Indian Financial System Dba1749

MBA(DISTANCE MODE)

DBA 1749

INDIAN FINANCIAL SYSTEM

III SEMESTERCOURSE MATERIAL

Centre for Distance EducationAnna University Chennai

Chennai – 600 025

DrDrDrDrDr.T.T.T.T.T.V.V.V.V.V.Geetha.Geetha.Geetha.Geetha.GeethaProfessor

Department of Computer Science and EngineeringAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.H.P.H.P.H.P.H.P.H.Peereereereereeru Mohamedu Mohamedu Mohamedu Mohamedu MohamedProfessor

Department of Management StudiesAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.C.C.C.C.C. Chella. Chella. Chella. Chella. ChellappanppanppanppanppanProfessor


Chennai - 600 025

DrDrDrDrDr.A.K.A.K.A.K.A.K.A.KannanannanannanannanannanProfessor


Chennai - 600 025

Copyrights Reserved(For Private Circulation only)

Editorial Board

ii

Author

MrMrMrMrMr. Mahammad R. Mahammad R. Mahammad R. Mahammad R. Mahammad Rafafafafafi Syi Syi Syi Syi Syed, AICWAed, AICWAed, AICWAed, AICWAed, AICWADeputy Manager Finance,

ETA General (P) Ltd, Seethakathi Chamber,5th Floor, 688, Anna Salai,

Chennai - 600 006

Reviewer

DrDrDrDrDr. J. J. J. J. J. Gopu. Gopu. Gopu. Gopu. GopuAssistant Professor,

Management Studies,BSA Crescent Engineering College

Chennai - 600 048

ACKNOWLEDGEMENT

The author has drawn inputs from several sources fo©r the preparation of this course material, to meet therequirements of the syllabus. The author gratefully acknowledges the following sources:

(i) Indian Financial System by M Y Khan, the McGraw-Hill Companies.

(ii) The Indian Financial System Markets, Institutions and Services byBharati V. Pathak, Pearson Education.

(iii) Financial Management by Ravi M. Kishore, Taxman’s Publicaion.

(iv) Professional Approach to Corporate Laws and Secretarial Practice by Munish Bhandari, BharatLaw House Pvt. Ltd, New Delhi.

(v) Advanced Accounting Volume I issued by the Institute of Chartered Accountants of India.

(vi) SEBI website, RBI website, BSE, NSE and OTCEI websites.

In spite of at most care taken to prepare the list of references any omission in the list is only accidental andnot purposeful.

Mr. Mahammad Rafi Syed

Author

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DBA 1749 INDIAN FINANCIAL SYSTEM

UNIT I INTRODUCTION

Indian financial system- Introduction – Institutional setup-savings and instruments- Money, Inflation and Interest,Banking and Non-Banking financial intermediaries- Financial markets-classification – Financial sector reforms-institutional structure- Discount Finance House of India (DFHI)- SEBI –Stock exchange- OTCEI –money andCapital markets –Characteristics and objectives –money market instruments –securities market in India –Regulatory framework.

UNIT II COMMERCIAL BANKS

Commercial banks –Functions and roles-Sources and application of funds-asset structure –Profitability –Regulatoryreforms –Deposits and advances –Lending rates –Reserve Bank of India.

UNIT III DEVELOPMENT BANKING

Development banking – Features, functions and roles-Term loans- Appraissal- Industrial Development Bank OfIndia – State Financial Corporation – Specialised development Finance insitutions – Investment banking-Merchantbanking- Institional framework- Venture capital- Credit ranking – Factoring services leasing and hire purchase –Insurance services.

UNIT IV NEW ISSUES MARKET

New issues market- Functions and issue mechanism- Book building – Reforms and investor protection –Relationshipbetween new isues market and stock exchange.

UNIT V MUTUAL FUNDS

Mutual funds in India – Regulatory mechanism – SEBI mutual fund guideliness – Mutual fund schemes – IRDA(Insurance Regulatory and Development Authority) regulations – Securitisation and assets reconstructioncompanies.

REFERENCE

1. Indian Financial System, M.Y.Khan, Tata Mcgraw Hill.

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CONTENTS

UNIT - IFINANCIAL SYSTEM IN INDIA

1.1 INTRODUCTION 11.2 LEARNING OBJECTIVES 21.3 INDIAN FINANCIAL SYSTEM 2

1.3.1 Savings and Investments 51.3.2 Types of Savings 81.3.3 Investments 91.3.4 Interest Rates and Inflation 10

1.4 FINANCIAL INSTITUTIONS 111.4.1 Financial Intermediaries 111.4.2 Financial Markets 181.4.3 Financial Instruments 271.4.4 Financial Services 28

1.5 FINANCIAL SECTOR REFORMS 281.6 BANKING SECTOR REFORMS 301.7 DISCOUNT AND FINANCE

HOUSE OF INDIA (DFHI) 311.8 MONEY LAUNDERING 321.9 DERIVATIVES MARKETS 331.10 OVER THE COUNTER EXCHANGE OF INDIA (OTCEI) 351.11 SECURITIES MARKET IN INDIA – REGULATORY REFORMS 371.12 REFORMS IN THE SECONDARY CAPITAL MARKET 39

UNIT IICOMMERCIAL BANKS

2.1 INTRODUCTION 472.2 LEARNING OBJECTIVES 472.3 BANKING HISTORY AND ITS DEVELOPMENT IN INDIA 472.4 TYPES OF BANKS 49

2.4.1 Public Sector Banks 492.4.2 Private Sector Banks 53

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2.4.3 Foreign Banks in India 532.4.4 Regional Rural Banks 58

2.5 FUNCTIONS OF COMMERCIAL BANKS 592.6 ROLE OF COMMERCIAL BANKS 632.7 CHARACTERISTICS OF BANKS 642.8 SOURCES AND APPLICATION OF FUNDS 64

2.8.1 Source of Funds its Structure 652.8.2 Application of Funds and its structure 66

2.9 BANKING REGULATORY REFORMS 692.10 RESERVE BANK OF INDIA 70

2.10.1 Central Board 702.10.2 Functions Of The Board For Financial Supervision (Bfs) 712.10.3 The Main Functions Of The Reserve Bank Of India Are 722.10.4 Subsidiaries Of Reserve Bank Of India 74

UNIT IIIDEVELOPMENT BANKING

3.1 INTRODUCTION 773.2 LEARNING OBJECTIVES 783.3 FEATURES OF DEVELOPMENT BANKS 783.4 FUNCTIONS OF DEVELOPMENT BANKS 783.5 DEVELOPMENT BANKS 79

3.5.1 The Industrial Development Bank Of India(Idbi) 793.5.2 Industrial Investment Bank of India (IIBI) 803.5.3 Industrial Financial Corporation of India (IFCI) 813.5.4 The Export Import Bank of India (EXIM) 823.5.5 Tourism Finance Corporation of India (TFCI) 83

3.6 REFINANCE INSTITUTIONS 843.6.1 Small Industrial Development Bank of India (SIDBI) 843.6.2 National Bank for Agriculture and Rural

Development (NABARD) 853.7 SPECIALIZED FINANCIAL INSTITUTIONS 86

3.7.1 Infrastructure Development Finance Company (IDFC) 863.7.2 IFCI Venture Capital Funds 873.7.3 ICICI Venture Capital Fund 87

3.8 MERCHANT BANKING 883.9 VENTURE CAPITAL 90

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3.10 CREDIT RANKING 933.10.1 Credit Rating Agencies in India 95

3.11 FACTORING SERVICES 1053.11.1 International Factoring: 1083.11.2 Forfaiting: 109

3.12 LEASING AND HIRE PURCHASE 1093.12.1 Leasing: 1093.12.2 Hire Purchase 112

UNIT IVNEW ISSUE MARKETS

4.1 INTRODUCTION 1174.2 LEARNING OBJECTIVES 1174.3 NEW ISSUE MARKETS 117

4.3.1 Primary Stock Market 1184.3.2 Secondary Stock Market 118

4.4 NEW ISSUE MARKET – ISSUE MECHANISM 1204.4.1 Un-listed Companies – Initial Public Offer 1214.4.2 Pricing of Issues 1234.4.3 Initial Public Offer (IPO) 126

4.5 PRIVATE PLACEMENT 1344.5.1 Preferential Issues 1344.5.2 Qualified Institutional Placements (QIP’s) 1354.5.3 Issue of capital by designated financial institution 1354.5.4 OTCEI issues 135

4.6 SEBI (DISCLOSURE AND INVESTOR PROTECTION)GUIDELINES’ 2000 136

UNIT VMUTUAL FUNDS

5.1 INTRODUCTION 1395.2 LEANING OBJECTIVES 1405.3 MUTUAL FUNDS IN INDIA 1405.4 ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS 141

5.4.1 Advantages of Mutual Funds 1415.4.2 Disadvantages of Mutual Fund 143

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5.5 TYPES OF MUTUAL FUNDS 1455.6 NET ASSET VALUE 1485.7 SEBI (MUTUAL FUND) REGULATIONS, 1996. 1495.8 ASSET MANAGEMENT COMPANY 1545.9 SEBI (MUTUAL FUND) REGULATIONS, 1996 1595.10 MUTUAL FUNDS AND CREDIT RATING 1655.11 INSURANCE 167

5.11.1 Introduction 1675.11.2 Life Insurance Businesses in India. 1695.11.3 Type of products under Life Insurance Business 1705.11.4 Types of general insurance policies 1725.11.5 Insurance Regulatory and Development Authority Act, 1999 173

5.12 SECURITISATION AND ASSETS RECONSTRUCTIONCOMPANIES 1755.12.1 Guidelines: Issued by the RBI Has Been Reproduced

Which are In The Nature of Recommendatory 177

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1 ANNA UNIVERSITY CHENNAI

UNIT I

FINANCIAL SYSTEM IN INDIA

1.1 INTRODUCTION

In general to survive and success we need to have an adequate finance and in fact thecredibility of an enterprise depends upon its sound financial position. The term Financecan be expressed as mobilization of funds to meet the desired objectives and goals of theorganization. The financial functions can be viewed as Investment decisions, Financial Mixdecisions, Dividend or Profit allocation decisions and short-term asset mix decision. Itmay be difficult to separate the finance functions from the other functions like production;marketing and so on.

For example, recruitment of skilled and unskilled employees in the productiondepartment is clearly a responsibility of the production department with the help of humanresource department; but it requires payment of wages and salaries and other monetarybenefits, and hence involvement of finance is an inseparable in the entire organization system.A system may be viewed as a set of sub-systems with so many elements which areinterdependent and interlinking with each other to produce the purposeful result with in theboundary. Hence, the term system in the context of finance means a set of complex andclosely connected financial institutions, instruments, agents, markets and so on which areinterdependent and interlinking with each other to produce the economic growth with inthe country.

A well organised financial system provides adequate capital formation through savings,finance and investments. An investment depends upon Savings and inturn Savings dependsupon earnings of an individual or profits of the organisation. For example Mr. X currentearnings Rs 10 lac per annum and his current expenditure is Rs 9 lac per annum then hissavings becomes Rs 1 lac, which he can invest, like wise if the company earns more profitsit leads to more investments into various sectors.

In fact savers may or may not have technical or professional skills to convert ortransfer their savings into active investments. This transfer process is effectively fulfilled bythe financial system to facilitate economic growth through the channel of finance. We can

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recollect at this point of time the term Financial Management which means procurement offunds and their effective utilization to maximize the profit of the organisation.

1.2 LEARNING OBJECTIVES:

(1) Learn the concept of financial growth in India(2) Understand about the financial intermediaries(3) Under standing about various financial instruments and services(4) Understand the regulations framed by the SEBI with respect to capital market and

financial market.

1.3 THE INDIAN FINANCIAL SYSTEM – AN OVERVIEW

In the early 1950’s India adopted a closed-circle character which denotes narrowgrowth in industrial entrepreneurship, limited industrial securities market and more restrictionson financial intermediaries and so on. In the recent past the Indian Financial System hasunder gone sea changes and invented many new channels of financial sub-systems throughthe process of financial reforms.

Institutional Setup:

The concept of nationalization came in the year 1948 by nationalizing the ReserveBank of India. The Reserve Bank of India was set up in the year 1935 with the sharecapital of Rs 5 Crore which was entirely owned by the private share holders in the beginning.The Reserve Bank of India is acting as central bank in India and it is different from theCentral Bank of India. After India’s Independence, in the context of close integration itspolicies and those of the Government, the Reserve Bank became a state owned institutionfrom 1st January 1949. The Banking Regulation Act was enacted in the same year (1949)to provide regulations and supervision of Commercial Banks.

In 1951, there were 566 private commercial banks in India and majority of whichwere confined to major cities, however the savings in the form of bank deposits accountedeven less than 1% of the national income, whereas expected 12% savings from householdsector. At this point of time, the RBI as well as Government of India emphasizes to prepareplans which will facilitate to mobilise savings in order to raise the investment rate andchannel resource to identified sectors of the economy, notably agriculture and industry.

In this context the first Five Year Plan was taken birth in the year 1951, the planningstrategy was based on the concept of a mixed economy were the public and private sectorsplays vital role with regard to mobilization of savings and enhancing the investment activitiesin India. Hence, the Reserve Bank of India was took the responsibility of developing theinstitutional infrastructure in the financial system. The Commercial Banking system in Indiawas expanded to take care of general banking activities of accepting the deposits andfacilitating the short term working capital loans to the industry. In the absence of well


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developed capital market, establishment of Development Finance Institutions (DFI’s) andState Finance Corporations (SFC’s) are inevitable to cater the long term financing needsof the industry at the national and state level respectively.

The concept of nationalization was followed in the subsequent period by setting up ofthe State Bank of India in the year 1956 by taking over the then Imperial Bank of India. Infact the Imperial Bank was formed in the year 1921 by the process of amalgamation ofthree presidency banks (namely the Bank of Bengal, the Bank of Bombay and the Bank ofMadras). The State Bank of India is not a nationalized bank; however it was set up by theGovernment of India by taking over the Imperial Bank of India.

It is important to note that the establishment of Unit Trust of India in the year 1963 byan Act of Parliament to provide a channel for retail investors for participating in the primaryas well as secondary market (namely capital market). The Unit Trust of India has beenestablished with the purpose of promoting the development of securities markets, bymobilizing household savings for investment in corporate stocks and bonds market. Initiallythe UTI was set up by the RBI and later on in the year 1978 UTI de-linked from the RBIand the Industrial Development Bank of India (IDBI) took over the regulatory andadministrative control in the place of RBI. Further the UTI has been bifurcated into twoseparate entities in the year 2003. One is the Specified Undertaking of the Unit Trust ofIndia which comes under the rules framed by the Government of India and other one iscalled UTI Mutual Funds Ltd which is functioning under the Mutual Funds Regulations.The Unit Trust of India is India’s first Mutual Fund Organisation.

The unforgettable history in the Indian Financial System is nationalization of 14 privatebanks in the year 1969 by way of an ordinance issued by the Government of India, whichwas later on replaced by an act of parliament. Further six major commercial banks in theprivate sector whose deposits worth more than or equal to Rs 200 crore were nationalisedin the year 1980.

For the purpose of providing the risk coverage security for the life of Individuals theLife Insurance Corporation of India was set up in the year 1956 by merging 245 domesticand foreign insurance companies that were operated in India. The Life Insurance of Indiais the largest Non-banking Financial Institution which mobilizes the huge savings from thepublic at large and the funds will be deployed to the best advantage of the investors as wellas with the best interest of the nation. In order to provide the security to non-life segmentthe General Insurance Corporation (GIC) was established in the year 1972. The GeneralInsurance Corporation is not meant to offer returns but is a protection against contingencieslike accidents, illness, fire, burglary etc. The General Insurance Corporation has foursubsidiaries namely (i) The National Insurance Company Limited (ii) New India AssuranceCompany Limited (iii) Oriental Insurance Company and (iv) United India InsuranceCompany Limited.

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In December, 2000, the subsidiaries of the General Insurance Corporation of Indiawere restructured as independent companies and at the same time GIC was converted intoa national re-insurer. Parliament passed a bill de-linking the four subsidiaries from GIC inJuly, 2002. At present there are 14 general insurance companies including the ECGC andAgriculture Insurance Corporation of India and 14 life insurance companies operating inthe country.

A land mark in the history of co-operative credit system was the establishment ofNational Bank for Agriculture and Rural Development (NABARD) in the year 1982 withthe objectives to create institutional arrangements at national level for financing, guiding andcontrolling the co-operative credit system.

The need to catering the capital market or securities market in India was fulfilled bythe stock exchanges; in fact the Bombay Stock Exchange (BSE) is the 1st stock exchangein India which was established in the year 1875. The main objectives of BSE are to promote,develop, and safeguard the interest of members as well as investors. Subsequently theNational Stock Exchange (NSE) was established in the year 1992 with the intention toprovide a nation wide stock trading facilities to the participants. Over The Counter Exchangeof India (OTCEI) was incorporated in 1990 under the Companies Act 1956 and isrecognized as a stock exchange under Section 4 of the Securities Contracts RegulationAct, 1956. The OTCEI was set up to aid small companies or enterprising promoters inraising finance for new projects in a cost effective manner and to provide investors with atransparent & efficient mode of trading.

Investor’s attention is highly dragged by the credit rating agencies in India. CreditRating is the assessment of a borrower’s credit performance. Credit Rating helps investorsto decide their investment pattern. Basically the credit rating has symbols which denote theperformance or credit worthiness of the respective companies. These symbols may beAAA, AA, BBB, B, C, D to denote the performance of the respective companies to theinvestor. For example AAA which means highest safety in terms of repayment of principaland interest and in case of BBB which means moderate safety in terms of timely paymentof interest and principal. In India the rating will start with the request of the company,however, the Reserve Bank of India and Securities and Exchange Board of India madecredit rating as mandatory for the issue of commercial paper and certain categories ofsecurities and debentures.

Accordingly following credit rating institutions are established in India namely (a) CreditRating Information Services of India Limited (CRISIL) was established in the year 1988,(b) Investment Information and Credit Rating Agency of India Limited was established inthe year 1990 and (c) Credit Ratings Analysis and Research Limited (CARE) was establishedin the year 1993.


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Apart from the above, the Non-Banking Financial Institutions namely the DevelopmentFinancial Institutions or Term lending financial institutions and Non-Banking FinancialCompanies (NBFC’s) are taken the birth since 1950. These institutions are playing vitalrole in the Indian Financial System by providing medium and long term financial assistanceand engaged in promotion and development of industry, agriculture and other key sectors.The Development Financial Institutions so called development banks performs the specialtasks which generally not undertaken by commercial banks. These financial institutions canbe grouped into all India Financial Institutions as well as State Level Institutions which canbe discussed in detail under Unit III.

It is needless to say that The Indian Financial System highly regulated by the regulatingauthorities namely Reserve Bank of India (RBI), The Securities Exchange Board of India(SEBI), Securities Contract (Regulation) Act, The Insurance Regulatory and DevelopmentAuthority (IRDA), The Foreign Exchange Management Act (FEMA), Companies Actand other regulatory bodies from time to time.

1.3.1 Savings and Investments

Domestic savings are inevitable for putting India on a high growth path. Substantialsavings are possible with liberalization of financial markets and strong structural reforms.Financial Intermediaries provide a link in between saving and investment. Basically thesaving of individuals depends on their income, their occupation and size of the city inwhich they resides. Like wise investments also depends on return, liquidity and security.At this junction we would like to discuss three types of saving (economic) units which areessential to understand relationship between savings and investments.

(i) Saving-surplus units or Surplus Spending Economic Units(ii) Saving-deficit units or Deficit Spending Economic Units(iii) Neutral Units

(i) Saving-surplus units or Surplus Spending Economic Units:

Excess of income over expenditure of house hold sectors and other sectors can beclassified as Saving-surplus units. These units try to lend or invest their surplus into profitableinvestments with the help of financial intermediaries. These financial intermediaries play avital role to transfer the savings of the Savings-surplus units to the Savings Deficit units.This process is Called capital formation.

(ii) Saving-deficit units or Deficit Spending Economic Units:

Excess of expenditure over income of the units or sectors. These units finance theirneed by borrowing or by decreasing their financial assets. The surplus saving units anddeficit units can be brought together by the Financial Intermediaries. In India, the corporatesectors and the Government sectors can be categorized as saving-deficit units.

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(iii) Neutral Units:

Means those units whose expenditures are equal to savings.

The role of financial system in the saving and investment can be measured in terms ofNational Income Accounts and Flow of Funds Accounts.

(i) National Income Accounts:

In India, the national income accounts prepared by the Central Statistical Organisation(CSO) and the same published by the Government of India. The National Income Accountsprepared based on the entire production in the Indian economy and earnings derived fromthe production. The Indian Economy can be classified into six categories:

(i) Agricultural Sectors, Mining Sectors, Fishing Sector and so on(ii) Manufacturing Sector, Real Estate Sector and Power Sector and so on.(iii) Service Sector, Transport Sector and Trade or commerce Sector etc.(iv) Banking and Insurance Sector and Development Banking sector etc.,(v) Public Administration and Defense Sector etc.,(vi) Export and Import Sector namely Foreign Sector.

On combination of all the above sectors out put net result can be termed as GrossNational Product (GNP). If we deduct from the GNP the non cash expenditure (monetarysavings) namely the depreciation we will get the Net National Product (NNP). The NetNational Product can be measured as net production of goods and services in the IndianEconomy during the year. It gives an idea of the net increase in the total production in thecountry.

So many times we use to read in the news papers and hear from our friends regardingthe Gross Domestic Product (GDP). It is nothing but gross out put of the Indian Economyexcept Foreign Sector. It means to say increase in savings causes increase in investmentswhich ultimately causes increase in agriculture yield, manufacture and service sectors output, as a result growth in trade and commerce, which leads to increase in the Gross DomesticProduct (GDP).

The National Income Accounts represents macro economic data such as GrossDomestic Product, Gross National Product and Net National Product along with savingsand investments. The National Income Accounts also provide us the information regardingSurplus Saving Units and Surplus Deficit Units but does not provide us link between theseunits. This gap can be filled up by the Flow of Funds Accounts by interlinking varioussectors of the Indian Economy.


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(ii) Flow of Funds Accounts:

The flow of funds explains us the role of financial system in the generation of income,savings and investments. These accounts highlight the channel of cross intersectioncomparison between savings and investments. The nature of financial activities in the IndianEconomy can be studied under the flow of funds accounts. Flow of Funds accounts providesthe information regarding the savings and investments of the Indian Economic Sectorsnamely Hose-hold Sectors, Private Sectors, Banking sectors, Public Sectors and so on soforth. These sectors participate in the financial activities by borrowing from surplus savingunits for the purpose of lending to the saving deficit units.

Domestic Savings:

Savings can be broadly based on the three sectors namely

(i) Household Savings(ii) Private Corporate Savings(iii) Public Sector Savings

(i) Household Savings:

(a) The household sector savings are a predominant source of domestic savings (about76 percent in 2004-05) and a substantial part of the growth in the GD rate emanates fromthe growth. The latest annual report of the Reserve Bank of India gives the data on householdsavings which forms the largest component of aggregate savings in India. The savings ofhouseholds can be viewed as Individuals, Proprietor ship or Partnership firms and allNon-corporate enterprises.

(b) Household savings consist of two segments namely savings in the form of physicalassets and financial assets. The physical assets include land and buildings, plant andmachinery and stocks held by individuals, firms and other non-corporate enterprises. Thefinancial assets consists of currency holdings of households, deposit holdings of banks andnon-bank companies, life insurance fund, provident and pension funds, the Unit Trust ofIndia and other financial institutions, claims on Government consisting of net purchases ofbonds and small savings assets by households, and the net purchases of shares anddebentures by households.

(c) Prior to financial sector reforms, household savings will primarily be in the form ofphysical assets and as the financial system matures, financial intermediation will channelisemore savings into the financial side and finance more productive investments. Till the mid-nineties, household savings in financial assets were more than household savings in theform of physical savings. Now as per the latest estimates available, it is the physical savingsthat are more than those in financial assets. In fact more than 52 per cent of the totalhousehold savings are in the form of physical assets compared to 44 per cent in the early

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nineties. This shift in saving towards physical assets shows is that, at present householdsavings in the system are being driven not by current incomes, but on expected future cashflows.

(ii) Private Sectors Savings:

Private corporate savings comprises of savings from private financial institutions, non-government institutions and non financial companies and so on so forth. As per the CentralStatistical Organisation, data on corporate finances indicate a general improvement incorporate profitability during the current year. The rate of private corporate savings stoodat around 3.7 per cent of GDP in the 1990s improved to 4.8 per cent in 2004-05. This ratecould be slightly lower in 2005-06 as reflected in a slowdown in profitability of the corporatesector as compared to 2004-05. Yet, corporate results for the first two quarters of 2006-07 indicate a buoyant growth in company profits which could translate into improved rateof corporate savings for the current financial year (2006-07).

(iii) Public Sector Savings:

Public Sector Savings consist of savings from Government sectors, AdministrativeDepartments and so on. The increases in public sector savings have been the result ofsignificant reductions in the dissavings of the government administration. The reduction indissavings by the government as mirrored in reducing revenue deficits of the central andstate governments have halved from 7 per cent of GDP in 2001-02 to 3.7 per cent in2004-05; it was further fallen to 3.1 per cent in 2005-06. Savings from departmententerprises like railways, telecom and infrastructure developments remained largely stagnantcontributors to the Gross Development Product (GDP).

With efforts being directed to meet the targets, public sector savings can be expectedto be further consolidated in the current year; the budget estimates for 2006-07 havepegged revenue deficits of the central government (as a percentage of GDP) at 2.1 percent. As per the RBI’s latest compilation of state budgets data reveal that the combinedrevenue deficits of states have declined from 1.2 per cent in 2004-05 to 0.5 per cent eachin the next two years.

1.3.2 Types of Savings

We have various types of savings which can be expect from the household savings,private sector savings and public sector savings as follows:(a)a)Regular Savings Accounts:

These accounts are termed as Savings Bank Account, Recurring Deposits and CurrentAccounts. Saving account and Recurring Deposits gives some interest, but current accountgives nil rate of interest but it allows you to operate with negative balance. Savings Bankaccounts are sometimes called “passbook” accounts. It is an easy way to start a saving


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program because of low opening deposit requirements. There may be limitations on thenumber of withdrawals. Today banks offer a wide range of financial services to help youto save.

(b) Certificates of Deposit (CDs):

Savings can be parked in the form of “term deposit” accounts in the banks becauseyou agree to leave your money in the account for a specified period (called the “term” or“maturity”) in return the institution giving you a higher rate of interest. Terms vary from1year to 10 years. Some CDs do not allow additional deposits. Typically, the funds arereinvested after the term is reached, unless you specify otherwise within a given period.Usually, there are also penalties for early withdrawal.

(c) Savings in the Bonds:

Savings can be converted into the various bonds like Government Bonds, PublicSector Undertaking Bonds, Corporate Bonds, State Loans, Treasury Bills and so on.

(d) Savings in the Institutional Investments:

The Life Insurance Corporation of India (LIC), The Unit Trust of India and EmployeesProvident Fund (EPF) bagged nearly one third of total financial savings in India. Savings inthe form of Insurance policies are products designed to cover the risks of losses fromcertain predetermined events. Savings in the form of Mutual Funds is an emerging area andstill 80% of the mutual funds market occupied by the UTI. Savings in the form of Pensionplans are designed to provide for the retirement of the investor. These institutional investorsprocure the savings from the household sectors, private sector and public sector units.

(e) Savings in company shares and securities:

Savings of the household, private and public sector units can be invested in to thecompany shares, debentures, bonds and deposits etc,. These savings may be short term;medium term or long term depends on the interest of investors.

1.3.3 Investments

The investment process starts when savings facilitate to invest in various profitableventures. Banks and financial institutions lend their funds to the household units and corporateunits. The investments should earn reasonable and expected rate of return on investments.Certain investments like bank deposits, public deposits, debentures bonds etc., will carryfixed rate of return namely interest payable periodically. In case of investments in shares ofcompanies, the periodical payments in the form of dividend are not assured, but it mayensure higher return than fixed income investments but carries higher risk.

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Sources of Investible Funds

Apart from the indicators of domestic savings, the other widely quoted indicators ofinvestment activities are the direct sources of investible funds, namely, capital raised bycompanies in the primary markets, loan disbursements by various financial institutions aswell as the banking sector and foreign investment inflows. While equities in capital marketsare an avenue for household sector savings, they also represent a portion of the investiblefunds available to the corporate sector. Investments in the shares and securities can bedirectly invest by the Foreign Direct Investments and indirectly invest by the ForeignInstitutional Investors. Investments highly influenced by the interest rates and inflation.

1.3.4 Interest Rates and Inflation

There is linear relationship between interest rates and inflation. In other words, bothtend to move either up or down together. However, the caveat is that interest rates willalways follow inflation rates or, put simply, when inflation goes up, interest rates go up andwhen inflation comes down, interest rates tend to fall. This relation ship can be explained inthe following chart.

Inflation rates increases when the economy is overheating. It means to say that whenReserve Bank of India prints lot of money or when macro economic policies go bad. Forexample we assume that the Reserve Bank and Government of India follows the righteconomic policies. hence, money becomes cheaper because of more printing or there islow interest rate. This position can be described as “Loose Money Policy”. We know thatMoney is the back bone of any economy. When the interest rate is low, persons start toborrow the money to invest into their business or buy things which they like. Over a periodof time the price they pay for the money is interest.

In India for the past few years the interest rates were low and people and corporateentities has been increased their borrowings for various purpose. For example Peoplebought residential houses, cars, air conditioners television set and so on and companiesbuilt factories, purchase plant and machineries, furniture and fixtures and so on.


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This situation denotes the economic growth which results rapid increase in incomesand profits as a whole increase in Gross Domestic Product. At this point of time prices forthe product will go up, as we know if demand increases the price of the product alsoincreases. Over a period of time, prices of goods tend to go up and that results in inflationbecause most of these goods are usually part of a basket that constitutes the WholesalePrice Index or the Consumer Price Index.

The Reserve Bank of India will take steps to increase the interest rates so as to coolthe economy. However, interest rates can not be increased beyond a particular level whichcauses the recession. At the level of higher interest rates money becomes costly this situationcan be called “tight money policy”. The intention of the Reserve Bank of India is that whenit increases rates, people and companies will borrow less and therefore there will be lesspurchases and investments.

Then over a period of time incomes of the people and profits of the companies willcome down as a result slow growth in Gross Domestic Product. At this point of timeinflation drops and the Reserve Bank of India will usually lower interest rates to strengthenthe economy. This cycle continues round the clock. This is an example through which wecan understand the interest, money and inflation relation ship. There are some other factorsmay also describe the relationship of interest, money and inflation.

1.4 FINANCIAL INSTITUTIONS

The Financial Institutions can be broadly grouped under (1) Financial Intermediaries,(2) Financial Markets, (3) Financial Instruments and (4) Financial Services which are mainpillars to the Indian Financial System

1.4.1 Financial Intermediaries

Financial Intermediaries also termed as Financial Institutions. We can classify thefinancial intermediaries into two groups one is organized financial intermediaries and otherone is unorganized financial intermediaries.

