FM302-MANAGEMENT OF FINANCIAL SERVICES

FINANCE SPECILIZATION

Mr.LALIT TANKAsst. Professors, MBA Department,

Bhagawan Mahavir College of Management, SuratEmail id: lalittank@gmail.com

COURSE CONTENTS

Module No.1• Introduction to Indian Financial systemReserve bank and financial system.structure of banking and non-banking

companies.Introduction to different markets- Capital,

Money, Primary, Secondary Markets.Module No.2

• Asset/Fund based financial servicesLeasing, hire purchase

Module No.3Consumer credit, factoring and forfeiting , Bill

discounting, Housing finance, Insurance services, venture capital financing, Mutual fund services

Module No.4Merchant banking services : all services related to issue management

Module No.5Credit rating, Stock broking, depositories,

custodial services and short selling and securities lending and borrowing services, Credit cards.

CHAPTER -1INTRODUCTION TO INDIAN

FINANCIAL SYSTEM

INDIAN FINANCIAL SYSTEM

• The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations.

Constituents of a Financial System

Financial System

• An institutional framework existing in a country to enable financial transactions.

• Three main parts– Financial assets (loans, deposits, bonds, equities, etc.)– Financial institutions (banks, mutual funds, insurance

companies, etc.)– Financial markets (money market, capital market, forex market,

etc.)

• Regulation is another aspect of the financial system (RBI, SEBI, IRDA, FMC)

Financial assets/Instruments

• Enable channelizing funds from surplus units to deficit units

• There are instruments for savers such as deposits, equities, mutual fund units, etc.

• There are instruments for borrowers such as loans, overdrafts, etc.

• Like businesses, governments too raise funds through issuing of bonds, Treasury bills, etc.

• Instruments like PPF, KVP, etc. are available to savers who wish to lend money to the government

Financial Institutions

• Includes institutions and mechanisms which– Affect generation of savings by the community– Mobilization of savings– Effective distribution of savings

• Institutions are banks, insurance companies, mutual funds- promote/ mobilize savings

• Individual investors, industrial and trading companies- borrowers

Financial Markets

• Money Market- for short-term funds (less than a year)– Organised (Banks)– Unorganised (money lenders, chit funds, etc.)

• Capital Market- for long-term funds– Primary Issues Market– Stock Market– Bond Market

Function of the Financial System

• Prevision of liquidityliquidity refers to cash or money and other assets which can be converted into cash readily without loss of value and time.

• Mobilization of savings

Weaknesses of India financial systemLack of co-ordination between different

financial institutions.Monopolistic market structures -LIC in life insurance -UTI in mutual fund Dominance of development banks in industrial

financing Inactive and erratic capital market Imprudent financial practice

Reserve Bank of India (RBI)

Establishment of RBI

The reserve bank of India was

established on April 1,1935 in accordance with the

provisions of the reserve bank of India Act, 1934.

The central office of the reserve bank

was initially in Calcutta but was permanently moved

to Mumbai in 1937. the central office is where the

governor sits and where policies are formulated.

Objectives of RBI

• To maintain the internal value of the nation’s currency.

• To preserve the external value of the currency• To secure reasonable price stability.• To promote economic growth with rising

levels of employment, out and real income

Functions of a RBI• Monetary policy functions• Currency issue and management• Maintaining value of currency• Anchor economic growth expectation• Monetary regulation and management• Regulation of interest rates• Financial sector regulation and supervision• Exchange management and control• Credit control• Liquidity management• Clearing and settlement • Development of financial market• Policy oriented research• Collection of data and publication of reports• Institution building

Role of the Reserve Bank of India

• Banker to the government• Banker to the banks• Bank’s supervision• Monetary regulation and management• Foreign exchange and management• Promotional functions

Supervisory/regulatory function of RBI

• Licensing of banks• Approval of capital, reserves and liquid assets of

banks• Branch licensing policy• Inspection of banks• Control over management• Audit • Credit information service• Deposit insurance • Training and banking education

RBI –ORGANISATION STRUCTURE

Introduction to different Markets

• Capital Market, Money Market, • Primary Market, Secondary Market

Money Market

• The market for dealing with financial assets and sec. which have a maturity period of up to one year.

