses
Risk Management
Losses on Merchant Chargebacks & Fraud
Processor (Third Party Entities): Provides credit card processing, billing, reporting and
settlement, and operational services to the Issuer/Acquirer. The Card Processing market is a
highly concentrated market with players like First Data and TSYS processing more than half
of all US card transactions. The two main services that the Third Party Processors offer are
Issuing Services and Acquiring Services -
Issuing services
Functions: Most activities of card Issuers
Income = Transaction Processing fees + Software Licensing & Maintenance
Expense = Data processing & Communications expense
Acquiring services
Functions: Most activities of card Acquirers
Income = Merchant fees + Processing fees + ISO/MSP fees
Expense = Data processing & Communications expense + Losses on
Chargebacks + Depreciation
Independent Sales Organization (ISO): An outside company (not MasterCard/VISA
member, non-bank) that offers merchant accounts and may process credit card transactions
for a transaction fee. ISOs enter into a contract with Acquiring banks to offer bankcard
acquiring services, through registered or unregistered sales agents or employees
Association: An organization owned by members, which services and obtains processing
services for members. Members include commercial/retail banks, credit unions etc. Following
are few main characteristics of Association -
License members (Issuers, Acquirers) to issue & accept payment cards
However, associations themselves do NOT issue cards / set card fees / set credit
limits / set interest rates, or solicit merchants / set discount rates
Serve as the nerve center connecting the issuing & acquiring sides
Provide the interchange systems to transfer data and funds between members
(transaction processing – VisaNet, BankNet)
Offer a variety of product programs and services to improve member profitability and
minimize member risk
E.g. ‘Verified by Visa’, SET
Implement rules and regulations that govern the interchange of transactions between
members
Undertake brand advertising and promotional campaigns
A card Association -
Merchant: A retailer, or any other person, firm, or corporation that, according to a Merchant
Agreement, agrees to accept credit cards, debit cards, or both, when properly presented.
Cardholder: The person to whom a financial transaction card is issued or an additional
person authorized to use the card
The following diagram depicts typical activities in transaction processing using a card
involving all the entities described above -
The following table shows lists the description of the various entities involved in a Credit card
processing
Entity Description
This is a bank / financial institution that issues a credit product
Issuing Bank
Cardholder portfolio account is created when a credit application is
Cardholder
approved.
Account
This defines the processing rules for all the accounts under a business
Business Portfolio
venture of the same card offering type. This entity may hold billing rules,
Account
auth limits, collection strategies, and other properties that can be defined
at this level. Examples of Business portfolio account may include Chase
Visa Classic, Chase Visa Gold, etc
Identifies the different card types that the Credit system supports.
Card Product
Examples may be proprietary cards, Visa, MasterCard
Authorization engines are used to authorize credit transactions. The
Authorization
authorization engine uses the account information, merchant information,
Engine
and other related information to approve / decline / refer an authorization
transaction. There can be more than one authorization engines for a
business portfolio.
Provides credit scores that are used by Issuers to process card
Credit Bureau
applications
Third party to whom Issuer outsources the cardholder collection activities
Collection Agency
An outside company with which the Issuer contracts to provide cardholder
Issuer Processor
transaction processing activities.
Bank designated by the Issuer to receive the Issuer’s daily net settlement
Issuer Clearing
advisement. The clearing bank (may be the Issuer itself) will also conduct
Bank
funds transfer activities with the net settlement bank and maintain the
Issuer’s clearing account.
This is a bank / financial institution that acquires merchant transactions
Acquirer
Bank designated by Acquirer to receive the Acquirer’s daily net settlement
Acquirer Clearing
advisement. The clearing bank (may be the Acquirer itself) will also
Bank
conduct funds transfer activities with the net settlement bank and maintain
the Acquirer’s clearing account.
An outside company with whom the Acquirer contracts to provide
Acquirer Processor
merchant processing services
A merchant account is created when a merchant application is approved.
Merchant Account
A merchant account is necessary for a merchant to accept payment by
Foundation Course in Banking
credit card
Contains presentments and other financial messages that need to be
Clearing file
matched with corresponding authorizations
This file is for enabling member settlement
Funding file
Transaction Types
• Administrative
Others These are routine transactional activities to
• Network
ensure completion of the various activities
• Reconciliation
• File Maintenance involved in a transaction processing cycle
• Fee transactions
Major Players
The following table shows some of the leading US card organizations and their respective roles in
the Credit card industry:
Leading US Market Card Organizations
SUMMARY
• Cards are one of the most widely used mechanisms for transactions
world wide. There are several types of cards used –
o Debit cards
o ATM cards
o Credit cards
o Chip cards
o Smart cards
• ACH enables batch-processed, value-dated electronic funds transfer
between originating and receiving financial institutions.
• Emerging payments systems are –
o Online Bill Payment (EBPP, EIPP)
o Person to Person Payments (P2P)
o Internet currencies, digital cash, e-Wallet
o Electronic Benefit Transfer (EBT)
• There are various entities involved in the credit card transaction
processing cycle -
o Issuer
o Acquirer
o Third party Processor
o Independent Sales organization
o Association
o Merchant
o Card holder
• Chargeback and Chargeback reversals are legitimate ways to cancel
the credit card transactions within a limited time frame
Foundation Course in Banking
Private Banking covers banking services, including lending and investment management, Private
banking primarily is a credit service, and is less dependent on accepting deposits than retail
banking.
The Federal Reserve Supervisory Letter defines private banking as personalized services such
as money management, financial advice, and investment services for high net worth clients.
Although high net worth is not defined, it is generally taken at a household income of at
least $100,000 or net worth greater than $500,000. Larger private banks often require even
higher thresholds - Several now require their new clients to have at least $1 million of investable
assets. As per the World Wealth Report 2001 by Merrill Lynch / Cap Gemini, there are currently
over 7.2 million millionaires in the world with a combined asset base exceeding US$ 27 trillion
which is projected to grow to over US$ 45 trillion by the end of 2005.
CLIENT SERVICES
A typical private banking division of a large bank would offer the following financial services to its
Private clients:
Risk Management
Strives to reduce exposures for its clients across the world through a variety of hedging tools,
taking positions in derivative markets etc
Liquidity
Management of a Client’s liquidity (cash etc) needs through short-tem credit facilities, flexible
cash management services etc. An exclusive cash management service with "sweep" facility is a
Private Banking feature. The sweep automatically transfers excess funds over a pre-determined
limit out of your current account into a higher yielding reserve account, optimizing your return on
short-term cash. Funds are on call so they remain easy to access.
Structured Lending
Provides tailored lending to provide long-term liquidity to clients, or investment capital
Foundation Course in Banking
Hedge Funds
This is a private investment partnership, and is usually run by Private Banks. Hedge funds are
highly speculative and they use a variety of techniques such as leverage, short-selling, and use of
derivatives. Several hedge funds also utilize some form of arbitrage, such as those where they
can take advantage of movements expected to occur in the stock price of two companies
undergoing a merger or other similar event. In most cases, investors in a hedge fund need to be
duly accredited.
How have average hedge fund returns performed vis-a-vis market levels?
“Multibillion dollar Quantum Fund managed by the legendary George Soros, for instance,
boasted compound annual returns exceeding 30% for more than a decade.”
“Off Shore Hedge Funds: Survival and Performance: 1989-1995," a study by Yale and NYU
Stern economists, indicates that, during that six-year period, the average annual return for
offshore hedge funds was 13.6%, whereas the average annual gain for the S&P 500 was
16.5%. Even worse, the rate of closure for funds rose to over 20% per year, so choosing a
long-term hedge fund is trickier even than choosing a stock investment.
Are hedge funds not immune to risk?
Led by Wall Street trader John Meriwether and a team of finance wizards and Ph.Ds, Long
Term Capital Management imploded in the late 1990s. It nearly sank the global financial
system and had to be bailed out by Wall Street's biggest banks. In 2000 George Soros shut
down his Quantum Fund after sustaining stupendous losses.
• However, the institution can earn substantial fees for managing client
assets or performing other cash management and custodial services.
To grow, private banks need to lure new wealthy investors away
from direct investing or from investing with major mutual funds such
as Fidelity or Merrill Lynch.
The diagram below shows the various departments in the Private Banking division of a bank.
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INVESTMENT MANAGEMENT
Investment Management can be defined as the process of managing money, which includes
investments such as real estate, financial instruments such as stock, mutual fund, bonds or
equipment that has monetary value that could be realized if sold. Very often, terms such as
money management, asset management etc. are used interchangeably.
In achieving the above goals, an Investment Manager uses the following approaches/principles:
• Asset Mix is the primary determinant of portfolio return, optimum
portfolios are designed using asset allocation tools
• International Diversification - Investment in world wide stocks
reduces risk and improves returns
• Screens/Filters - Variety of quantitative and qualitative screens to
identify candidate investments, interviews with fund managers prior
to investing and continuous due diligence.
• Capital preservation - Preserve the wealth of investors and ensure
erosion free investment
• Alternative Investments - Investing in hedge fund and futures to
have strong returns. These assets generally earn returns consistent
with those of equities. By combining alternative investments with
equities, the asset manager can generate superior returns while
reducing the ups and downs of the portfolio.
M a rk e t a n d A n a
D a ta
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RESEARCH
Research is one of the primary inputs towards deciding what kind of asset or financial instrument
to invest in. It involves performing a variety of qualitative and quantitative analysis to determine
the ideal portfolio mix. His includes an in depth analysis about the institution issuing the
instrument, estimating future growth, industry analysis, trend analysis of historical prices etc.
Some of the pre-requisites for performing meaningful research to aid investment decision making
are as follows:
Research team
The first step is to put together a dedicated research team. It is critical that the team members not
only understand the financial market dynamics but also have knowledge on Model building and
Econometrics. The success of the research team is usually evaluated relative to a benchmark
return.
Data
The research team must have easy access to a variety of data. The collection and maintenance
of the database is very important. Tactical decisions need to be made quickly as new data keeps
pouring in. It is best to invest in a database system that takes the new data and automatically
runs the quantitative analyses.
Computing
While most top-down data management exercises can be handled within Excel, the bottom up
projects are not feasible within a spreadsheet. The bottom-up projects may include up to 10,000
securities along with vectors of attributes for each security.
ASSET ALLOCATION
Passive Approach
The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns
subject to the risk and cash flow constraints. Thus the investor’s characteristics determine the
right mix for the portfolio. In coming up with the mix, the asset manager uses diversification
strategies; asset classes tend to be influenced differently by macro economic events such as
recessions or inflation. Diversifying across asset classes will yield better trade offs between risk
and return than investing in any one risk class. The same observation can be made about
expanding portfolios to include both domestic and foreign assets.