Organized financial intermediaries comes under the purview of regulating authoritiesnamely Reserve Bank of India, Securities Exchange Board of India, Companies Act,Securities Contract (Regulation) Act and so on. Whereas unorganized financial institutionsare not cover under the purview of these regulating authorities, such type of institutions are

Financial Internediaries Finanacial Markets Financial FinancialInrtruments Services

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called local money lenders, pawn brokers etc. Our study is mainly focusing on formal ororganized financial intermediaries only.

Organised financial intermediaries can be classified as Banking Institutions, Non-Banking Financial Institutions, Insurance Companies and Housing Finance Companies.These financial intermediaries plays vital role in the capital formation by means of mobilizingsavings and facilitating the allocation of funds in an effective manner.

These intermediaries provide the convenience to the small investors by mobilizingtheir savings in the form of divisibility and distribute the claims at the time of maturity orredemption.

The Structure of the Financial Intermediaries or Institutions can be depict as follows:

(A) Term Lending Financial Institutions (ie Development Banks)

(a) Industrial Financial Corporation of India (IFCI)(b) Industrial Investment Bank of India (IIBI)(c) Infrastructure Development Finance Company (IDFC)(d) Small Industrial Development Bank of India (SIDBI)(e) National Bank for Agriculture and Rural Development (NABARD)(f) The Export Import Bank of India(g) Industrial Development Bank of India (IDBI)(h) State Financial Corporations(i) State Industrial Development Corporations (SIDC’s) etc,

(B) Non-Banking Financial Companies (NBFC’s)

(a) Hire Purchase Finance Company(b) Equipment Leasing Companies(c) Housing Finance Companies(d) Venture Capital Fund Companies(e) Chit Fund Companies


NOTES


(f) Stock Broking Firms(g) Merchant Banking Companies etc,

(C) Investment Institutions

(a) Mutual Fund Companies (c) Pension Funds (d) Insurance Companies etc,

1.4.1.1 Banking Institutions

The term Financial Intermediary is handicapped in the absence of the banking sectors.The Indian Banking System regulated and monitored by Reserve Bank of India. The termbanking has been defined by the Banking Regulation Act as “the accepting, for the purposeof lending or investment, of deposits of money from the public, repayable on demand orotherwise and withdrawable by cheque, draft, order or otherwise”. From this definitionwe came to know two important functions of the banks one is acceptance of deposits andlending of funds.

The essential characteristics of banks:

(i) Acceptance of deposits from the public. (ii) Investment or lending the money to meet the short term, medium and long

term requirements. (iii) Repayable the deposits on demand or otherwise and (iv) Withdrawable by means of any instrument whether a cheque or otherwise.

(a) Public Sector Banks in India

Public Sector Banks are those banks in which Government of India has major shareholding. No doubt public sector banks came to occupy dominant role in the bankingstructure. Before 1969, State Bank of India (SBI) was the only public sector bank inIndia, since then the following banks joined in the public sector banks list.

List of Public Sector Banks in India

(1) Indian Bank (2) Bank of India (3) Union Bank (4) Syndicate Bank (5) StateBank of Saurashtra (6) State Bank of Travancore (7) Bank of Maharashtra (8) VijayaBank (9) UCO Bank (10) Indian Overseas Bank (11) Punjab National Bank (12) DenaBank (13) State Bank of Hyderabad (14) State Bank of Bikaner & Jaipur (15) StateBank of India (16) State Bank of Mysore (17) State Bank of Indore (18) CorporationBank (19) Allahabad Bank (20) Andhra Bank (21) Canara Bank (22) Bank of Baroda(23) Oriental Bank (24) Punjab & Sind Bank (25) Industrial Development Bank of India(26) Industrial Credit and Investment Corporation of India (27) Unit Trust of India Bank(28) United Bank.

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(b) Private Sector Banks:

Private Banks have played a major role in the development of Indian banking industry.They have made banking more efficient and customer friendly. In the process they havejolted public sector banks out of complacency and forced them to become more competitive.

We have the following major private banks in India:

(1) Bank of Rajasthan (2) Bharat Overseas Bank (3) Catholic Syrian Bank (4)Centurion Bank of Punjab (5) Dhanalakshmi Bank (6) Federal Bank (7) HDFC Bank (8)ICICI Bank (9) IDBI Bank (10) IndusInd Bank (11) ING Vysya Bank (12) Jammu &Kashmir Bank (13) Karnataka Bank (14) Karur Vysya Bank (15) Kotak Mahindra Bank(16) SBI Commercial and International Bank (17) South Indian Bank (18) United WesternBank (19) UTI Bank (20) YES Bank

(c) Regional Rural Banks:

Regional rural banks in India penetrated every corner of the country and extended ahelping hand in the growth process of the country. Regional rural banks initially started itsbusiness to promote agricultural sector development. The State Bank of India has 30Regional Rural Banks spread over across 13 states in the country. There are other bankswhich function for the development of the rural areas in India. These Regional Rural Banksplays a vial role in rural banking in the economy of the country by providing the help andfinancing farmers, rural artisans, agriculturists, entrepreneurs and so on. They are The HaryanaState Co-operative Apex Bank Ltd, The National Bank for Agriculture and RuralDevelopment, The Haryana State Co-operative Apex Bank Ltd. commonly called asHARCOBANK, National Bank for Agriculture and Rural Development (NABARD),United Bank of India and Sindhanur Urban Southarda Co-operative Banks etc.,

(d) Co-operative Banks

Co-operative Banks in India are registered under the Co-operative Societies Act.The cooperative bank is also regulated by the RBI. They are governed by the BankingRegulations Act 1949 and Banking Laws (Co-operative Societies) Act, 1965. Cooperativebanks in India finance rural sectors in the areas such as farming, Cattle, Milk, personnelfinance, consumer finance and so on so forth.

By virtue of specialised knowledge, training, ability and professionalism theseintermediaries easily mobilise the funds in small denominations from the public at large andinvest in various types of investments by diversifying the risk involved in the investments togenerate optimum returns on investments which can be distributed by way of dividends orinterest to the investors at large.


NOTES


A well developed financial intermediary system promotes the sound financial marketswhich causes the economical growth in the country. Financial Intermediaries offer thefollowing services namely Issue Management, Underwriting, Portfolio Management,Corporate Advisory, Stock Broking, Capital Re-structuring, Merger and Acquisitionsand so on so forth. We will discuss in detail regarding banking sectors in the unit II.

1.4.1.2 Non Banking Financial Intermediaries

The term Non-Banking Financial Intermediaries can be bifurcate into three sub partsnamely (a) Term Lending Financial Institutions, (b) Non-Banking Financial Companiesand (c) Investments Institutions.

Term Lending Financial Institutions

These institutions also called as Development Banks. They are Industrial FinancialCorporation of India (IFCI), Industrial Investment Bank of India (IIBI), InfrastructureDevelopment Finance Company (IDFC), Small Industrial Development Bank of India(SIDBI), National Bank for Agriculture and Rural Development (NABARD), The ExportImport Bank of India, Industrial Development Bank of India (IDBI), State FinancialCorporations, State Industrial Development Corporations (SIDC’s) etc,

Industrial Finance Corporation of India (IFCI)

The Industrial Finance Corporation of India was established in the year 1948 asIndia’s first development bank. The main objective for which IFCI was established, are tomake medium and long term credit available to the industrial undertakings. The main functionsare direct financial support to industrial units for undertaking new projects, expansion,modernization, diversification etc., subscription and underwriting of public issues of sharesand debentures, guaranteeing of foreign currency loans and also deferred paymentguarantees, merchant banking, leasing and equipment finance.

Industrial Investment Bank of India (IIBI)

This institution was established in the year 1997 by converting the erstwhile IndustrialReconstruction Bank of India. The main functions of the Industrial Investment Bank ofIndia are; invest in the capital market instruments, leasing and hire purchase business,providing the short, medium and long term loans and underwriting the shares and so on.

Infrastructure Development Finance Company (IDFC)

IDFC was established in the year 1997 with the intention to promote consultancyand advisory services to state governments for formulating a power sector strategy, tointegrate the entire logistics chain in India, to provide the financial assistance to varioustelecommunication and Information Technology sectors, providing finance and projectservices for the development urban infrastructure and so on .

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Small Industrial Development Bank of India (SIDBI)

SIDBI was established by passing an Act under parliament in the year 1989. TheSIDBI provides services such as the principal financial institution for the promotion, financingand development of industries in the small scale sectors and to coordinate the functions ofother institutions engaged in similar activities.

National Bank for Agriculture and Rural Development (NABARD)

NABARD also came into exist in the year 1982 by an Act of parliament. It serves asan apex refinancing agency for the institutions providing investment and credit for promotingdevelopment activities in rural areas, coordinates and supervise the rural financing activitiesof all institutions engaged in developmental work etc,.

The Export Import Bank of India (EXIM Bank)

The Export Import Bank of India is a public sector financial institution was set up inthe year 1981. The main objective of this bank is financing, facilitating and promotingIndia’s trade and commerce, provides the project finance, Trade finance, Exim bank alsoact an intermediary for facilitating the forfeiting transaction between the Indian exporterand the overseas forfeiting agency etc.,

Industrial Development Bank of India (IDBI)

Industrial Development Bank of India (IDBI) was set up by an Act of parliament as awholly owned subsidiary of the Reserve Bank of India. Later on in the year 1976, theIDBI ownership was transferred to the Government of India. The main functions of IDBIare vested with the responsibility of co-ordinating the working of institutions engaged infinancing, promoting and developing industries.

It has evolved an appropriate mechanism for this purpose. IDBI also undertakes/supports wide-ranging promotional activities including entrepreneurship developmentprogrammes for new entrepreneurs, provision of consultancy services for small and mediumenterprises, up gradation of technology and programmes for economic upliftment and soon.

IDBI can finance all types of industrial concerns covered under the provisions of theIDBI Act. With over three decades of service to the Indian industry, IDBI has grownsubstantially in terms of size of operations and portfolio. IDBI has directly or indirectlyassisted all companies that are presently reckoned as major companies in the country.


NOTES


State Financial Corporations

State Financial Corporations were established in the respective states to meet the financialrequirements of small and medium enterprises. The State Financial Corporations providefinancial assistance by way of term loans, equity subscription, debentures, discounting ofbills of exchange seed capital assistance.

State Industrial Development Corporations (SIDC’s)

SIDC’s are incorporated under the Companies Act 1956 as wholly owned undertakingof the respective state governments. These corporations provide tax benefits under thestate government’s schemes to attract the investments. State Industrial DevelopmentCorporations provide the rupee loans, direct subscription to shares and securities and theyalso borrow funds from the house hold units, private companies and public sectorundertakings by way of issue of bonds or debentures.

Students are requested to refer the Unit III for detailed discussion regarding Termlending Financial Institutions.

1.4.1.3 Non-Banking Financial Companies (NBFC’s)

A Non-Banking Financial Company (NBFC) is a company registered under theCompanies Act, 1956 and is engaged in the business of loans and advances, acquisition ofshares/stock/bonds/debentures/securities issued by Government or local authority or othersecurities of like marketable nature, leasing, hire-purchase, insurance business, chit businessbut does not include any institution whose principal business is that of agriculture activity,industrial activity, sale/purchase/construction of immovable property.

A non-banking institution which is a company and which has its principal business ofreceiving deposits under any scheme or arrangement or any other manner, or lending inany manner is also a non-banking financial company (Residuary non-banking company).

The NBFC’s functions are similar to that of Banking Companies; however, there arefew differences as follows:

The various typer of NBFC’S are as follows:

(i) Non-Banking Financial Companies (NBFC’s) cannot accept demand deposits; whereasBanking Companies accepts deposits.

(ii) It is not a part of the payment and settlement system and as such cannot issue chequesto its customers by NBFC’s and

(iii) Non-Banking Financial Companies are not insured or guaranteed by any governmentbody unlike a bank deposit, where up to Rs 1 lac per bank is insured by the Deposit andCredit Insurance Corporation, a subsidiary of the Reserve Bank of India.

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(a) Hire Purchase Finance Company (b) Equipment Leasing Companies (c) Housing Finance Companies (d) Venture Capital Fund Companies (e) C hit Fund Companies (f) Stock Broking Firms (g) Merchant Banking Companies etc,

We have elaborately dealt with each one of the above NBFC’s in the Unit III namelyDevelopment Banking.

1.4.1.4 Investment Institutions:

Investment institutions means procurement of funds from public and institutionalinvestors at large to meet the long term, medium term and short term requirements of theinvestors by providing reasonable returns with negligible risk. They can be viewed in thefollowing terms. This list is only an illustrative but not exhaustive. The detailed study ofthese institution are explained in the Unit V.

(a) Mutual Fund Companies (c) Pension Funds (d) Insurance Companies etc,

1.4.2 Financial Markets

The Indian Financial Market promotes the enormous savings of the economy, byprovi ding an effective channel of returns to the investors from whom the savings are mobilized.Hence, the term Financial Markets can be defined as a market for the exchange of capitaland credit including the money markets and the capital markets. Financial Markets arefacilitating tools for procurement of funds and invest in to various assets. The main activitiesof Financial Markets can be viewed as sale or purchase of shares or stocks, bonds, bills ofexchange, commodities, future and options, foreign currency etc.

The Financial Markets can be classified into:

(i) Money market, (ii) Credit market, (iii) Capital market, (iv) Government securities market,and (v) foreign exchange market. In view of the importance of Government securitiesmarket in the Indian financial system it is bifurcated as separate segment though it is part ofdebt-market and thus of capital market. Each market is unique in terms of the nature ofparticipants and the instruments in the market. The process of financial sector reforms hasaimed at widening and deepening each market and moved towards integrating these marketsdomestically as also with global markets.


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Financial Markets

1.4.2.1 Money Market

The Money Market refers to the market for short term debt instrument which hasmaturity less than one year. The Money Market provides the borrower to borrow thefunds for shorter period with lowest cost of funds. At the same time it is also facilitates tothe investor a platform to invest his savings which can generate interest thereon. MoneyMarkets does not have an organised trading market place such as the stock exchange forits primary issue and secondary market trades.

The participants in the money market are banks, primary dealers, and financialinstitutions, mutual funds, non-bank financial companies, manufacturing companies, StateGovernments, provident funds, non-resident Indians, overseas corporate bodies, foreigninstitutional investors and trusts.

The RBI and Securities and Exchange Board of India (SEBI) regulate the participantsand use of instruments in the money market depending upon their respective roles in thefinancial system. For instance, financial institutions and mutual funds are allowed only aslenders in the call money market but are permitted to buy and sell Commercial Paper.

Functions of Money Market

Money market as we know it is a market for short term funds. The money marketgenerally expected to perform the following functions:

(1) It provide as an equilibrium mechanism to even out demand and supply the shortterm funds.

(2) It act as focal point for influencing liquidity and general level of interest rates inthe economy.

(3) It also provides reasonable access to the users and providers of short term fundsto fulfill their investment and borrowing requirements respectively.

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There are several instruments in the money market which can be summarized asfollows

i) Treasury Bills (T-Bills)ii) Certificate of Deposits (CD’s)iii) Gilt-edged Securitiesiv) Commercial Papersv) Repurchase Agreements (Repo’s)vi) Bankers Acceptancevii) Inter Bank Participation Certificateviii) Money Market Mutual Funds (MMMF’s)

(i) Treasury Bills (T-Bills):

Treasury Bills are generally issued by the Government for periods ranging from 14days to 364 days through regular auctions. T-Bills are highly liquid instruments and demandfrom banks, financial institutions and corporations. These T-Bills are issued by the ReserveBank of India on behalf of the Government of India. For mobilizing short term cash thesebills are created by the Government to meet its short term requirements. Treasury Bills canbe redeemed prior to the final date of maturity.

(ii) Certificate of Deposits (CD’s)

Certificate of Deposits are popular money market instruments having lock in periodof 15 days after which they can be sold. The Scheme of Certificate of Deposits wasintroduced by the Reserve Bank of India. As per the Reserve Bank of India these Certificateof Deposits can be issued by any scheduled commercial banks, co-operative banks butother than Land Development Banks. Certificate of Deposits can be subscribed by anindividual as well as by an institution.

The minimum size of the deposit is Rs 5 lakhs and thereafter in multipules of Rs 5lakhs. Premature closure of Certificate of Deposits is not permitted and buy –back ofthese deposits is prohibited. Certificate of Deposits can be compared with the FixedDeposits of the banks and the major difference between the two being that CD’s aretransferable from one party to another, where as Fixed Deposits are non-transferable.

Certificate of deposits are unsecured negotiable promissory notes issued by commercialbanks and development financial institutions while the commercial banks CD’s are issuedon discount to face value basis. The discount rates of commercial deposits are marketdriven.

The maturity period ranges from 91 days for the CD’s issued by the banks, one to 3years if CD’s issued by the Development Financial Institutions. Investing into the CD’s isuse full to the investors which can be explained in the following example.


NOTES


For Example: X ltd has Rs 20 lacs to invest in Certificate of Deposit of a leadingnationalized bank @8% per annum. What money is required to be invested now?

Answer:

Rate of interest = 8% No of days to maturity = 91 daysInterest on Re 1 for 91 days = 0.08 x 91/365 = 0.019945Maturity value after 91 days on Re 1 = Re. 1.019945Investment today = Rs 20 lacs / 1.019945

If we want Rs 20 lakhs after 91 days our investment today is Rs 19,60,890/-

(iii) Gilt-edged Securities

The Government securities and fixed rate bonds, floating rate bonds, zero couponbonds, capital index bonds etc., can be grouped under Gilt-edged securities. These arerisk less securities. The maturity pattern of Government securities are ranging from 1 yearto 10 years. These securities are less liquid than treasury bills and demand for thesesecurities is mainly from banks.

(iv) Commercial Papers

The concept of commercial paper was introduced in India during the year 1990 onthe recommendation of Vaghul Committee. Commercial Papers are now popular debtinstrument for short term borrowing which is one of the source of mobilizing the short termfunds to the highly rated corporate borrowers. Commercial papers are generally allowedto issue by the corporate borrowers having good ranking in the market as established by acredit rating agency.

Now a days Primary Dealers (PD’s) and Satellite Dealers (SD’s) were allowed toissue the commercial papers for short term borrowing. Commercial Papers are issued atdiscount rate which is determined by the issuing company based on its credit rating.Banks and companies are allowed to buy the commercial papers and the company whichis issuing commercial paper has to have not less than Rs 4 crores Net Worth. The commercialpapers can be issued in denominations of Rs 5 lakh

The concept of issue of commercial papers can be explained with the help of thefollowing example:

Example: X Ltd issued Commercial Paper worth Rs 10 crores as per the followingdetails:

Date of issue : 17th January. 2008

Date of maturity : 17th April, 2008

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No of days : 90 days (from 17th Jan 08 to 17th April 08)

Rate of interest : 11.25% per annum.

Net amount will best received by the company on issue of commercial paper is asfollows:

90 days 11.25Interest for 90 days = —————— x ———— = 2.7740

365 days 100

2.7740Rs10 crores x ————————— = Rs 26, 99,126 or say Rs 27 lakhs

100 + 2.7740

Net amount will be received by the company is Rs 9.73 crores (ie Rs 10 crores lessRs 27 lakhs).

(v) Repurchase Agreements (Repo’s)

Repurchase Agreements also called as buy back or ready forward and in shortRepo’s. Repurchase Agreement arises when one party sells a security to another partywith an agreement to buy it back at a specified time and price. Like wise the buyer purchasesthe securities, with an agreement to resell the same to the seller on an agreed date and at apredetermined price. The same transaction is called as repo from the seller point of viewand reverse repo from the viewpoint of the buyer. Basically repo’s are short term instrumentwith risk free for balancing short term liquidity needs.

Banks have often resorted to ready forward deals among themselves, as also withDiscount and Finance House of India (DFHI) and Securities Trading Corporation of India(STCI) to overcome short term financial crunches. At present the Reserve Bank of India isallowed repo’s trading between banks, cooperative banks, Discount and Finance Houseof India and Securities Trading Corporation of India. Repos are usually entered into witha maturity of 1-14 days. Initially, there were lot of restrictions on banks to deal with repo’sbecause securities scam and other scams. Later on due to libaralisation the restrictions aregradually reduced.

Types of Repo’s: we have at present two types of repo’s namely

• Inter-Bank Repo’s and• Reserve Bank of India Repo’s.


NOTES


Inter-Bank Repo’s

Banks, along with primary dealers are permitted to undertake ready forwardtransactions through the Special General Ledger (SGL) account maintained by the ReserveBank of India. At present all Central Government dated securities, State GovernmentSecurities and T-bills of all maturities have been made eligible of repo’s. The non bankentities holding SGL account with the Reserve Bank of India can enter into reverse repotransactions with banks or primary dealers, in all Government securities.

Reserve Bank Repo’s

Reserve Bank of India undertake the repo’s or reverse repo’s with the banks andPrimary Dealers as part of Open Market Operations (OMO’s). It is a mechanism throughwhich the Reserve Bank of India borrows money from banks. This process can be doneby selling the government securities to repurchase later to influence the short term liquidity.

Primary dealers include Discount and Finance House of India, Securities TradingCorporation of India, ICICI Securities, SBI Gilts, PNB Gilt and Gilt securities TradingCorporation.

(vi) Bankers Acceptance

A banker’s acceptance is a draft against a bank ordering the bank to pay somespecified amount of at a future date. The bankers’ acceptance is very safe security and isused as a money market instrument.

Banker Acceptance (BA) is an order to pay a specified amount of money to theholder of the instrument on a given date. These are usually used in foreign trade transactionsin which the seller wants to insure they will be paid for the goods sent. A commercial bankissues the BA to the seller in place of the buyer, who pays for the BA, and whose creditrating may not be as strong as the bank.

This is especially useful when the creditworthiness of a foreign trade partner is unknown.Acceptances sell at a discount from the face value:

One advantage of a banker’s acceptance is that it does not need to be held untilmaturity, and can be sold off in the secondary markets where investors and institutionsconstantly trade BAs.

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(vii) Inter Bank Participation Certificate

The Inter Bank Participation Certificate is yet another short term money instrument bywhich the banks can raise money or deploy short term surplus. Inter Bank ParticipationCertificates can be issued only by scheduled commercial banks these can be on risk sharingbasis and other one is without risk sharing basis.

(viii) Money Market Mutual Funds (MMMF’s)

Money Market Mutual Funds acts as bridge in-between small investors and moneyborrowers. MMMF’s mobilizes the funds from small saving savers and invest into shortterm debt instruments or money market instruments. MMMF’s are allowed to offer acheque writing facility in a tie up with banks to provide more liquidity.

1.4.2.2 Credit Markets

The credit market can be classified by maturity of finance - short-term and long-term.The distinction between the short-term and long-term credit institutions is increasingly gettingblurred, but it is still possible to classify them in terms of their traditional objectives. Short-term finance is extended in the form of cash credit limits and term loans with maturity of lessthan one year. Institutions mainly extending such loans are commercial banks, cooperativebanks and non-bank finance companies.

Recently, development financial institutions have also entered into this foray. Long-term finance is extended in the form of term loans technically for a period of over one yearbut substantively and in practice for a period of over three years. Institutions extendingsuch loans are developmental financial institutions, specialized financial institutions andinvestment institutions. Recently, commercial banks are extending their operations in thisarea.

Sources of credit can be classified into internal (rupee credit) and external (foreigncurrency loans through external commercial borrowings and foreign currency denominatednon-resident deposits under FCNR-B). Significant changes have been brought about incredit markets, particularly since April 1997. Banks are easily the most critical players inthis market.

The RBI is moving away from micro regulation to macro management of banks. Alldeposit rates are freed except for savings accounts and term deposits up to 30 days.Banks have been given the freedom to evolve their own methods of assessing workingcapital and also the freedom for credit dispensation without consortium obligations. Banksare now allowed to freely fix their lending rates beyond Rs. 2 lakh, and within a ceiling of13.5 per cent for loans amounting to Rs. 25,000 - Rs. 2 lakh. Of course, some lendingrates for export activity are also regulated.


NOTES


1.4.2.3 Capital Market

Capital Market is the market for long term finance with the maturity period more thanone year. The Capital Market deals with the stock markets which provide financing throughthe issuance of shares or common stock in the primary market, and enable the subsequenttrading in the secondary market, Capital Markets also deals with Bond Market whichprovide financing through issuance of Bonds in the primary market and subsequent tradingthereof in the secondary market.

Functions of Capita Markets:

1. The organised and regulated capital market motivates individual to save and investfunds. The availability of safe and profitable source of investment is an essential criteriato create propensity to save and invest on the part of the earning public.

2. It provides for the investors a safe and productive channels for investment of savingsand secure the recurring benefit of return thereon, as long as the savings are retained.

3. It provides liquidity to the savings of the investors, by developing a secondary capitalmarket, and thus makes even short term savings, consistently available for long-termusers

4. It thus mobilises savings of large number of individuals, families and associations andmake the same available for meeting the large capital needs of organised industry,trade and business and for progress and development of the country as a whole andits economy.

The primary financial assets in the capital market include the following:

(i) Treasury Bonds:(ii) Common Stock:(iii) Corporate Long Term Bonds(iv) Mortgages

1.4.2.4 Government Securities Market

The Government Securities market constitutes the principal segment of the debt market.The participants in this market as issuers are the Central and State Governments. The maininvestors are the RBI, insurance companies, banks, State Governments, provident funds,individuals, corporates, NBFCs, financial institutions, and to a limited extent FIIs andNRIs.

Reforms initiated in the recent period include, introduction of Treasury Bills of varyingmaturities, abolition of tax deduction at source on interest income from Government securities,and permitting FIIs to invest in debt instruments including dated Government securities asalso allowing them to hedge their foreign currency risk in the forward markets.

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The monetary policy of October 1997 announced the introduction of uniform priceauction in respect of 91-Day Treasury Bills as an experimental measure with a view tobroadening the investor base and removing the winners curse; the introduction of pre-announced notified amounts for all auctions of Government securities, and the intention toaccept non-competitive bids outside the notified amount in order to ensure moretransparency in the primary auction process. FIIs with 30 per cent ceiling on investment indebt, are being allowed to invest in Government securities in addition to corporate debt.

1.4.2.5 Foreign Exchange Market

When an organization or person in one country wants to buy goods or services inanother, they must normally exchange their own currency for that of the country they arebuying from. As a result, those who are dealing with foreign trade or commerce have aneed to buy the currency of another country to make transactions. This exchange is donein the foreign currency market.

State Bank of India is the single-largest participant in the forex market, accounting forabout 40 per cent of the value of total customer transactions. In the inter-bank segment ofthe market, SBI along with a few other banks constitute the market-makers, i.e., bankswhich are always ready to quote two-way price both in the spot and forward markets.Foreign banks are predominant among the other participants.

The customer segment is dominated by the Indian Oil Corporation and certain otherlarge public sector giants like Oil and Natural Gas Commission, Bharath Heavy ElectricalsLtd., Steel Authority of India Ltd., Maruti Udyog, etc. There is a perceptible presence oflarge private sector corporates like, Reliance Group, Tata Group, and Larsen and Tubro.Of late, foreign institutional investors have accounted for a large supply in the market.

The RBI also buys and sells foreign exchange at its discretion to ensure orderlyconditions in the market. Till recently, the market was dominated by trade-related flowsand was not driven by financial market expectations inasmuch as the arbitrage opportunitiesbetween the Indian and offshore money (financial asset) markets were highly restricted.Nevertheless, the market-makers are now better-placed to give quotes with narrowerspreads than before.

Some major initiatives in the Foreign Exchange Market

(i) Corporates are now allowed to sell and buy in the forward market beyond sixmonths on a presumptive basis, subject to certain conditions. This has resulted inextending the forward market beyond six months.

(2) In fact, forward quotes for periods of more than six months and up to 12 monthsare now available on a regular basis and at narrower spreads.

(3) Authorised Dealers (ADs) are now allowed to run long-term rupee-forex swapbooks.


NOTES


(4) This has resulted in better avenues of forex exposure management. Forward coverfor FIIs in debt instruments and for NRI depositors in respect of deposits held inNRI and FCNRB schemes has been allowed enabling these participants to hedgetheir exposures.

1.4.3 Financial Instruments

Financial instruments can be broadly divided into two parts namely primary securitiesand secondary securities. Primary securities are further divided into equity shares, preferenceshares, debt instruments and various combinations of these. Secondary markets furtherdivided into time deposits, Mutual Funds and insurance polices.

Some of the various financial instruments deal with in the international market alsobriefly discussed below:

(i) Euro Bonds(ii) Foreign Bonds(iii)Fully Hedged Bonds(iv)Floating Rate Notes(v) Euro commercial Papers(vi)Foreign currency options(vii)Foreign currency futures

(i) Euro Bonds

Euro bonds are debts instruments denominated in the currency issued out side thecountry of the that currency. For examples a Yen note floated in the Germany.

(ii) Foreign Bonds

These are the debts instruments denominated in a currency which is foreign to the borrowerand is sold in the country of that currency. For example a British firm placing dollardenominated bonds in USA.

(iii) Fully Hedged bonds

In foreign bonds, the risk of currency fluctuation exist. Fully hedged bonds eliminatesthe risk by selling in the forward markets the entire steam of principal and interest payment.

(iv) Floating Rate Notes

These are issued up to 7 years maturity. Interests are adjusted to reflect the prevailingexchange rates. They provide cheaper money than foreign loans.

(v) Euro commercial papers

Euro Commercial Papers are short term money market instruments. They are formaturities less than one year. They are usually designated in US dollars.

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(vi) Foreign Currency Option:

A foreign currency option is the right to buy or sell, spot, future or forwards, a specifiedforeign currency. It provides a hedge against financial and economic risks.

(vii) Foreign currency Futures:

Foreign currency Futures are obligations to buy or sell a specified currency in thepresent for settlement at a future date.

1.4.4 Financial Instruments

Financial services have been growing rapidly with the emergence of new investmentflows in financial reconstitute a large and growing sector in almost all economies. Trade andinvestment flows in financial services have been growing rapidly with the emergence of newand growing markets in developing and transition economies, with modernization, rapidtechnological change, use of new financial instruments, and financial and trade liberalization.

The financial services sector is also quite large and complex and covers a wide rangeof activities and instruments, including for instance, corporate banking, derivatives, factoring,foreign exchange trading, pensions and investment fund management, advisory andconsultancy services, insurance broking and underwriting, project finance, securities trading,venture capital, and wholesale and retail banking services. Given the range of instrumentsand activities that fall under the purview of the financial services sector, there are also alarge number of players

1.5 FINANCIAL SECTOR REFORMS

Financial Reforms has been excellently explained by Dr. Rakesh Mohan, DeputyGovernor, Reserve Bank of India at the International Monetary Fund, Washington D.C.-2004. We have discussed some of important issues dealt by him in the Reserve Bank ofIndia bulletin regarding financial reforms in India.

The initiation of financial reforms in the country during the early 1990s was to a largeextent conditioned by the analysis and recommendations of various Committees/WorkingGroups set-up to address specific issues. The process has been marked by ‘gradualism’with measures being undertaken after extensive consultations with experts and marketparticipants.

From the beginning of financial reforms, India has resolved to attain standards ofinternational best practices but to fine tune the process keeping in view the underlyinginstitutional and operational considerations. Reform measures introduced across sectorsas well as within each sector were planned in such a way so as to reinforce each other.Attempts were made to simultaneously strengthen the institutional framework while enhancingthe scope for commercial decision making and market forces in an increasingly competitive


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framework. At the same time, the process did not lose sight of the social responsibilities ofthe financial sector.