• RBI defines the money market as “A market for short term financial assets that are close substitutes for money, facilitates the exchange of money for new financial claims in primary market as also for financial claims, already issued, in the secondary market”

Money Market Instruments

• Money market instruments are those which have maturity period of less than one year.

• The most active part of the money market is the market for overnight call and term money between banks and institutions and repo transactions

• Call money/repo are very short-term money market products

Money Market Instruments

• Certificates of Deposit• Commercial Paper• Inter-bank participation certificates• Inter-bank term money• Treasury Bills• Bill rediscounting• Call/notice/term money• CBLO (Collateralized Borrowing and Lending Obligation) • Market Repo

Features of a money market

• Market purely for short –term funds or financial assets• Its deals with financial assets having maturity period up

to one year.• it deals with those assets which can be convert in to

cash readily without loss and mini transaction cost • Transaction have to be conducted without the help of

brokers

Objectives of money market

• To provide a parking place to employ short-term surplus

• To provide room for overcoming short-term deficits.

• To enable the central bank to influence and regulate liquidity in the economy through its intervention in this market.

• To provide reasonable access to the users of short-term funds to meet requirements.

Characteristics of a Developed Money Market

• Highly organized banking system• Presence of a central bank• Availability of proper credit instrument• Existence of sub-brokers• Sufficient resources• Existence of secondary markets• Demand and supply of funds

Importance of Money Market

• Development of money market• Development of capital market• Smooth functioning of commercial banks• Effective central bank control• Formulation of suitable monetary policy• Non-inflation source of finance to

government

Composition of Money Market

The money market consist of following sub market.

• Call money market• Commercial bills market• Acceptance market• Treasury bill market

Call money market

The call money market refers to the market for extremely short period loans, say one day to fourteen days.

These loans are repayable on demand at the option of either the lender or the borrower.

Advantages of call money market

• High liquidity• High profitability• Maintenance of statutory reserve ration

(SRR)• Safe and cheap• Assistance to central bank operation

Drawbacks of call money market

• Uneven development

• Lack of integration

• Volatility in call money rates

Commercial bills market or discount Market

• Definition“An instrument in writing

containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to ,or the order of certain person or to the bearer of the instrument”.

Types of billsMany types of bills are in circulation in a

bill market• Demand bills are also called sight bills. these bills are

payable immediately as soon as they are presented to the drawer no time of payment is specified and hence they are payable at sight.

• Documentary billwhen bills have to be accompanied by

document of title to goods like railway receipt, lorry receipt, bill of lading etc.the bills are called doc.bills.

• Inland and foreign bills inland bills are those drawn upon a person

resident in India and are payable in India. foreign bills are drawn outside India and they may be payable either in India or outside India.

• Export bills and import billsexport bills are those drawn by Indian exporters on

imports outside India and importer bills are drawn on Indian importers in India by exporters outside India.

• Indigenous billsindigenous bills are those drawn and accepted

according to native custom or usage of trade.

Advantages of Commercial bills market

• Liquidity• Self-liquidating and negotiable asset• Certainty of payment• Ideal investment• Simple legal remedy• High and quick yield• Easy central bank control

Drawbacks of Commercial bills market

• Absence of bill culture• Absence of rediscounting among banks• Stamps duty• Absence of secondary market• Difficulty in ascertaining genuine trade bills• Limited foreign trade• Absence of acceptance service • Attitude of banks

Treasury bill marketA treasury bill nothing but a promissory

note issued by the Govt. under discount for a specified period stated therein. the govt.promises to pay the specified amount mentioned therein to the bearer of the instrument on the due date.

T.B are issued only by the RBI on behalf of the govt. TB are issued for meeting temporary govt. deficits.

