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END TERM EXAMINATION
THIRD SEMESTER [MBA] DECEMBER 2006
PAPER CODE: - MS219 SUBJECT: Financial Markets and Institutions
Q1).Indian Financial system has under gone complete metamorphosis afterindependence in terms of institutions, markets and instruments. Discuss in the context of
first and second generation reforms in the financial sectors since 1991.
Financial institution - A financial system can be defined at the global, regional or firm
specific level. The firm's financial system is the set of implemented procedures that track
the financial activities of the company. On a regional scale, the financial system is the
system that enables lenders and borrowers to exchange funds. The global financial
system is basically a broader regional system that encompasses all financial institutions,
borrowers and lenders within the global economy.
The financial system conveys resources from lenders to borrowers, and transfers risks
from those who wish to avoid them to those who are willing to take them. It is a complex
interactive system, events in one component of which can have significant repercussions
elsewhere. There are also complex interactions between financial transactions and other
forms of economic activity, as consequence of which a malfunction of the financial
system can cause a malfunction of the economy, and vice-versa. The system has evolved
by adaptation and innovation, and the conduct of its participants has been modified from
time to time by regulations designed to preserve its stability
The financial system of any country consists of
(a) specialised and non-specialised financial institutions
(b) organised and unorganised financial markets
(c) financial instruments and services which facilitate transfer of funds.
Significance of Institutions are as follows:
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Financial institutions have tended to play down their potential role in moving towards
sustainable development, believing that such matters are primarily the role of
government. Financial markets normally supply financial capital with the intention that is
should ideally increase, and at least should be safeguarded. Financial institutions can
respond quickly to new opportunities, particularly when the potential is presented to them
in a clear and consistent manner,Banking system and the Financial Institutions play very
significant role in the economy. First and foremost is in the form of catering to the need
of credit for all the sections of society An efficient banking system must cater to the
needs of high end investors by making available high amounts of capital for big projects
in the industrial, infrastructure and service sectors. At the same time, the medium and
small ventures must also have credit available to them for new investment and expansion
of the existing units. Rural sector in a country like India can grow only if cheaper credit is
available to the farmers for their short and medium term needs.
Credit availability for infrastructure sector is also extremely important. The success of
any financial system can be fathomed by finding out the availability of reliable and
adequate credit for infrastructure projects. Fortunately, during the past about one decade
there has been increased participation of the private sector in infrastructure projects.
The banks and the financial institutions also cater to another important need of the
society i.e. mopping up small savings at reasonable rates with several options. The
common man has the option to park his savings under a few alternatives, including the
small savings schemes introduced by the government from time to time and in bank
deposits in the form of savings accounts, recurring deposits and time deposits. Another
option is to invest in the stocks or mutual funds. The economic development greatly
depends on the rate of capital formation. Now, the capital formation depends upon
whether finance is made available in time, in adequate quantity, and on favorable terms
all of which a good financial system could achieve .A efficient financial system helps inmobilizing the savings thus results in economic growth of a economy. A financial system
helps output to increase by moving the economic system towards the existing PPF or by
moving the PPF of the economy rightwards. This is done by transforming a given total
amount of wealth into more productive forms. It induces people to hold less of savings in
the form of precious metals, real estate land, consumer durables, currency and to replace
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these assets by bonds, shares, units etc. It also helps to increase the volume of investment.
Thus financial institutions play a quite significant role in the economic growth of a
economy
Q2).a . Distinguish between financial integration and financial intermediates? what is the
role of each in development of an efficient financial system?
b .Flow of funds accounts provide a virtual mine of information for the financialpolicy making on the part of authorities of a country explain
Ans. Difference between financial integration and financial intermediates
Financial integration Financial intermediates
Financial integration is defined asintegration between two or more
dimension of financial services within or
between financial services sector.
Financial intermediates is defined as
mediator between client and financial
sectors(i.e. institutes, agencies etc.)
Financial integration can be of
geographic and functional integration.
Financial intermediates can be internal
agent or external agent.