However, for fulfilling such objectives, rather than using administrative fiat or coercion,attempts were made to provide operational flexibility and incentives so that the desiredends are attended through broad interplay of market forces. The major aim of the reformsin the early phase of reforms, known as first generation of reforms, was to create anefficient, productive and profitable financial service industry operating within the environmentof operating flexibility and functional autonomy.

While these reforms were being implemented, the world economy also witnessedsignificant changes, ‘coinciding with the movement towards global integration of financialservices’. The focus of the second phase of financial sector reforms starting from thesecond-half of the 1990s, therefore, has been the strengthening of the financial system andintroduction of structural improvements.

Two brief points need to be mentioned here. First, financial reforms in the early 1990swere preceded by measures aimed at lessening the extent of financial depression. However,unlike in the latter period, the earlier efforts were not part of a well-thought out andcomprehensive agenda for extensive reforms.

Second, financial sector reform in India was an important component of thecomprehensive economic reform process initiated in the early 1990s. Whereas economicreforms in India were also initiated following an external sector crisis, unlike many otheremerging market economies where economic reforms were driven by crisis followed by aboom-bust pattern of policy liberalisation, in India, reforms followed a consensus drivenpattern of sequenced liberalisation across the sectors. That is why despite several changesin government there has not been any reversal of direction in the financial sector reformprocess over the last 15 years.

The main objectives of the financial reforms in India are

a. Drepression that existed earlier;b. Create an efficient, productive and profitable financial sector industry;c. Enable price discovery, particularly, by the market determination of interest rates

that then helps in efficient allocation of resources.d. Provide operational and functional autonomy to institutions.e. Prepare the financial system for increasing international competition.f. Open the external sector in a calibrated fashion.g. Promote the maintenance of financial stability even in the face of domestic and external shocks.

We can classify the reforms in financial sectors into banking sector reforms, reformsin the government securities market and reforms in the foreign exchange market.

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1.6 BANKING SECTOR REFORMS:

(i) Granting of operational autonomy to public sector banks, reduction of publicownership in public sector banks by allowing them to raise capital from equitymarket up to 49 per cent of paid-up capital.

(ii) Transparent norms for entry of Indian private sector, foreign and joint-venturebanks and insurance companies, permission for foreign investment in the financialsector in the form of Foreign Direct Investment (FDI) as well as portfolio investment,permission to banks to diversify product portfolio and business activities.

(iii) Settling up of Lok Adalats (people’s courts), debt recovery tribunals, asseteconstruction companies, settlement advisory committees, corporate debtrestructuring mechanism, etc. for quicker recovery/ restructuring. Promulgation ofSecuritisation and Reconstruction of Financial Assets and Enforcement of SecuritiesInterest(SARFAESI), Act and its subsequent amendment to ensure creditor rights.

(iv) Setting up of INFINET as the communication backbone for the financial sector,introduction of Negotiated Dealing System (NDS) for screen-based trading ingovernment securities and Real Time Gross Settlement (RTGS) System.

Reforms in the Government Securities Market:

(i) Administered interest rates on government securities were replaced by an auctionsystem for price discovery. Automatic monetization of fiscal deficit through theissue of ad hoc Treasury Bills was phased out.

(ii) Primary Dealers (PD) were introduced as market makers in the governmentsecurities market.

(iii) For ensuring transparency in the trad MSS) has been introduced, which hasexpanded the instruments available to the Reserve Bank for managing the surplusliquidity in the system.

(vi) 91-day Treasury bill was introduced for managing liquidity and benchmarking.Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issuedand exchange traded interest rate futures were introduced. OTC interest ratederivatives like IRS/ FRAs were introduced.

(vii) Foreign Institutional Investors (FIIs) were allowed to invest in government securitiessubject to certain limits.

Reforms in the Foreign Exchange Market:

(i) Replacement of the earlier Foreign Exchange Regulation Act (FERA), 1973 bythe market friendly Foreign Exchange Management Act, 1999. Delegation ofconsiderable powers by RBI to Authorised Dealers to release foreign exchangefor a variety of purposes.

(ii) Introduction of additional hedging instruments, such as, foreign currency-rupeeoptions. Authorised dealers permitted to use innovative products like cross-currencyoptions, interest rate and currency swaps, caps/collars and forward rate agreements(FRAs)in the international forex market.


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(iii) Permission to various participants in the foreign exchange market, includingexporters, Indians investing abroad, FIIs, to avail forward cover and enter intoswap transactions without any limit subject to genuine underlying exposure.

(iv) FIIs and NRIs permitted to trade in exchange-traded derivative contracts subjectto certain conditions.

(v) Foreign exchange earners permitted to maintain foreign currency accounts.Residents are permitted to open such accounts within the general limit of US $25,000 per year.

1.7 DISCOUNT AND FINANCE HOUSE OF INDIA (DFHI)

With an objective to strengthen the infrastructure of fixed income securities market inIndia, Discount and Finance House of India (DFHI) was incorporated by Reserve Bankof India (RBI) along with other Public Sector Banks (PSBs) and All-India FinancialInstitutions (FIs) under the Companies Act 1956, on March 8, 1988.

After receiving certificate of commencement of business on April 25, 1988, the companystarted its operation with an initial paid up capital of Rs 100 crore (RBI – Rs 51 crore,PSBs – Rs 33 crore and FIs – Rs 16 crore). However, in order to broad base the activityof the company, the paid up capital was subsequently increased to Rs 150 crore in 1989-90 and further to Rs 200 crore during 1991-92.

DFHI since its inception has been actively trading in all the money market instruments(viz. call/notice/term money, commercial bills, treasury bills, certificate of deposit andcommercial paper) and its business turnover has grown progressively over the years.

With effect from the year 1992-93, DFHI has been authorised to deal in DatedGovernment Securities also. After the company was accredited as a Primary Dealer (PD)in February 1996, its operations have increased significantly particularly in Treasury Billsand Dated Government Securities.

Meanwhile, over a period of time RBI took a policy decision to divest theirshareholdings in favor of the existing share holders. Thus State Bank of India (SBI) becamethe major shareholder and DFHI became a subsidiary of SBI from 31.03.2003.

SBI Gilts Ltd. a subsidiary of SBI and established in the year 1996 was also an activeparticipant in the market and one of the top five PDs. As both the companies were engagedin the same line of business, it was decided to merge SBI Gilts Ltd with DFHI Ltd in April2004. Accordingly, from June 2004 the name of the merged entity was changed to SBIDFHI Ltd.

SBI DFHI Ltd, now a subsidiary of SBI is the largest PD in the market in terms of networth. The company is a major participant in the wholesale Debt Market both in thePrimary and Secondary Market segment

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SBI DFHI is one of the leading player in the fixed income securities market andmarket maker in Government Securities and Treasury Bills. The company deals with thefollowing:

• Treasury Bills• Central Government Dated Securities• State Government Securities• PSU Bonds• Inter-Corporate Deposits• Commercial Paper• Interest Rate Swaps

Besides, participation in Repo Market of GOI Securities and Treasury Bills as well asthe participation in the Inter-Bank Call/Notice/Term Money market, both as a borrowerand as a lender is possible through the company.

SBI DFHI also provides the Constituent Subsidiary General Ledger (CSGL) accountfacility which enables even those entities which otherwise do not have an SGL Accountfacility with the RBI to reap the full benefits of investing in Government Securities. Onpurchase of Treasury Bills/Government Securities, they will be credited to the CSGL account,whereas on sale they will be debited from the CSGL account. Moreover, SBI DFHI willreceive coupon payments/redemption proceeds from RBI and pass on to the CSGL accountholder as and when such payments fall due.

Advantages in dealing with SBI DFHI

• Promoted as a subsidiary by Reserve Bank of India and at present a subsidiary ofState Bank of India, the largest Commercial Bank in India. Hence, enjoys anexcellent credit rating in the market.

• Since there is no brokerage or any other hidden charges price transparency isassuredin our transactions.

• It take care of the entire procedural formalities involved in securities purchase /sales to the best satisfaction of our customers.

• Good branch network for easy interface across the country

1.8 MONEY LAUNDERING

It is a serious threat not only to the financial system of countries, but also to theirintegrity and sovereignty. Money Laundering means the process involves cleaning of moneyearned through illegal activities like extortion, cross border terrorism etc. To prevent moneylaundering and connected activities, confiscation of proceeds of crime, and Act has beenpassed in the Parliament called “the Prevention of Money Laundering Act, 2002.


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1.9 DERIVATIVES MARKETS

The Derivatives Market commenced in India in the year 2000 after the SecuritiesExchange Board of India granted the permission. Derivatives market has had a slow growthin India in the initial period.

The International Monetary Fund defines the term Derivatives as “financial instrumentsthat are linked to a specific financial instrument or indicator or commodity and throughwhich specific financial risks can be traded in financial markets in their own right. The valueof financial derivatives derives from the price of an underlying item, such as asset or index.Unlike debt securities, no principal is advanced to be repaid and no investment incomeaccrues.”

The current price of an asset is determined by the market demand and supply of theasset. However, the future price of an asset is difficult to ascertain, which means unknown.The price of an asset after one month or six months may increase, decrease or remains thesame. Buyers and sellers often like to hedge their bets against this uncertainty about futureprice by making a contract for future trading at a specified price at the present this type ofcontract can be termed as Derivatives.

For Example

Suppose you expect that six months from now the price of the U.S. dollar with respectto the Canadian dollar will be higher than it is today, and would like to purchase US$1,000 six months from now at today’s rate. Suppose the current price of US $1,000 isCAN $1,200.

Another person expects that the price of the U.S. dollar will decrease over the comingsix months, and is willing to sell U.S. dollars at today’s rate. Both of you can make acontract that will be exercised six months from now. Interestingly, neither of you needs toput down any currency today when signing the contract. When the contract matures,transactions must be carried out at the agreed-upon rate. This type of contract is called aforward contract.

Alternatively, suppose the contract is sold for a non-refundable fee of $25. If theprice of the U.S. dollar goes up, you are likely to exercise your right. On the other hand, ifthe price of the U.S. dollar goes down, you will be better off not exercising your right; inthis case, you are losing only the fee. This type of contract is known as a ’call option.’Similarly, a ’put option’ gives the owner the right to sell rather than buy.

Types of Derivatives

The most common Derivative contracts are forwards, futures, options and swap

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Forward Contracts

A forward contract is an agreement between two parties namely a buyer and a sellerto purchase or sell something at a later date at a price agreed upon today. For example, anequipment lease is a forward commitment. By signing a one-year lease, the lessee agreesto use the equipment for the next twelve months at a predetermined rate. Like-wise, thelessor agrees to provide the equipment for the next twelve months at the agreed price.

Now suppose that six months later the lessee finds better equipment and decides toswitch over. The forward commitment remains in effect, and the only way the lessee canget out of the contract is to sublease the equipment. Because there is usually a market forsubleases, the lease is even more like a futures contract than a forward contract.

Any type of contractual agreement that calls for the future purchase of a good orservice at a price agreed upon today and without the right of cancellation is a forwardcontract.

Future Contracts

A futures contract is an agreement between two parties – a buyer and a seller to buyor sell something at a future date. The contact trades on a futures exchange and is subjectto a daily settlement procedure. Future contracts evolved out of forward contracts andpossess many of the same characteristics. In essence, they are like liquid forward contracts.

Unlike forward contracts, however, futures contracts trade on organized exchanges,called future markets. For example, the buyer of a future contact, who has the obligation tobuy the good at the later date, can sell the contact in the future market, which relieves himor her of the obligation to purchase the good. Likewise, the seller of the futures contract,who is obligated to sell the good at the later date, can buy the contact back in the futuremarket, relieving him or her of the obligation to sell the good. Future contacts also differfrom forward contacts in that they are subject to a daily settlement procedure. In the dailysettlement, investors who incur losses pay them every day to investors who makeprofits.

Options Contracts

Options are of two types namely call option and put option. Calls give the buyer theright but not the obligation to buy a given quantity of the underlying asset, at a given priceon or before a given future date. Puts give the buyer the right, but not the obligation to sella given quantity of the underlying asset at a given price on or before a given date.


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Swap

Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can be regarded as portfolios of forwardcontracts. The two commonly used swaps are interest rate swaps and currency swaps.

Interest rate swaps: These involve swapping only the interest related cash flows betweenthe parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties,with the cash flows in one direction being in a different currency than those in the opposite

direction.

1.10 OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

OTCEI was incorporated in 1990 as a Section 25 company under the CompaniesAct 1956 and is recognized as a stock exchange under Section 4 of the Securities ContractsRegulation Act, 1956. The Exchange was set up to aid enterprising promoters in raisingfinance for new projects in a cost effective manner and to provide investors with a transparent& efficient mode of trading. It allows listing of small and medium sized companies. Theminimum issued share capital required of a company that wants to be listedon OTCEI is Rs.3 million and the maximum Rs.250 million.

Companies engaged in investment, leasing, finance, hire purchase, amusement parksetc.and companies listed on any other recognized stock exchange in India are not eligiblefor listing on OTCEI. Also, listing is granted only if the issue is fully subscribed to by thepublic and sponsor. OTCEI is promoted by the Unit Trust of India, the Industrial Creditand Investment Corporation of India, the Industrial Development Bank of India, the IndustrialFinance Corporation of India and others and is a recognised stock exchange under theSCR Act.

OTCEI is a role model of the NASDAQ market of USA; OTCEI introduced manynovel concepts to the Indian capital markets such as screen-based nationwide trading,sponsorship of companies, market making and scripless trading. As a measure of successof these efforts, the Exchange today has 115 listings and has assisted in providing capitalfor enterprises that have gone on to build successful brands for themselves like VIP Advanta,Sonora Tiles & Brilliant mineral water, etc.

Need of OTCEI:

Innovative companies are critical to developing economies like India, which isundergoing a major technological revolution. With their abilities to generate employmentopportunities and contribute to the economy, it is essential that these companies not onlyexpand existing operations but also set up new units.

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The key issue for these companies is raising timely, cost effective and long term capitalto sustain their operations and enhance growth. Such companies, particularly those thathave been in operation for a short time, are unable to raise funds through the traditionalfinancing methods, because they have not yet been evaluated by the financial world. At thispoint of time the concept of OTCEI was rightly thought off.

OTCEI, with its entry guidelines and eligibility requirements tailored for such innovativeand growth oriented companies, is ideally positioned as the preferred route for raisingfunds through Initial Public Offer (IPOs) or primary issues, in this country.

The Exchange has three types of intermediaries namely Members, Dealers andSponsors, who contribute to the Exchange’s activities by trading and enabling listing ofcompanies on the Exchange. Members and Dealers may carry out the activities of trading,underwriting, market making and participation in bought out deals, but Dealers cannotsponsor an issue for listing. Sponsors can perform the function of sponsorship of issues,but are not permitted to participate in second market activities.

Benefits

a. The OTCEI has set up a national, automated screen based and ringless stockmarket. It helps companies raise finance from the capital market in a cost effectivemanner and provides a convenient and effective avenue of capital market investmentfor investors at large.

b. While the other recognised stock exchanges require that in order to have itssecurities listed the company should have an issued capital of not less than Rs. 3crores out of which normally 25% is to be offered to the public, the minimumissued equity share capital of a company for eligibility for listing on the OTCEI isRs 30 lacs.

c Listing on OTCEI is advantageous to companies because of the high liquidity ofthese securities, which is a result of compulsory market making, improved accessand speed of transactions resulting from the extensive network of electronicallyinterlinked counters.arial

d Companies can obtain a fair price of their securities by negotiating the same withthe sponsors (who are members of the OTCEI) and save unnecessary issueexpenses by placing their securities with the sponsors who will in turn off load thesecurities to the public. This mechanism is now popularly known as a bought outdeal.

e. OTCEI’s wide computerized net work will be spread all over India and will makeinvestment easier. All deals will be entered into through remote terminals which willbe connected to the mainframe computer of the OTCEI. The exchange will enabletransactions to be completed quickly and investors can settle the deals across thecounter within a few days. The exchange will also provide liquidity to investors asevery scrip listed on the OTCEI will have at least two makers who will continuouslygive two way quotes.


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1.11 SECURITIES MARKET IN INDIA – REGULATORY REFORMS

Indian securities market has been adequately strengthened by regulatory andsupervisory framework through the legislative and administrative measures in the recentpast. These legislations are prepared based on the international standards prescribed bythe International Organization of Securities Commissions (IOSCO). We can view theseregulatory reforms in the following lines.

The securities market in India is under the eye sight of the following regulatory authoritiesnamely Companies Act, Securities Contract (Regulation) Act, Securities and ExchangeBoard of India.

Reforms in the capital market or securities market can be enlighten in the primarymarket as well as secondary market.

Reforms in the primary capital market(1) The Securities and Exchange Board of India came into existence as statutory

body in the year 1992 for regulating the securities market in India. The SEBI wasformed to meet the objectives of investor protection and orderly development of thecapital market.

(2) SEBI is the primary body responsible for regulation of the securities market, derivingits powers of registration and enforcement from the SEBI Act. There was an existingregulatory framework for the securities market provided by the Securities ContractRegulation (SCR) Act and the Companies Act, administered by the Ministry of Financeand the Department of Company Affairs (DCA) under the Ministry of Law, respectively.SEBI has been delegated most of the functions and powers under the SCR Act andshares the rest with the Ministry of Finance. It has also been delegated certain powersunder the Companies Act.

(3) With the help of merchant bankers, investment and consulting agencies and the registrarto the issue the scope of primary market has been widened.

(4) Many mutual funds sponsored by banks and financial institutions leads theinstitutionalization process begins in early 1990s.

(5) Companies having dematerialized form of shares are not required to quote face valueper share of Rs 10 and Rs 100, this concept was withdrawn. The companies whichhave already issued shares in the form of Rs 10 or Rs 100 as face value can also beeligible to split their shares into any denomination and at the same time they are allowed

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to consolidate. However, shares can not be issued in the decimal of rupees say pershare is Rs 10.50.

(6) A significant change in the capital market reforms is the granting of permission toforeign institutional investors such as mutual funds, pension funds, and country funds,to function in the Indian market. In this process the ceiling on the foreign institutionalinvestors has been increased from 40% to 49%.

(7) Reforms also facilitated the Indian companies to procure funds at internationally byissuing the Global Depository Receipts (GDR’s), American Depository Receipts(ADR’s), Foreign Currency Convertible Bonds (FCCB’s) and External CommercialBorrowings (ECB’s).

(8) Infrastructure companies allowed their debt securities to list on stock exchanges evenprior to the listing of equity shares.

(9) RBI also has regulatory involvement in the capital markets regarding foreign exchangecontrol, liquidity support to market participants and debt management through primarydealers. It is RBI and not SEBI that regulates primary dealers in the Governmentsecurities market.

(10) SEBI Act of 1992 has introduced self-regulatory organizations [SROs] for regulatingvarious participants in the securities market. But they are not yet operational. A clearregulatory framework has yet to be set up, and relevant market participants are notready to regulate themselves for professional purposes. The only market related SROsin India whose regulatory frameworks have been well established and which are actuallyfunctioning are the recognized stock exchanges.

(11) In respect of unlisted companies, the existing requirement of a tract record of dividendpayout ratio in the last 3 years out of 5 years for initial public offer has been relaxed.Under the new norms, the company will have to demonstrate an ability to pay dividendrather than to show the past history.

(12) The major reforms which have taken place in Indian markets include screen basedtrading, electronic transfer of securities, dematerialization, rolling settlement., riskmanagement practices and introduction of derivative trading and so on. The net resultof these initiatives can be seen in the form of efficient and transparent trading &settlement processes in our exchanges.

(13) A code of conduct on advertisement has been issued for mutual funds with the intentionthat to protect investor from any misleading information.

(14) In addition to the merchant bankers various intermediaries namely portfolio mangers,registrars to an issue, share transfer agents, underwriters, debenture trustees, bankersto an issue, custodian of securities, venture capital funds etc are brought under thepurview of the SEBI.

(15) It is mandatory to those public listed companies coming with Rs 10 crore or moreinitial public offer is required to make offer through dematerialized form.


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(16) Incorporation of Securities Contracts (Regulation) Act, 1956 with the objectto prevent undesirable transactions in securities by regulating the business of dealingtherein, by providing for certain other matters connected therewith.

(17) SEBI (Disclosure and Investor Protection) Guidelines, 2000 provides the process ofbook building wherein allocation of 5% for mutual funds, proportionate allotment toQualified Institutional Buyers and margin requirement for Qualified Institutional Buyers.

(18) Securities Appellate Tribunal (SAT) is formed to help or for justification to any personaggrieved with the orders of the SEBI or an adjudicating authority. Such aggrievedperson against the order of SEBI or an adjudicating authority prefer to appeal in theprescribed form by accompanied the prescribed fee to a Securities Appellate Tribunalwith in 45 days from the date on which a copy of the order is received by him.

(19) During the year 2003, SEBI has brought sweeping changes in the initial public offernorms. According to the new norms, companies floating IPO’s should have net tangibleassets of Rs 3 crore in each of the preceding two years of which not more than 50%should be held in monetary assets.

(20) After the legal framework for derivatives trading was provided by the amendment ofSCRA in 1999 derivatives trading started in a gradual manner with stock index futuresin June 2000. Later on options and single stock futures were introduced in 2000-2001 and now India’s derivatives market turnover is more than the cash market andIndia is one of the largest single stock futures markets in the world.

1.12 REFORMS IN THE SECONDARY CAPITAL MARKET

(1) SEBI has taken several measures to improve the integrity of the secondary market.Legislative and regulatory changes have facilitated the corporatization of stockbrokers.Capital adequacy norms have been prescribed and are being enforced. A mark-to-market margin and intra day trading limit have also been imposed.

(2) The Securities Contract (Regulation) Act, 1956 provides the broad frame work ofthe present scheme of stock exchange regulation in India. As per SCRA stockexchange means any body of individuals, whether incorporated or not, constitutedbefore corporatisation and demutualization or a body corporate incorporated underthe Companies Act for the purpose of assisting or regulating or controlling the businessof buying, selling or dealing in securities.

For our understanding corporatisation means the succession of a recognized stockexchange, being a body of individuals or a society registered under the Societies RegistrationAct by another stock exchange, being a company incorporated for this purpose. Likewisedemutualisation means the segregation of ownership and management from the tradingrights of the members of a recognized stock exchange in accordance with a scheme by theSEBI.

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(3) The Over The Counter Exchange of India was established in the year 1992 to meetthe small corporate sectors needs followed by the National Stock Exchange of India(NSE) in the year 1994 and the interconnected stock exchange of India (1999).

(4) In fact, on almost all the operational and systemic risk management parameters,settlement system, disclosures, accounting standards, the Indian Securities Market isat par with the global standards. Indeed, on a few paradigms, it is ahead of the globalbenchmarks. Some of those initiatives are:

- T+2 settlement cycle.- On line monitoring of positions and margins and automatic disablement of terminals.- Corporate governance index as a measure of wealth creation, management and distribution.- Establishment of CLA.- Central counterparty.- Commencement of Straight Through Processing

(5) The National Stock Exchange set up a separate clearing corporation namely ‘TheNational Securities Clearing Corporation to act as a counter party to all trades executedin the capital market segment of the exchange.

(6) To safe guard the investor protection, to enhance the process of dematerialization ofsecurities through depository system, the National Securities Depository Limited wasset up in the year 1996.

(8) All listed companies are required to disclose or furnish to stock exchanges the materialchanges and also publish un-audited financial statements on a quarterly basis.

(9) Significant change in secondary market is introduction of corporate governance.Corporate Governance is a system and process design to protect the interest ofstakeholders of the company. In this process the SEBI has appointed under theChairmanship of Kumar Mangalam Birla on corporate governance in India and thecommittee suggested the implementation of the code through stock exchanges.

(10) SEBI strictly prohibited the insider trading treating it as a criminal offence. Insidertrading means ‘an insider namely any person who is a director or deemed director orofficer or employee who has reasonably expected to have access to or who hasreceived or has had access to unpublished sensitive information in respect of securitiesof a company deal in securities (subscribing, buying or selling or agreeing to subscribeor buy or deal in any securities by any person either as a principal or agent) of a thesaid listed company.

(11) The Securities Contract (Regulation) Act, 1956 has been amended for introductionof the derivatives trading through the stock exchanges. Both the NSE and BSEfacilitated the derivatives trading in addition to the regular trading.


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(12) In the year 2001, the Central Government of India has established the InvestorEducation and Protection Fund, with the objectives to promote the awareness amongthe investors and safeguard the interests of the investor.

13) Stock exchanges were advised to amend the Clause 41 of the Listing Agreement tomake it mandatory for listed companies to publish the number of investor complaintsreceived, disposed of, unresolved along with the quarterly result.

(14) As per the delisting rules the stock exchanges will have to compulsorily delist a companyif has suffered losses during the preceding three consecutive years and its networthhas turned negative, trading in its securities has remained suspended for more than 6months or infrequently traded during the last 3 years, violates the regulations framedby the SCR Act, SEBI Act or Depositories Act, the public share holding in the companyfallen down the minimum level prescribed by the listing agreement.

(15) Foreign Institutional Investors (FII’s) and NRI’s are permitted to invest in all exchangetraded derivatives. Stock brokers who registered under the stock exchange andSEBI are allowed to trade in commodity derivatives etc.

We will overview the reforms and developments which are taken place during theperiod 1992 -2003

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Source: Chartered Secretary, April 2004.


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Brief summary regarding intermediary role in each market has been given below:

Summary

Indian Financial System is complex and fast chaining. The concept of nationalizationcame in the year 1948 by nationalizing the Reserve Bank of India. The Reserve Bank ofIndia was set up in the year 1935 with the share capital of Rs 5 Crore which was entirelyowned by the private share holders in the beginning.

The Reserve Bank of India is acting as central bank in India and it is different fromthe Central Bank of India. After India’s Independence, in the context of close integrationits policies and those of the Government, the Reserve Bank became a state owned institution

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from 1st January 1949. The Banking Regulation Act was enacted in the same year (1949)to provide regulations and supervision of Commercial Banks

Credit Rating is the assessment of a borrower’s credit performance. Credit Ratinghelps investors to decide their investment pattern. Basically the credit rating has symbolswhich denote the performance or credit worthiness of the respective companies.

These symbols may be AAA, AA, BBB, B, C, D to denote the performance of therespective companies to the investor. For example AAA which means Highest safety interms of repayment of principal and interest and in case of BBB which means moderatesafety in terms of timely payment of interest and principal.

Hence under the entire concept by putting in to the following formatted so as we canable to understand

The Structure of the Financial Intermediaries or Institutions can be depict as follows:

(A) Term Lending Financial Institutions (ie Development Banks)

a. Industrial Financial Corporation of India (IFCI)b. Industrial Investment Bank of India (IIBI)c. Infrastructure Development Finance Company (IDFC)d. Small Industrial Development Bank of India (SIDBI)e. National Bank for Agriculture and Rural Development (NABARD)f. The Export Import Bank of Indiag. Industrial Development Bank of India (IDBI)h. State Financial Corporationsi. State Industrial Development Corporations (SIDC’s) etc,

(B) Non-Banking Financial Companies (NBFC’s)(a) Hire Purchase Finance Company(b) Equipment Leasing Companies(c) Housing Finance Companies(d) Venture Capital Fund Companies


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(e) Chit Fund Companies(f) Stock Broking Firms(g) Merchant Banking Companies etc,

(C) Investment Institutions

a) Mutual Fund Companiesb) Pension Fundsc) Insurance Companies etc,

We also understand the financial markets by splitting it into four parts as follows

Self examination questions

(1) Explain the financial growth in the Indian Financial System(2) Explain the Indian Financial Markets(3) What role the financial intermediaries are playing in the Indian Financial Market.(4) Explain the NBFC’s(5) Give the list of Nationalized Banks(6) Explain the role of Development banks in India and their importance in the Indian

Financial System(7) Comment on the regulatory frame work in the context of financial reforms(8) Explain the DFHI and importance in the financial system(9) Explain the Regulatory frame work in the context of securities market.(10) Explain the term savings and investments.(11) Elucidate the relationship between interest and inflation.(12) Explain the types of savings(13) Please explain the credit market and capital market and distinguish between these

two.

(14) Write short notes on

i. Treasury Bills (T-Bills)ii. Certificate of Deposits (CD’s)iii. Gilt-edged Securitiesiv. Commercial Papersv. Repurchase Agreements (Repo’s)vi. Bankers Acceptancevii. Inter Bank Participation Certificateviii. Money Market Mutual Funds (MMMF’s)

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(15) What do you mean by NBFC’s and how they are differ with normal banks(16) Please list out few NBFC’s and their purpose of incorporation.(17) Write some thing about Derivatives market(18) Explain the OTCEI and how it functions in the secondary market(19) List out the Development banks and their objectives.


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UNIT II

COMMERCIAL BANKS

2.1 INTRODUCTION

For the past three decades India’s banking system has several outstanding achievementsto its credit. The most striking is its extensive reach. It is no longer confined to onlymetropolitans or cosmopolitans in India. In fact, Indian banking system has reached evento the remote corners of the country. This is one of the main reason of India’s growthprocess.

A well organized banking system is a pre-requisite for economic growth of any country.Banks play an important role in the functioning of organized money markets. They act asa conduit for mobilizing funds and channelising them for productive purposes. The Indianbanking can be broadly categorized into four types namely

1. Commercial Banks2. Regional Rural Banks3. Co-operative Banks4. Development Banks (ie Term-lending institutions)

2.2 LEARNING OBJECTIVES

• After this study you should understand the important role playing by thecommercial banks

• understand the regulatory reforms of the banking regulation authority• you should be familiarize with Bank assets and liability structure• learn the role of Reserve Bank of India in the Indian Financial System.

2.3 BANKING HISTORY AND ITS DEVELOPMENT IN INDIA

The General Bank of India was set up in the year 1786. Next came Bank of Hindustanand Bengal Bank. The East India Company established Bank of Bengal (1809), Bank ofBombay (1840) and Bank of Madras (1843) as independent units and called it PresidencyBanks. These three banks were amalgamated in 1920 and Imperial Bank of India wasestablished which started as private shareholders banks, mostly Europeans shareholders.the Government of India brought The Banking Companies Act, 1949 which was laterchanged to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of

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1965). The Reserve Bank of India was set up in the year 1935 with the share capital of Rs5 Crore which was entirely owned by the private share holders in the beginning. TheReserve Bank of India is acting as central bank in India and it is different from the CentralBank of India

During the period 1955, the Government of India nationalized Imperial Bank of Indiawith extensive banking facilities on a large scale specially in rural and semi-urban areas. Itformed State Bank of india to act as the principal agent of RBI and to handle bankingtransactions of the Union and State Governments all over the country. In the process ofnationalization 14 major banks has been nationalized and six banks later on nationalized.

The following are the steps taken by the Government of India to Regulate BankingInstitutions in the Country:

I. 1949 : Enactment of Banking Regulation Act.II. 1955 : Formation of State Bank of India.III. 1959 : Formation of SBI subsidiaries.IV. 1961 : Insurance cover extended to deposits.V. 1969 : Nationalisation of 14 major banks.VI. 1971 : Creation of credit guarantee corporation.VII.1975 : Creation of regional rural banks.VIII1980 : Nationalisation of six banks with deposits over 200 crore.