Active Approach
Portfolio managers often deviate from the passive mix by using “Market timing”. To the extent that
portfolio managers believe that they can determine which markets are likely to go up more than
expected and which less than expected, they will alter the active-passive mix accordingly. Thus, a
portfolio manager who believes that the stock market is over valued and is ripe for a correction,
while real estate is under valued, may reduce the proportion of the portfolio that is allocated to
equities and increase the proportion allocated to real estate. Market strategists at all of the major
investment firms influence the asset allocation decision.
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There have been fewer successful market timers than successful stock pickers. This can be
attributed to the fact that it is far more difficult to gain a differential advantage at market timing
than it is at stock selection. For instance, it is unlikely that one can acquire an informational
advantage over other investors at timing markets. But it is still possible, with sufficient research
and private information, to get an informational advantage at picking stocks. Market timers
contend that they can take existing information and use it more creatively or in better models to
arrive at predictions for markets, but such approaches can be easily imitated.
Then they work systematically down from this very broad perspective translating these top-down
views into more specific economic and market forecasts. This is an analytical process; trying to
identify those profound structural changes in global economies and societies, seeing what effects
are likely to filter down and in time affect the value of ordinary investments.
An illustrative model of “top down” approach will look as follows:
• Build country-by-country forecasting models based on benchmark
return
• Validation of models
• Forecast out of sample returns
• Sort country returns
• Invest in portfolio of highest expected return countries
• Information in both the volatility and correlation is used in
determining optimal portfolio weights
"Hedge" strategies are also possible. This involves taking long positions in the highest expected
returns countries and short positions in the lowest expected returns countries.
Bottom Up Approach
The idea is to select individual securities. From a variety of methods, forecasted winners are
purchased and forecasted losers are sold. “Bottom up" investor would try to find investments that
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are attractive because of something particular to them -- i.e., their terrific growth potential, say, or
the fact that their assets are selling for less than their intrinsic worth. So an investor who practices
the "bottom up" approach might screen through a long list of stocks to find ones that look like a
buy on the basis of their fundamentals.
PORTFOLIO EXECUTION
There are many individual strategies that may show promise in terms of beating the market.
However, very few portfolio managers actually accomplish the same objective. One very
important reason is the failure on the part of most studies to factor in both the difficulties and the
costs associated with executing strategies.
Trading speed
The need to trade fast and the desire to keep transactions costs low will come into conflict.
Investors who are willing to accept trades spread out over longer periods will generally be able to
have much lower trading costs than investors who need to trade quickly. Long term value
investors will be less affected by trading costs than short term investors trading on information.
INVESTMENT PHILOSOPHIES
Portfolio Managers follow different investment philosophies. Some examples are:
Passive Diversification
Some Portfolio Managers believe that markets are efficient; even if they are inefficient, the cost of
exploiting the inefficiency is more the returns that can be earned. Hence, they are willing to
accept market returns. They try to construct portfolios that resemble the market index, often
indexing to broadest possible indices.
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Momentum Investing
Markets tend to stay in trends: if prices have gone up (down) quickly, they will tend to keep going
up (down). Portfolio Managers who subscribe to this school, use price momentum indicators,
relative strength indicators and charts. They have short time horizons and speedy execution
styles.
Market Timing
It is possible to forecast the direction of markets (i.e. to time markets) using identified variables
like market timing models/indicators. Such Portfolio Managers usually take large bets on the
market (in either direction), attempt tactical Asset Allocation in sectors, and use Hedge funds
(selling overvalued and buying undervalued asset classes). An example would be George Soros
and his Quantum Fund.
Contrarian Investing
Markets tend to correct themselves; if prices have gone up (down) quickly, they will tend to go
down (up). If investors are too bullish (bearish), stocks are more likely to go down (up). Such
Portfolio Managers have usually short time horizons, are willing to hold unpopular investments
and use specialist short sales.
Example: In the middle of March this year, the war with Iraq was just starting. The SARS
epidemic was raging across Asia. Travellers, whether for business or pleasure, were staying
at home in fear of terrorism – whether in the guise of chemical or biological warfare, or old
fashioned high explosives. The airline, tourism, and hotel industries were warning of the worst
conditions in living memory. The FTSE 100 index fell to an eight-year low of 3,300.
Guess what? If you had invested then, at the pit of misery you would have made 27 per cent
in around three months to the middle of June.
All major international banks offer asset management services. Some key players include:
• Morgan Stanley
• Bankers Trust
• Boston Partners
• Pacific Investment Management Co. (PIMCO)
MUTUAL FUNDS
A mutual fund is a fund that pools together money from many investors and invests it on behalf of
the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling
shares of the fund to investors that includes individuals and institutions, much like any other
company can sell stock in itself to the public. These funds take the proceeds of the money from
the sale of the shares and invest it in other instruments like bonds, stocks etc. In return for the
money they give to the fund when purchasing shares, shareholders receive an equity position in
the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders
are free to sell their shares at any time, although the price of a share in a mutual fund will
fluctuate daily, depending upon the performance of the securities held by the fund.
Now you must be wondering that why do people buy mutual funds when they can directly buy the
instruments that these mutual funds invest in. after all what is the need of having a middleman?
There are numerous reasons for investing in the mutual fund. They are:
• Diversification: With a mutual fund one can diversify the investment both across companies
and across asset classes. When some assets are falling in price, others are likely to be rising,
so diversification results in less risk than if you purchased just one or two investments.
• Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.
• Low Investment Minimums: One doesn’t need to be wealthy to invest in mutual funds. Most
mutual funds will allow you to buy into the fund with as little $1,000 or $2,000.
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• Convenience: When you own a mutual fund, you don't need to worry about tracking the
dozens of different securities in which the fund invests; rather, all you need to do is to keep
track of the fund's performance.
• Low Transaction Costs: Mutual funds are able to keep transaction costs low because they
benefit from reduced brokerage commissions for buying and selling large quantities of
investments at a single time.
• Regulation: Mutual funds are regulated stringently by the government. Thus this reduces the
risk for the end investor.
• Professional Management: Mutual funds are managed by a team of professionals, which
usually includes one mutual fund manager and several analysts.
So mutual funds are full of benefits. Now you must be wondering if the mutual fund what the
disadvantages of mutual funds are. There are plenty of disadvantages:
• Fees and Expenses: Most mutual funds charge management and operating fees that pay for
the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few
mutual funds charge high sales commissions.
• Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average more
than half of the mutual funds fail to do better than the market returns.
• Loss of Control: The mutual fund managers are the people who decide upon the strategy to
invest. Thus the investor loses the control of his money to the fund manager.
• Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to
provide protection against simultaneous withdrawals. This provides investors with liquidity,
but due to the large cash reserve the mutual funds do not invest all cash in asset and thus
provide investor with lowered returns.
A money market fund is a type of mutual fund that is required by law to invest in low-risk
securities. These funds have relatively low risks compared to other mutual funds and pay
dividends that generally reflect short-term interest rates. Unlike a "money market deposit account"
at a bank, money market funds are not federally insured.
Money market funds typically invest in government securities, certificates of deposits, commercial
paper of companies, and other highly liquid and low-risk securities. While investor losses in
money market funds have been rare, they are possible.
tobacco business. The portfolio can be customized to cater to his individual needs and
preferences.
• Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue.
However, in case of SMA tax advantages to investor results from tax loss harvesting strategy
Disadvantages
• There is no requirement for the reporting of the holding and there is no specific governing
regulation unlike the mutual funds
• There is no board in case of SMA, one hires the manager to manage the asset and there is
no board to sue if something goes wrong
• Closing an SMA would require moving the individual’s security to another manager, which is
a complicated and time consuming exercise.
• It is difficult to find an appropriate comparable to benchmark the performance of SMA.
HEDGE FUNDS
Hedge funds are very similar to mutual funds except that they are targeted at High Networth
individuals as explained in the previous chapter. Hedge funds are exempt from many of the rules
and regulations governing other mutual fund which allows them to accomplish aggressive
investing goals. They are restricted by law to no more than 100 investors per fund, and as a result
most hedge funds set extremely high minimum investment amounts, ranging anywhere from
$250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a
management fee; however, hedge funds also collect a percentage of the profits (usually 20%).
SUMMARY
• Private Banking covers personalized services such as money
management, financial advice, and investment services for high net
worth clients. High net worth is generally taken at a household
income of at least $100,000 or net worth greater than $500,000.
Larger private banks often require even higher thresholds of at least
$1 million of investable assets
•A typical private banking division of a large bank would offer financial
services like:
o Investment Management and Advice
o Risk Management
o Liquidity Management
o Structured Lending
o Enhanced banking facilities
o Issuer Capital formation
• Core functions in private banking include the following:
o Sales and Marketing / Client Prospecting
o Client Management, Servicing and delivery
o Financial Planning
o Portfolio Analysis and Optimization
o Market Activities
o Research
o Compliance controls
• Private Banking Front Office covers functions like Sales & Client
prospecting, Contact Management, Account Aggregation and
Financial Advisory services.
• Private Banking Middle/Back Office covers functions like Asset
Allocation, Research, Portfolio Analysis, Risk Management, Trade
Processing, Compliance and Documentation
•
• Investment Management aims at managing investors’ money
efficiently and cost effectively to generate superior investment
returns. The ultimate objective is to deliver equity type returns with
lesser volatility risk and achieve capital preservation
• An Asset Manager uses the following approaches/principles:
o Asset Mix
o International Diversification
o Screens/Filters
o Capital preservation
o Alternative Investments
• Asset Allocation can be done passively or actively.
o Passive Approach - The portfolio manager has to decide on the mix of assets that
maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the
investor’s characteristics determine the right mix for the portfolio.
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o Active Approach - Portfolio managers often deviate from the passive mix by using
“Market timing”. To the extent that portfolio managers believe that they can determine
which markets are likely to go up more than expected and which less than expected,
they will alter the active-passive mix accordingly.
• Fund managers generally adopt an individual "investment
philosophy" which
overlays their investment management style. The following are the
two quantitative approaches to tactical global asset management.
• The "top down" investor begins by looking at the “big picture” -
economy or broad trends in society to identify individual countries
and then sectors that will benefit from the prevailing conditions.
• The “bottom up” investor selects individual securities. From a variety
of methods, forecasted winners are purchased and forecasted losers
are sold. “Bottom up" investor would try to find investments that are
attractive because of something special to the security.