Financial integration cannot help in risk
diversification benefit.
Financial intermediates can help in risk
diversification benefit.
Example
Mutual funds, global banks.
Example
Brokers, factoring.
Financial integration promotes the adoption of modern technology and payment systems
to achieve cost effective financial intermediation services.
Role of each in development of an efficient financial system
The financial system is the system that allows the transfer of money between savers (andinvestors) and borrowers. A financial system can operate on a global, regional or firm
specific level.
Financial systems are crucial to the allocation of resources in a modern economy. They
channel household savings to the corporate sector and allocate investment funds among
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firms; they allow inter temporal smoothing of consumption by households and
expenditures by firms; and they enable households and firms to share risks. These
functions are common to the financial systems of most developed economies
Financial system now become more integrated. Financial integration involves a blending
of relational contracts (or activities) with market-based contracts (or activities).As such,
financial integration may represent the transitional phase of the financial system from
relational to more arms-length form. It may represent that threshold point where market
based structure is about to supplant the relatively bank-dominated system of emerging
economies
Factors behind greater integration are The government entry in a very big way in the wholesale trading of a large no. of
commodities.
An unprecedented expansion of a network of rural branches of bank
A transformation in the perception of the role of financial institutions.
Financial markets and financial intermediaries perform the function of channeling funds
from agents who have saved funds and want to lend to agents who need funds andwant to borrow.
Financial intermediaries play a number of special roles, and help solve a number of
special problems, in the process of indirect finance.
Financial intermediaries can help solve this problem by gathering information about
potential borrowers and screening out bad credit risks. Financial intermediaries can help
solve this problem by monitoring borrowers activities
(b) Flow of funds accounts provide a virtual mine of information for the financial policymaking on the part of authorities of a country explain
Yes, fund flow statement provide virtual mine for financial policy making by theauthorities by providing:
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(1)The flow-of-funds system is a quadruple-entry system compared to the double-entry
system of the national income products accounts, that is, a given transaction is recorded
twice in the accounts of both economic units involvedon cease debit and on ceasecreditwhile only on entry for each participating unit is made in the national income and
product accounts.
(2)The flow-of-funds statement distinguishes considerably larger number of sectors thanthe national income and products accounts now do. Specifically consumers, corporatebusiness, nonfarm non corporate business, farm business, the banking system (with four
subsectors), life-insurance companies, pension plans, other insurance companies, saving
and loan associations, and non profit organizations constitute separate sectors in thepublished flow-of-funds statements. No separate figures for these sector saresh own in
the national income and product accounts, which distinguish, in so far as detail is
concerned, only between two private sectorsconsumers (including non- profitorganizations) and business.
(3)The flow-of-funds statement provides information chases and sales by each sector
(where applicable or where figures are available) on the following 12 types of financial
assets, none of which enter into the national income and profit accounts: gold andTreasury currency, currency an demand deposits, time deposits, savings and loan and
credit unions shares, bank loans, Federal obligations, State and local obligations,
corporate securities, mortgages, consumer credit, and trade credit.
(4)The flow-of-funds statement is published only on annual basis and so far only withconsiderable delay, while the main aggregates in the national income and product
accounts are estimated quarterlyandarereleasedlesthan2monthsafterthendofthe quarter.
(5)The flow-of-funds statement includes figures for the holdings of claims and liabilities,
though no to f equity securities and tangible assets, of each sector, information that doesnot figure in the national income and product accounts. This feature, however, is not
necessarily in the flow-of-funds statement
Q3 (a) Briefly examine the two segment of Indian securities market ?mention the
specific areas where the SEBI has succeded in toning them up?
The securities market is divided into two interdependent segments:
The primary market provides the channel for creation of funds through issuance
of new securities by companies, governments, or public institutions. In the case of
new stock issue, the sale is known as Initial Public Offering (IPO).
The secondary market is the financial market where previously issued securitiesand financial instruments such as stocks, bonds, options, and futures are traded.