The Reserve Bank of India acts a centralized body monitoring any discrepancies andshortcoming in the system. Since the nationalization of banks in 1969, the public sectorbanks or the nationalized banks have acquired a place of prominence and has since thenseen tremendous progress. The need to become highly customer focused has forced theslow-moving public sector banks to adopt a fast track approach.

The unleashing of products and services through the net has galvanized players at alllevels of the banking and financial institutions market grid to look anew at their existingportfolio offering. Conservative banking practices allowed Indian banks to be insulatedpartially from the Asian currency crisis.

Indian banks are now quoting at higher valuation when compared to banks in otherAsian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problemslinked to huge Non Performing Assets (NPAs) and payment defaults. Co-operative banksare nimble footed in approach and armed with efficient branch networks focus primarily onthe ‘high revenue’ niche retail segments.

The Indian banking has finally worked up to the competitive dynamics of the ‘new’Indian market and is addressing the relevant issues to take on the multifarious challenges ofglobalization. Banks that employ IT solutions are perceived to be ‘futuristic’ and proactiveplayers capable of meeting the multifarious requirements of the large customers base. Private


NOTES


banks have been fast on the uptake and are reorienting their strategies using the internet asa medium The Internet has emerged as the new and challenging frontier of marketing withthe conventional physical world tenets being just as applicable like in any other marketingmedium.

The Indian banking has come from a long way from being a sleepy business institutionto a highly proactive and dynamic entity. This transformation has been largely broughtabout by the large dose of liberalization and economic reforms that allowed banks toexplore new business opportunities rather than generating revenues from conventionalstreams (i.e. borrowing and lending).

The banking in India is highly fragmented with 30 banking units contributing to almost50% of deposits and 60% of advances. Indian nationalized banks (banks owned by thegovernment) continue to be the major lenders in the economy due to their sheer size andpenetrative networks which assures them high deposit mobilization. The Indian bankingcan be broadly categorized into nationalized, private banks and specialized bankinginstitutions.

2.4 TYPES OF BANKS

2.4.1 Public Sector Banks

Public sector banks comprise the State Bank of India, its seven subsidiaries alsocalled ‘associated banks of State Bank of India. These are State Bank of (1) Bikaner andJaipur, (2) State Bank of Hyderabad, (3) State Bank of Indore, (4) State Bank of Maysore,(5) State Bank of Patiala, (6) State Bank of Saurashtra and (7) State Bank of Travencoreand nineteen nationalized banks and other public sector banks namely IDBI, ICICI andUTI and so on.

Fourteen banks were nationalized on 19th July 1969 and another six on 15th April1980. However, with the merger of New Bank of India with Punjab National Bank, thenumber of nationalized banks presently stands at nineteen. the entire share capital of mostof these banks is entirely held by the Central Government of India. However, there areindications of reduction in government stake in these banks. For ready reference we havementioned a list of nationalized banks.

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Types of banks can be broadly bifurcated into schedule commercial banks and nonscheduled commercial banks. The entire banking system in India can be explained in theform of following chart.


NOTES


Note: Non-scheduled bank in India” means a banking company as defined in clause(c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduledbank

Our study in this unit is permitted to the scheduled commercial banks only.

We are placing here for our understanding purposes regarding consolidated balancesheet of scheduled commercial banks prepared by the RBI

BANKS

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NOTES


2.4.2 Private Sector Banks

Under the Indian Financial System the private banks contribution is un-detachablefrom the economic growth of the country. They are playing a vital and crucial role byserving to household units and corporate sectors. It is important to make a list of thoseprivate banks.

(1) Bank of Rajasthan (2) Bharat Overseas Bank (3) Catholic Syrian Bank (4)Centurion Bank of Punjab (5) Dhanalakshmi Bank (6) Federal Bank (7) HDFC Bank (8)ICICI Bank (9) IDBI Bank (10) IndusInd Bank (11) ING Vysya Bank (12) Jammu &Kashmir Bank (13) Karnataka Bank (14) Karur Vysya Bank (15) Kotak Mahindra Bank(16) SBI Commercial and International Bank (17) South Indian Bank (18) United WesternBank (19) UTI Bank (20) YES Bank

2.4.3 Foreign Banks in India

There were 29 foreign banks in India operating the banking activities. The presenceof foreign banks in India has benefited the financial system by enhancing competition,transfer of technology and specialized skills resulting in higher efficiency and greater customersatisfaction. Foreign banks are enabled large Indian companies to access foreign currencyresources from their overseas branches in times of foreign currency constraint.

New foreign banks are allowed to conduct business in India after taking intoconsideration the financial soundness of the bank, international and home country ranking,rating, international presence and political relation ship between two countries.

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Foreign banks and their performance have been explained with the numeric values;


NOTES


Statement II : Foreign Banks : Total Assets,Gross NPA,Net NPA

-

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Statement III : Foreign Banks : Expenditure


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Statement IV : Foreign Banks : Expenditure

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2.4.4 Regional Rural Banks

Rural Banking in India started since the establishment of banking sector in India.Rural Banks in those days mainly focused upon the agro sector. Regional rural banks inIndia penetrated every corner of the country and extended a helping hand in the growthprocess of the country. SBI has 30 Regional Rural Banks in India known as RRBs.

The rural banks of SBI are spread in 13 states extending from Kashmir to Karnatakaand Himachal Pradesh to North East. The total number of SBIs Regional Rural Banks inIndia branches is 2349. Till date in rural banking in India, there are 14,475 rural banks inthe country of which 2126 are situated in remote rural areas. Apart from SBI, there areother few banks which functions for the development of the rural areas in India. Few ofthem are as follows.

Regional Rural Banks (RRB’s) growth in terms of number of branches

Expansion of Regional Banking: 1975-1990

Purposewise Advances of RRBs, Outstanding (end of Sept, 1990)

The Haryana State Co-operative Apex Bank Ltd:

The Haryana State Cooperative Apex Bank Ltd. commonly called as HARCOBANKplays a vital role in rural banking in the economy of Haryana State and has been providingaids and financing farmers, rural artisans, agricultural labourers, entrepreneurs,etc. in thestate and giving service to its depositors.


NOTES


NABARD

National Bank for Agriculture and Rural Development (NABARD) is a developmentbank in the sector of Regional Rural Banks in India. It provides and regulates credit andgives service for the promotion and development of rural sectors mainly agriculture, smallscale industries, cottage and village industries, handicrafts. It also finance rural crafts andother allied rural economic activities to promote integrated rural development. It helps insecuring rural prosperity and its connected matters.

Sindhanur Urban Souharda Co-operative Bank

Sindhanur Urban Souharda Co-operative Bank, popularly known as SUCO BANKis the first of its kind in rural banks of India. The impressive story of its inception is interestingand inspiring for all the youth of this country.

United Bank of India:

United Bank of India (UBI) also plays an important role in regional rural banks. It hasexpanded its branch network in a big way to actively participate in the developmental ofthe rural and semi-urban areas in conformity with the objectives of nationalisation.

Syndicate Bank

Syndicate Bank was firmly rooted in rural India as rural banking and have a clearvision of future India by understanding the grassroot realities. Its progress has been abreastof the phase of progressive banking in India especially in rural banks.

2.5 FUNCTIONS OF COMMERCIAL BANKS:

Banks borrow the money and lend the money is the main business of the banks, toachieve this banks generally perform the following function.

(1) Accepting the deposit: banks borrowing the money from the saving surplus units inthe different forms in which the investors or customers are interested to invest. In thisprocess banks are accepting the following kinds of deposits from the boanks

(a) Demand Deposits(b) Fixed Deposits(c) Saving Bank Deposits

(i) Demand Deposits: These are deposits which are in the nature of current accountwhich can be facilitated to the investors to withdraw the money at given point of timewithout giving any prior notice to the bank. These deposits are highly liquid thereforebanks are advised to have hundred percent reserve for these type of deposits since depositorhave right to withdraw money at any given point of time.

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Generally these types of accounts are maintain by the investors who are in running thebusiness. Moreover the banks should provide the cheque facility to the customers, that isthe account holders make payment to the parties. Further on behalf of the holders ofdemand deposits (current accounts) banks collect cheques, demand drafts, dividendwarrants, postal orders and so on. These deposit holders did not get any interest on theirsavings.

(ii) Fixed Deposits: These deposits are those deposits which are time bound and maturedonly after some specified period of time. However, there is possibility of taking loan againstthese deposits by the investors from the banks. These deposits time period start from 15days to few years.

(iii) Saving Bank Deposits: These are deposits generally made by the investors whoseincome is constant namely salary, service income etc. for their short term holding. Banksare providing the cheques to these holders and paying interest on the sum of savings deposits.

(2) Advancing Loans:

Another main function of commercial bank is to give loans to the needy. Banks willlend the money to the house hold sectors and corporate sectors at the specified rate ofinterest. Hence, we can say that main revenue of the commercial bank is the interest ontheir lending. At the same time banks also keep with them some amount of money to meetthe demand of their depositors and running expenses and so on. The banks generallyallowed the loans to the household sectors and corporate sectors in the following channels:

(i) Over draft:

This is a very good facility provided by banks to their customers who has currentaccount with the them. Banks are generally honour the cheques drawn by the customers ofcurrent account even though sufficient cash is not available in the said account whose creditterms are good with the bank. However, banks will charge the interest at higher rate thanthe interest on deposits.

(ii) Cash credit loans:

This is an ideal facility providing by the banks, hence, borrower is sanctioned a creditlimit up to which he is allowed to borrow the money. Cash Credit (CC) will be sanctioningby banks only after thorough verification of the credit worthiness’ of the borrower whoshould have to have the current account with such bank. Banks will charge the interest onlyon the portion of actual money withdrawn from the CC account but not the entire amountsanctioned to the borrower. Of course the banks allow the CC only against the hypothecationof current assets of the borrower for example stock of raw material, semi finished goodsand finished goods.


NOTES


(iii) Demand Loans:

These are those types of loans which can be given to the borrower at a time the entireamount and recollect from them on demand by the banks at any time. interest will becharged by the banks on the entire amount of loan. Generally, these loans are required bythe stock brokers to meet the short term credit requirements.

(iv) Secured Loans:

These can be classified as personnel loans and short term business loans. For examplevehicle loan to the individuals, working capital requirement to firms and so on so forth.Banks will charge interest on the entire amount loan sanctioned to the borrowers.

(v) Mortgage loan:

A mortgage loan is a very common type of debt instrument, used to purchase realestate. Under this arrangement, the money is used to purchase property. Commercialbanks, however, are given security - a lien on the title to the house - until the mortgage ispaid off in full. If the borrower defaults on the loan, the bank would have the legal right torepossess the house and sell it, to recover sums owing to it.

In the past, commercial banks have not been greatly interested in real estate loansand have placed only a relatively small percentage of their assets in mortgages. As theirname implies, such financial institutions secured their earning primarily from commercialand consumer loans and left the major task of home financing to others. However, due tochanges in banking laws and policies, commercial banks are increasingly active in homefinancing.

(3) Credit Creation:

Commercial banks functions as credit creation treating as very important. Creditcreation means banks create deposits in the process of their lending operations, when thebanks mobilize savings; it lends the funds that remain after providing for reserves. Theamount lent is either deposited in the same bank or in some other bank.

For example: A bank mobilizes the funds from some depositors worth Rs 110,000 inthe form of deposits. The banks as per bank norms after taking say 10% towards reserve,lend the remaining money of Rs 99,000 either in the form of deposit in the same bank or insome other bank. The bank again, after keeping aside reserve of 10%, lends the remainingamount of Rs 89,100. this process continues and repeats in all banks simultaneously whichwill result in credit creation.

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(4) Transfer of Money

Banks are acting as cheaper source of fund transfer by way of demand drafts, cheques,Electronic Clearance (ECS), ATM and so on so forth. In fact if we have an account in theform of savings bank or current bank account through which fund transfer can be donefrom one account to another with in the same bank without any charge within a shorterperiod of time.

(5) Ancillary Functions

Apart from the above, the following ancillary functions also undertaking by thecommercial banks.

(A) Collection & Payment of Cheques.

(B) Standing instruction to subsidiaries.

(C) Acting as correspondence.

(D) Collecting of bills- electricity, gas, VAT, telephone etc.

(E) Purchase & sales of stocks/ share-act as a banker to issue

(F) Miscellaneous or general services

(i) Safe custody- bailee

(ii) Lockers-trustee

(iii) Remittance facilities –DD, TT, MT and PO

(iv) Advisory services

• Providing credit reports

• Opening L/C.

• Demand in forese Travers Cheque only Authorized Dealer branches.

• Complete service in Foreign Trade.

• Other services: Debit Card, Credit Card, On-line banking SMS banking.

• Creation of credit: a multiplier effect, Deposit creates credit and credit creates deposits– derivative deposit.

From the above we came to know that the commercial banks functions mainly basedon the following which are generally not performing by Non Banking Financial Companies.


NOTES


(A) Acceptance of deposit: (B) Lending (C) Investment

Apart from the various functions as listed out above carried out by the commercialbank, the two important ones are those relating to discounting of bills and acceptance andendorsement of bills on behalf of customers.

Discounting and Collection of Bills:

A bank may either straightaway purchase a bill or any other credit instrument from acustomer or may collect it on his behalf. If it purchases or discounts the bill the amountwould be immediately credited to the account of the customer less discount charges anddebited to Discounted Bills Account. If on the other hand, a bill is to be collected for acustomer, the particulars of the bill would be recorded in a special book called as Bills forCollection Register.

Rebate on bills discounted:

If a bank discounts a bill of exchange, the full amount of the discount earned is creditedto discount account but some of the bills discounted may not mature for payment by theclose of the year, as a result, the amount of discount in respect of such bills would not havebeen earned during the year. On this consideration, the unexpired portion of such discountis carried forward by debiting the discount account and crediting rebate on bills discountaccount.

2.6 ROLE OF COMMERCIAL BANKS

(1) Promotion of Savings:

Investors will save their money for various future needs like pension, education,marriage, and so on. Commercial banks promote the savings by providing the wide rangeof deposits with varying combinations of liquidity and interest to suit the requirement ofinvestors. Commercial banks play a vital role during the period of inflation. (Students areadvised to refer the unit I regarding interest and inflation).

(2) Mobilization of Savings:

As we know the banks are playing an important role as financial intermediaries. Thesebanks so called financial intermediaries provide the link between the surplus saving unitsand surplus deficit units by transferring the funds from surplus units to deficit units. Theexcess of interest collected by the banks from the barrowers exceeds the interest paid tothe depositors is the margin or profit to the banks.

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(3) Allocation of Funds:

Corporate sectors to the grate extent depend on the funds mobilization from the outside. Mobilization of funds by issuing the shares is generally insufficient hence; these unitsdepend on commercial banks for further funding. Commercial banks cater the needs ofthe firms by allocating the funds in the form of long term loans, medium and short termloans. The interest collected by the banks based on the rate suggested by the ReserveBank of India.

(4) Promotion of Trade, Production and Investments:

Commercial banks are those financial intermediaries who encourage the savings toenhance investments. Banks are not only generating savings by collecting from others butalso they themselves create deposits when they lend money to investors or other users.Now days the bank deposits especially demand deposit as much good money as thecurrency printed by the Reserve Bank of India. This leads to more investments whichcauses more productivity ultimately results economic growth in the country.

2.7 CHARACTERISTICS OF BANKS

Banks have the following characteristics which distinguish them from most othercommercial enterprises:

1. Banks have custody of large volumes of monetary items, including cash andnegotiable instruments, whose physical security has to be ensured. It means tosay banks need to posses formal operating procedures, well defined limits forindividual discretion and rigorous system of internal control.

2. Banks engages in a large volume and variety of transactions in terms of bothnumber and value.

3. Banks normally operate through a wide net work of branches and departmentswhich are geographically dispersed.

4. They often assume significant commitments without any transfer of funds. Theseitems commonly called ‘off-balance sheet’ items, may not involve accountingentries.

5 Banks in India are regulated by governmental authorities and the resultant regulatoryrequirements frame

2.8 SOURCES AND APPLICATION OF FUNDS

Form A of the Third Schedule to the Banking Regulation Act 1949, contains the formof balance sheet and Form B contains the form of profit and loss account. The Sources ofFunds and Application of Funds for the commercial banks can be described as follows:


NOTES


2.8.1 Source of Funds ITS Structure

(a) Capital

The main source of funds for commercial banks is the capital which has to disclose inthe balance sheet as per the following structure.

(i) For Nationalized banks the capital owned by the Central Government as onthe date of balance sheet including contribution from Government, if any forparticipating in World Bank Projects should be shown.

(ii) For Banks Incorporated Outside India the amount brought in by banks byway of start up capital as prescribed by RBI should be shown under this head.

(iii) For other banks the capital must be comprises ofAuthorised CapitalIssued CapitalCalled up Capital less calls unpaidAdd: forfeited shars

(b) Reserves:

The commercial banks source of finance is the reserves which need to show in thebalance sheet as per the structure required by the Banking Regulation Act.

Statutory ReservesCapital ReservesShare PremiumRevenue and other Reserves

In the Revenue and other reserves opening balance, additions during the year and deductionsduring the year are to be shown separately in respect of each item.

(c) Deposits

The commercial bank mobilizes the source of funds through the following depositswhich can be classified as follows;

(a) Demand deposits which consist of deposits from banks and other banks.(b) Savings bank deposits(c) Term deposits which consist of deposits from banks and other banks(d) Deposits of branches in India(e) Deposits of branches outside India

(d) Borrowings

Another main source of funds for the commercial banks are borrowings which has todisclosed in the balance sheet as follows:

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g. Borrowings India• Reserve Bank of India• Other Banks• Other institutions and Agencies

h. Borrowings outside India.

(e) Other Liabilities and Provisions

These are also for the time being as source of funds only. For example; Bank supposeto pay in the year 2006 – 07 the interest to the other banks but not paid during the sameyear it means the money not gone out which can be considered as source for the year 2006– 07. As per the Banking Regulation Act 1949, the other liabilities and provisions has toshow in the bank books as follows:

(A) Bills Payable(B) Inter-office adjustments(C) Interest accrued(D) Other provisions

2.8.2 Application of funds and struture

(i) Cash, Bank Balances and Money at call and Short Notice:

The commercial banks invest or spend their funds into other banks most liquid funds,as per the Banking Regulation Act, 1949 the asset structure should be as follows

Cash and Bank Balances with Reserve Bank of India

(1) Cash in hand (including foreign currency)(2) Balances with Reserve Bank of India

a. In Current Accountb. In Other Account

Balances with Banks and Money at Call and Short Notice

(i) In India

a.Balances with banks i .In current Accounts ii In other Current Accountsb.Money at call and short notice i.With banks ii.With other institutions


NOTES


Out side India(i) in Current Account(ii) in other Deposit Accounts(iii) Money at call and short notice

(b) Investments

The application of fund for the commercial banks is the investments into variousassets as follows:

(I) Investments in India in:

(i) Government Securities(ii) Other approved securities(iii) Shares(iv) Debentures and Bonds(v) Subsidiaries and / joint ventures(vi) Others if any

(II) Investments outside India in

(i) Government securities(ii) Subsidiaries and / or joint ventures abroad(iii) Other investments if any

(c) Advances:

The commercial banks are extending the advances and loans to the clients to mobilizeprofits. It is one of the sources of application of fund for the banks. the assets structure incase of advances has to show as follows.

(A) (i) Bills purchased and discounted(ii) Cash credits, overdrafts and loans repayable on demand(iii) Term loans

(I) Secured by tangible assets(II) Covered by bank or government guarantee(III) Unsecured

(C ) Advances in India’

(i) Priority sectors(ii) Public Sectors(iii) Banks(iv) Other advances if any

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Advances out side India

(i) Due from Banks(ii) Due from others(iii) Bills Purchased and discounted(iv) Syndicated banks(v) Others if any

(ii) Fixed Assets:

The commercial bank generally has to invest to purchase the fixed assets which includeland and buildings, furniture and fixtures and so on. Hence, there is an application of fundswhich can be properly structured in the balance sheet of the respective banks

(i) Fixed Assets(ii) Other Assets

ii. Inter office adjustmentsiii. Interest accruediv. Tax paid in advance or tax deducted at sourcev. Stationery and stampsvi. Non-banking assets acquired in satisfaction of claimsvii. Others.

As per the Banking Regulation Act the income or profitability structure is as follows

I. IncomeInterest on depositsInterest on Reserve Bank of India or inter bank borrowings

II. Other incomeIII. Expenditure

Interest expendedOperating expensesProvisions and contingencies

IV. Profit or LossNet Profit or loss for the yearProfit or loss brought forward

V. AppropriationsTransfer to statutory reservesTransfer to other reservesTransfer to Government or Proposed DividendBalance carried over to balance sheet.


NOTES


2.9 BANKING REGULATORY REFORMS

Banking regulatory reforms we have referred here, with reference to various speechesand seminars given by our honorable Dr. Y V Reddy Governor of the Reserve Bank ofIndia.

(1) The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991),essentially catered to the needs of planned development in a mixed-economyframework where the public sector had a dominant role in economic activity.

(2) The interest rates in the banking system have been largely deregulated except forcertain specific classes; these are: savings deposit accounts, non-resident Indian (NRI)deposits, small loans up to Rs.2 lakh and export credit.

(3) As part of the reforms programme, initially, there was infusion of capital by theGovernment in public sector banks, which was followed by expanding the capitalbase with equity participation by the private investors.

(4) One of the major objectives of banking sector reforms has been to enhance efficiencyand productivity through competition. Guidelines have been laid down for establishmentof new banks in the private sector and the foreign banks have been allowed moreliberal entry. Since 1993, twelve new private sector banks have been set up. Asalready mentioned, an element of private shareholding in public sector banks hasbeen injected by enabling a reduction in the Government shareholding in public sectorbanks to 51 per cent.

(5) As a major step towards enhancing competition in the banking sector, foreign directinvestment in the private sector banks is now allowed up to 74 per cent, subject toconformity with the guidelines issued from time to time.

(6) Consolidation in the banking sector has been another feature of the reform process.This also encompassed the Development Financial Institutions (DFIs), which havebeen providers of long-term finance while the distinction between short-term andlong-term finance provider has increasingly become blurred over time. The complexitiesinvolved in harmonising the role and operations of the DFIs were examined and theRBI enabled the reverse-merger of a large DFI with its commercial banking subsidiarywhich is a major initiative towards universal banking.

(7) In 1994, a Board for Financial Supervision (BFS) was constituted comprising selectmembers of the RBI Board with a variety of professional expertise to exercise‘undivided attention to supervision’.

(8) The Credit Information Companies (Regulation) Bill, 2004 has been passed by boththe Houses of the Parliament

(9) Major amendments relate to requirement of prior approval of RBI for acquisition offive per cent or more of shares of a banking company with a view to ensuring ‘fit and

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proper’ status of the significant shareholders, aligning the voting rights with the economicholding and empowering the RBI to supersede the Board of a banking company

(10) There have been a number of measures for enhancing the transparency and disclosuresstandards. Illustratively, with a view to enhancing further transparency, all cases ofpenalty imposed by the RBI on the banks as also directions issued on specific matters,including those arising out of inspection, are to be placed in the public domain.

(11) The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent i.e.,one percentage point above the international norm; and second, the banks are requiredto maintain a separate Investment Fluctuation Reserve (IFR) out of profits, towardsinterest rate risk, at five per cent of their investment portfolio under the categories‘held for trading’ and ‘available for sale’. This was prescribed at a time when interestrates were falling and banks were realizing large gains out of their treasury activities

(12) The regulatory framework in India, in addition to prescribing prudential guidelinesand encouraging market discipline, is increasingly focusing on ensuring goodgovernance through “fit and proper” owners, directors and senior managers of thebanks. Transfer of shareholding of five per cent and above requires acknowledgementfrom the RBI and such significant shareholders are put through a ̀ fit and proper’ test.Banks have also been asked to ensure that the nominated and elected directors arescreened by a nomination committee to satisfy ̀ fit and proper’ criteria.

(13) Directors are also required to sign a covenant indicating their roles and responsibilities.The RBI has recently issued detailed guidelines on ownership and governance inprivate sector banks emphasizing diversified ownership. The listed banks are alsorequired to comply with governance principles laid down by the SEBI – the securitiesmarkets regulator.

2.10 RESERVE BANK OF INDIA

The Reserve Bank of India was established on April 1, 1935 in accordance with theprovisions of the Reserve Bank of India Act, 1934 as the Central Bank. Though originallyprivately owned, since nationalization in 1949, the Reserve Bank is fully owned by theGovernment of India. The Central Office of the Reserve Bank was initially established inCalcutta but was permanently moved to Mumbai in 1937.

The Reserve Bank of India describes the basic functions of the Reserve Bank as:“...to regulate the issue of Bank Notes and keeping of reserves with a view to securingmonetary stability in India and generally to operate the currency and credit system of thecountry to its advantage.”

2.10.1 Central Board

To monitor, effective supervision of functions and direction of the bank affairs the ReserveBank of India formed a Board. The Reserve Bank’s affairs are governed by a central


NOTES


board of directors. The board is appointed by the Government of India in keeping with theReserve Bank of India Act.

i. Appointed/nominated for a period of four yearsii. Constitution:

(b) Official Directors• Full-time : Governor and not more than four Deputy Governors

(c) Non-Official Directors• Nominated by Government: ten Directors from various fields and one

government Official• Others: four Directors - one each from four local boards

Local Boards

(a) One each for the four regions of the country in Mumbai, Calcutta, Chennai andNew Delhi

(b) Membership consist of five members each appointed by the Central Governmentfor a term of four years

2.10.2 Functions of the Board for Financial Supervision (BFS)

To advise the Central Board on local matters and to represent territorial and economicinterests of local cooperative and indigenous banks; to perform such other functions asdelegated by Central Board from time to time. The Reserve Bank of India performs thisfunction under the guidance of the Board for Financial Supervision (BFS). The Board wasconstituted in November 1994 as a committee of the Central Board of Directors of theReserve Bank of India.

The objective of BFS is to undertake consolidated supervision of the financial sectorcomprising commercial banks, financial institutions and non-banking finance companies.The Board is constituted by co-opting four Directors from the Central Board as membersfor a term of two years and is chaired by the Governor. The Deputy Governors of theReserve Bank are ex-officio members. One Deputy Governor, usually, the DeputyGovernor in charge of banking regulation and supervision, is nominated as the Vice-Chairmanof the Board.

(a) restructuring of the system of bank inspections(b) introduction of off-site surveillance,(c) strengthening of the role of statutory auditors and(d) Strengthening of the internal defences of supervised institutions.

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Legal Framework

Umbrella Acts

• Reserve Bank of India Act, 1934: governs the Reserve Bank functions• Banking Regulation Act, 1949: governs the financial sector

Acts governing specific functions

• Public Debt Act, 1944/Government Securities Act (Proposed): Governsgovernment debt market

• Securities Contract (Regulation) Act, 1956: Regulates government securities market• Indian Coinage Act, 1906:Governs currency and coins• Foreign Exchange Regulation Act, 1973/Foreign Exchange Management Act, 1999:

Governs trade and foreign exchange market• Acts governing Banking Operations• Companies Act, 1956:Governs banks as companies• Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980:

Relates to nationalisation of banks• Bankers’ Books Evidence Act• Banking Secrecy Act• Negotiable Instruments Act, 1881• Acts governing Individual Institutions• State Bank of India Act, 1954• The Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003• The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act,

1993• National Bank for Agriculture and Rural Development Act• National Housing Bank Act• Deposit Insurance and Credit Guarantee Corporation Act

2.10.3. The Main Functions of The Reserve Bank of India are

1. The Reserve Bank of India is the regulator and supervisor of the financial system:

2. RBI defines the guidelines according to which the banking operations within whichthe country’s banking and financial system functions. It tries to protect depositors’interests and provides cost-effective banking services to the public by monitoring thefunctioning of banks. If a bank does not solve a customers problem they can approachthe Reserve bank of India through the Banking Ombudsman Scheme

3. Foreign exchange inflow and outflow is regulated by the the Foreign ExchangeManagement Act, 1999 of RBI. All money transfer out of India, for both personaland trade purposes is subject to limits defined by RBI.

4. The Reserve Bank of India issues currency - notes and coins of various denominations.It also issues and exchanges or destroys damaged currency and coins not fit for


NOTES


circulation. The design of the currency is periodically modified to prevent circulationof fake currency.

5. The RBI is the banker to the Government of India. It performs merchant bankingfunction for the central and the state governments. Government departments bankwith the Reserve bank of India. For example, in Mumbai, the Income tax departmentissues tax refunds drawn on the Reserve bank of India.

6 RBI is the banker to all major banks. It maintains banking accounts of all scheduledbanks in India. Deposits of up to Rs 1 lakh in scheduled banks are insured. Cashwithdrawal tax is applicable only for withdrawals from scheduled banks. Smaller co-operative banks usually are not scheduled banks. Bank interest rates increase ordecrease according to the RBI lending rates

7. The Reserve Bank of India also regulates the trade of gold. Currently 17 Indianbanks are involved in the trade of gold in India. RBI has invited applications frommore banks for direct import of gold to curb illegal trade in gold and increasecompetition in the market.

8. In March 2006, RBI has issued know your customer guidelines for non bankingfinance companies (NBFC). Customer whose deposit balance with the NBFC is

less than Rs 50,000 or outstanding credit more than Rs 1 lakh need not provide all thedocuments. The customers will be categorized as low risk, medium risk and high

risk. Sahara India is one of the largest NBFC in India.

9. RBI buys and sells foreign currency to maintain the exchange rate of Indian Rupeevs foreign currencies like the US Dollar, Euro, Pound sterling and Japanese yen.Trends in exchange rate value for these currencies are available on their website.

10. Depending on the liquidity in the money markets, RBI sets the maximum interest rate, Indian banks can offer on NRI dollar deposits. From March 2006, banks can offeran interest rate equal to the London Interbank Offered Rate (LIBOR) - an internationalbenchmark rate on dollar deposits.

11. The cash reserve ratio (CRR) is the percentage of deposits that banks in India shouldkeep with RBI . This also depends on the liquidity in the money markets and is

currently 5%. The reverse repo rate is the rate at which RBI absorbs fundsfrom banks.

12. RBI also regulates the opening /installation of ATM (Automatic Teller Machines). Itis trying to increase the density of the ATMs in rural areas. Fresh currency notes for ATMs are supplied by RBI.

13. There are about 1050 clearing houses which settle transactions related to cheques,drafts and pay orders. The State Bank of India manages 567 clearing houses, mainlyin the smaller cities and towns.

14. The annual monetary policy is announced in April every year.

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15. An outstation cheque from metro cities (Mumbai, Delhi, Chennai, Kolkatta) costsbanks only 50 paise for clearing through the RBI clearing system but banks likeICICI bank charge Rs 100 for clearing the cheque. RBI has asked banks to displaythe service charges on their website, but only 5 banks have complied so far.

16. RBI regulates the opening of branches by banks and ensures that they follow theKnow Your Customer guidelines.

2.10.4. Subsidiaries of Reserve Bank of IndiaThe RBI has four fully owned following subsidiaries namely:

i. National Housing Bank (NHB)ii. The National Bank for Agriculture and Rural Development (NABARD).iii. The Deposit Insurance and Credit Guarantee for Agriculture and Rural Development

Finance Company (IDFC).iv. Bharatiya Reserve Bank Note Mudran Private Limited.