• Portfolio Managers follow different investment philosophies. Some
examples are:
o Passive Diversification
o Passive Value Investing
o Momentum Investing
o Market Timing
o Contrarian Investing
• There are several variants of investment management that have
manifested in terms of firms offering products to suit specific needs
of investors. Some of them are
o Institutional Asset Management
o Mutual Funds
o Separately Managed Accounts
o Hedge Funds
o Pension Funds
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INVESTMENT BANKING
Investment Banks assist clients in raising money in order to grow and expand their businesses.
Their activities include:
• Originating and managing issues of securities
• Underwriting
• Market Making
• Principal buying or selling securities on a spread basis
CORPORATE FINANCE
The bread and butter of a traditional investment bank, corporate finance generally performs two
different functions:
• Mergers and acquisitions advisory - Banks assist in negotiating and
structuring a merger between two companies. If, for example, a
company wants to buy another firm, then an investment bank will
help finalize the purchase price, structure the deal, and generally
ensure a smooth transaction.
• Underwriting - The process by which investment bankers raise
investment capital from investors on behalf of corporations and
governments that are issuing securities (both equity and debt).An
Underwriter guarantees that the capital issue will be subscribed to
the extent of his underwritten amount. He will make good of any
shortfall.
SALES
Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson, or 3) the
private client service representative. Brokers develop relationships with individual investors and
sell stocks and stock advice.
Institutional salespeople develop business relationships with large institutional investors.
Institutional investors are those who manage large groups of assets, for example pension funds
or mutual funds.
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Private Client Service (PCS) representatives lie somewhere between retail brokers and
institutional salespeople, providing brokerage and money management services for high net
worth individuals.
Salespeople make money through commissions on trades made through their firms.
TRADING
Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies,
either by carrying an inventory of securities for sale or by executing a given trade for a client.
Traders deal with transactions large and small and provide liquidity (the ability to buy and sell
securities) for the market. (This is often called making a market.) Traders make money by
purchasing securities and selling them at a slightly higher price. This price differential is called the
"bid ask spread."
RESEARCH
Research analysts follow stocks and bonds and make recommendations on whether to buy, sell,
or hold those securities. Stock analysts typically focus on one industry and will cover up to 20
companies' stocks at any given time. Some research analysts work on the fixed income side and
will cover a particular segment, such as high yield bonds or U.S. Treasury bonds.
Corporate finance bankers rely on research analysts to be experts in the industry in which they
are working. Salespeople within the I-bank utilize research published by analysts to convince their
clients to buy or sell securities through their firm.
Reputed research analysts can generate substantial corporate finance business as well as
substantial trading activity, and thus are an integral part of any investment bank.
SYNDICATE
The hub of the investment banking wheel, syndicate provides a vital link between salespeople
and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a
knock-down drag-out affair between and among buyers of offerings and the investment banks
managing the process. In a corporate or municipal debt deal, syndicate also determines the
allocation of bonds.
Marketing
Once the SEC has approved the prospectus, the company embarks on a road show to sell the
deal. A road show involves flying the company's management coast to coast (and often to
Europe) to visit institutional investors potentially interested in buying shares in the offering.
Typical road shows last from two to three weeks, and involve meeting literally hundreds of
investors, who listen to the company's presentations, and then ask scrutinizing questions. Often,
money managers decide whether or not to invest thousands of dollars in a company within just a
few minutes of a presentation. The marketing phase ends abruptly with the placement of the
stock, which results in a new security trading in the market.
Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the
course of the next few quarters.
Insiders of the company cannot sell any shares for a specified period of time, this is
known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)
UNDERWRITING
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An Underwriter is a broker/dealer or an investment bank. He guarantees that the capital issue will
be subscribed to the extent of his underwritten amount. He will make good of any shortfall. The
contract between the issuer and the Lead or Managing Underwriter is the Underwriting Agreement.
The agreement states the terms and conditions of the offering, such as, the Underwriting Spread
(the amount the underwriters make on sales), the Public Offering Price (POP), and the amount of
proceeds from the offering that will go to the issuer.
Managing Underwriters - The Manager (lead underwriter) is the broker/dealer awarded the
issue, who generally handles the relationship with the issuer and oversees the underwriting
process.
Syndicate - To share the risk, and more efficiently distribute the offering to the public,
broker/dealers will join together in a Joint Trading Account. The syndicate profits by selling the
securities and earning a Spread (i.e., the POP less the amount paid to the issuer). Syndicate
members share the risk and are responsible for any unsold securities.
Selling Group - comprises of broker/dealers chosen to assist the syndicate in marketing the
issue in a broker (agency) capacity. Selling Group firms are not members of the syndicate, and
are not at risk for the securities. All broker/dealers involved in the underwriting of non-exempt
securities must be NASD member firms.
Types of Underwriting
2. Best-efforts underwriting - The underwriters act as agents or brokers for the issuer, and
attempt to sell all the securities in the market. The best efforts underwriter is not at risk, and
any unsold securities remain with the issuer. Two sub-types of best efforts are All-or-None
and Mini-max. An all-or-none underwriting may be canceled by the issuer if the entire issue is
not sold in a given time period. A mini-max underwriting requires a minimum amount to be
sold. If the underwriter sells the minimum, they may then attempt to sell the maximum
(usually being the entire issue). However, if the minimum is not sold, the issuer may cancel
the underwriting.
What is an agreement in which the underwriter is legally bound only to attempt to sell the
securities in a public offering for the firm?
When the investment banker bears the risk of not being able to sell a new security at the
established price, what is this is known as?
On the day that a lock-up period expires, the market value of the stock will most likely
________. (Increase/decrease/remain same.)
3. Third Market – Where listed securities are traded OTC (over-the-counter), and
broker/dealers acting as market markers offer an alternative to trading on the exchange itself.
An example would be a broker/dealer that maintained an inventory of IBM stock (which trades
on the NYSE), and buys and sells that stock to other brokers and customers using a
negotiated, over-the-counter method of trading.
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4. Fourth Market – The Instinet, a system for direct over-the-counter institutional trading that
bypasses broker/dealers and thus reduces the cost of large institutional Block Trades.
All the stock exchanges are registered with the SEC, and they have a “self regulation”
mechanism. The Maloney Act of1938 enabled the NASD to be the SRO for the second, third and
fourth markets.
Specialist
Specialists conduct the auction as a broker or dealer and maintain a fair and orderly market by
matching up buyers and sellers. The specialist is not an employee of the exchange and may
trade for their own account, as well as trading as an agent for CHB orders.
Broker Dealer
Executes orders for others Executes orders for themselves
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An individual firm could act as a broker on one trade and a dealer on another. When acting as a
broker, the firm is taking customer orders and acting as their agent to buy or sell the security. For
this service, the broker charges a commission. A firm acting as a dealer is the actual buyer or
seller, taking the other side of a trade. The price at which market makers will buy or sell a
particular security is known as the Bid or Ask Price.
Market Maker
• Provide continuous bid and offer prices within a prescribed
percentage spread for shares designated to them
• 4 to 40 (or more) market makers for a particular stock depending on
the average daily volume.
• Play an important role in the secondary market as catalysts,
particularly for enhancing stock liquidity
Registered Representatives
• An individual who has passed the NASD's registration process and is
licensed to work in the securities industry
• Usually a brokerage firm employee acting as an account executive
for clients
• Sell to the public; they do not work on exchange floors
1. Market Orders is executed at once, "at the market." A market order guarantees execution,
but does not guarantee a price. The final price is determined by supply and demand.
2. Limit Orders - Some investors may want to buy or sell, but only at a specific price. A Limit
order is executed at a set price or better and will not be executed if that price is not met. For
example, a customer owns XYZ stock, which is currently trading at $50/share. They would
like to sell the stock, but only if they can get a price of $55 or more. The investors would place
a Sell Limit at $55/share, an order that will be executed only if a price of $55 or better is
available. Similarly an investor who seeks to buy, but only at a certain price or better, might
enter a Buy Limit at $45/share.
3. Stop order - If the market price hits or passes through the stop price (Trigger), a market
order is Elected. For example, an investor bought stock at $50/share. The investor wants the
price of the stock to go up, but wishes to limit the losses if the stock price falls. Such an
investor might place a Sell Stop order at $45, and now if the market price falls to $45 or
below, the stop is triggered and a market order is elected. Another example might be a
Technical Trader who believes that if the stock goes up to a certain price, it is signaling the
beginning of a Bullish run. This investor might enter a Buy Stop at $51, for example. Now, if
the stock rises to $51 or above, a market order is triggered to buy the stock. A potential
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problem with a stop order is that it triggers a market order, which does not guarantee a
purchase or sale price. A stop order must be triggered (activated or elected) before execution
as a market order.
4. Stop Limit order - If the investors placed an order for $51 Stop, $52 Limit, the order would
be elected at $51, but would not be filled (executed) unless a price of $52 or better was
available. Now, the investor has eliminated the risk of buying the stock without guaranteeing
the price. A stop limit order, once triggered, becomes a limit order.
5. Do-not-reduce Order - Indicates that the order price should not be adjusted in the case of a
stock split or a dividend payout.
A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at 21.07 & you
can be filled at 21.06? True/False
If you want to limit your risk on a long position you can place a sell stop order? True/false
If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at 15.01 if
you place a market order? True/False
Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who maintain an
inventory of a particular stock, and buy and sell the stock from and to customers).
The largest system for displaying OTC market quotes is Nasdaq (The NASD’s Automated
Quotation system). Broker/Dealers subscribe to various levels of the Nasdaq system depending on
their functional needs. Level 1 service (i.e., the Inside Quote or Representative Quote) is the
highest bid and lowest ask prices of all market makers, and is used by registered reps. Level 2
service is for traders, and lists all market makers' firm quotes on price and size. Level 3 service also
displays all quotes, and is used by market makers to enter quotes.
If you were selling stock, to whom would you sell? Dealer C has the highest bid of 9.1, while a
buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote, therefore, would be
9.1 – 9.25, the highest bid and the lowest ask.
Sales
Sales team is responsible for canvassing business. They are staffed with Account
Executives/Account Managers who solicit business from retail and wholesale customers.
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New Accounts
New Account department is responsible for receiving customer account opening applications and
documenting the customer data. They are the custodians for various documents like New account
form, Signature cards, Margin Agreements, Lending Agreements and Option Trading
Agreements. Only when the required documents are received, the account can legally operate.
Order Room
Orders are taken by dealers in order room and they are executed in the best possible manner.