The Securities and Exchange Board of India (SEBI), the regulatory authority for
Indian securities market, was established in 1992 to protect investors and improve
the microstructure of capital markets. In the same year, Controller of Capital
Issues (CCI) was abolished, removing its administrative controls over the pricing
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of new equity issues. In less than a decade later, the Indian financial markets
acknowledged the use of technology (National Stock Exchange started online
trading in 2000), increasing the trading volumes by many folds and leading to the
emergence of new financial instruments.
SEBIprotects the interests of investors in securities and promotes the development of thesecurities market. The board helps in regulating the business of stock exchanges and any
other securities market. SEBI is also responsible for registering and regulating the
working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees
of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers,
investment advisers, and such other intermediaries who may be associated with securities
markets in any manner.
The board registers the venture capitalists and collective investments like mutual funds.
SEBI helps in promoting and regulating self regulatory organizations.
(b) List the regulatory guidelines for issue of commercial paper in India?
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note. CP, as a privately placed instrument, was introduced in India in 1990
with a view to enabling highly rated corporate borrowers to diversify their sources ofshort-term borrowings and to provide an additional instrument to investors.
Subsequently, primary dealers, satellite dealers and all-India financial institutions were
also permitted to issue CP to enable them to meet their short-term funding requirementsfor their operations.
The guidelines for issue of CP incorporating all the amendments issued till date is givenbelow:
Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) that havebeen permitted to raise short-term resources under the umbrella limit fixed by the
Reserve Bank of India are eligible to issue CP.
I. A corporate would be eligible to issue CP provided:(a) the tangible net worth of the company, as per the latest audited balance sheet, is not
less than Rs. 4 crore;
(b) company has been sanctioned working capital limit by bank/s or all-India financial
institution/s; and(c) the borrowal account of the company is classified as a Standard Asset by the
financing bank/s/ institution/s.
All eligible participants shall obtain the credit rating for issuance of Commercial Paperfrom either the Credit Rating Information Services of India Ltd. (CRISIL) or the
Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
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Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other
credit rating agencies as may be specified by the Reserve Bank of India from time to
time, for the purpose.
CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by
a single investor should not be less than Rs. 5 lakh (face value).
The aggregate amount of CP from an issuer shall be within the limit as approved by its
Board of Directors or the quantum indicated by the Credit Rating Agency for thespecified rating, whichever is lower.
An Foreign Investor can issue CP within the overall umbrella limit fixed by the RBI, i.e.,
issue of CP together with other instruments, viz., term money borrowings, term deposits,certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its
net owned funds, as per the latest audited balance sheet.
CP can be issued either in the form of a promissory note or in a dematerialised formthrough any of the depositories approved by and registered with SEBI.
CP will be issued at a discount to face value as may be determined by the issuer.
No issuer shall have the issue of CP underwritten or co-accepted.
* Every issuer must appoint an Issuing and Paying Agent (IPA) for issuance of CP.
*Investors shall be given a copy of IPA certificate to the effect that the issuer has a validagreement with the IPA and documents are in order.
Q4). Write Short Notes on:
a) Credit rating
b) Consortium Finance
c) Bill discounting
d) Venture Capital Maximum Permissible Bank Finance
A. CREDIT RATING
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Credit ratings assess the credit worthiness of an individual cooperation or even country.
It is an evaluation made by a credit rating agencyof the debtor's ability to pay back the
debt and the likelihood ofdefault.
Credit rating are calculated from financial history and current assets and liabilities. Credit
ratings are not based on mathematical formulas. Instead, credit rating agencies use their
judgment and experience in determining what public and private information should be
considered in giving a rating to a particular company or government. A credit rating tells
a lender or investor the probability of the subject being able to pay back loan. A poor
credit rating indicates a high risk of defaulting on a loan and thus lends to higher interest
rate. A credit does not create fiduciary relationship between the agencies and the user.
Credit rating essentially establishes a link between risk and return.
Objective of Credit Rating: The main objective is to provide superior and low cost
information to investors for taking a decision regarding risk-return trade off, but it also
helps to market participants in the following ways;
Improves a healthy discipline on borrowers.