The National Housing Bank of India was established in the year 1998 under an act ofthe Parliament as wholly owned subsidiary of the RBI. It promotes housing finance institutionsboth at local and regional levels and provides financial and other support to such institutions.

As we know about the NABARD which has been discussed in the Unit I.

The Deposit Insurance and Credit Guarantee Corporation (DICGC) now convertedinto the Bank Deposits Insurance Corporation (BDIC) to make it an effective instrument inthe banking sector. The main key function of this corporation is to provide the deposit andcredit guarantee schemes.

During the process of disinvestment RBI disinvested its holding during the period2001-02 in the Discounted and Finance House of India and Securities Trading Corporationof India which were promoted for activating and expanding the money market and developingan active secondary market for government securities and public sector bonds, respectively.

Summary

We came to know that the banking system is back bone for any country. Our IndianBanking System highly regulated and monitored by various legal authorities. If the bankingsystem is sound we assume that the countries economy is very strong. The Reserve Bankof India acts a centralized body monitoring any discrepancies and shortcoming in the system.Since the nationalization of banks in 1969, the public sector banks or the nationalizedbanks have acquired a place of prominence and has since then seen tremendous progress.The need to become highly customer focused has forced the slow-moving public sectorbanks to adopt a fast track approach.


NOTES


Self exercise problems

Question 1: the following is an extract from Trial Balance of Overseas Bank Ltd. as at31st March 2007

Rs RsBills discounted 12,64,000Rebate on bills discounted not due onMarch 31st 2006 22,160Discount received 1,05,708

An analysis of the bills discounted is as follows;

Amount (Rs) Due date 2007 Rate of Discount(i) 1,40,000 June 5 14%(ii) 4,36,000 June 12 4%(iii) 2,82,000 June 25 14%(iv) 4,06,000 July 6 16%

Calculate Rebate on Bills Discounted as on 31st March 2007 and show necessaryjournal entry.

Question 2: From the following information prepare a Balance Sheet of Internationalbank Ltd. as on 31st March 2007 giving the relevant schedules and also specify at leastfour important principal Accounting Policies:

Rs in LakhsDebit Credit

Share capital 198.0019,80,000 shares of Rs 10 eachStatutory Reserve 231.00Net Profit Before Appropriation 150.00Profit and loss account 412.00Fixed Deposit Account 517.00Savings Deposit Account 450.00Current Account 28.00Bills Payable 0.10Cash credits 812.10Borrowing from other Banks 110.00Cash in Hand 160.15Cash with RBI 37.88Cash with other banks 155.87Money at Call 210.12Gold 55.23

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Government securities 110.17Premises 155.70Furniture 70.12Term loan 792.88

————— ———2,588.22 2,588.22====== ======

Additional information

Bills for collection Rs 18,10,000Acceptance and endorsement Rs 14,12,000Claims against the Bank not acknowledge as bed Rs 55,000Depreciation charges for premises Rs 1,10,000Depreciation on Furniture Rs 78,000

50% of the term loans are secured by government guarantees. 10% of cash credit isunsecured. Also calculate cash reserve required and statutory liquid reserves required.

Note cash reserves required 3% of demand and time liabilities; liquid reserve 30%.

Self Examination questions:

• Explain the functions and roles of the commercial banks in India• Explain the source of funds and application of funds for commercial banks• Explain the regulatory reforms in the banking sector• Reserve Bank of India is the central bank – comment.• List out the various types of banks and their objectives.


NOTES


UNIT III

DEVELOPMENT BANKING

3.1 INTRODUCTION

Any country’s financial strength depends obviously on the sound system and functionof the respective country’s banking system. The concept of Development Banking is notentirely differing with the concept of banking system. Of course there are some minorvariations between these two which we have come across in the unit I and unit II.

The concept of Development Bank was stared after the Second World War. TheWorld Bank and International Money Fund (IMF) are known as development banks atinternational level. These Development Banks also called Term Lending FinancialInstitutions. After independence the need of development banks was felt strongly. Theexisting industries required long term loans for their reconstruction, modernization, expansionand diversification.

At the same time new industries so called new entrepreneurs required enormousinvestment for setting up their businesses. This industrial requirements unable to meet byour commercial banks because of so many reasons which can be viewed as the commercialbanks very much happy by lending the short term loan namely working capital loan, cashcredit and so on but not long term loan with higher risk involvement. To fill this gapdevelopment financial institutions are emerged as oasis in the drat area.

Development Banks are basically financial agencies that provide medium and longterm funds and acts as catalytic agents in promoting balanced development of the country.Development Banks the name it self contain the development which means increase oraccelerate the growth of an economy which will leads to increase the Gross DomesticProduct. Therefore, Development banks take risks that ordinary banks will not.

Development bankers should be different; they should lend a helping hand in momentsof distress, and make up for the risk they take by extracting larger returns when the borrowerrecovers. For that reason, development banks should not operate on a fixed rate of interest.They should evolve a mechanism which depends on the health of the borrower. One

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possibility is to take a share of the profits. However, that is highly risky. Profit-relatedinvestment is best left to venture capitalists. In risk taking, development banks fall midwaybetween safety-conscious traditional banks and the daredevil venture capitalists.

In the Indian Financial System the crucial role playing by the following banks tostrengthen the Indian economy. We can group these banks into Development Banks (orTerm Lending Institutions), Refinance Institutions, Investment Institutions and Specializedfinancial institutions.


(1) After reading this unit you should be able to understand the concept of developmentbanks in India.

(2) Understand the concept of merchant banks(3) Understand the Venture capital companies and the factoring business(4) Learn the concept of leasing, hire purchasing

3.3 FEATURES OF DEVELOPMENT BANKS:

(a) To serve as an agent of development in various sectors, namely manufacturingindustry, service industry, business process outsourcing (BPO), Knowledge processoutsourcing (KPO), agricultural and international trad.

(b) Development Banks main objective is to accelerate growth of the Indian economy.(c) To allocate resources to high priority areas namely technology, infrastructure, bio-

technology sectors.(d) To promote the employment facilities in the private sector by initiating the steps

towards industrialization.(e) To develop entrepreneurial skills in the potential entrepreneurs.(f) To promote and develop the rural areas(g) To finance for infrastructure for small scale units, housing loans, and social utilities

etc.

3.4 FUNCTIONS OF DEVELOPMENT BANKS

(1) Planning, promoting and developing industries to fill the gaps in between industrialsectors.

(2) Coordinating with the institutions engaging in financing, promoting or developingindustries, agriculture, trade and commerce and service sectors.

(3) By providing innovating services by giving the ideas about new projects, undertakingfeasibility studies, and providing technical, financial and managerial aid forsuccessfully implementation of the underlying projects.

(4) Development Banks are helping by providing the services like merchant banks,venture capital and so on.

(5) Development banks generally undertake high profile projects which involve lesserreturn higher risk at the initial state of the project which generally commercial bankswould not under take.


NOTES


Development Banks

(1) Industrial Development Bank of India (IDBI) (it became commercialbank from 1st October 2004)

(2) Industrial Investment Bank of India (IIBI)(3) Industrial Financial Corporation of India (IFCI)(4) The Export Import Bank of India (EXIM)(5) Tourism Finance Corporation of India (TFCI)

Refinance Institutions.

(a) Small Industrial Development Bank of India (SIDBI)(b) National Bank for Agriculture and Rural Development (NABARD)

Investment Institutions or Investment Banks

(1) Mutual Fund Companies(2) Pension Funds(3) Insurance Companies etc,

Note: we have elaborately discussed regarding above banks in the Unit V

Specialized Financial Institutions:

(1) Infrastructure Development Finance Company (IDFC)(2) IFCI Venture Capital Funds(3) ICICI Venture Capital Fund

Apart from the above we also have state level institutions which are as follows:

(1) State Financial Corporations(2) State Industrial Development Corporations (SIDC’s) etc,

3.5 DEVELOPMENT BANKS

3.5.1 The Industrial Development Bankof India(IDBI)

Industrial Development Bank of India provides financial assistance for the establishmentof new projects as well as for expansion, diversification, modernization and technology upgradation of existing industrial enterprises.

Main functions of IDBI

(1) IDBI is vested with the responsibility of co-ordinating the working of institutions engaged in financing, promoting and developing industries. It has evolved an appropriate mechanism for this purpose.

(2) IDBI also undertakes/supports wide-ranging promotional activities including entrepreneurship development programmes for new entrepreneurs, provision of consultancy services for small and medium enterprises, up gradation of technology and programmes for economic upliftment of the underprivileged.

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IDBI’s role as a catalystIDBI’s role as a catalyst to industrial development encompasses a wide spectrum of

activities. IDBI can finance all types of industrial concerns covered under the provisions ofthe IDBI Act. With over three decades of service to the Indian industry, IDBI has grownsubstantially in terms of size of operations and portfolio.

Developmental Activities of IDBI(a) Promotional activities

In fulfillment of its developmental role, the Bank continues to perform a wide range ofpromotional activities relating to developmental programmes for new entrepreneurs,consultancy services for small and medium enterprises and programmes designed foraccredited voluntary agencies for the economic upliftment of the underprivileged. Theseinclude entrepreneurship development, self-employment and wage employment in theindustrial sector for the weaker sections of society through voluntary agencies, support toScience and Technology Entrepreneurs’ Parks, Energy Conservation, Common QualityTesting Centres for small industries.

(b) Technical Consultancy Organizations

With a view to making available at a reasonable cost, consultancy and advisory servicesto entrepreneurs, particularly to new and small entrepreneurs, IDBI, in collaboration withother All-India Financial Institutions, has set up a network of Technical ConsultancyOrganisations (TCOs) covering the entire country. TCOs offer diversified services to smalland medium enterprises in the selection, formulation and appraisal of projects, theirimplementation and review.

(c) Entrepreneurship Development Institute

Realising that entrepreneurship development is the key to industrial development, IDBIplayed a prime role in setting up of the Entrepreneurship Development Institute of India forfostering entrepreneurship in the country. It has also established similar institutes in Bihar,Orissa, Madhya Pradesh and Uttar Pradesh. IDBI also extends financial support to variousorganisations in conducting studies or surveys of relevance to industrial development.

3.5.2 Industrial Investment Bank Of India (IIBI)

Industrial Investment Bank of India (erstwhile Industrial Reconstruction Bank of India)was set up in 1985 under the IRBI Act, 1984 as the principal credit and reconstructionagency for aiding rehabilitation of sick and closed industrial units. With a view to convertingIRBI into a full-fledged all purpose development financial institution, it was incorporated asa government company in the name of Industrial Investment Bank of India Ltd. (IIBI),under the Companies’ Act, 1956 on March 17, 1997 thereby providing it with adequateoperational flexibility and financial autonomy.


NOTES


Besides project finance, IIBI also provides short duration non-project asset-backedfinancing in the form of underwriting/direct subscription, deferred payment guarantees andworking capital/other short-term loans to companies to meet their fund requirements.

During 1999-2000, while sanctions increased by 7.5% to Rs.23,381 million,disbursements declined by 14.7% to Rs.14,396 million. Up to end March 2000, IIBI’ssanctions and disbursements aggregated Rs.1,00,898 million and Rs.72,526 millionrespectively. As at end-March 2000, assistance of Rs.39,877 million was outstanding.

During the year, sanctions for asset creation increased by 7% to Rs.15,917 million,constituting 68.1% of the total. Sanctions by way of rupee loans at Rs.11,944 millionconstituted 75% of total assistance under asset creation, followed by direct subscription toshares and debentures of industrial concerns at Rs.3478 million (21.8%). Sanctions byway of rupee loans recorded an increase of 44.6%.

Disbursements for asset creation totalled Rs.8749 million, forming 60.8% of totaldisbursements. Disbursements by way of rupee loans increased by 2.9%, while by way ofdirect subscription to shares and debentures declined by 37.5%.

3.5.3 Industrial Financial Corporation Of India (IFCI)

IFCI was set up in the year 1948 to promote institutional credit to medium and largeindustries. The main functions are direct financial support to industrial units for undertakingnew projects, expansion, modernization, diversification etc., subscription and underwritingof public issues of shares and debentures, guaranteeing of foreign currency loans and alsodeferred payment guarantees, merchant banking, leasing and equipment finance.

Industrial Financial Corporation of India has played a vital role in the development ofcooperatives in the sugar and textiles industries. It has founded and developed institutionssuch as the Management Development Institute (MDI), the Investment and Credit RatingAgency (ICRA), the Tourism Finance Corporation of India (TFCI), and the RashtriyaGramin Vikas Nidhi.

Functions of IFCI

(1) Project Financing

One of the main functions of the IFCI is to fund green field projects. The financialassistance is provided by way of medium or long term credit for setting up new projects,expansion or diversification of business, modernization of existing business etc.

(2) Financial Assistance

The IFCI assisting various fund based schemes. The various fund based productsoffered are equipment finance, leasing and hire purchasing and so on.

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(3) Corporate Advisory Services

It provides the customized services in the area of investment appraisals, corporatisation,disinvestment, business restructuring, bid process management and formation of jointventures.

(4) Corporate Advisory Services to Foreign Investors

IFCI provides a comprehensive range of services to prospective foreign investors inthe various fields like facilitating the foreign business entities through information services,necessary office infrastructure for the start up operations of the project, coordination forobtaining the required approval, full filling all legal compliances etc.

Due to the challengeable and highly risky projects handled by the IFCI started reportinglosses from the year 1999 onwards in addition to these it has faces many difficulties such asoperational inefficiency, traditional sector financing, political interference, higher rate ofnon-performing assets.

The IFCI has initiated the process of restructuring of liabilities and is negotiating withthe investors for reduction of interest rate on deposit and bonds. IFCI also initiated actionsagainst those defaulted the loans.

3.5.4 The Export Import Bank Of India (EXIM)

The Export Import Bank of India is a public sector financial institution was set up inthe year 1981. The main objective of this bank is financing, facilitating and promotingIndia’s trade and commerce, provides the project finance, Trade finance, Exim bank alsoact an intermediary for facilitating the forfeiting transaction between the Indian exporterand the overseas forfeiting agency etc.

Export Import Bank of India is also known as Exim Bank of India and was establishedby an Act passed by the Indian Parliament in September, 1981. Export Import Bank ofIndia is fully owned by the Indian government and it started its operations in March, 1982.

The major objectives of Export Import Bank of India are to provide economicassistance to importers and exporters and to function as the apex financial institution. Itsservices include export credit, overseas investment finance, agri & SME finance, film financeand finance for units that are export oriented.

The total amount of loans disbursed by Export Import Bank of India amounted to Rs.150,389 million in 2005- 2006 and in the following year, this figure increased to Rs. 220760million

The net profit of the Bank came to around Rs. 2707 million in 2005- 2006. In thefollowing year this figure increased to Rs. 2994 million. The head office of Export Import


NOTES


Bank of India is located in Mumbai and its regional offices are located at Pune, Kolkata,Hyderabad, New Delhi, Bangalore, Chennai and Ahmedabad. The Bank’s overseas officesare located at London, Washington D.C., Dakar, Dubai, Singapore and Johannesburg.

3.5.5 Tourism Finance Corporation Of India (TFCI)

TFCI was incorporated as a Public Limited Company under the Companies Act,1956 on 27th January 1989 and became operational with effect from 1st February 1989on receipt of Certificate of the Commencement of Business from the Registrar of Companies.TFCI has been notified as a Public Financial Institution under section 4A of the CompaniesAct, 1956.

Tourism Finance Corporation of India Ltd. (TFCI) provides project-related servicesand tourism-related studies/ services. TFCI provides financial assistance to enterprises forsetting up and/or development of tourism-related projects, facilities and services, such ashotels, holiday resorts, multiplexes and entertainment centers, education and sports, safariparks, rope-ways, cultural centers and convention halls.

TFCI has been providing consultancy services to different central and state agenciesby undertaking assignments to cover macro and micro level tourism-related studies/exercisesto facilitate identification, conceptualization, promotion/implementation of specific tourism-related projects and for taking policy level decisions with respect to investment andinfrastructure augmentation. TFCI’s range of activities in the consultancy division coverstourism-related studies, surveys and project-related services.

Resource mobilization

TFCI has been mobilizing resources through a combination of debt and equity. Itmade a public issue of equity shares in 1994. TFCI’s shares are listed in National StockExchange, Mumbai, Delhi, Ahmedabad and Madras stock exchanges and dematerialisedwith National Securities Depositories Ltd. (NSDL and Central Securities DepositoryServices (I) Ltd. (CSDSL).

Besides the paid up capital of Rs. 67.42 crores and the internal generations, TFCImeets its requirements of funds by way of borrowings viz. private placements of bonds,line of credit from institutions /banks, certificate of deposit etc, at competitive rates with aview to keep the cost of funds at minimum level.

TFCI provides all forms of financial assistance for new, expansion, diversification/modernization projects in tourism industry and/ related activities, facilities and services, inthe following forms:

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• Rupee Loans• Underwriting of public issues of share/ debentures and direct subscription of such

securities• Guarantee for deferred payments and credits raised in India and/or abroad• Equipment Finance• Equipment Leasing• Assistance under Suppliers of Credit• Advisory Services

3.6 REFINANCE INSTITUTIONS

3.6.1 Small Industrial Development Bank of India (SIDBI)

SIDBI was established by passing an Act under parliament in the year 1989. TheSIDBI provides services such as the principal financial institution for the promotion, financingand development of industries in the small scale sectors and to coordinate the functions ofother institutions engaged in similar activities

Services Providing by SIDBI

(1) Refinances

• Loans granted by PLIs for new SSI projects and for expansion, technologyupgradation, modernisation, quality promotion.

• Loans sanctioned by PLIs to small road transport operators, qualified professionalsfor self-employment, small hospitals and nursing homes and to promote hotels andtourism-related activities.

(2) Directly finances

• SSI units for new/expansion/diversification/modernisation projects.• Marketing development projects which expand the domestic and international

marketability of SSI products.• Existing well-run SSI units and ancillaries/sub-contracting units/ vendor units for

modernisation and technology upgradation.• Infrastructure development agencies for developing industrial areas.• Leasing and hire purchase companies for offering leasing/hire purchase facilities to

SSI units.• Existing export-oriented units to enable them to acquire ISO-9000 Series

Certification• SSIs to obtain credit rating from accredited credit rating agencies.• Small scale entrepreneurs using innovative indigenous technology and expertise


NOTES


SIDBI provides foreign currency loans to

• Import equipment by existing export-oriented SSIs and new units having definiteplans for entering export markets.

• Execute confirmed export orders by way of pre-shipment credit/letter of creditand provides post-shipment facilities.

3.6.2 National Bank For Agriculture And Rural Development (Nabard)

NABARD also came into exist in the year 1982 by an Act of parliament. It serves asan apex refinancing agency for the institutions providing investment and credit for promotingdevelopment activities in rural areas, coordinates and supervise the rural financing activitiesof all institutions engaged in developmental work etc,.Functions of NABARD:

1. Serves as an apex financing agency for the institutions providing investment andproduction credit for promoting the various developmental activities in rural areas.

2. Takes measures towards institution building for improving absorptive capacity ofthe credit delivery system, including monitoring, formulation of rehabilitationschemes, restructuring of credit institutions, training of personnel, etc.

3. Co-ordinates the rural financing activities of all institutions engaged in developmentalwork at the field level and maintains liaison with Government of India, StateGovernments, Reserve Bank of India (RBI) and other national level institutionsconcerned with policy formulation

4. Undertakes monitoring and evaluation of projects refinanced by it.5. NABARD’s refinance is available to State Co-operative Agriculture and Rural

Development Banks (SCARDBs), State Co-operative Banks (SCBs), RegionalRural Banks (RRBs), Commercial Banks (CBs) and other financial institutionsapproved by RBI. While the ultimate beneficiaries of investment credit can beindividuals, partnership concerns, companies, State-owned corporations or co-operative societies, production credit is generally given to individuals.

NABARD has its head office at Mumbai, India

NABARD operates throughout the country through its 28 Regional Offices and oneSub-office, located in the capitals of all the states/union territories.Each Regional Office[RO]has a Chief General Manager [CGMs]as it’s head, and the Head office has several Topexecutives like the Executive Directors[ED], Managing Directors[MD], and theChairperson.It has 336 District Offices across the country, one Sub-office at Port Blairand one special cell at Srinagar. It also has 6 training establishments.

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3.7 SPECIALIZED FINANCIAL INSTITUTIONS

3.7.1 Infrastructure Development Finance Company (IDFC)

IDFC was established in the year 1997 with the intention to promote consultancy andadvisory services to state governments for formulating a power sector strategy, to integratethe entire logistics chain in India, to provide the financial assistance to varioustelecommunication and Information Technology sectors, providing finance and projectservices for the development urban infrastructure and so on

Infrastructure Development Finance Company (IDFC) is a leading infrastructurefinancing institution providing a wide range of financing products and fee-based services toinfrastructure projects and their sponsors. The company works closely with governmententities and regulators-central and state, in India to advise and assist in formulation policyand regulatory frameworks in infrastructure development.

Functions of IDFC

(a) Exclusive focus on infrastructure and leading innovator in infrastructure financing:the company has been founded with the sole objective of providing and promotingprivate financing of Indian infrastructure. The company has extensive domainknowledge, particularly with regard to project structuring appraisal and riskevaluation.

(b) Advisory Role: The Company has strong relationship with the Government thatgives access to decision makers in government entities and multilateral developmentagencies. As a result, the company plays a significant role in the direction ofinfrastructure policy in the country.

(c) Strong Asset Quality: IDFC has the strongest asset quality position that has beenachieved due to its strong credit and project appraisal skills and disciplined riskmanagement practices. The company has 0.7% gross and zero net non-performingassets as of March 31, 2004 and 2005.

(d) Low Administrative Expenses: The Company has very low establishment andadministrative expenses, being only 0.4% of average total assets as of March 31,2005.

(e) Risk Management: The Company has a Project Finance Group, responsible formonitoring credit risk at the transaction level. The Risk Management Group isresponsible for managing the portfolio credit risk, market risk and operationalrisk. These groups are independent from business development groups. The currentpolicy of the company is to limit exposure to any particular sector to 50 percent oftotal assets. The company has the policy to limit exposure to a single borrowerand to a group to 20% and 50% of total capital funds (comprising Tier-I and Tier-II capital) on their contractual obligations.


NOTES


3.7.2 IFCI Venture Capital Funds

IFCI Venture Capital Funds Ltd. (IVCF) was originally set up by IFCI as a Societyby the name of Risk Capital Foundation (RCF) in 1975 to provide institutional support tofirst generation professionals and technocrats setting up their own ventures in the mediumscale sector, under the Risk Capital Scheme. In 1988, RCF was converted into a company,Risk Capital and Technology Finance Corporation Ltd. (RCTC), when it also introducedthe Technology Finance and Development Scheme for financing development andcommercialisation of indigenous technology. To reflect the shift in the company’s activities,the name of RCTC was changed to IFCI Venture Capital Funds Ltd. (IVCF) in February2000.

Over the years, IVCF has provided financial assistance to new ventures, supportedcommercialisation of new technologies, helped in widening entrepreneurial base in thecountry. It is IVCF who has catalysed introduction of concept of venture capital activity inIndia.

3.7.3 ICICI Venture Capital Fund

ICICI Venture (formerly TDICI Limited) was founded in 1988 as a joint venture withthe Unit Trust of India. Subsequently, ICICI bought out UTI’s stake in 1998 and ICICIVenture became a fully owned subsidiary of ICICI. ICICI Venture also has an affiliationwith the Trust Company of the West (TCW), which provides it a platform for networkingIndian companies with global markets and technology. Strong parentage and affiliates forICICI Venture also translates into access to a broad spectrum of financial and analyticalresources thus enabling a keen understanding of the Indian financial markets andentrepreneurial ethos.

Financial year 2002-3 was a landmark year for ICICI Venture. ICICI Venture raisedthe largest Indian Private Equity Fund and also engineered effective exits and enhanced thevalue of its existing portfolio. ICICI Venture Funds launched four new domestic fundswhereas six existing funds under management were either liquidated or were in the processof liquidation. The most significant achievement of ICICI Venture was the successful FirstClosing of the Rs. 750 billion India Advantage Fund launched this year.

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Source: www.icicibank.com

3.8 MERCHANT BANKING

A merchant bank is a bank whose function is to provide long term equity and loanfinance for industrial and other companies, particularly new securities. Merchant Bankeracts as a financial intermediary in providing long term finance to the corporate. The merchantbanks are called as investment banks in United State of America.

Functions of Merchant Banks

(1) Management of issue of corporate securities of existing companies and newly floatedcompanies.

(2) Offering financial expertise in merger, takeover, capital reorganization to corporatesectors

(3) Management of Investment trusts


NOTES


(4) Handling insurance business(5) Loan syndication and corporate advisory services(6) Portfolio management(7) Custodial and Depository Services(8) Broking the corporate securities(9) Advise for foreign funds mobilization(10) Liquidity management(11) Underwriting commission(12) Leasing and financing(13) Acting as trustees for debentures issue(14) Mobilization of funds and maintenance of funds(15) Venture capital financing arrangement.

Merchant bankers require compulsory registration with SEBI to carry out the merchantbanking activities. In case of category I merchant banker the registration fee is Rs 2.50 lacand the same amount has to pay every year as renewal fee. In case of category II Rs 1.50lac at the time of registration and for the first two years and Rs 50,000 for the third year.In case category III Rs 1.00 lac annually for the first two years and Rs 25,000 for the thirdyear and category IV Rs 50,000 annually, for the first two years and Rs 1,000 for the thirdyear. These fees are subject to change as per SEBI.

Category I merchant bankers means - minimum net worth as per SEBI is Rs 5 croreCategory II merchant bankers means - minimum net worth as per SEBI is Rs0.50 croreCategory III merchant bankers means - minimum net worth as per SEBI is Rs 0.20 croreCategory IV merchant bankers means – minimum net worth as per SEBI is Rs nil.

A merchant banker who is associated with the issuer company as a promoter ordirector or associate director should not lead or manage its issue. However, a merchantbanker holding securities of a company can lead or manage its issue if the securities areproposed to be listed on the OTCEI and market makers have been proposed to beappointed as per the offer document.

The maximum number of lead managers is related to the size of the issue. For examplean issue of a size less than Rs 50 crore, two lead managers are appointed. For the sizegroup of Rs 50 crore to Rs 100 crore and Rs 100 crore to 200 crore the maximumpermissible lead managers are three and four respectively. In case of issue size is in betweenRs 200 crore to Rs 400 crore five lead manages and if the size still increases then maximumnumber if lead managers will be five or more.

We have list of merchant banker in India and whose ranking in the business of merchantbanking as follows:

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Ranking of Merchant Banking in India

Note: OE: Overall Excellence; FSS: Financial Soundness; QPS: Quality Product/Service;QM: Quality Management; INN: Innovativeness.

3.9 VENTURE CAPITAL

The Venture Capital (VC) Industry is a major source of funding for the entrepreneurialcommunity. The industry itself has evolved over a number of years, but has only recentlyemerged as a popular career for many professionals. The industry focus is on early stage,pre-IPO funding opportunities. Typically a fund will be raised, that will be invested in anumber of different opportunities that are reasonably high risk. In return for the investment,the VC receives an equity stake in the business.

The VC also helps the business develop its management team, and takes seats on theboard of the company. VCs are typically interested in making few large investments, due tothe manpower needed to support each investment (recruiting and board seats). They focusnot only on the business opportunity that is presented to them, but closely on the managementteam that is offered. In order for an entrepreneur to have an audience with a VC, s/heneeds to have a pre-existing connection (a reference to the VC).

Without this, the VC is unlikely to review the business plan. This further supports thenotion that the VC and entrepreneurial community in Silicon Valley is a ecosystem thatbenefits from the mutual relationships that are already established, and is resistant to outsiderslooking in A recent growth of alternative sources of pre-IPO investment is coming fromAngel Investors. These are typically successful entrepreneurs (cashed out) who are lookingfor additional investment opportunities in order to remain connect to entrepreneur community.

Venture capital provides a source of funds through investment, usually in panies orprojects that are start-up or at a very early stage of product development. These projectsand organizations usually would not attract sources of finance such as loans and could not


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raise money in the major public stock markets (such as the London Stock Exchange).Limited equity capital is available to some early companies via AIM or Ofex markets.

Definition

Venture capital can be defined as funds that are generally invested in the form ofequity or quasi-equity which rarely affords any guarantee. Investments may take the formof simple shareholder’s equity (common or preferred shares), as well as options, warrants,convertible debentures and other vehicles.

The structure of the investment generally depends on the company’s needs and its stage ofdevelopment, taking into account the objectives of both the entrepreneur and the investor.As a result, this form of financing is risky, which the investor hopes will be offset by aproportional return on his investment. The return is generally realized out of the capital gainor the increase in the company’s share value.

Investment strategy of the Venture capital companies

With respect to investment strategy, venture capitalists have this in common:

1. They all strive to invest their money in companies that offer strong growth potential anda promising strategic position on their respective markets.

2. They Endeavour to increase the value of their investments by providing the entrepreneurwith capital, of course, but also with the expertise, the network and the experiencenecessary to accelerate the company’s growth.

3. They invest for the medium and long term, in order to develop the company’s potentialto the fullest and thus maximize the return for all shareholders.

The usual mechanism for venture investment is through the formation of a new company.The company will own rights to the intellectual property (patents etc.) that stem from

earlier research activities and will probably employ or have consultancy contracts with thescientists behind the research work. The venture capital firm buys a shareholding in thenew company, thereby providing the company with money for development work.Frequently, more than one venture capital firm may invest in a company, even at an earlystage in its development.

Venture capital firms are often instrumental in ‘assisting’ the founders to develop theirbusiness.

This may involve a range of activities including:

(a) strengthening and broadening the management team by recruiting individuals witspecific expertise

(b) working with the management team to raise further finance from other investors orby listing on a stock exchange combining specific technologies or projects to expandthe company’s portfolio

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Advantages of Venture Capital(i) Because the investment is in the form of capital, the company’s financial structure

and financial ratios are improved accordingly, giving the entrepreneur the necessaryflexibility and financial capacity to achieve his objectives;

(ii) Little or nothing to repay in the short term, so that the capital invested and fundsgenerated internally can be used exclusively to accelerate the company’s growth;

(iii) In most leveraged buy-outs and start-ups, it is the principal source of financingavailable;

(iv) The venture capitalist is not there to manage the company, but to stimulate itsgrowth through active strategic support and constructive involvement, by givingthe entrepreneur the benefit of his own experience as well as that of his businessnetwork;

(v) Easier access to additional capital should the need arise.

Types of finance

(1) Equity Finance

The venture capital undertakings generally requires funds for a longer period but maynot be able to provide returns to the investors during the initial periods. Therefore theventure capital finance is generally provided by way of equity share capital .

(2) Conditional Loan

A conditional loan is repayable in the form of a royalty after the venture is able togenerate sales. No interest is paid on such loans. In India venture capital financiers chargesroyalty ranging between 2 and 15 percent.

(3) Income Note

It is a hybrid method of funding which combines the features of both conventional laonand conditional loan. The entrepreneur has to pay both the interest and royalty on sales butat substantially low rates.

(4) Participating Debentures

The participating debentures means which carries charges in three phases in the startup phase no interest is charged, next stage a low rate of interest is charged up to a particularlevel of operation, after that, a higher rate of interest is required to be paid.