Every order has detailed instructions like:
• Buy/Sell
• Quantity
• Limit/Market
• Security details etc.
The relationships among the various departments can be pictorially represented as below:
S a le s N a m e A c c o u n ts (N a m e & A d d re s s )
A c c o u n t e x e c u tiv e • O p e n A c c o u n ts
(H om e o r B ra nocffic h e • E x e c u tin g C ha n g e s
R e p o rts O rd e r T ic k e ts
O rd e r R o o m
O T C M a rk e t Exchanges
• E x e c u tio n re c o rd in g
E x ec ution • C o n firm in g G T C o r d ers
R ep o rts • P e n d in g O rd e rs
C o n tra B ro k e rs
P u rc h a s e & S a le s (P & S )
C o n firm a tio n
C le a rin g C o rp • R e c o rd in g C lie n ts
(C NS ) • F ig u ra tio n (in c lu d in g a c cru e d in tere s t)
• C o m p a ris o n (re c o n c ilem en t)
• B o o kin g
D e p o s ito ry
C a s h ie rs M a rg in
• R e ce iv e & D e liv e r • A c co u n t M a in te n a n c e
B a n ks • V a u ltin g • S a le s s u p p o rt
• B an k L o a n • Is s u e c h e c k s
• S to c k L o a n /b o rro w • Ite m s d u e
• T ra n sfe r • E x te n s io n s
• R eo rg a n iz a tio n • C lo s e– O u ts
B ro k e ra g e s • D e liv e r y o f s e c u ritie s
T ra n s fe r S to c k R e c o rd A c c o u n tin g
Agent • A c co u n t n u m b e rin g & c o d in g • B o o kk e e p in g
• A u d its • D aily c a s h re c o r d
• S e c u rity M o v e m e n ts • A dju s te d tra il b a la n c e
• T rail B ala n c e
• P & L S ta te m e n t
D ivid e n d P ro x y
• C a sh D iv iddesn • P ro x y v o tin g
• S to c k s p lits • In form a tio n flo w to c u s to m e r s
• D u e b ills
• B o n d In te re s t
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Margin
Margin or Credit Department monitors the status of the customer accounts. As explained in the
previous pages, they are also responsible for margin calls. The typical activities of this
department are:
• Account Maintenance
• Sales Support
• Clearing Checks
• Items pending (Money due, stocks due)
• Closing out
Cashiering
They are responsible for movement of securities and funds within the brokerage firm. They take
care of the following functions:
• Receiving and delivering
• Vaulting
• Hypothecations
• Security Transfers
• Stock Lending
Corporate Action
Corporate Action refers to dividend declarations, stock splits etc. The Corporate Action
department makes sure that the rightful owners (as on the Record Date) receive the dividends,
Splits etc.
Accounting
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The Accounting department records, processes and balances the movement of money in the
brokerage firm. They produce the Daily Cash Records and Trial Balance, Balance Sheet and
Profit & Loss statements on a periodic basis.
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Compliance
The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide Self
Regulatory Organizations. The compliance department is responsible for ensuring that all the
rules and regulations are complied with and reported on time.
They also make sure that the newer regulations like Anti Money Laundering Act are implemented
inside the firm.
Questions
1. All of these are different types of brokerage accounts except?
a) Margin Account b) Cash Account c) IRA Account d) Nostro Account
2. A market order that executes after a specified price level has been reached is called?
a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order
3. A brokerage or analyst report will contain all of the following except?
a) a detailed description of the company, and its industry.
b) an opinionated thesis on why the analyst believes the company will succeed or
fail.
c) a recommendation to buy, sell, or hold the company.
d) a target price or performance prediction for the stock in a year.
e) a track record of the analyst writing the report.
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MARKET INDICES
Index of market prices of a particular group of stocks.
Index Types
Value Weighted Index is a stock index in which each stock affects the index in proportion to its
market value. Examples include Nasdaq Composite Index, S&P 500, Hang Seng Index, and
EAFE Index. They are also called capitalization weighted index.
Price Weighted Index is a stock index in which each stock affects the index in proportion to its
price per share. (Eg) Dow Jones Industrial Average
3M Alcoa
AlliedSignal American Express
AT&T Boeing
Caterpillar Chevron
Citigroup Coca-Cola
DuPont Eastman Kodak
Exxon General Electric
General Motors Goodyear
Hewlett-Packard IBM
International Paper J.P. Morgan
Johnson & Johnson McDonald
Merck Philip Morris
Procter & Gamble Sears
Union Carbide United Technology
Wal-Mart Walt Disney
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RISK MANAGEMENT
A ship is safe in the harbor…But that is not what ships are built for!
Risk is any element of the operating environment that can cause loss or failure. Risks are difficult
to define and they keep changing constantly. For example, if we ask two derivative traders to
identify the biggest risks faced by them, we may get different answers.
Let us look at an example of an Export Oriented Unit. Most or all of their revenue is earned in
foreign exchange where as costs are in domestic currency. Expenses like cost of raw material,
salaries, are paid out in Indian Rupees. If rupee appreciates significantly, the exporter’s profits
may be significantly affected. This is summarized with a numerical example in the following table:
Scenario 1 Scenario 2
INR/USD 50 45
Revenues in USD 100 million 100 million
Revenues in INR 5000 million 4500 million
Costs 4000 million 4000 million
Net Profit 1000 million 500 million
A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of exchange rate
risk. Of course, in times of dollar appreciation, the firm will end up making pots of money!
Define
What are the risks?
Measure Manage
How to estimate the risk? Set tolerance limits and act
DEFINING RISKS
The following are some of the possible risk types.
Credit risk is the possibility of loss as a result of default, such as when a customer defaults on a
loan, or more generally, any type of financial contract.
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Liquidity risk is the possibility that a firm will be unable to generate funds to meet contractual
obligations as they fall due.
Operational risk is the possibility of loss resulting from errors in instructing payments or settling
transactions.
Legal risk is the possibility of loss when a contract cannot be enforced -- for example, because
the customer had no authority to enter into the contract or the contract turns out to be
unenforceable in a bankruptcy.
Market risk is the possibility of loss over a given period of time related to uncertain movements in
market factors, such as interest rates, currencies, equities, and commodities.
MEASURING RISKS
Once the risks have been identified, the next step is to choose the quantitative and qualitative
measures of those risks. Risk is essentially measured in terms of the following factors:
a. The probability of an unfavorable event occurring (expressed as a number between 0 and
1)
b. The estimated monetary impact on organization because of the event
The unfavorable events differ for different types of risk. For example, in case of market risk, future
events refer to market scenarios. These scenarios impact each portfolio prices differently
depending on its composition.
Risk measurement is a combination of management, quantitative analysis and information
technology. Serious technology investment is required for accurate measurement and reporting.
One of the commonly used methodologies for market risk is “Value At Risk”
Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and to
combine all of the factors into a single number which is a good indicator of the overall risk level.
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VaR Calculation
A generic step-wise approach to calculate would be:
• Get price data for you portfolio holdings.
• Convert price data in to log return data. (Log Return: u i = ln (Si / Si-1)
where Si is the price of the asset on day i)
• Calculate standard deviations of each instrument or each proxy.
• Calculate preferred confidence level. 99% = 2.33 * standard
deviation.
• Multiply position holdings by their respective Standard Deviation at a
99% confidence level. This results in a position VaR at a 99%
confidence level.
Assume that you have a holding in IBM Stock worth $10 million. You have calculated the
standard deviation (SD) of change over one day in IBM is $ 0.20.
A. Monte-Carlo Simulation
It is a simulation technique. First, some assumptions about the distribution of changes in market
prices and rates (for example, by assuming they are normally distributed) are made, followed by
data collection to estimate the parameters of the distribution. The Monte Carlo then uses those
assumptions to give successive sets of possible future realizations of changes in those rates. For
each set, the portfolio is revalued. When done, you've got a set of portfolio revaluations
corresponding to the set of possible realizations of rates. From that distribution you take the 99th
percentile loss as the VaR.
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A firm that sells product X under a pure/perfect competition market* wants to know the
probability distribution for the profit of this product and the probability that the firm will loss
money when marketing it.
The equation for the profit is: TP = TR - TC = (Q*P) - (Q*VC+FC)
Assumptions:
• The Quantity Demanded (Q) fluctuates between 8,000 and 12,000 units
• All other similar Output factors are also simulated to reflect the change.
A simple simulation worksheet is prepared to with 50000 iterations for Q. It shows the profit
number (with frequency) under various scenarios of quantity sold. This translates into a near
Normal Curve with a Mean and Standard Deviation.
Using the required confidence interval from the normal curve and the standard deviation, a
VaR limit is generated from this distribution.
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B. Historical Simulation
Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions about
the distribution of changes in market prices and rates. Instead, it assumes that whatever the
realizations of those changes in prices and rates were in the past is the best indicator for the
future.
It takes those actual changes, applies them to the current set of rates and then uses those to
revalue the portfolio. When done, you've got a set of portfolio revaluations corresponding to the
set of possible realizations of rates. From that distribution, we can calculate the standard
deviation and take the 99th percentile loss as the VaR.
C. Variance-Covariance method
This is a very simplified and speedy approach to VaR computation. It is so, because it assumes a
particular distribution for both the changes in market prices and rates and the changes in portfolio
value. It incorporates the covariance matrix (correlation effects between each asset classes)
primarily developed by JP Morgan Risk Management Advisory Group in 1996. It is often called
Risk Metrics Methodology. It is reasonably good method for portfolio with no option type products.
Thus far, it is the computationally fastest method known today. But this method is not suited for
portfolio with major option type financial products.
MANAGING RISKS
There are multiple strategies to manage risks. Some of the commonly followed ones are:
1. Diversification
2. Hedging or Insurance
3. Setting Risk Limits
4. Ignore the risk!
All the above strategies will reduce the risk – but may not eliminate them. The top management
will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will be
responsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to day
basis and take action whenever the limits are breached.
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SUMMARY
• Risk, defined as the deviation from expectation, is an extremely
important concept for financial services industry.
• The nature of banking business gives rise to many different risks in
this business. Credit risk, Liquidity risk, Operational risk, Legal risk,
Market risk are some examples.
• Risk management is a 3-step process: Defining, Measuring and
Managing risks. Risk is measured in terms of the probability and the
potential monetary impact should the adverse event occur.
• Risk measurement is a combination of management, quantitative
analysis and information technology. Serious technology investment
is required for accurate measurement and reporting. One of the
commonly used methodologies for market risk is “Value at Risk”
• There are multiple ways of managing risks. Rejecting credit if the
credit rating is bad is one operational measure to avoid high risk.