Lends greater credence to financial and other representations,
Facilitates formulation of public guidelines on institutional investment,
Helps merchant bankers, brokers, regulatory authorities, etc. in discharging their
functions related to debt issues,
Encourages greater information disclosure, better accounting standards, and
improved financial information(helps in investors protection),
May reduce interest costs for highly rated companies,
Acts as a marketing tool
Functions of a Credit Rating Agency
A credit rating agency serves following functions:
http://en.wikipedia.org/wiki/Credit_rating_agencyhttp://en.wikipedia.org/wiki/Default_(finance)http://en.wikipedia.org/wiki/Credit_rating_agencyhttp://en.wikipedia.org/wiki/Default_(finance) -
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1. Provides quality and dependable information:. A credit rating agency is in a
position to provide quality information on credit risk which is more authenticate and
reliable.
2. Provides information at low cost: Most of the investors rely on the ratings assigned
by the ratings agencies while taking investment decisions. These ratings are published
in the form of reports and are available easily on the payment of negligible price. It is
not possible for the investors to assess the creditworthiness of the companies on their
own.
3. Provide easy to understand information: Rating agencies first of all gather
information, then analyze the same. At last these interpret and summaries complex
information in a simple and readily understood formal manner. Thus in other words,
information supplied by rating agencies can be easily understood by the investors.
They need not go into details of the financial statements.
4. Provide basis for investment: An investment rated by a credit rating enjoys higher
confidence from investors. Investors can make an estimate of the risk and return
associated with a particular rated issue while investing money in them.
5. Healthy discipline on corporate borrowers: Higher credit rating to any credit
investment enhances corporate image and builds up goodwill and hence it induces a
healthy/ discipline on corporate
6. Formation of public policy: Once the debt securities are rated professionally, it
would be easier to formulate public policy guidelines as to the eligibility of securities
to be included in different kinds of institutional port-folio.
B. CONSORTIUM FINANCE
Consortium is a Latin word, meaning 'partnership, association or society.
A consortium is an association of two or
more individuals, companies,organizationsorgovernments(or any combination of these
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entities) with the objective of participating in a common activity or pooling their
resources for achieving a common goal.
Under consortium financing, several banks (or financial institutions) finance a single
borrower with common appraisal, common documentation, joint supervision and
follow-up exercises, these banks have a common agreement between them, the
process is somewhat similar to loan syndication.
The Consortium approach to project delivery is chosen because of the desire to share
as evenly as possible the risk inherent in that project. It is like a establishing a
temporary business without the formal structure or tax liabilities, a business that is
governed by the rules laid down in a consortium agreement.
Advantages
1. Ease of Formation- No formal procedure must be followed. Also no capital is
required to create the consortium.
2. Flexibility- Members of consortium can change their contractual agreement at any
time to suit changed circumstances.
3. Ease of termination- Consortia can be set to expire on a given date or on the
occurrence of certain events without the formal requirements needed in the case ofdissolution of the corporation
4. Tax transparency-The consortium is not directly subject to taxation however the
individuals are.
5. Confidentiality- Some of the members may choose to be undisclosed parties in
dealings with third parties.
6. Costs-The cost of running a contractual joint venture is generally lower thanrunning Joint Venture Company.
Disadvantages
1. Liability- It is difficult for a consortium member to restrict or limit its liability.
Members may even become liable to third parties for the nonperformance of other
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members of the consortium or debts of such members incurred in undertaking the
common project.
2. External Relationships and Funding-Third parties often find it difficult to enter
into a contract with a non legal entity like consortium. Because it is non legal
entity the funding is also normally available to the individual members and not the
consortium itself.
3. Lack of permanent structure- The lack ofpermanent structure makes it difficult
for a consortium to establish a long termbusiness relationship with third parties
C. BILL DISCOUNTINGThe act of handling over an endorsed Bill of Exchange for ready money is called
discounting the bill of exchange.