Returns of Venture Capital Company

Venture capitalists need high returns on those projects that do succeed because not allprojects they back will succeed. Venture firms normally manage money that originates inless-specialised investment institutions, such as those which manage pension funds. Theventure capital companies need to deliver a good rate or return to those investors. Inevaluating investment prospects, the venture capital firm will weigh up the various risks


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(see ‘due diligence’), length of time their money is likely to be tied up, and the level ofreturn they need to deliver to their investors.

The value of a venture firm’s shareholding may increase as a new company grows butthis is just ‘paper money’ until there is an opportunity to sell the shares. Typically thiscomes when a company makes a public offering or when it is acquired by another company.Venture capital firms will expect to sell their shares at many times the price they originallypaid.

3.10 CREDIT RATING

Credit Rating is assessment of borrower’s financial worth. Credit rating enablesinvestors to draw up the credit risk profit and assess the adequacy or otherwise of the riskpremium offered by the market. It is really helpful to the investor because of time savingand enables hi take a quick decision and provides him better choice among availableinvestment opportunities.

In India credit rating industries got prominent growth namely

(a) Credit Rating Information Services of India Limited (CRISIL)(b) Investment Information and Credit Rating Agency of India Limited (ICRA)(c) Credit Analysis and Research Limited (CARE)

In India the CRISIL is the market leader in the credit rating industry. In the year 1992the RBI introduced compulsory requirement of Credit Rating. The SEBI followed thesame pattern making it mandatory for bonds. For private placements, rating is notmandatory but banks and mutual funds ask for a rating. The credit rating industry really gotgood credit rating in the minds of investors because in 1997, the penetration of rating, thatis the number of rated issues out of the total number of issues was 35%. In the year 2002,it was 97%. Now the credit rating agencies has transited from a regulatory driven marketto an investor driven market.

Rating Methodology

The rating of financial instruments requires in depth analysis of relevant factors thataffect the credit worthiness of the issuer. These analyses can be Business analysis, Financialanalysis, Management evaluation and Fundamental analysis.

Business Analysis means it covers it may be demand and supply, market position inthe industry, operating efficiency of the production processes of the firm, its cost structureso on and so forth.

Financial Analysis means accounting quality, income recognition, auditors remarks,off balance sheet items, earning protection, adequacy of cash flows, Audited profit andloss account and balance sheet of the firm, projections prepared and so on.

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Management Evaluation includes a study of track record of promoters, and the topmanagement, managerial skills of the top management to overcome adverse situations,goals, philosophy, strategies.

Fundamental analysis means liquidity management, asset quality, profitabilitymanagement and tax brackets and so on.

Rating symbols

Investor’s attention is highly dragged by the credit rating agencies in India. CreditRating is the assessment of a borrower’s credit performance. Credit Rating helps investorsto decide their investment pattern. Basically the credit rating has symbols which denote theperformance or credit worthiness of the respective companies. These symbols may beAAA, AA, BBB, B, C, D to denote the performance of the respective companies to theinvestor. For example AAA which means Highest safety in terms of repayment of principaland interest and in case of BBB which means moderate safety in terms of timely paymentof interest and principal.

In India the rating will start with the request of the company, however, the ReserveBank of India and Securities and Exchange Board of India made credit rating mandatoryfor the issue of commercial paper and certain categories of securities and debentures

SEBI Regulations for Credit Rating Agencies in India

As per the Securities and Exchange Board of India (Credit Rating Agencies)Regulations, 1999

(a) Only commercial banks, public financial institutions, foreign banks operating inIndia, foreign credit rating agencies, and companies with minimum net worth of Rs100 crore as per its audited annual accounts for the previous five years are eligibleto promote the credit rating agencies in India.

(b) Rating agencies should have minimum net worth of Rs 5 crore(c) Rating agencies cannot assess financial instruments of their promoters who have

more than 10 per cent stake in them.(d) Rating agencies cannot rate a security issued by an entity which is a borrower of its

promoter or a subsidiary of its promoter or an associate of its promoter if there arecommon chairmen, directors between credit rating agencies.

(e) Rating agencies cannot rate a security issued by its associate or subsidiary, if thecredit rating agency or its rating committee has a chairman, director or employee,who is also a chairman, director or employee of any such entity.

(f) SEBI has the power to cancel the certificate or impose the penalty if rating given bythe rating agency proved false or if the agency fails to comply with any condition orcontravenes any of the provisions of the act.


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3.10.1 Credit Rating Agencies in India

3.10.1.1 Credit Rating Information Services Of India Limited (Crisil)

CRISIL was incorporated jointly by ICICI, UTI, GIC, United India InsuranceCompany, LIC and domestic and foreign companies as the first credit rating agency inIndia. CRISIL provides rating and risk assessment services to manufacturing companies,banks, non-banking financial companies, financial institutions, housing finance companies,municipal bodies and companies in the infrastructure sector. CRISIL’s comprehensiveofferings include ratings for long-term instruments such as debentures/bonds and preferenceshares, structured obligations (including asset-backed securities) and fixed deposits; italso rates short-term instruments such as commercial paper programmes and short-termdeposits.

As part of bank loan ratings, CRISIL also rates credit facilities extended to borrowersby banks. In addition, CRISIL undertakes credit assessments of various entities includingstate governments. CRISIL also assigns financial strength ratings to insurance companies.

CRISIL through the years has continued to innovate and play the role of a pioneer inthe development of the Indian debt market. CRISIL has pioneered the rating of subsidiariesand joint ventures of multinationals in India and has rated several multinational entities,both start-up entities as well as players with a well established track record in India. Overthe years, CRIS IL has also developed several structured ratings for multinational entitiesbased on Guarantees from the parent as well as Standby Letter of Credit arrangementsfrom bankers.

The rating agency has also developed a methodology for credit enhancement ofcorporate borrowing programmes through the use of partial guarantees. In essence, CRISILis uniquely placed in its experience in understanding the extent of credit enhancement arisingout of such structures

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Milestones of the CRISIL


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source: www.crisil.com-milestones


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3.10.1.2 Investment Information And Credit Rating Agency Of India (Icra

ICRA Limited (formerly Investment Information and Credit Rating Agency of IndiaLimited) was set up in 1991 by leading financial/investment institutions, commercial banksand financial services companies as an independent and professional Investment Informationand Credit Rating Agency. Today, ICRA and its subsidiaries together form the ICRAGroup of Companies (Group ICRA). ICRA is a Public Limited Company, with its shareslisted on the Bombay Stock Exchange and the National Stock Exchange.

ICRA Limited (ICRA)ICRA Management Consulting Services Limited (IMaCS)ICRA Techno Analytics Limited (ICTEAS)ICRA Online Limited (Online)

Range of Services of ICRA

(1) As an early entrant in the Credit Rating business, ICRA Limited is one of the mostexperienced Credit Rating Agencies in the country today. ICRA Rates rupee-denominated debt instruments issued by manufacturing companies, commercialbanks, non-banking finance companies, financial institutions, public sectorundertakings and municipalities, among others. ICRA also Rates structuredobligations and sector-specific debt obligations such as instruments issued by Power,Telecom and Infrastructure companies. The other services offered includeCorporate Governance Rating, Stakeholder Value and Governance Rating, Ratingof Claims Paying Ability of Insurance Companies,Poject Finance Rating, and Lineof Credit Rating.

(2) Recently, ICRA, along with National Small Industries Corporation Limited NSIC),has launched a Performance and Credit Rating Scheme for Small Scale Enterprisesin India. The ervice is aimed at enabling Small and Medium Enterprises (SMEs)improve their access to institutionalcredit, increase their competitiveness, and raisetheir market standing. Grading Services

(3) The Grading Services offered by ICRA employ pioneering concepts andmethodologies, and include Grading of: Construction Entities; Real EstateDevelopers and Projects; Mutual Fund Schemes and Fund Houses; HealthcareEntities; Maritime Training Institutes; and Initial Public Offers (IPOs). The Gradingof Construction Entities seeks to provide an independent opinion on the quality ofperformance of the entities Graded. Similarly, the Grading of Real Estate Developersand Projects seeks to make property buyers aware of the risks associated withreal estate projects and with the developers’ ability to deliver in accordance withthe terms agreed. ICRA’s Mutual Fund Gradings aim at providing an independentopinion on the credit/performance risks associated with investing in various MutualFund schemes and on the managerial and governance quality of Asset ManagementCompanies.

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(4) ICRA’s Healthcare Gradings present an independent opinion on the quality of careprovided by healthcare entities. In the education sector, ICRA offers the innovativeservice of Grading of Maritime Training Institutes in India. In IPO Grading, anICRA assigned IPO Grade represents a relative assessment of the “fundamentals”of the issue Graded in relation to the universe of other listed equity securities inIndia.

(5) Information Services: The Information Services Division focuses on providingauthentic data and value-added products used by intermediaries, financial institutions,banks, asset managers, institutional and individual investors, and others. TheDivision’s portfolio of products includes sector/industry-specific studies/publications, corporate reports, and mandate-based studies (customised research).

(6) Advisory Services: ICRA Management Consulting Services Limited (IMaCS), asubsidiary of ICRA, offers wide-ranging management Advisory Services coveringthe areas of Strategy Practice, Risk Management Practice, Regulatory Practice,Transaction Practice, and Content. While Strategy Practice focuses on improvingan organisation’s competitiveness across its value chain, Regulatory Practice advisesclients like governments and regulators on formulation of economic and financialpolicies. Under Transaction Practice, IMaCS provides consulting service at atransaction level to infrastructure projects, while under Risk Management Practiceadvice is offered on the efficient management of risk to banks and other lenders.

(7) Online Software and Business Process Outsourcing: ICRA Online Limited, asubsidiary of ICRA, provides technology solutions, both in the form of productsand services, targeted at distributors of third-party financial products, insurancebrokers, and stock broking houses. The Business Process Outsourcing (BPO)Division of ICRA Online serves financial services companies, financial institutions,investment banks, private equity and venture capital funds, boutique investmentadvisors, market researchers, financial information vendors, consulting companies,and the like. The focus is on high-end knowledge processing like financial modelling,data analysis, valuation, outsourced research, equity research, fixed income research,financial assets pricing, financial report writing, and econometric analysis.

(8) Software Development: ICRA Techno Analytics Limited (ICTEAS), a subsidiaryof ICRA, offers a complete portfolio of Information Technology (IT) solutions tomeet the dynamic needs of present day businesses. The services range from thetraditional development of client-server, web-centric and mobile applications tothe generation of cutting edge business analytics. An in-depth knowledge of varioustechnology areas enables ICTEAS provide end-to-end services of excellent quality.ICTEAS uses a mix of onsite/offshore strategies to optimise bottom-line benefitsfor its customers.

3.10.1.3 Credit Analysis And Research Limited (Care)

Credit Analysis & Research Ltd. (CARE Ratings) is a full service rating company thatoffers a wide range of rating and grading services across sectors. CARE has an unparalleldepth of expertise. CARE Ratings has completed over 3850 rating assignments havingaggregate value of about Rs 8071 billion (as at December 2007), since its inception in


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April 1993. CARE is recognised by Securities and Exchange Board of India (Sebi),Government of India (GoI) and Reserve Bank of India (RBI) etc. CARE was promotedby major Banks/FIs (financial institutions) in India. The three largest shareholders of CAREare IDBI Bank, Canara Bank and State Bank of India. CARE, is set-up with two divisions:

3.11 FACTORING SERVICES

Factoring is a unique service which is providing by factor to his clients. The conceptof factoring is very popular mechanism of managing, financing and collecting receivables indeveloped countries like USA and UK and has extended to number of other countries inthe recent past including India.

Nature of Factoring:

Factoring is an innovative financial and management support to a client. It is basicallya method of converting a non productive, inactive asset namely receivables into a productiveasset namely cash by selling receivables to a company that specializes in their collectionand administration. As per this arrangement, the person purchase the firm receivables iscalled factor and the person selling the receivables (ie Sundry Debtors) is called seller orclient. The person who purchases the goods from the seller is called purchaser.

Now we will understand in a better manner the definition of factoring as ‘a businessinvolving a continuing legal relationship between a financial institution (the factor) and abusiness concern (the client) selling goods or providing services to trade customer (thebuyer) where by the factor purchases the client’s accounts receivable and in relationthereto, controls the credit, extended to customers and administers the sales ledger’. TheFactoring business allowed to the subsidiary of nationalized banks. Since 1991 factoringservices areoffering by SBI Factors (a subsidiary of the SBI) and Canbank Factors Limited(a subsidiary of Canara Bank)

Thus factoring means a contract between the suppliers of goods or service and thefactor.

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Factoring Services or Functions

(1) Credit Administration

A factor provides full credit administration services to his client. Since the factorymaintains an account for all customers of all items owing to them, they have effective controlover it so that collection of dues can be made on or before due date. Factor will inform tothe client about the balances in the account, the overdue bills, the financial standing of thebuyers and so on.

(2) Credit Collection and protection

The factor will collects the receivables on behalf of his client and relieves him from thebotheration of the bad debts and collection administration and so on. This helps to theclient to concentrate more on productivity.

(3) Financial Assistance

Factoring concept came to meet the financial needs of the firms. On account ofpurchase of the book debts and receivables from the client the factor will pay part amountor full amount depends upon the factoring agreement.

(4) Other functions or services

In developed countries like the USA or UK , factor provides multiple services namelyproviding information on prospective buyer, providing financial counseling, assisting theclient in managing its liquidity and preventing sickness, financing acquisition of inventoriesand providing facilities for opening letter of credit by the client and so on.

Types of factoring

(1) Notified Factoring

In this type of factoring, the customer is intimated about the assignment of debt to thefactor and also directed to make payments to the factor instead of the firm. Then the buyer(customer) will make the payment to the factor.

(2) Non- notified or confidential Factoring

This type of factoring provides that facility to the seller the agreement between himand factor is not disclose to this buyer namely customer.

(3) Factoring With-Recourse or Without-Recourse

Whether notified Factoring or not can be classified into with recourse factoring andwithout recourse factoring. In case of with recourse factoring the seller will carry the creditrisk in respect of receivables he sold to the factor. The factor will have recourse in the


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event of non payment for whatever reason including the financial inability of the buyer (iecustomer).

In the case of without recourse factoring the bad debts are borne by the factoringagent or factor.

(4) Credit Factoring or Invoice Factoring

In this type of factoring the factor purchase the book debts with recourse to the sellerand provides finance, interest will be charged by the factor until the bill amount is collectedfrom the buyer of goods.

(5) Maturity Factoring

It means the seller will handed over the receivables to the factoring but the money willpay by the factor only after collected from the buyer. It is nothing but receivables sent forcollection.

Benefits of Factoring

a) The factor performs the basic functions of administrating the book debts, creditcontrol and collection dues and so on.

b) The factor facilitates to reduce the operating cycle by providing the cash in advanceie before due date

i) Firms can improve their financial liquidity position and concentrate moreon the business activities rather than to waste the valuable time to spendon debtors’ collection.

ii) Due to professionalism and experience of the factor, client will get soundadvises on the critical areas like product design, production methods,product mix and so on.

iii) Seller can avail the finance from the factor (who pays up to 80% to 95%of the receivable value). The problem of additional working capital doesnot arise.

Illustration 1

‘A small firm has a total credit sales of Rs 80 lakh and its average collection period is80 days. The past experience indicates that bad-debt losses are around 1 per cent ofcredit sales. The firm spends about Rs 1,20,000 per annum on administering its credit sale.This cost includes salaries of one officer and two clerks who handle credit checking,collection, etc., telephone and telex charges.

These are avoidable cost& A factor is prepared to buy the firm’s reveivables. He willcharge 2 per cent commission. He will also pay advance against receivables to the firm atan interest rate of 18 per cent after withholding 10 per cent as reserve. What should thefirm do?

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Answer: Rs 80 lacs

Average level of Receivables = ———————————— x 80 days = Rs 17, 77,778 360 days

Factoring commission = 2% x 17,77,778 = Rs 35,556

Reserve = 10% x 17,77,777 = Rs 1,77,778

Advance available = Rs 17,77,778 – 35,556 = Rs15,64,444

Advance to be paid = Rs 15,64,444 – (18% x 15,64,444 x 80/360)

= Rs 15,01,866

Total factoring charges = Rs 35,556 x 360/80 = Rs 1,60,002(comm. + interest) = Rs 62,578 x360/80 = Rs 2,81,601

———————Rs 4,41,603

Less firms savingsCost of credit administration = 1,20,000Bad debts = 80,000 Rs2,00,000

—————Net cost on account of factoring Rs 2,41,603

==========Effective rate of return = 2,41,603 / 15,64,444 = 15.44%

Cost of factoring is 15.44% this can be compare to the other possible source of costand take the appropriate decision.

3.11.1 International Factoring

International Factoring means it is a comprehensive range of receivables management.International factoring is essential to an exporter who requires factoring services to relaxfrom the problems of collecting receivables in a foreign country and tensions arising fromthe unfamiliarity with customer’s credit worthiness.

Under this type of factoring generally four parties are involved (i) Exporter (seller),(ii)Factor in the exporter’s Country (iii) Importer and (iv) Factor in the Importer’s country.


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3.11.2 Forfaiting:

It means discounting of international trade receivable on 100% without recourse basis.Forfaiting is advantageous to the exporter who converts his export sales receivables intocash sales. Basically it is non-recourse and off-balance sheet financing. It eliminates allrisks from the exporter’s mind. Forfaiting acts as elimination of interest rate fluctuation asit involves upfront discounting.

3.12 LEASING AND HIRE PURCHASE

3.12.1 Leasing

Introduction:

Lease financing denotes procurement of assets through lease. Leasing business hasgot tremendous popularity in the USA and UK and spread to other countries includingIndia.. In India, the concept was pioneered in 1973 when the First Leasing Company wasset up in Madras. Lease as a concept involves a contract whereby the ownership, financingand risk taking of any equipment or asset are separated and shared by two or moreparties. Thus, the lessor may finance and lessee may accept the risk through the use of itwhile a third party may own it. Alternatively the lessor may finance and own it while thelessee enjoys the use of it and bears the risk. There are various combinations in which theabove characteristics are shared by the lessor and lessee.

A lease transaction is a commercial arrangement whereby an equipment owner ormanufacturer conveys to the equipment user the right to use the equipment in return for arental. In other words, lease is a contract between the owner of an asset (the lessor) and itsuser (the lessee) for the right to use the asset during a specified period in return for amutually agreed periodic payment (the lease rentals). The important feature of a leasecontract is separation of the ownership of the asset from its usage.

Lease financing is based on the observation made by Donald B. Grant: “Why own acow when the milk is so cheap? All you really need is milk and not the cow.”

As per the Accounting Standard 17 issued by the Institute of Chartered Accountantsof India, defines the term lease as “an agreement whereby a lessor conveys to the lessee,in return for rent, the right to use an asset for an agreed period of time.

Lease finance can be said to be ‘a contract between lessor and lessee whereby theformer acquires the equipment or goods or plant as required and specified by the lesseeand passes on the goods to the lessee for use for a specific place and in considerationpromises to pay the lessor a specified sum in a specified mode at specific interval and at aspecified place’.

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Features of Lease

The important features of lease contract are as follows

(a) the lease finance is a contract(b) the parties involved in the contract are lessor and lessee(c) the lease pertaining the specified period of time(d) the lessee uses the equipments under lease for a specified period of time(e) the lessee in consideration pays the lease rentals to the lessor(f) the lessor is the owner of the asset even though the asset is used by the lessee for

a specified period of time.

Types of Leases

Basically there are two types of leases namely (1) Financial Lease and (2) Operatinglease. The other types of lease depends upon the lease agreements which may be (3) saleand lease back (4) leveraged leasing and (5) sales aid leasing.

(1) Financial Lease

Long-term, non-cancelable lease contracts are known as financial leases. The essentialpoint of financial lease agreement is that it contains a condition whereby the lessor agreesto transfer the title for the asset at the end of the lease period at a nominal cost. At lease itmust give an option to the lessee to purchase the asset he has used at the expiry of thelease.

Under this lease the lessor recovers 90% of the fair value of the asset as lease rentalsand the lease period is 75% of the economic life of the asset. The lease agreement isirrevocable. Practically all the risks incidental to the asset ownership and all the benefitsarising there from are transferred to the lessee who bears the cost of maintenance, insuranceand repairs. Only title deeds remain with the lessor. Financial lease is also known as ‘capitallease’. In India, financial leases are very popular with high-cost and high technologyequipment.

(2) Operating Lease

An operating lease stands in contrast to the financial lease in almost all aspects. Thislease agreement gives to the lessee only a limited right to use the asset. The lessor isresponsible for the upkeep and maintenance of the asset. The lessee is not given any upliftto purchase the asset at the end of the lease period. Normally the lease is for a short periodand even otherwise is revocable at a short notice. Mines, Computers hardware, trucks andautomobiles are found suitable for operating lease because the rate of obsolescence is veryhigh in this kind of assets.


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Characteristics of Operating Lease

(1) The lease can be canceled by the lessee prior to its expiration.(2) The lessor is undertaking the maintenance and up keep the asset(3) The lessee is not given any right to purchase the asset at the end of the lease period(4) The sum of all the lease rental paid by the lessee need not provide for the recovery

of the cost of the assets(5) The lessor has the option to lease out the asset again to some other party.

(3) Sale and lease back:

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to aparty (the buyer), who in turn leases back the same asset to the owner in consideration oflease rentals. However, under this arrangement, the assets are not physically exchangedbut it all happens in records only. This is nothing but a paper transaction. Sale and leaseback transaction is suitable for those assets, which are not subjected depreciation butappreciation, say land. The advantage of this method is that the lessee can satisfy himselfcompletely regarding the quality of the asset and after possession of the asset convert thesale into a lease arrangement.

Under this transaction, the seller assumes the role of a lessee and the buyer assumesthe role of a lessor. The seller gets the agreed selling price and the buyer gets the leaserentals. It is possible to structure the sale at agreed value (below or above the fair marketprice) and to adjust difference in the lease rentals. Thus the effect of profit /loss on sale ofassets can be deferred.

(4) Leveraged Lease:

Under leveraged leasing arrangement, a third party is involved beside lessor andlessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from thethird party i.e., lender and the asset so purchased is held as security against the loan. Thelender is paid off from the lease rentals directly by the lessee and the surplus after meetingthe claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled todepreciation allowance associated with the asset.

(5) Sales aid leasing:

A leasing company will enter into an agreement with the seller, usually manufacturer ofthe equipment, to market the latter’s product through its leasing operations. The leasingcompany will also get commission for such sales, which add up to its profits.

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Advantages of leasing:

(1) From the view point of lesee:

(a) It permits the lessee for altenative use of funds without incurring huge capitalinvestment on an asset

(b) It helps to conserve the funds which can be used to improve the liquidity and canbe used for some other urgent purposes

(c) The lessee can get lease finance upto 100% of the cost(d) It is an easy method of financing capital asset having a heavy cost involved(e) lease rentals are deductible expenses for getting income tax benefits.

(2) From the view point of Lessor:

(a) It is an asset based financing for a productive purpose and it is safer than normalcourse of financing business.

(b) The Lessor can claim depreciation and will also enjoy the tax benefit(c) Lease rentals provide regular income and there is no liquidity problem.

Disadvantages from the leasing business

(1) The main disadvantage is accounting procedure and accounting guidelines(2) lease financing compare to other methods is costly for the lessee(3) The financial lease has all the rigidities of other methods of financing(4) As the lessee is not the owner of the asset generally he wound not take care the maintenance of the machine or equipment.

3.12.2 Hire Purchase

Hire purchase is a type of installment credit under which the hire purchaser, called thehirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repaymentof principal as well as interest, with an option to purchase. Under this transaction, the hirepurchaser acquires the property (goods) immediately on signing the hire purchase agreementbut the ownership or title of the same is transferred only when the last installment is paid.The hire purchase system is regulated by the Hire Purchase Act 1972.

This Act defines a hire purchase as “an agreement under which goods are let on hireand under which the hirer has an option to purchase them in accordance with the terms ofthe agreement and includes an agreement under which:

(1) The owner delivers possession of goods thereof to a person on condition that suchperson pays the agreed amount in periodic installments.

(2) The property in the goods is to pass to such person on the payment of the last ofsuch installments, and

(3) Such person has a right to terminate the agreement at any time before the propertyso passes”.


NOTES


Hire purchase should be distinguished from instalment sale wherein property passesto the purchaser with the payment of the first instalment. But in case of HP (ownershipremains with the seller until the last instalment is paid) buyer gets ownership after payingthe last instalment. HP also differs form leasing

Small scale firms can acquire industrial machinery, office equipment, vehicles, etc.,without making full payment through hire purchase. With the help of assets acquired throughhire purchase they can produce and sell. From the earning payments can easily be made ininstallments. Ultimately the ownership of assets can be acquired. Now several agencieslike National Small Industries Corporation (NSIC) provide machinery and equipment tosmall scale units on hire purchase basis and on lease basis. NSIC follows the followingHire Purchase procedure and Hire Purchase Scheme for financing plant and machinery tosmall scale units.

The concept of the hire purchase has been presented as below:

Source: lesson 15 Rekha Rani

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Difference Between Lease Financing and Hire Purchase

SUMMARY

Development Banks are basically financial agencies that provide medium and longterm funds and acts as catalytic agents in promoting balanced development of the country.Development Banks the name it self contain the development which means increase oraccelerate the growth of an economy which will leads to increase the Gross DomesticProduct. Therefore, Development banks take risks that ordinary banks will not.

Development Banks

(1) Industrial Development Bank of India (IDBI) (it became commercial bank from1st October 2004)

(2) Industrial Investment Bank of India (IIBI)(3) Industrial Financial Corporation of India (IFCI)(4) The Export Import Bank of India (EXIM)(5) Tourism Finance Corporation of India (TFCI)


NOTES


Refinance Institutions.

(1) Small Industrial Development Bank of India (SIDBI)(2) National Bank for Agriculture and Rural Development (NABARD)

Investment Institutions or Investment Banks

(1) Mutual Fund Companies (2) Pension Funds (3) Insurance Companies etc,

Note: we have elaborately discussed regarding above banks in the Unit V

Specialized Financial Institutions

(4) Infrastructure Development Finance Company (IDFC)(5) IFCI Venture Capital Funds(6) ICICI Venture Capital Fund

Apart from the above we also have state level institutions which are as follows:

(1) State Financial Corporations

(2) State Industrial Development Corporations (SIDC’s) etc,

By this time we have come across the concept of development bank and financial institutions.

SELF EXAMINATION QUESTION

Problem 1:

The past experience indicates that bad debt losses are 1.5% on sales. The expenditureincurred by the firm in administering its receivable collection efforts are Rs 5 lacs. A factoris prepared to buy the firm’s receivables by charging 2% commission. The factor will payadvance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% asreserve. Calculate the effective cost of factoring to the firm and effective interest rate to thefirm.

Problem 2

A factory needs equipment for use. It has the option of outright purchase or leasingthe equipment. Data are given below. Recommend the best option that the factory shouldchoose.Option I

Purchase outright for a cost of Rs 80 lacs. It is to be entirely financed by a term loan@ 18% p a. interest on outstanding payable on a yearly basis. The term loan to be repaidin eight equal instalments of Rs 10 lacs each, beginning from second year-end. The economic

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life of the equipment is assessed to be ten years. The equipment will be depreciated @10% p a on straight line basis, with insignificant salvage value at the end of the economiclife? The essential maintenance express would be as detailed below:

Year Maintenance Cost in Rs lacs1 4.002 4.403 4.884 5.475 6.186 7.057 8.118 9.419 11.0110 13.00

Option II

The equipment may be leased for a ten year period. The maintenance of the equipmentwill be done by the lessor. The lessee has to be pay Rs 8 lac annual rental at the beginningof each year over the lease period

Note: Assume that the lessee is in a tax bracket of 50% and average cost of capital ofthe lessee firm as 14% p a.

Present value table factor for discounting @ 14% pa given below may be used forready reference.

1 2 3 4 5 6 7 8 9 100.877 0.769 0.675 0.592 0.519 0.465 0.400 0.351 0.308 0.270

THEORY QUESTIONS

(1) Explain the list of Development and specialized banking institutions(2) Explain the Regional Rural Banks in India(3) Please explain term Venture capital and how it works(4) Who is a merchant banker? what is his role in the Indian Financial System?(5) Define the term lease and explain the leasing business(6) What do you mean Hire purchasing? Explain with suitable examples.(7) Distinguish between the hire purchase and leasing(8) What are the advantages we have in case of leasing and hirepurchase?(9) Explain the concept of factoring and its advantages(10) Explain the concept of factoring.(11) Write short note on ForfeitingInternational Factoring


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UNIT IV

NEW ISSUE MARKETS4.1 INTRODUCTION

Companies incorporated under the Companies Act, 1956 are generally mobilisingthe share capital and other long term loan funds from out side the organization for capitalformation. Generally the procurement of funds will take place through the securities marketwhich has two inter-dependent and inseparable segments namely New Issues Market andthe Secondary Market. The securities market, however, refers to the markets for thosefinancial instruments or claims that are commonly and readily transferable by sale.

4.2 LEARNING OBJECTIVES:

(1) Understand the new issue market and secondary market(2) After reading this you should be familiar with the primary stock market and

secondary market(3) Understand various methods of mobilization of funds through new issue.(4) Know the SEBI guidelines for investors protection.

4.3 NEW ISSUE MARKETS:

New issue market is also very often called as primary market. The primary marketfacilitates the channel for sale of new securities whereas the secondary market deals within securities previously issued. Companies mobilized the funds with the cheaper cost tomaximize the profit of the organization. To provide the funds for the new projects as wellas for the existing projects with the intention to expansion, or modernization, diversificationand up-gradation of the technology, companies choose the channel of primary market byissuing the new securities. The source of mobilizing the funds by issuing the securities canbe take place in any one of the following manner or on combination of all.

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No doubt the new issue market (NIM), become the predominant channel for financingcorporate sector investments in India after the liberalization of the capital market from theyear 1992.

New issue market can be defined as ‘a market that issues new securities on anexchange’. Companies, governments and other groups obtain financing through debt orequity based securities. Primary markets are facilitated by underwriting groups, which consistof investment banks that will set a beginning price range for a given security and thenoversee its sale directly to investors. As we know that only public limited companies canissue securities to public. Private limited companies should not issue their shares to public.

At this point of time it is worthy to know some thing about the Primary Stock Marketand Primary Stock Market.

4.3.1 Primary Stock Market

Primary stock market also called as public issues. New capital can be raise by issuingof equity shares, preference shares, debentures or Right Issues by corporates. Newlyfloated companies or existing companies may tap the equity market by offering publicissues. When equity shares are exclusively offered to the existing shareholders, it is called“Rights Issue”. When a Company after incorporation initially approaches the public for thefirst time for subscription of its public issue it is called Initial Public Officer (IPO). Thetransactions relating to the primary market i.e. public/rights issues are not carried out throughstock exchanges. However, there is an effective control of SEBI at every stage of publicissue. The successful floating of a new issue requires careful planning, timing of the issuewhich will be fulfilled by the specialized institutions such as Underwriters, merchant bankersand registrars of the issue.

4.3.2 Secondary Stock Market

Secondary market essentially provides platform for purchase and sale of securitiesby investors. The trading platform of stock exchanges is accessible only through brokersand trading of securities is confined only to stock exchanges. In fact the secondary marketconcept begins in the year 1850’s with the introduction of joint stock companies withlimited liability. The first stock exchange in India was established in the year 1875 by theNative share and stock brokers association now known as the Bombay Stock Exchange.