Types of Treasury bill

• There are two types of TBordinary treasury bills are issued to the

public and other financial institution for meeting the short term financial requirements of the central govt.

ad hocs treasury are always issued in favor of the RBI only.

Importance of TB• Safety• Liquidity • Ideal short-term investment• Ideal fund management• Statutory liquidity• Source of sort term funds• Non-inflationary monetary tool• Hedging facility

Defects of TB poor yield absence of competitive bids absence of active trading

Commercial papers (CP) • A Cp Is an unsecured promissory note issued with a fixed

maturity by a company approved by RBI, negotiable by endorsement and delivery, issued in bearer form and issued at such discount on the face value as may be determined by the issuing co.

• Short-term borrowings by corporate, financial institutions, primary dealers from the money market

• Can be issued in the physical form (Usance Promissory Note) or demat form

• Introduced in 1990• When issued in physical form are negotiable by endorsement

and delivery and hence, highly flexible• Issued subject to minimum of Rs. 5 lacs and in the multiple of

Rs. 5 lacs after that• Maturity is 7 days to 1 year• Unsecured and backed by credit rating of the issuing company• Issued at discount to the face value

• Certificate of depositCD are short term deposits instruments

issued by bank and financial institutions t raise large sums of money.

• Repo instrument.Repurchase transaction the borrower parts

with securities to the lender with an agreement to repurchase them at the end of the fixed period at a specified price.

• At the end of the period the borrower will repurchase the securities at the predetermined price.

Capital Markets• What is Capital Market

It is an organized market mechanism for effective and efficient

transfer of money capital or financial resources from the investing class

to the entrepreneur class in the private and public sector of the

economy.

•Capital market for long term funds.

•The capital market provides long term debt and equity finance for

govt. and corporate.

•Capital market facilitates the dispersion of business ownership and

reallocation of financial resources among corporate and industries.

Dimensions of capital market

• The capital market is directly responsible for the following activities.

• Mobilization or concentration of national saving for economic development.

• Mobilization and import of foreign capital and foreign investment capital plus skill to fill up the deficit in the required financial resources to maintain the expected rate of economic growth.

• Productive utilization of resources • Directing the flow to funds of high yields and also

strive for balanced and diversified industrialization.

Capital market mechanism

•Individuals •Institutions•Government

Capital Market•Stock exchange•New issue market •Finance and investment corp.

•Individuals •Institutions•Government

Supply of funds

•Investors •Lenders•Sellers of money capital

• Entrepreneurs•Borrowers•Clearing house for long term or permanent finance

• Buyers of money capital

Middlemen Demand for funds

Capital Market Structure

Marketable Securities Non-Marketable Securities

Govt. securities

Corporate securities

PSUs Bonds

UTI Mutual Funds

Bank Deposits

Deposits with Companies

Loans and advances of banks and FIs.

POC and deposits

New Issues Market players –original

Stock market intermediaries

New Issues Market players –for Issues

Special features of the Indian capital market

• Greater reliance on debt instrument as against equity and in particular borrowing from financial institution.

• Issues of debenture, particularly convertible debentures with automatic or compulsory from conversion into equity without the normal option given to investors.

• Avoidance of underwriting by some cos. Reduce.• Fast growth of mutual funds and subsidiaries of

banks for financial services.

Capital market instruments

• Equity shares • Preference shares • Non-voting equity shares• Cumulative convertible preference shares• Company fixed deposits• Debentures/ bonds • Global depository receipts

Structure of Capital MarketsPrimary Markets Secondary Markets

When companies need financial resources for its expansion, they borrow money from investors through issue of securities.

The place where such securities are traded by these investors is known as the secondary market.

Securities issued a)Preference Sharesb)Equity Sharesc)Debentures

Securities like Preference Shares and Debentures cannot be traded in the secondary market.

Equity shares is issued by the under writers and merchant bankers on behalf of the company.

Equity shares are tradable through a private broker or a brokerage house.