Diversification spreads the total risk to the business over multiple
markets, thus reducing the impact of risk from any one market on the
overall business. Another way to reduce risk is to transfer or trade
the risk, for example by buying insurance.
• However, any risk reduction measure has its own cost. Therefore,
one has to achieve a balance between the cost of risk management
and the benefit of those risk reduction measures.
• Risk managers aim to reduce the risk to a manageable and known
level through various risk reduction measures. They use risk
management systems to track and analyze the risks.
• A good risk management system not only calculates the risk based
on a set of parameters, but also allows the risk managers to drill
down the risk to lowest components, carry out sensitivity, what-if
analyses, generates customizable reports and sends alerts
automatically when the risk crosses a defined tolerance limit.
• The Risk Manager in a bank will be responsible for identifying the
risks, setting up tolerance limits, measuring the risk on a day to day
basis and take action whenever the limits are breached.
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Custody Services
INTRODUCTION
The custody service business evolved from safekeeping and settlement services provided by
banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping
services to their customers. The banks routinely settled trades and processed income for their
own investments. Their customers kept and took their securities out of safekeeping to settle
trades or for bond maturities. As time evolved, the banks realized that their expertise in securities
processing and their image as a safe repository would be valuable to their customers and they
began to promote their securities processing ability as an enhanced value-added service.
The following are the key drivers in the growth of custody services:
• The wide range of financial instruments and the emerging markets
spreading across geographies resulted in growing interest of
investors. The potential benefits associated with the investments
resulted in growth of custody services.
• The increasing use of global custodians to replace their own
networks of local custodians by Investment managers and banks.
• The state withdrawing from its role of primary pension provider,
causing citizens to invest in defined contribution pensions and
mutual funds in record numbers - with custody banks serving the
pension funds and mutual funds, their money managers and the
banks acting for high net worth individuals.
• The introduction of floating exchange rates and lifting of exchange
controls in many major economies resulted in rapid development of
the market for international debt instruments.
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Securities Marketplace
Securities marketplace is a mechanism for bringing together those seeking investment and those
seeking capital. These entities can be individual or institutional .The securities market can be
classified as primary market and secondary market. For the purpose of the discussion we would
concentrate on secondary market and its working mechanism.
Investors
An investor is an entity that owns a financial asset. In general there are two types of investor, the
individual and the institutional investor.
• Individual Investor
• Institutional Investor
o Mutual Fund Managers
o Pension Funds
o Insurance companies
o Hedge Funds
Brokers
Broker is an intermediary who executes customer orders for a pre-defined commission. A
"broker" who specializes in stocks, bonds, commodities act as an agent and must be registered
with the exchange where the securities are traded. The brokers can be classified based on the
types of the services offered.
Dealers
Dealer is an entity who is ready and willing to buy a security for its own account (at its bid price)
or sell from its own account (at its ask price). They are individual or firms acting as a principal in a
securities transaction.
Custodians
A custodian is responsible for safekeeping the documentary evidence of the title to property like
share certificates etc. The title to the custodian’s property remains vested with the original holder,
or in their nominee(s), or custodian trustee, as the case may be. Based on confirmation from
customers, clearing corporation assigns the obligation of settlement upon the custodian. In
general the services provided by the custodians are classified in two main areas:
• Holding of Securities and Cash
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• Clearing of trades
• Determining obligations of members,
• Arranging for pay-in of funds/securities,
• Receiving funds/securities,
• Processing for shortages in funds/securities,
• Arranging for pay-out of funds/securities to members,
• Guaranteeing settlement.
Examples of important clearing corporations across the globe are National Stock Clearing
Corporation in USA (NSCC), Sega Intersettle in Switzerland, Clearstream & Euroclear of
European Union and so on.
Depository
The depository can be either domestic or international securities and depending upon that they
are known as either National Central Securities Depository or International Central Securities
Depositories (ICSDs).
Clearing Banks
Clearing banks are a key link between the custodians and Clearing Corporation for funds
settlement. Every custodian maintains a dedicated settlement account with one of the clearing
banks. Based on his obligation as determined through Clearing Corporation, the clearing member
makes funds available in the clearing account for the pay-in and receives funds in case of a
payout. In most of the cases the custodians act as a clearing bank also.
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Primary Market: It is a market for new security issue. In this market the securities are directly
purchased from the issuer. For e.g. an investor directly buying security issued by IBM.
Secondary Market: A market in which an investor purchases a security from another investor
rather than the issuer. We can divide the secondary market into wholesale and retail parts. The
wholesale market is the market in which professionals, including institutional investors, trade with
one another. Transactions are usually large. The retail market is the market in which the
individual investor buys and sells securities.The principal OTC market is the National Association
of Securities Dealers Automated Quotations (NASDAQ). The wholesale market for corporate
equities is conducted on a number of exchanges as well as over the counter (OTC). The New
York Stock Exchange (NYSE) dominates. Other U.S. exchanges include the American Stock
Exchange (AMEX), also in New York City, and five regional exchanges – the Midwest, Pacific,
Philadelphia-Baltimore-Washington,
Some other Markets are:-
• Dealer Markets
• Auction Markets
• Hybrid Markets
Safekeeping
A bank is responsible for maintaining the safety of custody assets held in physical form at one of
the custodian’s premises, a sub-custodian facility, or an outside depository. The banks may hold
assets either off-premises or on –premises
On-Premises
The banks hold the securities/assets in physical form in its vault. The securities (e.g., jewelry, art,
coins) are kept in physical form by the bank .The banks also holds the securities, which are not
maintained in the book entry form.
The banks providing the safekeeping services needs to follow certain norms related to the
security and movement of securities. The bank provides security devices consistent with
applicable law and sound custodial management. The bank ensures appropriate lighting, alarms,
and other physical security controls. The banks ensure that assets are out of the only vault when
it receives or delivers the assets following purchases, sales, deposits, distributions, corporate
actions or maturities.
Off-Premises
The evolution of depository has resulted in vast majority of custodial assets being held in book
entry form. Custodians reconcile changes in the depository’s position each day as a change in
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The trade process is initiated in a variety of ways in which a customer decides either to buy or sell
securities. The customer goes to either a Broker/ Dealer or a bank’s trading desk through its
investment manager. The bank in turn would coordinate with a broker who has access to the
exchange. The client sends across his order details through communication network. The client
order contains standard features like:
• Buy or Sell
• Specific Quantity
• Specific Security
The brokers typically record the order if the order has been placed through a broker or otherwise
the trader directly maintains the details of the order.
Order Types
There are two basic types of order: market orders and limit orders.
• Market orders are instructions to buy or sell stock at the best
available price. They are the most common types of orders.
• Limit orders tell your broker to buy or sell stock at the limit price or
better. The limit price is a price you set when placing the order. For a
given purchase, it is the most you will pay; for a given sale, it is the
minimum you will accept. You can also place a limit order to buy
along with one to sell. For example, if XYZ Corporation is currently
trading at $42 per share, you can place a limit order to buy 100
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An order book is a placeholder for every order entered into the system. As and when valid orders
are entered or received by the trading system, they are first numbered, time stamped and then
scanned for a potential match. If a match is not found, then the orders are stored in the books as
per the price/time priority. Price priority means that if two orders are entered into the system, the
order having the best price gets the higher priority. Time priority means if two orders having the
same price is entered, the order that is entered first gets the higher priority. Best price for a sell
order is the lowest price and for a buy order, it is the highest price
Order Matching
The buy and sell orders are matched based on the matching priority. The best sell order is the
order with the lowest price and a best buy order is the order with the highest price. The
unmatched orders are queued in the system by the following priority:
All stop loss orders entered are stored in the stop loss book. These orders can contain two prices.
• Trigger Price. It is the price at which the order gets triggered from the
stop loss book.
• Limit Price. It is the price for orders after the orders get triggered
from the stop loss book. If the limit price is not specified, the trigger
price is taken as the limit price for the order. The stop loss orders are
prioritised in the stop loss book with the most likely order to trigger
first and the least likely to trigger last. The priority is same as that of
the regular lot book.
• The stop loss condition is met under the following circumstances:
Sell Order - A sell order in the stop loss book gets triggered when the
last traded price in the normal market reaches or falls below the
trigger price of the order.
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Buy Order - A buy order in the stop loss book gets triggered when the last traded price in the
normal market reaches or exceeds the trigger price of the order. When a stop loss order with IOC
condition is there, the order is released in the market after it is triggered. Once triggered, the
order scans the counter order book for a suitable match to result in a trade or else is cancelled by
the system.
1.1.5 Trade Execution
The trade execution is carried out on a stock exchange after an order is placed. Order
modification and/or order cancellation is required to handle any abnormality. An order in entered
into the trading system by the brokers and they specify the information regarding the trade
details. The trade details typically contain information like security Name, Quantity, Price, Order
Duration etc. The order is entered into the order book and gets executed as per the time and
price condition as specified in the order. The order matching for the execution takes place in the
stock exchange. The order modification and order cancellation takes place before the order gets
executed i.e. if the order is there in the order books of the exchange and is waiting to be executed
the request for order modification is entertained by the stock exchange. The stock exchange
prepares a NOE (Note of Execution) with the trade details and sends it across to the Broker/
Dealer and to the clearing corporation giving details of the trade. The date the trade is executed is
known as the Trade Date, and is referred as ”T“ or T+0.
The order execution process for a customer sell order (individual investor placing order through a
broker) goes through the following cycle:
• Trade Date
• Trade Time
• Value Date
• Operation
• Quantity
• Security
• Price
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The process of trade enrichment involves the selection, calculation and attachment to a trade of
relevant information necessary for efficiently servicing the clients. The trade components, which
require enrichment, are:
• Calculation of cash value: The cash value calculation is done
keeping the trade components in consideration.
• Counter party Trade confirmation requirement: The trade details
needs to be enriched to determine if the counter party needs the
trade confirmation and if at all it needs the trade confirmation, the
format in which the confirmation would be send across to them.
• Selection of custodian details: The client might have multiple
accounts with multiple or single custodian. The investor would send
the custodian details at which the settlement would take place. The
trade details are enriched with the account number of the custodian,
which will handle the cash/ securities settlement.
• Method of Transaction reporting: The transaction reporting depends
upon the security group as well as the country in which the
transaction has occurred. For e.g. the UK equities may require one
method of reporting whereas the international bonds would require
another method.
determines exactly what the counter parties to the trade expect to receive. Clearance is a service
normally provided by a Clearing Corporation (CC).