The Secondary Market deals with the sale/purchase of already issued equity/debtsby the corporates and others. The sale/purchase of these securities are carried out at thespecific Stock Exchange(s), where the companies get their public issues listed for trading.The main function of the secondary market is to provide liquidity to the listed securities byenabling a holder to easily convert the securities into cash through the stock exchanges.


NOTES


The secondary market also acts as an important indicator of the investment climate inthe economy. When prices of existing securities are rising and there is large trading in theexisting shares, such a boom in the secondary market correspondingly signifies that newissues if floated at that point of time would be successfully subscribed.

‘Differences between New Issue Market and Stock exchanges:

Functions of New issue market or primary market

The securities market provides a linkage between the savings and investment acrossthe entities, time and space. The securities market also mobilizes savings and channelisesthem through securities into preferred enterprises. We can list out the main functions of thenew issue market is as follows:

(1) Transfer of resources from savers to entrepreneurs: The main function of newissue market is to facilitate the transfer of funds from saving surplus units to entrepreneurswho are intended to start new business or expand existing one. Basically new issue marketserves the purpose of mobilizing funds directly or indirectly for those who require themfrom investors.

(2) Origination: It means that the work of investigation and analysis and processing ofnew proposals. Investigation and analysis of new issue can be performed by sponsors ofissues. Investigation means a careful study of technical, financial, and legal aspects of theissuing company. Sponsors to the issue will get adequate satisfaction because in the processof origination they may render some services which are in the nature of advisory they aredetermination of price and class of security to be issue, the time and place of issue, methodof flotation and technique of selling and so on.

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(3) Underwriting: New issue market easily gets underwriters to the issue due to theorigination. However, origination by it self will not guarantee the success of an issue.Underwriting an issue of shares or debentures involves entering into a contract with aperson known as underwriter, who may be an individual, partnership or company,undertaking that in the event of the shares or debentures not being subscribed by the publicor only a part of them being subscribed, he shall take up the balance. Simply underwritingprovided a form of guarantee for the new issue market in the event of risk arising from nonsubscription of public. The one of the important function of new issue market is underwritingfrom the company point of view as well as from the potential investor point of view.

(4) Distribution: the new issue process get complete only when the issuing companysuccessfully allot and distribute the securities to the investors. The sale of securities to theultimate investors can be described as distribution. This job successfully performed bybrokers and dealers in securities.

4.4 NEW ISSUE MARKET – ISSUE MECHANISM

The issue procedure in case of new issue is considered it is broadly based on thefollowing flow namely:

(i) Eligibility criteria(ii) Pricing of Issues(iii) Promoters contribution and lock in period(iv) Contents of offer document(v) Issue advertisement(vi) Initial Public Offer (IPO) and Public issue

i. E-IPOii. FPOiii. Issue of debt instrumentsiv. Book Building processv. Green Shoe Option

(vii) Right Shares(viii) Private Placement

i. Preferential Issuesii. Qualified Institutional Placements (QIP’s)iii. Issue of capital by designated financial institutioniv. OTCEI issues.

Eligibility Criteria:

The companies which are issuing their securities through offer document namelyprospectus in case of public issue or letter of offer in case of Right issue of shares has to


NOTES


compulsorily list their securities in the stock exchange(s) and need to full fill followingeligibility criteria’s:

(1) If the company going for public issue of securities in excess of Rs 50 lacs, a draftprospectus should be filed with the Securities and Exchange Board of India (SEBI)by their merchant banker at least 21 days prior to the date of filing it with theRegistrar of Companies. The same provision is applicable for right issue also, theonly difference is instead of prospectus, letter of offer has to file.

(2) All companies intending to issue shares and securities to public must enter into anagreement with a depository registered with the SEBI under the Securities andExchange Board of India (Depositories and Participants) Regulations, 1996.

(3) The eligibility norms differ based on the status of the company namely unlistedcompanies and listed companies in case of issue of equity shares and convertiblebonds are concerned.

4.4.1 Un-listed Companies – Initial Public Offer

Un-listed Company coming out with IPO has to compulsorily file offer documentwith SEBI and the Offer document to be filed with ROC for Registration purpose underSection 60 of the Companies Act.

However in the event of Un-Listed Company having a plan to raise money throughfriend and relatives, they can do so by way filing statement in lieu of prospectus undersection 70 of the Companies Act 1956. Every Unlisted Company coming out with IPOhas to make the initial listing application to the recognized stock exchange where they wantto list their securities. The same details to be mentioned in the offer document

Unlisted companies are allowed to issue their new issues in the public as initial publicoffer only when they satisfy the following conditions:

(1) The Net Tangible Assets of the new issue company at least Rs 3 crore in each ofthe preceding 3 full years, of which not more than 50% is held in monetary assets.

(2) The new issue company has to have track record of distributable profits in termsof Section 205 o the Companies Act for at least 3 out of the immediately 5 year.

(3) It has a net worth as per the audited balance sheet of at least Rs 1 crore in each ofthe preceding 3 full years

(4) If there is a change in the company’s name, at least 50% revenue for precedingone year should be earned from the new activity.

(5) The issue size should not exceed 5 times the pre-issue net worth.

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If the above conditions are not satisfied still the unlisted can company go for IPO bysatisfying the following two conditions

a. The issue is made through the book-building process with at least 50% of the netoffer to public being allotted to the qualified institutional buyer’s namely publicfinancial institutions, banks, mutual funds, foreign institutional investors registeredwith the SEBI, venture capital funds registered with the SEBI, insurance companiesregistered with IRDA, state industrial development corporations, provident fundwith minimum corpus of Rs 25 crore etc.

b. The minimum post issue face value of capital of the company would be Rs 10crore or there would be a compulsory market making for at least 2 years from thedate of listing of the shares.

Listed Companies – Public Issue

Listing means admission of the securities to dealings on a recognized stock exchange.The securities may be of any public limited company, Central or State Government, quasigovernmental and other financial institutions/corporations, municipalities, etc.

The objectives of listing are mainly to provide liquidity to securities; mobilize savingsfor economic development; protect interest of investors by ensuring full disclosures.

At this junction we have to under stand the initial public offer and public issue. InitialPublic Offer will issue by a new public limited company whereas public offer will issue bythe existing public limited company. Both the offers are inviting the public at large to investinto their securities.

The public limited company which is listed company is allowed to issue the securitiesin the public issue only when satisfies the following conditions

• The issue size in terms of the aggregate of the proposed issue and all previousissues made in the same financial year does not exceed 5 times its pre-issue networth as per the audited balance sheet of the last financial year.

• In case of name change of the issuer company within the last one year, the revenueaccounted for by the activity suggested by the new name should not be less than50% of its total revenue in the preceding one full financial year.

If the listed company not satisfied the above conditions still it can go for public issuethrough the process of Book Building.

The legibility criteria listed in the above not applicable for the following categoryentities, they are private limited companies, public sector banks, infrastructure companiesand listed companies in case of right issues.


NOTES


4.4.2 Pricing of Issues

Listed companies can quote the price freely for their securities and unlisted companieswhich is eligible to make public issue also freely can fix the price their securities. In case ofinitial public offer by an unlisted company if the issue price is Rs 500 or more per share, thesaid company would have discretion to fix the face value or par value per below 10 subjectto minimum of Re 1 per share, in other words the price is less than Rs 500, the face valuewould be Rs 10 per share. The same should clearly disclose in the offer document. If thecompanies already issued their shares at Rs 100 or Rs 10 per share as face value they canchange this standard denomination by splitting or consolidating them.

Any change in standard denomination can be permissible subject to the followingconditions

(1) The shares should not be issued in the denomination of fractions

(2) There should be one denomination for the shares of a company

(3) Any change in denomination is permissible only if article of association andmemorandum of association permit the same

(4) The company strictly follow the SEBI norms in this regard

Promoter’s contribution and lock in period

Promoter may be one who under takes to form a company with reference to a givenproject, and to set it going, and who takes the necessary steps to accomplish that purpose.Promoters are those persons who initiate the thought of incorporation of the company.They are the first persons to contribute into the given business. In case of public issue byunlisted companies the promoter’s contribution must be at least 20% of the post issuecapital. Similarly in case of public issue by listed companies promotes contribution shouldbe @20% of the proposed issue or share holding to the extent of 20% of the post issuecapital.

In any case promoters contribution in case of public issue must be minimum contributionof Rs 25,000 per individual and Rs 1 lac in case of firm and companies etc. the followingshare are generally not to consider for the purpose of finding out the minimum contribution.

(a) Bonus Shares

(b) Securities allotted to promoters by unlisted at price lower than price at whichoffered to public.

(c) Due to conversion of partnership firm into company promoters who are the partnersin the dissolved firm get the allotment lesser than the price at which they offer tothe public.

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Lock in period means the contribution of the promoters is remain untouched during aparticular period of time. It is essential to safe guard the public fund invested into the newissue company. In any case the minimum lock in period for the promoter’s contribution isfor a period of 3 years. In case of unlisted company promoter’s contribution is in excess ofthe required also has minimum lock in period of 1 year.

Contents of offer document

A public limited company has to compulsorily issue the prospectus to public where itis intended to issue securities to the public. Therefore initial public offer as well as publicissue for both purposes issue of prospectus compulsory. A offer document or prospectusas per section 2(36) of the Companies Act means ‘any document described or issued asprospectus and includes any notice, circular, advertisement or other document invitingdeposits form the public or inviting offers from the public for the subscription or purchaseof any shares or debentures of a body corporate.

As per section 56 of the Companies Act the contents of the prospectus has beenlisted out as follows. Its is only a illustrative list but not exhaustive.

(1) Name and address of registered office of the company

(2) Name of the stock exchange(s) where application for listing is made

(3) Declaration about refund of the issue if the minimum subscription of 90% is notreceived within 90 days form closure of the issue.

(4) Date of opening of the issue and date of closing of the issue

(5) Name and address of the auditors and lead managers

(6) Name and address of the underwriters and the amount underwritten by them

(7) Name and address of the trustees of the debenture trust deed in case of issue ofdebentures.

(8) Authorized, issued, subscribed and paid up capital, also paid up capital after thepresent issue or after conversion of debentures if any

(9) History and main objects and present business of the company, as also name andaddress of subsidiary if any.

(10)Promoters and their background.

(11)Nature of the business, size of the business and location of the business.

(12)Procedure and time schedule for allotment and issue of certificates.

(13)Issue of shares other than for cash.


NOTES


(14)Debentures and redeemable preference shares or other instruments issued but remaining outstanding on the date of the prospectus

(15)Rights of members regarding voting, dividend, lien on shares and the process ofrmodification of such rights and forfeiture of shares etc.

Issue advertisement

The term advertisement is so popular now days due to unchallengeable end lesscompetition and innovation in technology. The term advertisement can be defined as “anotice, brochures, pamphlets, circulars, show cards, catalogues, hoardings, placards,posters, insertions in news papers, pictures, films, cover pages of offer documents, or anyother print medium, radio, television programmes through any electronic medium”.

A lead merchant banker has to ensure the advertisement pattern for the new issue bycompliance with the guidelines framed thereon. In general issue advertisement shouldcomply the following compliances.

(1) Advertisement pattern should not mislead the potential investor

(2) It should be mirror of the offer document by disclosing all relevant information

(3) any thing which distract to the investor such as complex and ambiguity languageetc

(4) It should not motivate in such manner by giving guarantee regarding rapid growthin profit and in the business.

(5) Advertisement should not be in the form of run simultaneously with programmes ina narrow strip at the bottom of the television screen.

(6) If the data pertaining to financial matter it should show data for the past three yearsad include particulars relating to sales, gross profit, net profit, share capital andreserves and so on

(7) Advertisement should contain the risk factors in respect of the relevant new issue.

(8) No advertisement after 21 days from the date of filling the offer document with theSEBI till the close of the issue is to be issued, unless any risk factor required to bementioned in offer document are also mentioned in the advertisement.

(9) An announcement regarding closure of issue must be made only after lead merchantbanker is satisfied that at least 90% of the issue has been subscribed and a certificateto this extent also obtained from the registrar to the issue.

(10)Ensure that all legal requirements for the purpose of issue advertisement has beenfulfilled etc.

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Broadly we can identify the source of mobilization of funds for new issue by adoptingthe sound issue mechanism. In case of Initial Public Offer and Public Issue the methods bywhich the new issues can be made are as follows:

Initial Public Offer (IPO) and Public issue

• E-IPO• FPO• Issue of debt instruments• Book Building process• Green Shoe Option

4.4.3 Inirial Public offer (IPO)

This is a mechanism through which the companies are procured the funds to meettheir obligations. Funds can be raised through issue of prospectus to the general public atlarge. The price per share or security initially offer by the company may be at the facevalue of the securities or it may be at premium or at discount as the case may be. Toprevent any misstatement in the prospectus the Securities and Exchange Board of India(SEBI) has laid down the additional disclosure requirements as mandatory, they are

i. Name and registered office of the issuing companyii. Existing and proposed activities of the issuing companyiii. List of Board of directorsiv. Location of the industryv. Authorised, subscribed and proposed issue of capital to publicvi. Dates of opening and closing of subscription listvii. Name of Brokers, underwriters from whom application forms along with copies of

prospectus can be obtained.viii. Minimum subscription and so on so forth.

Issue of securities through IPO is costly. Issue of IPO involves the administrative costincluding printing the prospectus, advertisement, legal charges, consultancy charges,underwriting charges, brokerage charges, stamp duty, listing fee, registration charges andso on so forth’

4.4.3.1 E- IPO

In addition to the above normal IPO there is another system called initial public offerthrough stock exchange online system (E-IPO) is also available. This means to say that thenew issue company can issue securities to the public either trough the online system of thestock exchange or through the existing banking system. SEBI guidelines in this regardapplicable to those companies proposing to issue capital to public through the online systemof the stock exchange for offer of securities are listed below.


NOTES


(a) The company will have to first enter into an agreement with the stock exchangewhich must clearly address to resolve all kind of possible disputes.

(b) The company will have to appoint a registrar to the issue having electronicconnectivity with the stock exchange.

(c) The stock exchange intern must appoint stock brokers whose names alreadyregistered with SEBI and act as collection centers.

(d) During the period in which the issue open to for public subscription, applicantsmay approach brokers of the stock exchange trough which the securities are offeredthrough the online system to place an order

(e) The prospectus must clearly disclose list of all brokers appointed for the issuealong with the other intermediaries namely lead managers and registrars to theissue.

(f) The lead manager is responsible for entire operation to coordinate all activitiesamong various intermediaries who are connected in this issue.

4.4.3.2 Follow on Public Offering (FPO)

Follow on Public Offer means an offer of sale by listed companies to mobiles theirgrowth plans. Funds can be mobilised through FPO only highly reputed companies havinggood track record. Strictly speaking funds mobilsation through this channel is not worthydue to cumbersome procedural requirements and high cost and time. Now a days listedcompanies are preferring the Qualified Institutional Placement for mobilizing the funds.

Issue of debt instruments

Any corporate offering the issue of debentures which are convertible or nonconvertiblehas to fulfill the following requirement before the issue.

(1) Credit rating must be obtained from minimum two registered credit rating agenciespertaining to the issue of debt instrument and the same also mentioned in theprospectus also.

(2) Before issuing debts to the public the issuing company must appoint the debenturetrustees as per the provisions of the Companies Act and the same must be mentionedin the prospectus and in all subsequent communications sent to the debentureholders.

(3) With in the 3 months from the closure of the issue, a trust deed must be executedby the company infavour of the debenture trustees.

(4) A merchant banker has to ensure that the security created is adequate to cover theamount of debentures.

(5) In case of debentures obtained for the purpose of meeting the project finance thenthe debenture redemption reserve can be created up to the date of commercialproduction etc.

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4.4.3.3 Book Building

Book Building is basically a capital issuance process used in Initial Public Offer (IPO)which aids price and demand discovery. It is a process used for marketing a public offer ofequity shares of a company. It is a mechanism where, during the period for which the bookfor the IPO is open, bids are collected from investors at various prices, which are above orequal to the floor price. The process aims at tapping both wholesale and retail investors.The offer/issue price is then determined after the bid closing date based on certain evaluationcriteria.

As per the SEBI guidelines book building means ‘as a process under taken by whicha demand for the securities proposed to be issued by a body corporate is elicited and builtup and the price for such securities is assessed for the determination of the quantum of suchsecurities to be issued by means of a notice, circular, advertisement, document or informationmemorandum of offer document’.

Simply we can say that book building is process of price discovery. Book building isa process by which the issuer company before filing of the prospectus, builds-up andascertains the demand for the securities being issued and assesses the price at which suchsecurities may be issued and ultimately determine the quantum of securities to be issue. Inthe book building process, the book runner lead manager (BRLM) maintains a bookwherein the bids placed by individual and institutional investors through the syndicatemembers are recorded.

Book Building process:

(1) The Issuer (namely company) who is planning an IPO nominates a lead merchantbanker as a ‘book runner’ (namely merchant banker).

(2) The Issuer specifies the number of securities to be issued and the price band fororders.

(3) The Issuer also appoints syndicate members with whom orders can be placed bythe investors.

(4) The book runner prepares and submits the draft documents to the SEBI and obtainsan acknowledgement.

(5) The book runner also circulates the draft prospectus to invite the eligible syndicatemembers to join the syndicate of buyers.

(6) The syndicate members send the draft prospectus to their clients and obtain ordersfrom them for the securities.

(7) The final prospectus must be prepare and file with the Registrar of Companies(ROC) along with the procurement agreement

(8) The placement portion opens for subscription only after the prospectus is filed withthe ROC.

(9) The placement portion closes a day before the opening of the public issue portion.


NOTES


(10)Investors place their order with a syndicate member who inputs the orders intothe ‘electronic book’. This process is called ‘bidding’ and is similar to open auction.

(11)A Book should remain open for a minimum of 5 days.

(12)Bids cannot be entered less than the floor price.

(13)Bids can be revised by the bidder before the issue closes.

(14)On the close of the book building period the ‘book runner’ evaluates the bids onthe basis of the evaluation criteria which may include Price Aggression, Investorquality, Earliness of bids, etc.

(15)The book runner and the company conclude the final price at which it is willing toissue the stock and allocation of securities.

(16)Generally, the number of shares are fixed; the issue size gets frozen based on theprice per share discovered through the book building process.

(17)Allocation of securities is made to the successful bidders.

We will try to explain the entire process of the book building in the following charterin such a manner in a simplified manner.

Book-building options

Corporate sectors may raise capital in the primary market by way of an initial publicoffer, rights issue or private placement. An Initial Public Offer (IPO) is the selling of securitiesto the public in the primary market. This Initial Public Offering can be made through thefixed price method, book building method or a combination of both.

In case the issuer chooses to issue securities through the book building route then asper SEBI (Disclosure and Investor Protection) Guidelines, an issuer company can issuesecurities in two ways:

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(A) 75% Book Building Process: under this process 75% of public issue can beoffered to institutional investors through book building process and the balance25% of public issue can be offered to the public through prospectus and shall bereserved for allocation to individual investors who had not participated in biddingprocess.

(B) Offer to Public through Book Building Process:(i) 100% of the net offer to the public through the book building route. (or).(ii) 75% of the net offer to the public through the book building process and 25% of

the net offer to the public at the price determined through book building process.

100% book building means that entire issue is completed in a single stage, withouthaving to make a mandatory fixed price offering. The SEBI granted the permission to theissuer to go for 100 percent book building without offloading any portion of the issue in themarket. The main condition here is the size of the issue has to be at least Rs 25 crore andthe issue has to be fully underwritten.

Generally the 100% book building process is in the form of demat and the allotmentin the stipulated proportions to the various categories of investors for example not less than50% for qualified institutional investors and not less than 25% for the retail segment andbalance portion for the non institutional investors. The lead manage has enlarge theiroperations and increase the concentration on nation wide to collect bids, due to retailparticipation in the bid. The 100% book building process will takes place quickly becausethe public offering and allotment process would take place through the stock exchangenetwork.

In case of 75% book building, process can be sub divided into two parts namely theplacement portion and the public portion (ie the net issue offer to the public). The placementportion means a portion of the issue offered to the pubic through the syndicate by way ofthe book building process. Underwriters, merchant bankers, financial institutions, brokersand high net worth individual etc can be called as syndicate. The public portion means theoffer to the public, it can be viewed as retail offering. The price applicable to the publicoffer is arrived from the book building process. This 75% book building is available to allcorporates but only the condition is the size of the issue should not be less than Rs 100crore and underwriting is must to the extent of net offer to the public.

For example we will present here, how Bombay Stock Exchange (BSE) will functionin the case of book building.

BSE offers the book building services through the Book Building software that runson the BSE Private network.

This system is one of the largest electronic book building networks anywhere spanningover 350 Indian cities through over 7000 Trader Work Stations via eased lines, VSATsand Campus LANS.


NOTES


The software is operated through book-runners of the issue and by the syndicatemember brokers. Through this book, the syndicate member brokers on behalf of themselvesor their clients’ place orders.

Bids are placed electronically through syndicate members and the information iscollected on line real-time until the bid date ends.

In order to maintain transparency, the software gives visual graphs displaying price v/s quantity on the terminals

Merits of Book Building process

Book Building option is a good concept and represents a capital market which is inthe process of maturing. It provides to the issuer, intermediary and investor the followingbenefits or merits.

(1) Book building enables issuers to assess the demand and price for their issue.(2) The process cost for issuing the securities under building will reduce(3) Investors will be benefited at large because they can easily trust the price at which

the syndicate members have purchased the shares.(4) The price fixed through book building is reliable and the possibility of price falling

bellow par after listing is rare.(5) There would be no uncertainties as the issue is pre-sold(6) The issuer company can save advertisement and brokerage commissions(7) Investors have a voice in the pricing of issue(8) The issue price per share is market driven. Therefore reduction in the price below

par is also remote.(9) Transparency in allocation of funds is possible.(10)Book –building provides a good liquid and buoyant after market, etc.

Demerits of Book Building process

We have the following demerits also in case of new issue through book buildingprocess.

(1) Book building is use full to those issuers who are coming with large number ofshares and value

(2) The book building process works efficiently in matured market conditions, whereaswe are not have so matured market where the investor need to understand thevarious parameters affecting the market price.

(3) Transparency may not be available because Issuer Company may bias the syndicatemembers.

llustration: X Limited issued shares of Rs 100 each amounting to Rs1,000 crores.The company appointed a merchant banker as book – runner, who collected informationfrom various investors to book building purposes. The quoted price of various investorsto their syndicate members are as follows:

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Hence, the price will be calculated as per the weighted average price method as follows

(95x100) + (98x500) + (101x100) + (100x200) + (99x100)Weighted average price = ———————————————————————————

1,000

= Rs 98.50 per share

This means that the price is derived and recorded by the Issue manager namely bookrunner. Therefore, the same price is also finalise by the issuer company as issue price.

Difference between shares offered through book building and offer of shares throughnormal public issue:

4.4.3.4 Green Shoe Option:

Green shoe option means an option of allocating shares in excess of the sharesincluded in the public issue. Green shoe option is extensively used in international InitialPublic Offers as stabilization toll for post listing price of the newly issued shares. It hasbeen introduced in the Indian Capital market in Initial Public Offers using book buildingmethod. SEBI has introduced this option with a view to boost investor’s confidence byarresting the speculative forces which work immediately after the listing. Therefore, greenshoe option will ensure the price stability.

As per the SEBI (Disclosure & Investor Protection) Guidelines, 2000 the green shoeoption mechanism work as follows: some of the guidelines are mentioned below.


NOTES


(1) Issuing company is going for IPO of equity shares through Book building process,the said company can avail the green shoe option.

(2) The company so particular about the issue of green shoe option has to pass theresolution to this effect authorizing the public issue.

(3) The company has to appoint one of the lead manager (book runner) amongst theissue management team, as the Stabilizing Agent (SA).

(4) The Stabilized Agent in turn enter into a contract with issuer company, prior tofiling of offer document with SEBI, clearly stating all the terms and conditionsrelating to this option including the fee incurred by SA for this purpose.

(5) Issuer Company is allowed to accept oversubscription, subject to 15% of theoffer made to public.

(6) The Red Herring prospectus and the final prospectus shall contain the all theinformation as required by the SEBI namely, Name of the SA, The maximumnumber of shares allotted, the maximum amount of funds to be received and use ofthese additional funds and the same has to file with Registrar of Companies.

(7) The money received from the applicants against the over all allotment in the greenshoe option shall be kept in the separate bank account designated for this purpose.

(8) The excess money receive from the public must be returned within 2 working daysafter the close of the stabilization period.

(9) The register in respect of each issue having the green shoe option maintain by theS A must be preserved for the period of further 3 years

(10)All such other requirements from time to time required by the SEBI have to file.

4.4.3.5 Right Issues

This is the cheap way of raising finance. It is an issue of shares in which the existingshareholders have a pre-emptive right to subscribe for the new shares. In case of rightissue no prospectus is issued instead, existing equity shareholders are given right in proportionto the existing holding which entails them to take up a specified number of shares at astipulated price. The price for the share so offered is usually below listed price to make theoffer attractive.

As per section 81 of the Companies Act, 1956 a company increase its subscribedcapital by the issue of new shares, either after two years of its formation or after one yearof first issue of shares whichever is earlier, these have to be first offered to the existingshareholders with a right to renounce them in favour of a nominee. A company can do soby passing a special resolution to the same effect. In general these right shares can beissued by the company based on two reasons namely when the company is in need of cashto carry out existing operations and share price of the company are likely to fall since thesame amount of profit will be distributed to more number of shareholders.

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Advantages of Right issues

• Underwriting commission is low in case of right issues are concerned• Share holder have right on issue at low price generally lower than the market price.• Investor maintains his proportionate ownership in the case of right issue.

This process we can explain with the help of the following example:

Illustration: X Limited has 1,00,000 equity shares outstanding and it plans to issue20,000 new shares, then the number of rights needed to buy each new share is 5 (ie1,00,000/20,000). Suppose an investor hold 4,000 shares in the X Ltd. (ie 4%) hasenough right to buy 800 shares (ie 4,000/5) of the new share. Up on subscribing to thenew issue, the investor’s proportionate ownership is same 4% (ie 4,800/1,20,000).

4.5 PRIVATE PLACEMENT

The corporate sectors also find the avenues for mobilization of funds in addition to theabove for their new issue. In this process we will discuss the private placement for fundmobilization as one of the source. The private placement may be in the form of

• Preferential Issues• Qualified Institutional Placements (QIP’s)• Issue of capital by designated financial institution• OTCEI issues.

4.5.1 Preferential Issues

Preferential issue means is an issue of shares or convertible securities by listedcompanies to a select group of persons under section 81 (IA) of the Companies Act, 1956which is neither a right issue nor a public issue. Right issue or pubic issue generallyrequires more legal compulsions. Hence, many companies opt for preferential allotment ofshares for raising funds through private placements. These shares are generally allotted tothe promoters, foreign partners, technical collaborators and private equity funds. Approvalfrom the share holder must to issue the preferential shares.

Preferential share holders have the preferential right in respect of a claim on availableassets before the ordinary share holders. Issuer Company may issue the following types ofpreferential shares.

• Cumulative and Non-cumulative preferential shares• Cumulative Convertible preferential shares• Participating and Non-participating preferential shares• Redeemable and Irredeemable preferential shares


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The Companies Act, 1956 prohibits the issue of any preferential shares which isirredeemable or is redeemable after the expiry of a period of twenty years from the date ofissue.

4.5.2 Qualified Institutional Placements (QIP’s):

Qualified institutional Placement is an additional mode of mobilizing the funds by thelisted companies from the domestic market. A listed company which fulfils the requirementof minimum public share holding as per the listed agreement after that it can place on aprivate placement basis specified securities with the Qualified Institutional Buyers only.These securities include shares and other convertible or nonconvertible securities excludingwarrants.

The Qualified Institutional Buyers (QIB’s) are those institutional investors who aregenerally possess knowledge, experience to evaluate and invest in the capital market. Asper the SEBI guidelines qualified institutional buyers may be viewed as follows;

• Public Financial Institution as defined in section 4A of the Companies Act• Scheduled Commercial Banks• Mutual Funds• Foreign Institutional Investors (FII’s) registered with SEBI• Multilateral and Bilateral Development Financial Institutions• Venture Capital Funds registered with SEBI• State Industrial Development Corporations• Insurance Companies registered with the Insurance Regulatory ad Development

Authority• Provident Funds with minimum corpus of Rs 25 crores• Pension Funds with minimum corpus of Rs 25 crores• As per the SEBI guidelines the above said QIB’s are entitled to participate in the

primary issuance process

4.5.3 Issue of capital by designated financial institution

Designate Financial Institutions (DFI’s) coming to capital market for mobilization offunds trough an offer document has to comply the guidelines framed by the SEBI in thisregard. These are briefly discussed herein.

• In case of DFI’s there is no minimum requirement of promoter’s contribution.• DFI is allowed to allot the shares out of the proposed issue only to their permanent

employees including Managing Director or fulltime directors maximum of 20 sharesper employee.

• The DFI’ s has to have a good track record of consistency profitability in 3 out ofimmediately 5 preceding years.

• The offer document of DFI should contain the present equity and equity capitalafter conversion in the case of fully convertible debentures or partly convertibledebentures.

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• If the FDI’s issuing he new financial instruments for mobilizing funds such as deep-discount bonds, debentures with warrants, secured premium notes and so on shouldtake adequate steps to disclose in the offer document.

• All other factors that have been taken into account by the issuer namely (DFI’s).

4.5.4 OTCEI issues

Corporate sectors mobilizing the funds by issuing their equity shares or convertiblesecurities in an initial public offer by selecting the channel of Over The Counter Exchangeof India has to comply the following requirements.

(1) Shares and securities offer for sale through OTCEI resulting from a boughtout deal(BOD) are exempted from pricing norms specified for unlisted companies onlywhen the promoters would retain minimum 20% of the total issued capital with alock in period of 3 years from the date of allotment of securities in the proposedissue and two market makers are appointed in accordance with the guidelinesframed by the OTCEI in this regard.

(2) The companies issued capital from Rs 30 lacs to 3 crores has to make a minimumpublic offer 10% or Rs 20 lacs in face value whichever is higher.

(3) All other conditions from time to time required by the appropriate authority.

4.6 SEBI (DISCLOSURE AND INVESTOR PROTECTION) GUIDELINES’2000:

The new issue market has been regulated by SEBI in terms of SEBI guidelines theseare changed many times since inception in 1992 due to inconsistencies, market developmentad changing needs of the capital market and so on. SEBI Guidelines 2000 provides us acomprehensive frame work of primary capital issues by the companies.

These guidelines are applicable to all public issues by listed and unlisted companies,all offers for sale and right issues exceeding Rs 50 lacs by listed companies whose equityshare capital is listed. At the same time these guidelines are not applicable to a bankingcompany, Public Sector Banks, Infrastructure companies and right issue by a listed company.We have discussed relevant guidelines in the above at appropriate places.

Investor Education and Protection Fund

With the help of section 205C of the Companies Act, 1956 the Central Governmentof India empowers to form ‘the Investor Education and Protection Fund’. This fund iscreated with the amount of unpaid dividend accounts of companies, the application moneyreceived by the companies for allotment of securities and due for refund, unclaimed matureddeposits with the companies, interest accrued on the above items, grants given by the stateand central government of India and so on. This fund shall be utilized only for the purposeof investor’s awareness and protection of the investor interest.