People who apply for these securities are: a)High networth individualb)Retail investorsc)Employeesd)Financial Institutionse)Mutual Fund Housesf)Banks

Securities that are traded are traded by the retail investors.

One time activity by the company. Helps in mobilizing the funds for the investors in the short run.

What is Commodity market

Commodity markets are markets where raw orprimary products are exchanged.

It covers physical product (food, metals, electricity)markets but not the ways that services, including those of governments, nor investment nor debt, can be seen as a commodity.

History of Commodity Market Modern Commodity Market have their roots in thetrading of agricultural products. Wheat and corn, cattle and pigs, were widely traded

using standard instruments in the 19th century in the United States.

Historically, in ancient times Sumerian use of sheepor goats, or other peoples using pigs, rare seashells, orother items as commodity money, have tradedcontracts in the delivery of such items, to render tradeitself more smooth and predictable.

Size of the Market

•The trading of commodities includes physical trading of food items, Energy and Metals, etc. and trading of derivatives.

•In the five years up to 2007, the value of globalphysical exports of commodities increased by 17% while the notional value outstanding of commodity OTC derivatives increased more than 500% andcommodity derivative trading on exchanges morethan 200%.

• Agricultural contracts trading grew by 32% in 2007, energy 29% and industrial metals by 30%.

•Precious metals trading grew by 3%, with higher volume in New York being partially offset by declining volume in Tokyo.

• OTC trading accounts for the majority of trading in gold and silver

List of Traded Commodity

Agricultural (Grains, and Food and Fiber)•Livestock & Meat•Energy•Precious metals•Industrial metals

• Precious Metal:- Gold, Platinum, Palladium, Silver.•Industrial Metals:- Copper, Lead, Zinc, Tin,

Aluminium, Aluminium alloy, Nickel, Aluminiumalloy, Recycled steel.

Commodity Exchanges

• Abuja Securities and Commodities Exchange•Bhatinda Om & Oil Exchange Bathinda•Brazilian Mercantile and Futures Exchange•Chicago Board of Trade•Chicago Mercantile Exchange•Commodity Exchange Bratislava, JSC•Dalian Commodity Exchange•Dubai Mercantile Exchange•Intercontinental Exchange

Recent trends in Commodity Market

• The 2008 global boom in commodity prices - foreverything from coal to corn – was fueled by heateddemand from the likes of China and India.

•Speculation in forward markets.•Farmers are expected to face a sharp drop in cropprices as a result of bad rainfall.•Other commodities, such as steel, are also expected tofall due to lower demand

Assignment -1

• Q-1 Write in detail about Commodities market

• LAST DATE OF SUBMISSION :8/10/2010

LEASING

Meaning of Leasing

• Lease may be define as a contractual arrangement/ transaction in which a party owning an asset/equipment provides the asset for use to another /transfer the right to use the equipment to the user over certain/ for an agreed period of time for consideration in form of /in return for periodic payment (rental) with or without a further payment (premium).

• Lease is a contract whereby the owner of an asset grants to another party the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent.

PARTIES IN LEASING

• Leasing essentially involves the divorce of ownership from the economic use of an asset/equipment.

• LESSOR: Lessor is the owner of the asset that is being leased.

• LESSEE: Lessee is the receiver of the services of the asset under a lease contact.

Essential elements of leasing • Parties to the contract • Asset : The asset, property or equipment to be leased

is the subject matter of a contract of leasing finance.• Ownership separated from user: • Term of lease: lease term is the period for which the

lease agreement remains in operation.• Lease rentals: lease rental is the consideration which

the lessee pays to the Lessor for the lease transaction.• Modes of terminating lease.

Classification of Lease

1. Financial lease and operating lease 2. Sales and lease back and direct lease 3. Single investor lease and leveraged lease4. Domestic lease and international lease

1.Financial lease and operating lease

• In a finance lease the Lessor transfers to the lessee, substantially all the risks and rewards incidental to the ownership of the asset whether or not the title is eventually transferred.

• In such leases, the lessor is only a financier and is usually not interested in the assets.