According to the Indian Negotiable Instrument Act, 1881:
The bill of exchange is an instrument in writing containing an unconditional order,
signed by the maker, directing acertain person to pay a certain sum of money only to, or
tothe order of, a certain person, or to the bearer of that instrument.
Bill discounting is a major activity with some of the smaller Banks. Under this type of
lending, Bank takes the bill drawn by borrower on his (borrower's) customer and pays
him immediately deducting some amount as discount/commission. The Bank then
presents the Bill to the borrower's customer on the due date of the Bill and collects the
total amount. If the bill is delayed, the borrower or his customer pays the Bank a pre-
determined interest depending upon the terms of transaction
Business activities across borders are done through letter of credit. Letter of credit is an
instrument issued in the favor of the seller by the buyer bank assuring that payment will
be made after certain timer frame depending upon the terms and conditions agreed, it
could be either sight, 30 days from the Bill of Lading or 120 days from the date of bill of
lading. Now when the seller receives the letter of credit through bank, seller prepares the
documents and presents the same to the bank. The most important element in the same is
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the bill of exchange which is used to negotiate a letter of credit. Seller discounts that bill
of exchange with the bank and gets money. Discounting bill terminology is used for this
purpose. Now it is seller's bank responsibility to send documents and bill of exchange to
buyer's bank for onward forwarding to the buyer for the acceptance and the buyer finally,
accepts bill of exchange drawn by the seller on buyer's bank because he has opened that
LC. Buyers bank than get that signed bill of exchange from the buyer as guarantee and
release payment to the sellers bank and waits for the time span.
There are two types of bill discounting:
Import bill discounting.
Export bill discounting.
Import bill discount is a kind of short-term finance offered by the bank to the importer
according to his demand upon receiving the bills under the letter of credit and the import
collection items. They have the following virtues:
1. Reduce the funding occupied
2. Grasp the market opportunity.
While export bill discounting is financing of money in transit supplied by the bank. The
virtues for export bill discounting are:
1. Accelerate the funding circulation.
2. Improve the cash flow.
3. Save the financial expenses.
Processing of Bill Discounting
Credit assessment banks and NBFCs undertake a detailed appraisal of a customer
and thoroughly assess his creditworthiness before providing the bill discounting
facility.
Quantum of business undertaken by the party that is turnover of inventory.
Credit worthiness of drawer (client).
Credit worthiness of drawee and details of dishonor, if any.
Nature of customers industry.
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Precautions
1. The bills are drawn on the place where the finance company is operating.
2. The goods covered by the documents are those in which the party deals.
3. The amount of the bill commensurate with the volume of business turnover of the
party.
4. The description of goods mentioned in the invoice and railway receipt are same.
5. The goods are properly insured.
6. The bill is properly stamped.
7. Bill offered for discount do not cover goods whose prices fluctuate too much.
8. The bills are drawn in favor of the finance company and have been accepted by
the drawee.
D. VENTURE CAPITAL MAXIMUM PERMISSIBLE BANK FINANCE
Venture capital refers to risk capital supply to hi-tech growing companies particularly in
the form of equity participation it includes both startup capital and developmental capital.
Venture capital provides initial support to new companies using high technologies and
which have potential for high profits but suffers from capital inadequacy. Venture capital
is also known as risk capital. The origin of venture capital can be treated back to the USA
in 1946. The American research and development was formed as the first venture
organization which financed over 100 companies.
Q5)(a).. Role of RBI in Indian economy
Issuer of currency
Except for issuing one rupee notes and coins, RBI is the sole authority for the issue of
currency in India. The Indian government issues one rupee notes and coins. Major
currency is in the form of RBI notes, such as notes in the denominations of two, five, ten,
twenty, fifty, one hundred, five hundred, and one thousand. Earlier, notes of higher
denominations were also issued. But, these notes were demonetized to discourage users
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from indulging in black-marketoperations.
Banker to the Government
RBI acts as banker, both to the central government and state governments. It manages all the
banking transactions of the government involving the receipt and payment of money. In
addition, RBI remits exchange and performs other banking operations.