Clearance can be carried out on a gross or net basis. When clearance is carried out on a gross
basis, the respective obligations of the buyer and seller are calculated individually on a trade-by-
trade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer and
seller are offset yielding a single obligation between the two counter parties. Accordingly,
clearance on a net basis reduces substantially the number of securities/payment transfers that
require to be made between the buyer and seller and limits the credit-risk exposure of both
counter parties.
NETTING PROCESS
The Settlement process for the securities is expensive as moving securities and money involves
costs. Since a given trader may engage in dozens or even hundreds of trades each day, these
costs soon add up. One way to reduce these costs is through netting.
For example, suppose you sold the shares to Smith because you expected the price of GE to fall
Say an hour later the price does fall to 75 and you buy the shares back at that price. By
coincidence, you buy them from Smith. You and Smith could save a lot of transaction costs if you
netted the two transactions – your earlier sale and your later repurchase. Net, Smith owes you
10,000 x ($80 - $75) = $50,000. if Smith just pays you this amount, no securities and a lot less
money need change hands.
You could extend this idea beyond just netting pairs of specific transactions to a general bilateral
netting arrangement with Smith. You could keep a running tab of your trading in GE shares over
a period of time, and just settle your net position at the end of the period. You could save even
more if you engaged in multi-issue netting – netting your trade in all securities.
Continuous Net Settlement
The Continuous Net Settlement (CNS) System is an automated book-entry accounting system
that centralizes the settlement of compared security transactions and maintains an orderly flow of
security and money balances. Throughout the CNS processing cycles, the system generates
reports that provide participants with a complete record of security and money movements and
related information. CNS provides clearance for equities, corporate bonds, Unit Investment Trusts
and municipal bonds that are eligible at The Depository Trust Company (DTC). DTC is an
institution that provides depository services in US.
Clearing Process
A deal is struck between with Smith and you on Monday. That night your back-office people and
Smith’s each send electronic notification of the trade to the computer of the National Securities
Clearing Corporation (NSCC).
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The NSCC computer checks the two “confirms” against each other. If they match, the trade is
“compared”. NSCC confirms to each of you on Tuesday morning, with instructions for settlement
the same Thursday. If the trade does not compare, you are both notified and you can sort things
out and resubmit the trade before the settlement date.
On Wednesday, the day before the settlement, NSCC interposes itself between the two parties to
the transaction. That is, instead of the original deal between you and Smith, there are now two
deals – one between you and NSCC and the other between NSCC and Smith. You now have a
deal to sell 10,000 shares of GE to NSCC at 80, and Smith has a del to buy them from NSCC at
the same price. You receive a notice to deliver the shares to NSCC; Smith receives a notice to
make payment. By interposing itself in this way, NSCC is guaranteeing settlement to both of you.
Whether or not Smith pays up, you will get your money on time. Whether or not you deliver the
shares, Smith will get 10,000 shares of GE on Thursday.
• Fax:
• Telex
• S.W.I.F.T
• e-mail
• Paper
It is mandatory now days to settle trade on the value date and whenever there is a settlement
failure the authority imposes penalties to the party concerned.
SETTLEMENT TYPES
The settlement process has evolved over the period. Traditionally the settlement used to take
place with the physical delivery of the shares, but with advent of Certificate Immobilization the
Book Entry settlement system has evolved.
• Physical Settlement
• Book Entry Settlement
SETTLEMENT PERIOD
The settlement period is the time between the execution of the trade and the settlement of trade.
It is time allowed before the securities sold must be delivered to the buyer. The settlement
periods depend upon the type of the securities traded. Appendix C has the list of the settlement
period for different types of security.
SETTLEMENT PROCESS
Trade settlement occurs when securities and money are exchanged to complete the trade.
Settlement occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transaction
involves the delivery of the securities and the payment of funds between the buyer and seller.
The payment of funds is effected in the settlement system via a banking/payments system. A
depository typically carries out the delivery of securities. A trade is not declared settled until both
(funds and securities) transfers are final.
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Trade accounting and Reconciliation is the internal control process used by custodians to
manage trade transactions. In this process, the custodian determines that the customer’s
account has the necessary securities on hand to deliver for sales, that the customer’s
account has adequate cash or forecasted cash for purchases. It maintains the records of
trades internally and tries to match it with outside world. It tries to match the positions by
comparing positions of trades (Open and settled both).
Step 1: The transaction begins with the investor wishing to invest in equity. He contacts his broker
(buy side) with an order to buy and similarly an investor contacts his broker (sell side) to sell the
securities.
Step 2: The brokers place trade request on the exchange.
Step 3: The trade execution takes place in the exchange as per the conditions specified in the
order. The exchange prepares a NOE (Notice of Execution) and sends out to the Brokers and the
clearing corporation.
Step 4: The clearing corporation receives the matched instruction i.e. the trade details (quantity,
price etc) from the exchange. The trade details are entered into the Continuous net settlement
system to obtain the net positions for a broker at the end of the day. The clearing corporation
prepares a contract sheet with end of day positions for broker and sends it across to the
depository.
Step 5: The Brokers sends a confirmation to the client about the trade details and the clients in
turn inform their custodians about the receipt/delivery of shares.
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Step 1: The broker receives trade details from the clearing corporation and it enriches it with the
fees, commission and other tax related details and send across the confirmation to the client.
Step 2: The client prepares an Affirmation order and sends it across to the custodians about the
possible pay in/out of securities and funds.
Step 3: The clearing corporation prepares a final pay in/pay out details based on the affirmation
received from the client and send it across to the depository.
Step 4: The custodians also confirm with the depository about the pay in/ pay out details about
the funds and securities.
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Step 1: Pay In of securities: Clearing corporation advises depository to debit account of sell side
custodian and credit its account and the depository does it
Step 2:Pay in of funds (Clearing corporation advises clearing banks to debit account of buy side
custodian and credit its account and the clearing bank does it)
Step 3:Pay Out of securities (Clearing corporation advises depository to credit account of buy
side custodian and debit its account and depository does it)
Step 4: Pay Out of funds (Clearing corporation advises clearing banks to credit account of sell
side custodian and debit its account and clearing banks does it)
Step 5: The custodian 1 confirms the receipt of shares to the buying client.
Step 6: The custodian 2 confirms the delivery of shares to the selling client.
ASSET SERVICING
Asset servicing is a ”core“ ongoing service provided by custodians. This service includes
collecting dividends and interest payments, processing corporate actions and applying for tax
relief from foreign governments on behalf of customers.
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Receiving Corporate Action: The information regarding the corporate action is received from a
number of external sources. As the same corporate action data is supplied by many different
sources, a hierarchy of sources is maintained to prioritize the obtained data.
Maintaining Corporate Action: The Corporate actions are classified as either mandatory or
voluntary
• Mandatory Actions
It is a type of corporate action wherewith the shareholders are not
given the option to conditionalize their tender. e.g. stock splits,
mergers and acquisitions, liquidations, bankruptcies, reorganizations,
redemption’s, bonus issues etc
• Voluntary action
It is a type of corporate action wherewith the shareholders are given
the option to conditionalize their tender. They include rights offers,
tender offer, purchase order, exchange order etc.
Notification of Corporate Action: The notification is generated for the client of Voluntary and
Mandatory Corporate Actions. The notification process ensures that the client receives the
information of the corporate action. Maintaining Response of Corporate Action: The corporate
action response is maintained for voluntary corporate action responses against expiration dates
on a daily basis until the client responds with instructions.
Processing of Corporate Action :In this stage the Processing of corporate action is done to update
the records of the banks. As per the feedback received from the client in case of voluntary
actions, the records for the client are updated in the records of the banks. A similar method is
followed for the mandatory types of corporate action.
and use the proceeds effectively. The bank’s internal controls for income collection also include
an income map procedure that details each client’s expected income from a particular security.
Contractual income payments are posted to the customer’s account on the date they are due
rather than the date they are received by the custodian whereas the actual income payments are
posted to the customer’s account on the date they are received by the custodian
Maintaining Tax Information: The tax related information like standard tax rates, exemptions and
reductions available under local law are maintained. The details specifying the reduced rates
available by virtue of double taxation treaties are made available to the client. The market tax
reports, summarizing local taxes for each market are provided to the client.
Tax Calculation: The tax calculation process captures trade details and applies the corresponding
tax rates for computation of the tax.
Tax Reclamation: The tax reclamation process is used to reclaim the extra tax paid by the client.
It can be of two types:
Contractual Tax Reclaims: In this kind of reclamation the client's cash account is credited with
entitlements to tax relief according to a pre-determined schedule of time-frames, in place of when
the tax refund monies are received. The contractual time frame may be ‘n’ months after the
income pay date (where the value of n varies according to the market concerned) or payment
may be made, less a discount, with income payment. This can greatly assist clients in managing
available funds.
Non-contractual Tax Reclaims: In this type where tax relief is not obtained at source, the excess
tax withholding is reclaimed. The bank prepares the required reclaim form and completes the
associated reclaim process, pursuing items as appropriate and reporting their status to clients.
Cash Sweep
Cash sweep is a value added service provided by custodian banks to its customers. This service
ensures that the surplus cash in customers’ accounts are effectively invested in short-term
investment funds i.e. STIF (may be as short as an overnight fund) to generate additional returns.
The sweep can be done intra-day based on projected earnings of the particular account or end-
of-day based on actual surplus cash in the account. The STIFs invest money in money market or
euro dollar Deposit.
• Compliance Risk
• Credit Risk
• Strategic Risk
• Reputation Risk
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BENEFITS ADMINISTRATION
DEFINED BENEFITS
Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They
promise to pay a specified benefit at retirement age. They define the amount of retirement income
to be paid. The actual monthly (or annual) benefit is calculated using a specific formula stated in
the plan document. The benefit is usually paid at a specified time such as attainment of age 65.
A Defined Benefit Plan is an employer-sponsored retirement plan in which retirement benefits are
based on a formula indicating the exact benefit that one can expect upon retiring. Investment risk
is borne by the employer and portfolio management is entirely under the control of the company.
There are restrictions on when and how participant can withdraw these funds without penalties.
A private defined benefit plan is typically not contributory i.e. there are usually no employees
contributions, no individual accounts are maintained for each employee. The employer makes
regular contributions to the entire plan to fund the future benefits of the entire cohort of
participants. The employer, rather than the participant, bears the investment risk. Usually, the
promised benefit is tied to the employee's earnings, length of service, or both.