• It is for this reason that the such lease are also called as ‘fully payout leases’ as they enable a lessor to recover his

investment in the lease and derive a profit.• Assets included under such lease, are ships, aircraft, railway

wagons, lands, building heavy machinery and so on.

Features of finance lease• The lessee select the equipment according to his requirements, from its

manufacturer or dist.• The lessee negotiates and settles with the manfuct.or dist, the price, the

delivery schedule, installation, term of warranties, maintenance and payment and so on.

• The lessor purchases the equipment either directly from manfct. Or dist. Or from the lessee after the equipment is delivered.

• The lessor then leases out the equipment to lessee. The lessor retains the ownership while lessee is allowed to use the equipment.

• A finance lease provide a right or option, to purchase the equipment at a future date. This practice is rarely found in India.

• The lease is originally for a non-cancellable period is called the primary lease period. The lease is subject to renewal for the secondary lease period.

• The lessee is entitled to exclusive and peaceful use of equipment.

Operating lease

• An operating lease is one which is not a finance lease. In an operating lease, the lessor does not transfer all the risks and rewards incidental to the ownership of the asset and the cost of the asset is not fully amortised during the primary lease period.

• The lessor provides services attached to the leased asset, such as repair and technical advice. for this reason it called ‘service lease’

Features of operating lease

• An O.L is generally for a period significantly shorter than the economic life of the leased asset.

• Lease period are shorter than expected life of the asset, the lease rentals are not sufficient to totally amortise the cost of the assets.

• The lessor does not rely on the single lessee for recovery of his investment.

• O.L normally include maintenance clause requiring the lessor to maintain the lease assets and provide services such as insurance, support staff, fuel etc.

Examples of operating lease

• Providing mobile cranes with operators • Chartering of aircraft and ships, including the

provision of crew, fuel, support service.• Hiring of computers with operators • Hiring a taxi for a particular travel, which

includes service of driver, provision for maintenance, fuel, repairs.

2.Sale and lease back and direct lease

• It is an indirect form of leasing • The owner of an equipment/asset sells it to a leasing co.

(lessor) which leases it back to the owner(lessee).• Example: this type of leasing is the sale and lease back of safe

deposits vaults by bank under which banks sell them in their custody to a leasing co.at a market price substantially higher than the book value. The leasing co. turn offers these lockers on long term basis to the bank.

• The bank sub-lease the lockers to its customers.• The lease back arrangement in sale and lease back type of

leasing can be in the form of finance lease or operating.

Direct lease • In direct lease, the lessee, and the owner of the equipment are two

different entities. A direct lease can be two types.• Bipartite:1.Equipment supplier –cum lessor.2. Lessee such a type of lease is typically structured as an operating lease with

in-built facilities. like upgradition of equipment (upgrade lease).addition to the original equipment configuration.

• The lessor maintains the asset and if necessary, replace, it with a similar equipment in working condition (swap lease).

• Tripartite: such type of lease involves 3 different parties in the lease agreement: equipment, supplier, lessor, lessee.

• an innovative variant of tripartite lease is the sales-aid lease under which the equipment supplier arranges for lease finance in various form.

3.Single investor lease and leveraged lease.

• Single investor lease there are only two parties to the lease transaction, the lessor and lessee. The leasing co.(lessor) funds the entire investment by an appropriate mix of debt and equity funds.

• The debts raised by the leasing co. to finance the asset are without recourse to the lessee. That is in the case of default in servicing the debt by the leasing co. the lender is not entitled to payment from the lessee.

Leveraged lease• There are three parties to the transaction 1. Lessor (equity investor)2. Lender (loan participant)3. Lessee.• A leveraged lease is a lease in which the lessor puts up some of the money

required to purchase the asset and borrows the rest from a lender. The lender is given a senior secured interest on the asset and an assignment of the lease and lease payments. The lessee makes payments to the lessor, who makes payments to the lender.

• The term may also refer to a lease agreement wherein the lessor, by borrowing funds from a lending institution, finances the purchase of the asset being leased.