RBI provides short-term credit to the central government. Such credit helps the government
to meet any shortfalls in its receipts over its disbursements. RBI also provides short term
credit to state governments as advances.
RBI also manages all new issues of government loans, servicing the government debt
outstanding, and nurturing the market for governments securities. RBI advises the
government on banking and financial subjects, international finance, financing of five-year
plans, mobilizing resources, and banking legislation.
Managing Government Securities
Various financial institutions such as commercial banks are required by law to invest
specified minimum proportions of their total assets/liabilities in government securities. RBI
administers these investments of institutions.
The other responsibilities of RBI regarding these securities are to ensure -
Smooth functioning of the market
Readily available to potential buyers
Easily available in large numbers
Undisturbed maturity-structure of interest rates because of excess or deficit supply
Not subject to quick and huge fluctuations
Reasonable liquidity of investments
Good reception of the new issues of government loans
Banker to Other Banks
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The role of RBI as a banker to other banks is as follows:
Holds some of the cash reserves of banks
Lends funds for short period
Provides centralized clearing and quick remittance facilities
Exchange Manager and Controller
RBI manages exchange control, and represents India as a member of the international
Monetary Fund [IMF]. Exchange control was first imposed on India in September 1939 when
World War II started and continues till date.
Publisher of Monetary Data and Other Data
RBI maintains and provides all essential banking and other economic data, formulating and
critically evaluating the economic policies in India. In order to perform this function, RBI
collects, collates and publishes data regularly. Users can avail this data in the weekly
statements, the RBI monthly bulletin, annual report on currency and finance, and otherperiodic publications.
Credit control
Credit control is a very important function of RBI as the Central Bank of India. For smooth
functioning of the economy RBI control credit throughquantitative and qualitative methods.
Thus, the RBI exercise control over thecredit granted by the commercial bank.
5 (b) RBI guidelines on classification and valuation of investment of banks :
Non performing Assets
An asset, including a leased asset, becomes non performing when it ceases
to generate income for the bank. A non performing asset (NPA) is a loan or an advance
where:
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i. interest and/ or instalment of principal remain overdue for a period of more than 90
days in respect of a term loan,
ii. the account remains out of order respect of an Overdraft/Cash Credit (OD/CC),
iii. the bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted,
iv. the instalment of principal or interest thereon remains overdue for two crop seasons
for short duration crops,
v. the instalment of principal or interest thereon remains overdue for one crop season for
long duration crops,
vi. the amount of liquidity facility remains outstanding for more than 90 days, in respect
of a securitisation transaction undertaken in terms of guidelines on securitisation dated
February 1, 2006.
vii. in respect of derivative transactions, the overdue receivables representing positive
mark-to-market value of a derivative contract, if these remain unpaid for a period of 90
days from the specified due date for payment. Banks should, classify an account as NPA
only if the interest due and charged during any quarter is not serviced fully within 90
days from the end of the quarter.
ASSET CLASSIFICATION
Categories of NPAs
Banks are required to classify nonperforming assets further into the following three
categories based on the period for which the asset has remained nonperforming and the
realisability of the dues:
i. Substandard Assets
ii. Doubtful Assets
iii. Loss Assets
Substandard Assets
With effect from 31 March 2005, a substandard asset would be one, which has remained
NPA for a period less than or equal to 12 months. In such cases, the current net worth of
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the borrower/ guarantor or the current market value of the security charged is not enough
to ensure recovery of the dues to the banks in full. In other words, such an asset will have
well defined credit weaknesses that jeopardize the liquidation of the debt and are
characterised by the distinct possibility that the banks will sustain some loss, if
deficiencies are not corrected.
Doubtful Assets
With effect from March 31, 2005, an asset would be classified as doubtful if it has
remained in the substandard category for a period of 12 months. A loan classified
as doubtful has all the weaknesses inherent in assets that were classified as
substandard,with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently known facts, conditions and values
highly questionable and improbable.