A Defined Benefit plan provides a guaranteed level of benefits on retirement and the cost is
unknown for the employer. If the plan assets earn less than expected, the employer must make
larger contributions to ensure that the plan will have sufficient funds to pay promised benefits. If
the plan assets earn more than expected, the employer's contributions will decrease.
Defined Contribution
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A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of
money each year for an employee. The amount to be contributed to each participant's account
under the plan each year is defined (by either a fixed formula or by giving the employer the
discretion to decide how much to contribute each year). The size of a participant's benefit will
depend on:
• The amounts of money contributed to the individual's account by the
employer and, perhaps, by the employee as well;
• The rate of investment growth on the principal;
• How long the money remains in the plan (in most cases, the
employee, upon retirement, has the option of either receiving the
payment in a lump sum or by taking partial payments on a regular
basis while the balance continues to earn interest); and
• Whether the forfeitures of participants who leave before they are fully
vested can be shared among the remaining participants as a reward
to long-term employees.
Since benefits accumulate on an individual basis, these plans are sometimes referred to as
"individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward) of
investment experience is borne by the participant. Defined contribution plans can permit, and
sometimes require, that employees make contributions to the plan on either a pre-tax basis (as in
a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to,
permit employees to decide how the monies contributed into their accounts will be invested.
Defined contribution plans have gained popularity as employers have begun to ask their
employees to share responsibility for their retirement. The main purpose of a defined contribution
plan is to provide an investment vehicle for employees to accumulate retirement income.
The employer bears the investment The participant bears the investment
risk (the potential for investment risk.
gain or loss).
65.
Fig 2.1
3. RECENT DEVELOPMENTS
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RECENT DEVELOPMENTS
The anti money laundering rules are very important from a banking point of view. They are
described in greater detail later in the chapter.
Money Laundering
11
Extracted from Congressional Research Service, US and Federation of American Scientists -
www.fas.org
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In federal law, money laundering is the flow of cash or other valuables derived from, or intended
to facilitate, the commission of a criminal offence. Federal authorities attack money laundering
through regulations, criminal sanctions, and forfeiture. The Act bolsters federal efforts in each
area.
The Act expands the authority of the Secretary of the Treasury to regulate the activities of U.S.
financial institutions, particularly their relations with foreign individuals and entities. Regulations
have been promulgated covering the following areas:
• Securities brokers and dealers as well as commodity merchants,
advisors and pool operators must file suspicious activity reports
(SARs);
• Requiring businesses, which were only to report cash transactions
involving more than $10,000 to the IRS, to file SARs as well;
• Imposing additional “special measures” and “due diligence”
requirements to combat foreign money laundering;
• Prohibiting U.S. financial institutions from maintaining correspondent
accounts for foreign shell banks;
• Preventing financial institutions from allowing their customers to
conceal their financial activities by taking advantage of the
institutions’ concentration account practices;
• Establishing minimum new customer identification standards and
record-keeping and recommending an effective means to verify the
identity of foreign customers;
• Encouraging financial institutions and law enforcement agencies to
share information concerning suspected money laundering and
terrorist activities; and
• Requiring financial institutions to maintain anti-money laundering
programs which must include at least a compliance officer; an
employee training program; the development of internal policies,
procedures and controls; and an independent audit feature.
Crimes: The Act contains a number of new money laundering crimes, as well as amendments
and increased penalties for earlier crimes.
• Outlaws laundering the proceeds from foreign crimes of violence or
political corruption;
• Prohibits laundering the proceeds from cybercrime or supporting a
terrorist organization;
• Increases the penalties for counterfeiting;
• Seeks to overcome a Supreme Court decision finding that the
confiscation of over $300,000 for attempt to leave the country without
reporting it to customs
• Provides explicit authority to prosecute overseas fraud involving
American credit cards; and
• Permit prosecution of money laundering in the place where the
predicate offence occurs.
Forfeiture: The act allows confiscation of all of the property of participants in or plans an act of
domestic or international terrorism; it also permits confiscation of any property derived from or
used to facilitate domestic or international terrorism. Procedurally, the Act:
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Collecting information:
As part of a Customer Identification Program (CIP), financial institutions will be required to
develop procedures to collect relevant identifying information including a customer’s name,
address, date of birth, and a taxpayer identification number – for individuals, this will likely be a
Social Security number. Foreign nationals without a U.S. taxpayer identification number could
provide a similar government-issued identification number, such as a passport number.
Verifying identity:
A CIP is also required to include procedures to verify the identity of customers opening accounts.
Most financial institutions will use traditional documentation such as a driver’s license or passport.
However, the final rule recognizes that in some instances institutions cannot readily verify identity
through more traditional means, and allows them the flexibility to utilize alternate methods to
effectively verify the identity of customers.
Maintaining records:
As part of a CIP, financial institutions must maintain records including customer information and
methods taken to verify the customer’s identity.
identity of their customers and the clearing broker can rely on that information without having to
conduct a second redundant verification provided certain criteria are met.
The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced significant
legislative changes to financial practice and corporate governance regulation. The act is named
after its main architects, Senator Paul Sarbanes and Representative Michael Oxley, and of
course followed a series of very high profile scandals, such as Enron. It is also intended to "deter
and punish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and
protect the interests of workers and shareholders"
It introduced stringent new rules with the stated objective: "to protect investors by improving the
accuracy and reliability of corporate disclosures made pursuant to the securities laws". It also
introduced a number of deadlines, the prime ones being:
- Most public companies must meet the financial reporting and certification mandates for any end
of year financial statements filed after June 15th 2004
- smaller companies and foreign companies must meet these mandates for any statements filed
after 15th April 2005.
The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404, 401,
409, 802 and 906 are the most significant with respect to compliance. In addition, the Act also
created a public company accounting board, to oversee the audit of public companies that are
subject to the securities laws, and related matters, in order to protect the interests of investors
and further the public interest in the preparation of informative, accurate, and independent audit
reports for companies the securities of which are sold to, and held by and for, public investors.
Section 201 prohibits non audit services like bookkeeping, financial information systems design
and implementation, actuarial services, management services etc from the scope of practice of
auditors. They can however be taken up with the pre approval of the audit committee on a case
by case basis.
Section 501 seeks to improve objectivity of research by recommending rules designed to address
conflicts of interest that can arise when securities analysts recommend equity securities in
research reports. These rules are designed to foster greater public confidence in securities
research, and to protect the objectivity and independence of securities analysts.
12
Extracted from Sarbanes-Oxley forum
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Three Pillars
The underlying principle for the Accord is that Safety and soundness in today’s dynamic and
complex financial system can be attained only by the combination of effective bank-level
management, market discipline, and supervision.
The New Accord proposal is based on three mutually reinforcing pillars that allow banks and
supervisors to evaluate the various risks that banks face.
13
Extracted from Bank of International Settlements’ documents – www.bis.org
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Credit Risk: There is a choice between three increasingly sophisticated methods: the
Standardized, the Foundation Internal Ratings Based (‘IRB’) and the Advanced IRB Approaches.
complex approach (and therefore a more sophisticated risk management process) should lead to
a lower capital charge.
Operational Risk: Broadly, Operational Risk (OR) is defined as the risk of monetary losses
resulting from inadequate or failed internal processes, people, and systems or from external
events. The events characterize the inherent risks in doing business and are mostly managed by
putting in place controls. Some times controls may be ineffective or also fail because of weakness
in people, processes, systems or external events. Some times inherent risks themselves may
change because of the events in the external environment. Thus,
Operational risks = Inherent risks for which controls are not in place + Control risks
There is again a choice of approach: between a standardized and a more sophisticated Internal
Measurement Approach (‘IMA’).
CHECK 21
The Check Clearing for the 21st Century Act (Check Truncation Act, Check 21) promotes check
imaging through the introduction of a new payment instrument known as the substitute check
(also referred to as the Image Replacement Document or IRD). The substitute check, which
contains an image of the check, will be the legal equivalent of the original. Check 21 also
abolishes the paying bank's right to demand presentment of the original paper check as a
condition of payment, which allows the bank of first deposit to truncate the check upon image
capture. The Act is expected to speed the transition from traditional processing to imaged
processing and encourage the use of electronic check clearing.
Check 21 will reduce paper flow resulting from 45- 50 billion paper checks processed each year,
and, in many cases, will eliminate labor- and cost-intensive paper check handling, transportation,
and storage issues. Banks that convert to check imaging will realize many other benefits,
including:
• Savings associated with lower transit costs and courier charges
• Lower risk of lost items and/or transit delays
• Lower check processing errors resulting from reduced handling and
automated data capture from check images
• Fully automated Day 2 (return) processing enabled by image
exception item processing
• Compressed processing windows to enable later branch cutoff times
• Improved collection float due to faster clearing processes
Check 21 will lead to additional payment system efficiency industry-wide. It will allow financial
institutions to further leverage their investment in check imaging technologies.
4. GLOSSARY
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Agency bonds: Agencies represent all bonds issued by the federal government, except for those
issued by the Treasury (i.e. bonds issued by other agencies of the federal government).
Examples include the Federal National Mortgage Association (FNMA), and the Guaranteed
National Mortgage Association (GNMA).
Arbitrage: The trading of securities to profit from a temporary difference between the price of
security in one market and the price in another. This temporary difference is often called market
inefficiency.
Annualized Percentage or Return: The periodic rate times the number of periods in a year. For
example, a 5% quarterly return has an A.P.R. of 20%. It depends on the following:
• How much repayment
• How frequently
• Which component of loan – interest or principal
Authorization (Credit Cards): The act of ensuring that the cardholder has adequate funds
available against their line of credit. A positive authorization results in an authorization code being
generated, and a hold being placed on those funds. A "hold" means that the cardholder's
available credit limit is reduced by the authorized amount.
Beauty contest: The informal term for the process by which clients choose an investment bank.
Some of the typical selling points when competing with other investment banks for deals are:
"Look how strong our research department is in this industry. Our analyst in the industry is a real
market mover, so if you go public with us, you'll be sure to get a lot of attention from her."
Bloomberg: Computer terminals providing real time quotes, news, and analytical tools, often
used by traders and investment bankers.
Bond spreads: The difference between the yield of a corporate bond and a U.S. Treasury
security of similar time to maturity.
Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman Sachs,
Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman Brothers, Credit
Suisse First Boston.
Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the stocks,
bonds and securities sold by the investment banks. (The investment banks that sell these
products to investors are known as the sell-side.)
Capitalized Loan: A loan in which the interest due and not paid is added to the principal balance
of the loan. Capitalized interest becomes part of the principle of the loans; therefore, it increases
the total cost of repaying the loan because interest will accumulate on the new, higher principle.