• The lessor pays the lending institution back by way of the lease payments received from the lessee. Under the loan agreement, the lender has rights to the asset and the lease payments if the lessor defaults.

Domestic lease and international lease

• Domestic lease : a lease transaction is classified as domestic if all parties to the agreement, namely, equipment supplier, lessor and the lessee, are domiciled in the same country.

• International lease: if the parties to the lease transaction are domiciled in different countries, it is knows as international lease.

• Import lease : In an import lease, the lessor and the lessee are domiciled in different same country but the equipment supplier is located in a different country. The lessor imports the asset and leases it to the lessee.

• Cross border lease: when the lessor and the lessee are domiciled in different countries, the lease is classified as cross-boarder lease. The domicile of the supplier is immaterial.

• The domestic and international leases are differentiated on the basis of risk.

Profile/structure of leasing

• Major players can be categorized into 6 groups• Independent leasing cos.: a major part of their income is

derived from leasing. Some of them have financial/technical collaboration with overseas partners. They offer their services through direct advertisement, personal contacts, lease brokers including foreign banks and merchant banks.

• Other finance cos: • Manufacturer- lessors:• Financial institutions:• In-house lessors • Commercial banks

Salient features of the lease structures in India

• By and large, the structured lease fall in the category of finance lease. operating lease is not very popular primarily because of the virtual non-existence of resale market for most of the used equipments.

• The lease agreements do not provide for transfer of ownership to the lessee as such transactions are classified as hire purchase from the tax angle.

• The lease rentals are structured so as to recover the entire investment cost during the primary period.

• The lease rentals are payable generally in equated/level monthly instalments at the beginning of every month.

• Sale and lease back type of transactions are rare. Most of the are direct lease.

• By and large equipment leases are for capital investment not exceeding Rs.100 lakh.

Advantages of leasing • To the lessee.

1. Financing of capital goods.2. Additional source of finance.3. Less costly4. Ownership preserved 5. Avoids conditionality 6. Flexibility in structuring of rentals 7. Simplicity 8. Tax benefits 9. Obsolescence risk is averted.

Advantages to the lessor

• Full security • Tax benefit• High profitability • Trading on equity • High growth potential

Limitations of leasing

• Restrictions on use of equipment• Limitations of financial lease • Loss of residual value • Consequences of default• Understatement of lessee’s asset• Double sales-tax

Special provisions to leasing contract/transactions.

• Leasing as a bailment agreement• Liabilities of lessee (Bailee-whom the goods are delivered)

-Reasonable care -Not to make unauthorized use-To return the goods-Not to set up an adverse title -To pay the lease rental -To insure and repair the goods.

• Liabilities of lessor (bailor-who delivers the goods):-Delivery of goods -Peaceful possession-Fitness of goods-To disclose all defects

Remedies for Breach• Remedies to the lessor:

-Forfeiture-Damages -Repossession

• Remedies to the lessee.-Insurance of leased asset and claims necessity -Risk insured -Insurable interest -claims (treatment of claim proceeds)-sub-lease of leased asset right to sub lease-effect of sub lease -effect of termination of main lease

Lease documentation and agreement

• Proposes and essential requirement - The person executing the document should have the legal capacity to do; the doc. Should be in prescribed format; properly stamped, witnessed, and duly executed and stamped should be registered with appropriate authorities.

Master lease and supplemental lease agreements

• The lease agreement specifies the legal rights and obligations of the lessor and lessee. Usually a master lease agreement is signed which stipulates all the conditions that govern the lease. It specify the all the detail of –equipment detail –credit limit –rental profile –other details.

Clauses in lease agreement • Nature of the lease• Description of equipment• Delivery and re-delivery• Period • Lease rentals • Use • Title : ownership of

equipment

•Repairs and maintenance• Alteration•Peaceful possession•Charges•Indemnity clause•Inspection •Prohibition of sub leasing •Events of default and remedies •Applicable law