Loss Assets
A loss asset is one where loss has been identified by the bank or internal or external
auditors or the RBI inspection but the amount has not been written off wholly. In other
words, such an asset is considered uncollectible and of such little value that its
continuance as a bankable asset is not warranted although there may be some salvage or
recovery value.
Guidelines for classification of assets
Broadly speaking, classification of assets into above categories should be
done taking into account the degree of well-defined credit weaknesses and the extent of
dependence on collateral security for realisation of dues. Banks should establish
appropriate internal systems to eliminate the tendency to delay or postpone the
identification of NPAs, especially in respect of high value accounts. The banks may fix a
minimum cut off point to decide what would constitute a high value account depending
upon their respective business levels. The cutoff point should be valid for the entire
accounting year. Responsibility and validation levels for ensuring proper asset
classification may be fixed by the banks. The system should ensure that doubts in asset
classification due to any reason are settled through specified internal channels within one
month from the date on which the account would have been classified as NPA as per
extant guidelines.
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Availability of security / net worth of borrower/ guarantor.
The availability of security or net worth of borrower/ guarantor should not be taken into
account for the purpose of treating an advance as NPA or otherwise, except to the extent
provided as income recognition is based on record of
recovery.
Accounts with temporary deficiencies .
The classification of an asset as NPA should be based on the record of recovery.Bank
should not classify an advance account as NPA merely due to the existence of some
deficiencies which are temporary in nature such as non-availability of adequate drawing
power based on the latest available stock statement, balance outstanding exceeding the
limit temporarily, non-submission of stock statements and nonrenewal of the limits on the
due date, etc.
drawings are permitted in the account for a continuous period of 90 days even
though the unit may be working or the borrower's financial position
is satisfactory.
Q6). a) Briefly explain the use of Duration in management of Interest rate risk.
b) List the various theories concerning term structure of interest rates. Give
example from the various segments of the Indian financial market, which are
experiencing flat and downward sloping yield curves respectively.
A) Interest Rate Risk
The change in bond values as a result of change in market interest rate or required rate of
return of the investors is known as Interest rate risk. Investment is fixed interest securities
become risky because of existence of interest rate risk.
An investor needs a measure of average maturity on the basis of promised cash flows.
Effective maturity of a bond is known as duration of a bond. Duration is a measure of
time. Also it may be defined as the weighted average of the lengths of time until the
remaining cash flows are received. Hence duration is a measure of the length of time at
the end of which the investor would get his investment returned.
Duration is a measure of the interest rate risk of a bond. It shows the sensitivity of a
bonds price to interest rate changes and also takes into account the timing of the bonds
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cash flows. It is a measure of how responsive a bond price is to changing interest rates.
Duration is a relative change in prices with respect to changes in interest rates.
B) Theories of term structure of Interest rate risk
Several theories of interest rates have been structured to explain the shape, slope and
change of yield curve. Some of these are:
a) Market expectations (pure expectations) Theory
This theory assumes that the various maturities are perfect substitutes and suggests that
the shape of the yield curve depends on market participants' expectations of future
interest rates. Using this, future rates, along with the assumption that arbitrage
opportunities will be minimal in future markets, and that future rates are unbiasedestimates of forthcoming spot rates, is enough information to construct a complete
expected yield curve.
For example, if investors have an expectation of what 1-year interest rates will be next
year, the 2-year interest rate can be calculated as the compounding of this year's interest
rate by next year's interest rate.
More generally, rates on a long-term instrument are equal to the geometric mean of theyield on a series of short-term instruments. This theory perfectly explains the observation
that yields usually move together. However, it fails to explain the persistence in the shape
of the yield curve.
Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds
(because forward rates are not perfect predictors of future rates).