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Capture (Credit Cards): Converting the authorization amount into a billable transaction record.
Transactions cannot be captured unless previously authorized.
Commercial bank: A bank that lends, rather than raises money. For example, if a company
wants $30 million to open a new production plant, it can approach a commercial bank for a loan.
Commercial paper: Short-term corporate debt, typically maturing in nine months or less.
Commodities: Assets (usually agricultural products or metals) that are generally interchangeable
with one another and therefore share a common price. For example, corn, wheat, and rubber
generally trade at one price on commodity markets worldwide.
Comparable company analysis (Comps): The primary tool of the corporate finance analyst.
Comps include a list of financial data, valuation data and ratio data on a set of companies in an
industry. Comps are used to value private companies or better understand a how the market
values and industry or particular player in the industry.
Consumer Price Index: The CPI measure the percentage increase in a standard basket of
goods and services. CPI is a measure of inflation for consumers.
Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each year, until
maturity. In Thailand the coupon is usually paid semi-annually or annually.
Discount rate: The rate at which federal banks lend money to each other on overnight loans. A
widely followed interest rate set by the Federal Reserve to cause market interest rates to rise or
fall, thereby causing the U.S. economy to grow more quickly or less quickly.
Discount Rate for Credit Cards: A small percentage of each transaction that is withheld by the
Acquiring Bank or ISO. This fee is basically what the merchant pays to be able to accept credit
cards. The fee goes to the ISO (if applicable), the Acquiring Bank, and the Associations.
Fed: The Federal Reserve, which manages the country's economy by setting interest rates.
Federal funds rate: The rate domestic banks charge one another on overnight loans to meet
Federal Reserve requirements. This rate tracks very closely to the discount rate, but is usually
slightly higher.
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Fixed income: Bonds and other securities that earn a fixed rate of return. Bonds are typically
issued by governments, corporations and municipalities.
Float: The number of shares available for trade in the market. Generally speaking, the bigger the
float, the greater the stock's liquidity.
Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid on U.S.
Treasuries), allowing the interest rate to change as market conditions change.
Glass-Steagall Act: Passed in 1933 during the “Depression” to help prevent future bank failures.
The Glass-Steagall Act split America's investment banking (issuing and trading securities)
operations from commercial banking (lending). For example, J.P. Morgan was forced to spin off
its securities unit as Morgan Stanley. Since the late 1980s, the Federal Reserve has steadily
weakened the act, allowing commercial banks such as NationsBank and Bank of America to buy
investment banks like Montgomery Securities and Robertson Stephens. In 1999, Glass-Steagall
was effectively repealed by the Graham-Leach-Bliley Act.
Graham-Leach-Biley Act: Also known as the Financial Services Modernization Act of 1999.
Essentially repealed many of the restrictions of the Glass-Steagall Act and made possible the
current trend of consolidation in the financial services industry. Allows commercial banks,
investment banks, and insurance companies to affiliate under a holding company structure.
Gross Domestic Product: GDP measures the total domestic output of goods and services in the
United States. For reference, the GDP grew at a 4.2 percent rate in 1999. Generally, when the
GDP grows at a rate of less than 2 percent, the economy is considered to be in recession.
Hedge: To balance a position in the market in order to reduce risk. Hedges work like insurance: a
small position pays off large amounts with a slight move in the market.
High grade corporate bond: A corporate bond with a rating above BB. Also called investment
grade debt.
High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to
compensate investors for high risk of default. Credit rating agencies such as Standard & Poor's
rate a company's (or a municipality's) bonds based on default risk. Junk bonds rate below BB.
Institutional clients or investors: Large investors, such as pension funds or municipalities (as
opposed to retail investors or individual investors).
Lead manager: The primary investment bank managing a securities offering. An investment
bank may share this responsibility with one or more co-managers.
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League tables: Tables that rank investment banks based on underwriting volume in numerous
categories, such as stocks, bonds, high yield debt, convertible debt, etc. High rankings in league
tables are key selling points used by investment banks when trying to land a client engagement.
Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using that
company's own assets as collateral. LBOs were common in 1980s, when successful LBO firms
such as Kohlberg Kravis Roberts made a practice of buying up companies, restructuring them,
and reselling them or taking them public at a significant profit
LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR
represents the rate banks in England charge one another on overnight loans or loans up to five
years. LIBOR is often used by banks to quote floating rate loan interest rates. Typically the
benchmark LIBOR is the three-month rate.
Liquidity: The amount of a particular stock or bond available for trading in the market. For
commonly traded securities, such as big cap stocks and U.S. government bonds, they are said to
be highly liquid instruments. Small cap stocks and smaller fixed income issues often are called
illiquid (as they are not actively traded) and suffer a liquidity discount, i.e. they trade at lower
valuations to similar, but more liquid, securities.
Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting point for
pricing many other bonds, because Treasury bonds are assumed to have zero credit risk taking
into account factors such as inflation. For example, a company will issue a bond that trades "40
over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage point).
Making markets: A function performed by investment banks to provide liquidity for their clients in
a particular security, often for a security that the investment bank has underwritten. The
investment bank stands willing to buy the security, if necessary, when the investor later decides
to sell it.
Market Capitalization: The total value of a company in the stock market (total shares
outstanding x price per share).
Merchant Account: A special business account set up to process credit card transactions. A
merchant account is not a bank account (even though a bank may issue it). Rather, it is designed
to 1) process credit card payments and 2) deposit the funds into your (business) checking
account (minus transaction fees).
Money market securities: This term is generally used to represent the market for securities
maturing within one year. These include short-term CDs, repurchase agreements, commercial
paper (low-risk corporate issues), among others. These are low risk, short-term securities that
have yields similar to Treasuries.
Foundation Course in Banking
Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a. municipalities.
Municipal bonds are structured as tax-free for the investor, which means investors in muni's earn
interest payments without having to pay federal taxes. Sometimes investors are exempt from
state and local taxes, too. Consequently, municipalities can pay lower interest rates on muni
bonds than other bonds of similar risk.
Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for their
services. This generally includes a monthly fee and a small flat fee per transaction. These fees
may be consolidated into a single bill by the acquiring bank or ISO, along with their fees.
Pitchbook: The book of exhibits, graphs, and initial recommendations presented by bankers to a
prospective client when trying to land an engagement.
Pit traders: Traders who are positioned on the floor of stock and commodity exchanges (as
opposed to floor traders, situated in investment bank offices).
P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its earnings-
per-share. The higher the P/E ratio, the more expensive a stock is (and also the faster investors
believe the company will grow). Stocks in fast-growing industries tend to have higher P/E ratios.
Prime rate: The average rate U.S. banks charge to companies for loans.
Producer Price Index: The PPI measure the percentage increase in a standard basket of goods
and services. PPI is a measure of inflation for producers and manufacturers.
Proprietary trading: Trading of the firm's own assets (as opposed to trading client assets).
Prospectus: A report issued by a company (filed with and approved by the SEC) that wishes to
sell securities to investors. Distributed to prospective investors, the prospectus discloses the
company's financial position, business description, and risk factors.
Red herring: Also known as a preliminary prospectus. A financial report printed by the issuer of a
security that can be used to generate interest from prospective investors before the securities are
legally available to be sold. Based on final SEC comments, the information reported in a red
herring may change slightly by the time the securities are actually issued.
Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity, or ROE,
is a commonly used measure of how well an investment bank is doing, because it measures how
efficiently and profitably the firm is using its capital.
Risk arbitrage: When an investment bank invests in the stock of a company it believes will be
purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.)
Road-show: The series of presentations to investors that a company undergoing an IPO usually
gives in the weeks preceding the offering. Here's how it works: Several weeks before the IPO is
issued, the company and its investment bank will travel to major cities throughout the country. In
each city, the company's top executives make a presentation to analysts, mutual fund managers,
and others attendees and also answer questions.
Sales memo: Short reports written by the corporate finance bankers and distributed to the bank's
salespeople. The sales memo provides salespeople with points to emphasize when hawking the
stocks and bonds the firm is underwriting.
Securities and Exchange Commission (SEC): A federal agency that, like the Glass-Steagall
Act, was established as a result of the stock market crash of 1929 and the ensuing depression.
The SEC monitors disclosure of financial information to stockholders, and protects against fraud.
Publicly traded securities must first be approved by the SEC prior to trading.
Securitize: To convert an asset into a security that can then be sold to investors. Nearly any
income generating asset can be turned into a security. For example, a 20-year mortgage on a
home can be packaged with other mortgages just like it, and shares in this pool of mortgages can
then be sold to investors.
Short-term debt: A bond that matures in nine months or less. Also called commercial paper.
Syndicate: A group of investment banks that will together underwrite a particular stock or debt
offering. Usually the lead manager will underwrite the bulk of a deal, while other members of the
syndicate will each underwrite a small portion.
Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This fee is
collected by the acquiring bank or ISO and pays for the toll-free dial out number and the
processing network.
T-Bill Yields: The yield or internal rate of return an investor would receive at any given moment
on a 90-120 government treasury bill.
Tombstone: The advertisements that appear in publications like Financial Times or The Wall
Street Journal announcing the issuance of a new security. The tombstone ad is placed by the
investment bank as information that it has completed a major deal.
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Yield: The annual return on investment. A high yield bond, for example, pays a high rate of
interest.
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5. REFERENCES
Foundation Course in Banking
WEBSITES
WWW.BIS.ORG
WWW.IBRD.COM
WWW.SIAINVESTOR.COM
WWW.SIAC.COM
WWW.CNBC.COM
WWW.STOCKCHARTS.COM
WWW.MONEYCENTRAL.COM
WWW.MSNMONEY.COM
WWW.NYSE.COM
WWW.NASDAQ.COM
WWW.AMERITRADE.COM
WWW.ESCHWAB.COM
HTTP://FINANCE.YAHOO.COM
WWW.INVESTOPEDIA.COM
WWW.FT.COM
WWW.BLOOMBERG.COM
WWW.VANGUARD.COM
BOOKS
• The Bank Credit Card Business – American Bankers Association
• Value At Risk – Phillipe Jorions
• Principles of Corporate Finance – Brearley Myers
• Securities Operations – Michael T Reddy – New York Institute of
Finance
• After the Trade is Made – David M Weiss – New York Institute of
Finance
• Investment Analysis & Portfolio Management - Frank K. Reilly
&
• Keith C. Brown
• The Warren Buffet Way – Robert Hagstrom Jr
• One Up on the Wall Street – Peter Lynch