1) Interest rate risk 2) Reinvestment rate risk
b) Liquidity premium theory
The Liquidity Premium Theory is an offshoot of the Pure Expectations Theory. The
Liquidity Premium Theory asserts that long-term interest rates not only reflect investors
assumptions about future interest rates but also include a premium for holding long-term
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bonds (investors prefer short term bonds to long term bonds), called the term premium or
the liquidity premium. This premium compensates investors for the added risk of having
their money tied up for a longer period, including the greater price uncertainty. Because
of the term premium, long-term bond yields tend to be higher than short-term yields, and
the yield curve slopes upward. Long term yields are also higher not just because of the
liquidity premium, but also because of the risk premium added by the risk of default from
holding a security over the long term.
c) Market segmentation theory
This theory is also called the segmented market hypothesis.
In this theory, financial instruments of different terms are not substitutable. As a result,
the supply and demand in the markets for short-term and long-term instruments is
determined largely independently. Prospective investors decide in advance whether they
need short-term or long-term instruments. If investors prefer their portfolio to be liquid,
they will prefer short-term instruments to long-term instruments. Therefore, the market
for short-term instruments will receive a higher demand. Higher demand for the
instrument implies higher prices and lower yield. This explains the stylized fact that
short-term yields are usually lower than long-term yields. This theory explains thepredominance of the normal yield curve shape. However, because the supply and demand
of the two markets are independent, this theory fails to explain the observed fact that
yields tend to move together (i.e., upward and downward shifts in the curve).
Q7). Distinguish between :
(a) NBFCs and SFCs
(b) Cedit Gap and Maturity Gap
(c) Mutual fund and Asset management Company(AMC)
NBFCs and SFCs
NBFCs - Non-banking financial companies, or NBFCs, are financial institutions thatprovide banking services, but do not hold a banking license. These institutions are not
allowed to take deposits from the public. Nonetheless, all operations of these institutions
are still covered under banking regulations.
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NBFCs do offer all sorts of banking services, such as loans and credit facilities,
retirement planning, money markets, underwriting, and merger activites. The number of
non-banking financial companies has expanded greatly in the last several years as venturecapital companies, retail and industrial companies have entered the lending business.
SFCs - In order to provide medium and long term credit to industrial undertaking, which
fall outside the normal activities of commercial banks, a central industrial financecorporation was set up under the industrial Finance Corporations act, 1948.The state
governments wished that similar corporations should be set up in their states to
supplement the work of industrial financial corporation. The intention is that the Statecorporations will confine to financing medium and small scale industrial and will , as far
as possible consider only such access which are outside the preview of industrial fianc
corporation .
Credit Gap and Maturity Gap
Credit Gap- It refers to a situation where supply of credit does not match with that of
supply of the credit.Maturity Gap- A measurement of interest rate risk for risk-sensitive assets and
liabilities. The market values at each point of maturity for both assets and liabilities areassessed, then multiplied by the change in interest rate and summed to calculate the
net interest income or expense
This method, while useful, is not as popular as it once was due to the rise of newtechniques in recent years. Newer techniques involving asset/liability duration and value
at risk have largely replaced maturity gap analysis.
Mutual fund and Asset management Company(AMC)
Asset management Company
A company that invests its clients' pooled fund into securities that match its declaredfinancial objectives. Asset management companies provide investors with more
diversification and investing options than they would have by themselves.
Mutual funds, hedge funds and pension plans are all run by asset managementcompanies. These companies earn income by charging service fees to their clients
AMCs offer their clients more diversification because they have a larger pool of
resources than the individual investor. Pooling assets together and paying out
proportional returns allows investors to avoid minimum investment requirements oftenrequired when purchasing securities on their own, as well as the ability to invest in a
larger set of securities with a smaller investment.
Mutual Fund Company a regulated investment company with a pool of assets thatregularly sells and redeems its shares. A mutual fund is a collection of a wide number of
stock and bond combinations held by individuals that are entrusted to a mutual fund
companyThe manager of the mutual fund will develop the mutual fund with the purposeof making a certain investment objective A mutual fund is a collection of a wide number
of stock and bond combinations held by individuals that are entrusted to a mutual fund
company.
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Submitted To Submitted By:
Ms.Meenakshi Kaushik Ms. Nidhi Sharma
HoD, MBA Assistant Professor
RDIAS RDIAS
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