NOTES


Summary

Generally the procurement of funds will take place through the securities marketwhich has two inter-dependent and inseparable segments namely New Issues Market andthe Secondary Market. The securities market, however, refers to the markets for thosefinancial instruments or claims that are commonly and readily transferable by sale.

To provide the funds for the new projects as well as for the existing projects with theintention to expansion, or modernization, diversification and up-gradation of the technology,companies choose the channel of primary market by issuing the new securities. The sourceof mobilizing the funds by issuing the securities can be take place in any one of the followingmanner or on combination of all.

The issue procedure in case of new issue is considered it is broadly based on thefollowing flow namely:

• Eligibility criteria• Pricing of Issues• Promoters contribution and lock in period• Contents of offer document• Issue advertisement• Initial Public Offer (IPO) and Public issue

E-IPO FPO Issue of debt instruments Book Building process Green Shoe Option

• Right Shares• Private Placement

Preferential IssuesQualified Institutional Placements (QIP’s)Issue of capital by designated financial institutionOTCEI issues

As per the SEBI guidelines book building means ‘as a process under taken by whicha demand for the securities proposed to be issued by a body corporate is elicited and builtup and the price for such securities is assessed for the determination of the quantum ofsuch securities to be issued by means of a notice, circular, advertisement, document orinformation memorandum of offer document’.

Self Examination Questions:

(1) Explain the concept of Primary and Secondary Market(2) Explain the Initial Public Offer

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(3) Please explain the concept of Book Building and its importance in the case of newissue market.

(4) Write short note on

Right SharesE-IPOFPOIssue of debt instrumentsGreen Shoe Option

(5) Explain the SEBI guidelines regarding new issue of shares.


NOTES


UNIT V

MUTUAL FUNDS

5.1 INTRODUCTION

The small investors who generally lack expertise to invest on their own in the securitiesmarket use to say that ‘don’t put trust in money, put your money in trust’. In generalcommon investor is not competent enough to understand the intricacies of stock market.This is where mutual funds come to the rescue.

A mutual fund is a group of investors operating through a fund manager to purchase adiverse portfolio of stocks or bonds. Mutual funds are highly cost efficient and very easyto invest in. One of the most advantageous factor in the mutual fund is, it reduce the risk bydiversification and maximize the returns due to professional expertise of fund managersemployed by it.

Diversification means spreading out money across many different types of investments.When one investment is down another might be up. Hence, diversification of investmentholdings reduces the risk tremendously.

As per the definition of the Association of Mutual Funds in India (AMFI) “A mutualfund is a trust that pools the savings of a number of investors who share common financialgoal. Anybody with an investible surplus of as little as a few thousand rupees can invest inmutual funds. These investors buy units of a particular mutual fund scheme that has adefined investment objective and strategy”.

The term Mutual Fund also defined by the SEBI Regulations as “Mutual Fund meansa fund established in the form of a trust to raise monies through the sale of units to thepublic or a section of public under one or more schemes for investing in securities, inaccordance with Regulations”.

Mutual Fund creates the wealth of the investor and acts simply as financial intermediarythat allows a group of investors to pool their money together with a predetermined investmentobjective. When you invest in a mutual fund, you are buying shares or portion of the mutualfund and become a shareholder of the fund.

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The concept of Mutual Fund business started in India since 1963 with the formationof Unit Trust of India (UTI). We can elucidate the history of Mutual Funds in India intofour distinct phases.


1.Understand the concept of mutual funds2.Understand the SEBI regulation regarding mutual funds3.Understand the Credit Rating concept for mutual funds4.After learning this you should be in a position to advice profitable investments.5.Understand the various types of insurances available to minimize the risk and losses.

5.3 MUTUAL FUNDS IN INDIA

Phase 1

During 1964 to 1987 the only one company in India ruled the mutual fund businessnamely the Unit Trust of India. UTI maintained its monopoly and experienced a constantgrowth till 1987. The first scheme launched by Unit Trust of India was Unit Scheme 1964(US 64).

We are proud to say that Master Share was the first Indian offshore fund launched bythe UTI which was listed on the London Stock Exchange in the year 1986. At the end ofthe financial year 1987-88, the Unit Trust of India had Rs 6,700 crores of assets under itsmanagement.

Phase 2

During 1987 – 1993 the mutual fund business was taken over by various public sectorundertakings namely banks, Insurance Companies and so on. In this process the StateBank of India Mutual Fund was established in the year 1987 followed by Canbank MutualFund in the year 1989, Bank of India in the year 1990, Bank of Baroda Mutual Fund in theyear 1992, Life Insurance Corporation of India established its Mutual Fund business in theyear 1989 and General Insurance Corporation of India had also set up its Mutual Fundbusiness in the year 1990. At the end of the financial year the entire mutual fund industryhad assets under management of Rs 47,004 crores.

Phase 3

In the history of mutual funds a new era was started with the entry of private sectorsin the mutual funds industry during 1993 – 2003. During this period private domestic andforeign players were allowed in the mutual fund industry.

The erstwhile Kohtari Pioneer (now merged with Franklin Templeton) was the firstprivate sector mutual fund registered in July 1993. It is important to note that in the year1993 The Securities Exchange Board of India (SEBI) notified regulations bringing all mutual


NOTES


funds except UTI under a common regulatory frame work by issuing the Mutual FundRegulations.

The 1993 SEBI (Mutual Fund) Regulations was substituted by a more comprehensiveand revised Mutual Fund Regulations in 1996. The Mutual Fund industry now functionsunder the SEBI (Mutual Fund) Regulations 1996. As at the end of January 2003, therewere 33 mutual funds with total assets of Rs1, 21,805 crores out of this the Unit Trust ofIndia alone with Rs 44,541 crores of assets under its management.

Phase 4

During this phase (ie after the year 2003) the flow of funds into the mutual fundsindustry sharply increased. This positive growth in the mutual funds is due to tax benefitsand improvement in quality of investor service and so on and so forth.

In 2003, following the repeal of the Unit Trust of India Act, 1963 UTI was bifurcatedinto two separate entities. One is the Specified Undertaking of the Unit Trust of India withassets under its management of Rs.29,835 crores as at the end of January 2003,representing broadly, the assets of US 64 scheme.

These specified undertaking functions under an administrator and under the rulesframed by Government of India and does not come under the purview of the Mutual FundRegulations. The other one is called the UTI Mutual Fund Limited, sponsored by the StateBank of India, Punjab National Bank, Bank of Baroda, and Life Insurance Corporation ofIndia.

It is registered under the Securities Exchange Board of India and functions under theMutual Fund Regulations. The entire mutual funds industry assets under management as atthe end of financial year 2006-2007 is Rs 3,26,388 which occupies major portion of theIndian economy. As a whole mutual funds industry provides many advantages due to itsnature and size of the business.

5.4 ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS

5.4.1 Advantages of Mutual Funds

(1) Professional Management

In general we may not have the skill to find good stocks that suit our risk and returnand more over we find it difficult to find the time to track our investments but still wantreturns that can be had from equities. Hence, this need is successfully full filled by our fundmanager who will take care of our investments. A fund manager is an investment specialist,who provides us an in-depth understanding of the various securities and bonds.

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(2) Small Investments

Mutual Funds are very advantageous to those investors whose savings are very smallsay Rs 1,000 to 5,000 per month. These investors if they want to buy directly GovernmentSecurities which comes to minimum Rs 25,000 or to buy blue chip companies shareswhich also need more investment, thus mutual fund gives you an ownership by investing thesame Rs 1,000 to 5,000. That is; the mutual fund pools the savings from several investorsand invest the same at large into the number of securities.

(3) Diversified Portfolio

Mutual Funds invest in a number of companies across a broad cross-section ofindustries and sectors. This diversification reduces the risk because seldom all investmentsdecline at the same time and in the same proportion. In other words, don’t put all youreggs in one basket. The rationale for this is that even if one investment in your portfolioturns bad, the other investments will mitigate this loss.

(4) Liquidity

In open ended schemes, investors can get their money back promptly at net assetvalue related prices from the mutual fund itself within three to five working days from thedate of putting the request for redemption. In case of close ended schemes, investors cansell their units on a stock exchange at the prevailing market price or avail of the facility ofdirect repurchase at net asset value (NAV) related prices.

(5) Tax Benefits

There are many more tax saving mutual funds available and in fact dividends distributedby the mutual fund company are tax free in the hands of the investor. Mutual Fund alsogives us the advantage of capital gain taxation. If we hold units beyond one year, we get thebenefit of indexation.

(6) Convenient Administration

Basically Mutual Fund reduce paper work and help investors to avoid many problemssuch as delayed payment, unnecessary follow up with brokers and companies and so on.More over Mutual Funds save investors time and make investing easy and convenient.

(7) Return Potential

Mutual Fund gives us a constant potential growth in our investments due to theirportfolio management. Return on investments in Mutual Fund is relatively less when wecompare with the investments in to primary market as well as secondary market.


NOTES


(8) Low Costs

Mutual Funds are relatively less expensive to invest compared to directly investing incapital markets. Large scale operation results in lower costs such as brokerage, custodialand other fees.

(9) Transparency

Investors will get regular information through periodical account statement.

(10) Investors Protection

All Mutual Funds are registered with Securities and Exchange Board of India (SEBI)and they function with the provision of strict regulations designed to protect the interests ofinvestors. The operations of mutual funds are regularly monitored by SEBI.

5.4.2 Disadvantages of Mutual Fund

No doubt mutual funds are good investment vehicles to over come the complex andunpredictable changes which takes place in the financial market. However, even mutualfunds have some inherent disadvantages.

(1) No Assured Returns

Returns from Mutual Funds as a matter of fact depend on the securities and debtmarket. If the securities market is doing well then automatically the mutual funds industrywill also do well. That’s why mutual fund companies always says “mutual funds are subjectto market risk”. In addition, mutual funds are not insured or guaranteed by any governmentbody unlike a bank deposit. There are strict norms for any fund that assures returns and itis now compulsory to establish that they have resources to back such assurances.

(2) Restrictive Gains

We know that risk is low in case of mutual funds, which causes low return. Afundamental concept is “low risk and low return”.

(3) Expensive

Cost incurred in operating mutual funds include advisory fees, trustee fees, agentscommission, custodial fee and audit fees, transfer agent fees etc., from the AssetManagement point of view. From the investor point of view there may be entry load andexit load. For Example if an investor invests say Rs 10,000 in a scheme that charges a 2%entry load (also called Front-end Load) at a net asset value of Rs 10 per unit, the publicoffer price will be calculated as follows:

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Like wise, if the investor wants to repurchase (redeem) the mutual fund there may beexit load (also called Back-end Load) assume for example 2% then investor will get onlyRs 9.80 per unit.

(4) Poor Fund Management

Due to lack of professional knowledge and experience of the fund manager someschemes are performing poorly and fund managers being unaccountable for poor results.

(5) Excessive Diversification

Excessive diversification of portfolio results in losing focus on securities of key segments.Moreover, too much concentration on blue chip securities which are high priced and whichdo not offer more than average return.

(6) Switch over fees

Generally funds impose a switch over fee or transaction cost as a charge on transferof investment from one scheme to another within the same mutual fund company and alsoto switch over from one scheme to another within the same scheme.

Types of Mutual Funds:

Every scheme is bound by the investment objectives outlined by it in its prospectus,which determine the class or classes of securities it can invest in. As we know that theconcept of mutual fund is the portfolio management. Hence, in the process of diversificationof risk the fund manager will invest the pooled money into various sectors. Based on theasset classes, broadly speaking, the following types of mutual funds currently operate in theIndian Financial Market.


NOTES


5.5 TYPES OF MUTUAL FUNDS

(1) Equity Funds

Equity Funds are also called growth funds. The main objective of growth funds iscapital appreciation over the medium to long term. They invest most of the corpus inequity shares with significant growth potential and they offer higher return to investors inthe long run. Most equity funds are general in nature, and can invest in the entire basket ofstocks available in the market. They assume the risk associated with equity investments.There is no guarantee or assurance of returns. These schemes are usually close-endedand listed on stock exchanges.

(2) Debt Funds

Debt Funds are also called income funds. The main objective of income funds is toprovide safety of investments and regular income to investors. Such funds invest only indebt instruments, and are good option for investors, averse to take risk associated withequities. Such funds invest predominantly in income bearing instruments like bonds,debentures, Gilt-funds and commercial paper and so on. The return as well as risk islower in Debt Funds compared to equity funds.

(3) Balanced Funds

The main objective of Balanced Funds is to provide both capital appreciation andregular income. It means to say that balanced funds, whose investment portfolio includesboth debt and equity. As a result, from the risk point of view, they fall somewhere betweenequity and debt funds so as the portfolio is balanced. Balanced funds are the ideal mutualfund vehicle for investors who prefer spreading their risk across various instruments. TheNet Asset Value (NAV) of balanced funds is likely to be less volatile than the equity funds.

Mutual Fund Schemes

We can classify the mutual funds based on the objectives, functions and structure inthe following categories.

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(1) Open-ended mutual funds

An open ended mutual fund is a fund which continuously offers to sell and repurchaseits units at NAV related prices. The fund itself buy back the units surrendered and is readyto sell new units. Open-end funds keep some portion of their assets in short-term andmoney market securities to provide available funds for redemptions. A large portion ofmost open ended mutual funds is invested in highly liquid securities, which enables the fundto raise money by selling securities at prices very close to those used for valuations. Theseopen ended funds do not have fixed corpus fund which may increase or decrease dependingupon the purchase or redemption of units by investors.

(2) Close-ended Mutual Funds

Close-ended mutual funds are those mutual funds which has fixed corpus fund and astipulated maturity period ranging from 3 to 5 years. Primary example of such mutual fundis UTI Master Share. Investors can invest in the scheme at the time of the initial publicissue and thereafter they can buy or sell the units of the scheme on the stock exchangeswhere they are listed. The scheme remains open for a period not exceeding 45 days fromthe date of launch. The market price of the close-end funds is determined by supply anddemand and not by net asset value. It is so because if an investor sells units directly to thefund, he cannot enter the fund again, as units bought back by the fund cannot be reissued.

(3) Money Market Mutual Funds

These funds invest in short term debt securities in the money market like certificate ofdeposits, commercial papers, government treasury bills and so on. The objective of suchfunds is high liquidity with low rate of return. In practice, companies use to invest in thesefunds to park their short-term funds as a part of their financial management.

(4) Large Cap Funds and Mid Cap Funds

Large Cap Funds are those mutual funds, which seek capital growth by investingprimarily in the shares of large blue chip companies. These large cap funds can be namedas growth funds. Generally companies with a market capitalisation in excess of Rs 1,000crores are considered as large cap companies. Companies with a market capitalisationless than Rs 1,000 crores but more than Rs 500 crores generally considered Mid Capcompanies. Mutual Fund companies’ investments into these companies are called largecap funds and Mid Cap Funds respectively. Of course there is no hard and fast rule todecide the large cap and Mid Cap.

(5) Tax Saving Schemes

To motivate the investor’s tax rebate scheme these mutual funds emerged. Theseschemes offer various options like income, growth or capital appreciation. Equity Linked


NOTES


Savings Schemes (ELSS) and pensions schemes can be quote as examples for tax savingschemes.

(6) Load Funds and No Load Funds

Load means a charge or commission at the time of purchase or sale of mutual funds.It means to say that each time we buy or sell units in the fund, a commission will bepayable. Typically entry and exit loads range from 1% to 2%. It could be worth payingthe load, if the fund has a good performance track record. No Load Fund do not chargea commission at the time of purchase or sale of units. That is, each time you buy or sellunits in the fund, no commission will be payable.

(7) Gilt Funds

Gilt Funds means which deal exclusively in government securities. Reserve Bank ofIndia in fact encouraged setting up of gilt funds with a view to create a wider investor basefor government securities.

(8) Index Schemes

Index Schemes means that attempt to replicate the performance of particular indexsuch as the Bombay Stock Exchange (BSE) Sensex or the National Stock Exchange -50(NSE-50). An index fund is a mutual fund which invests in securities in the index on whichit is based namely BSE Sensex or NSE-50.

(10) Sectoral Schemes

Sectoral funds means the funds invest in specific core sectors like energy,telecommunications, Information Technology, Construction, Transportation, and FinancialServices.

(11) Exchange Traded Funds (ETF’s)

Exchange Traded Funds are index funds listed on stock exchanges and trade likeindividual stocks on the stock exchanges. The investment objective of an ETF is to achievethe same return as a particular market index. The ETF’s rely on an arbitrage mechanism tokeep the prices at which they trade roughly in line with the net asset values of their underlyingportfolios.

(12) Fund of Funds

Fund of Funds means a mutual fund that invests in other mutual funds. It means to saythat a Mutual fund company invests in a number of different securities on combination ofequity and debt of other mutual funds. Fund of Funds are designed to achieve greaterdiversification than traditional mutual funds.

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(13) Off-shore Funds

Off-shore Funds are those funds which attract foreign capital for investment in thecountry of the issuing company. They are also called cross border funds which lead toincrease in foreign currency and foreign exchange reserves. Such funds invest in securitiesof foreign companies with the Reserve Bank of India permission. The first Off-shore fundin India namely The India Fund was launched by the Unit Trust of India in the year 1986.

(14) Real Estate Mutual Funds (REMF’s)

Real Estate funds generally are classified as close ended mutual funds which investpredominantly in real estate and properties. These funds allow retail investors a chance toparticipate in the booming real estate business.

(15) Gold Exchange Traded Fund

Securities and Exchange Board of India granted permission in the year 2006, tointroduce the Gold Exchange Traded Fund (GETF) schemes by mutual funds. Thesefunds are permitted to invest into Gold, Gold related instruments. In India, investment ingold is a preferred avenue, hence GETF’s should be aimed at gold investors who candiversify the portfolio and increase their income.

(16) Systematic Investment Plans (SIP’s)

Under the systematic investment plan investors are allowed to invest in the equity andequity oriented mutual fund schemes a fixed sum of money periodically. This scheme giveshigher returns if the investor has a long term investment plan.

5.6 NET ASSET VALUE

The performance of a particular scheme of a mutual fund is denoted by Net AssetValue.

Therefore, the net asset value of the fund is the cumulative market value of the assetsof the fund net of its liabilities. As per the Association of Mutual Funds in India (AMFI),“Net Asset Value (NAV) is the market value of the assets of the scheme minus its liabilities.Per unit of NAV is the net asset value of the scheme divided by the number of units outstandingon the valuation date”.

NAV can be calculated as follows


NOTES


For example: If the market value of the securities of a mutual fund scheme is Rs 400 lacsand the mutual fund has issued 20 lacs units of Rs 10 each to the investors, then the NAVper unit of the fund is Rs 20.

The Net Asset Value is required to be disclosed by the mutual funds on a regular basisnamely daily or weekly depending up on the type of scheme.

There are following running expenses are charged directly to the scheme which affectsits Net Present Value. They are selling and distribution expenses, Brokerage charges,Registration charges, Audit fees, Custodian fees, Cost of Advertisement and investorcommunication. We can visualize some expenses which are affecting the Net Present Value(NAV). They are penalties and interest for violation of rules and regulations, Generaladministrative expenses not for any particular scheme, depreciation on fixed assets and soon.

5.7 SEBI (MUTUAL FUND) REGULATIONS, 1996

Mutual Fund – institutional set up

Institutional Set up of the Mutual fund can be described as a set up in the form of atrust, which has Sponsor, Trustees, Asset Management Company (AMC), and Custodian.Thus why, our elders use to say “put not your trust in money, put your money in trust”.

Sponsors:

As per definition of SEBI (Mutual Fund) Regulations “sponsor” means any personwho, acting alone or in combination with another body corporate, establishes a mutualfund. The sponsor of a mutual fund is akin to the promoter of a company as he gets thefund registered with the SEBI. The registration will be granted by the SEBI only onfulfillment of the following conditions.

(a) Sound Track Record:

The sponsor should have a sound track record and general reputation of fairness andintegrity in all his business transactions. For the purposes of this clause “sound track record”shall mean the sponsor should:

NOTES


DBA 1749

1. be carrying on business in financial services for a period of not less than five years;and

2. The net worth is positive in all the immediately preceding five years; and3. the net worth in the immediately preceding year is more than the capital contribution

of the sponsor in the asset management company; and4. the sponsor has profits after providing for depreciation, interest and tax in three out

of the immediately preceding five years, including the fifth year.

(b) SEBI approval for existing Mutual Fund: in the case of an existing mutual fund,such fund is in the form of a trust and the trust deed has been approved by the Board.

(c) Sponsors Contribution: the sponsor has contributed or contributes at least 40% tothe net worth of the asset management company:

Provided that any person who holds 40% or more of the net worth of an asset managementcompany shall be deemed to be a sponsor and will be required to fulfill the eligibility criteriaspecified in these regulations.

(d) Persons Employed by the Sponsors: the sponsor or any of its directors or theprincipal officer to be employed by the mutual fund should not have been guilty of fraud orhas not been convicted of an offence involving moral turpitude or has not been found guiltyof any economic offence.

(e) Appointment of Trustees, AMC and Custodians: Sponsors has to take care theactivities like appointment of trustees to act as trustees for the mutual fund in accordancewith the provisions of the regulations; appointment of asset management company (AMC)to manage the mutual fund and operate the scheme of such funds in accordance with theprovisions of these regulations; appointment of a custodian in order to keep custody of thesecurities and carry out the custodian activities as may be authorized by the trustees.

Trustees

As per the definition of SEBI (Mutual Fund) Regulations “trustees” mean the Boardof Trustees or the Trustee Company who hold the property of the Mutual Fund in trust forthe benefit of the unit-holders. The trustees have the power of superintendence and controlover the asset management company. They monitor the performance and compliance ofregulations by the mutual fund.

A mutual fund shall be constituted in the form of a trust and the instrument of trust shallbe in the form of a deed, duly registered under the provisions of the Indian RegistrationAct, 1908 (16 of 1908), executed by the sponsor in favour of the trustees named in suchan instrument.


NOTES


Contents of trust deed1. The trust deed shall contain such clauses as are mentioned in the Third Schedule

and such other clauses which are necessary for safeguarding the interests of theunitholders.

2. No trust deed shall contain a clause which has the effect of—(i) limiting or extinguishing the obligations and liabilities of the trust in

relation to any mutual fund or the unitholders; or(ii) indemnifying the trustees or the asset management company for

loss or damage caused to the unitholders by their acts of negligenceor acts of commission or omission.

Rights and obligations of the trustees

1. The trustees and the asset management company shall with the prior approval ofthe Board enter into an investment management agreement.

2. The investment management agreement shall contain such clauses as are mentionedin the Fourth Schedule and such other clauses as are necessary for the purpose ofmaking investments.

3. The trustees shall have a right to obtain from the asset management company suchInformation as is considered necessary by the trustees.

4. The trustees shall ensure before the launch of any scheme that the asset managementCompany, has, —

a. systems in place for its back office, dealing room and accounting;

b. appointed all key personnel including fund manager(s) for the scheme(s)and submitted their bio-data which shall contain the educationalqualifications, past experience in the securities market with the trustees,within 15 days of their appointment;

c. appointed auditors to audit its accounts;

d. appointed a compliance officer who shall be responsible for monitoringthe compliance of the Act, rules and regulations, notifications, guidelines,instructions, etc., issued by the Board or the Central Government and forredressal of investors grievances;

e. appointed registrars and laid down parameters for their supervision;

f. prepared a compliance manual and designed internal control mechanismsincluding internal audit systems;

g. specified norms for empanelment of brokers and marketing agents.

The compliance officer appointed under clause (d) of sub-regulation (4) shallimmediately and independently report to the Board any non-compliance observed by him.

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5. The trustees shall ensure that an asset management company has been diligent inempanelling the brokers, in monitoring securities transactions with brokers andavoiding undue concentration of business with any broker.

6. The trustees shall ensure that the asset management company has not given anyundue or unfair advantage to any associates or dealt with any of the associates ofthe asset management company in any manner detrimental to interest of theunitholders.

7. The trustees shall ensure that the transactions entered into by the asset managementcompany are in accordance with these regulations and the scheme.

8. The trustees shall ensure that the asset management company has been managingthe mutual fund schemes independently of other activities and have taken adequatesteps to ensure that the interest of investors of one scheme are not beingcompromised with those of any other scheme or of other activities of the assetmanagement company.

9. The trustees shall ensure that all the activities of the asset management companyare in accordance with the provisions of these regulations.

10. Where the trustees have reason to believe that the conduct of business of themutual fund is not in accordance with these regulations and the scheme they shallforthwith take such remedial steps as are necessary by them and shall immediatelyinform the Board of the violation and the action taken by them.

11. Each trustee shall file the details of his transactions of dealing in securities with theMutual Fund on a quarterly basis.

12. The trustees shall be accountable for, and be the custodian of, the funds and propertyof the respective schemes and shall hold the same in trust for the benefit of theunitholders in accordance with these regulations and the provisions of trust deed.

13. The trustees shall take steps to ensure that the transactions of the mutual fund arein accordance with the provisions of the trust deed.

14. The trustees shall be responsible for the calculation of any income due to be paidto the mutual fund and also of any income received in the mutual fund for theholders of the units of any scheme in accordance with these regulations and thetrust deed.

15. The trustees shall obtain the consent of the unitholders—

a. Whenever required to do so by the Board in the interest of the unitholders; orb. Whenever required to do so on the requisition made by three-fourths of the

unitholdersof any scheme; orc. When the majority of the trustees decide to wind up or prematurely redeem the

units.

16. The trustees shall ensure that no change in the fundamental attributes of any schemeor the trust or fees and expenses payable or any other change which would modifythe scheme and affects the interest of unitholders, shall be carried out unless,—

a. a written communication about the proposed change is sent to eachunitholder andan advertisement is given in one English daily newspaperhaving nationwide circulation as well as in a newspaper published in the


NOTES


language of region where theHead Office of the mutual fund is situated;and

b. the unitholders are given an option to exit at the prevailing Net Asset Valuewithout any exit load.

17 The trustees shall call for the details of transactions in securities by the key personnelof the asset management company in his own name or on behalf of the assetmanagement company and shall report to the Board, as and when required.

18 The trustees shall quarterly review all transactions carried out between the mutualfunds, asset management company and its associates.

19 The trustees shall 22[quarterly] review the networth of the asset managementcompany and in case of any shortfall, ensure that the asset management companymake up for the shortfall as per clause (f) of sub-regulation (1) of regulation 21.

20 The trustees shall periodically review all service contracts such as custodyarrangements, transfer agency of the securities and satisfy itself that such contractsare executed in the interest of the unitholders.

21 The trustees shall ensure that there is no conflict of interest between the manner ofdeployment of its net worth by the asset management company and the interest ofthe unitholders.

22 The trustees shall periodically review the investor complaints received and theredressal of the same by the asset management company.

23 The trustees shall abide by the Code of Conduct as specified in the Fifth Schedule.24 The trustees shall furnish to the Board on a half-yearly basis,—

a. a report on the activities of the mutual fund;b. a certificate stating that the trustees have satisfied themselves that there

have been no instances of self-dealing or front running by any of the trustees,directors and key personnel of the asset management company;

c. a certificate to the effect that the asset management company has beenmanaging the schemes independently of any other activities and in case anyactivities of the nature referred to in sub-regulation (2) of regulation 24 havebeen undertaken by the asset management company and has taken adequatesteps to ensure that the interests of the unitholders are protected.

25 The independent trustees referred to in sub-regulation (5) of regulation 16 shallgive their comments on the report received from the asset management company

Disqualification from being appointed as trustees

No person shall be eligible to be appointed as a trustee unless—

a. he is a person of ability, integrity and standing; andb. has not been found guilty of moral turpitude; andc. has not been convicted of any economic offence or violation of any securities

laws;

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d. No asset management company and no director (including independent director),officer or employee of an asset management company shall be eligible to beappointed as a trustee of any mutual fund.

e. No person who is appointed as a trustee of a mutual fund shall be eligible to beappointed as a trustee of any other mutual fund:

Provided that any mutual fund which is not in compliance with sub-regulation (3) or(4) as at the commencement of the Securities and Exchange Board of India (Mutual Funds)(Fifth Amendment) Regulations, 2006 shall ensure compliance therewith within three monthsfrom such commencement

f. Two-thirds of the trustees shall be independent persons and shall not be associatedwith the sponsors or be associated with them in any manner whatsoever.

5.8 ASSET MANAGEMENT COMPANY

As per the definition of the SEBI (Mutual Fund) Regulations “asset managementcompany” means a company formed and registered under the Companies Act, 1956 (1 of1956) and approved as such by the SEBI under its regulations. Every mutual fund isrequired to have an Asset Management Company and should enter into an agreement withthe trustees of the mutual fund to formulate schemes, raise money against units, invest thefunds in accrued securities and after meeting the permissible costs as per norms, distributeincome to the share holders of the fund.

Appointment of an asset management company

1. The sponsor or, if so authorised by the trust deed, the trustee, shall appoint anasset management company, which has been approved by the Board under sub-regulation (2) of regulation 21.

2. The appointment of an asset management company can be terminated by majorityof the trustees or by seventy-five per cent of the unitholders of the scheme.

3. Any change in the appointment of the asset management company shall be subjectto prior approval of the Board and the unitholders.

Eligibility criteria for appointment of asset management company

For grant of approval of the asset management company the applicant has to fulfil thefollowing :—

a. in case the asset management company is an existing asset management companyit has a sound track record, general reputation and fairness in transactions.

Explanation : For the purpose of this clause sound track record shall mean the net worthand the profitability of the asset management company;

b. the directors of the asset management company are persons having adequateprofessional experience in finance and financial services related field and not found


NOTES


guilty of moral turpitude or convicted of any economic offence or violation of anysecurities laws;

c. the key personnel of the asset management company 26[have not been foundguilty of moral turpitude or convicted of economic offence or violation of securitieslaws for any asset management company or mutual fund or any intermediaryregistration has been suspended or cancelled at any time by the Board;

d. the board of directors of such asset management company has at least fifty percent directors, who are not associate of, or associated in any manner with, thesponsor or any of its subsidiaries or the trustees;

e. the Chairman of the asset management company is not a trustee of any mutualfund;

f. the asset management company has a networth of not less than rupees ten crores:

Provided that an asset management company already granted approval under the provisionsof Securities and Exchange Board of India (Mutual Funds) Regulations, 1993 shall withina period of twelve months from the date of notification of these regulations increase itsnetworth to rupees ten crores :

Provided further that the period specified in the first proviso may be extended in appropriatecases by the Board up to three years for reasons to be recorded in writing:

Provided further that no new schemes shall be allowed to be launched or managed bysuch asset management company till the networth has been raised to rupees ten crores.

Explanation : For the purposes of this clause, “networth” means the aggregate of thepaid up capital and free reserves of the asset management company after deductingtherefrom miscellaneous expenditure to the extent not written off or adjusted or deferredrevenue expenditure, intangible assets and accumulated losses.

The Board may, after considering an application with reference to the matters specified insub-regulation (1), grant approval to the asset management company.

Terms and conditions to be complied with

The approval granted under sub-regulation (2) of regulation 21 shall be subject to thefollowing conditions, namely:—

a. any director of the asset management company shall not hold the office of thedirector in another asset management company unless such person is an independentdirector referred to in clause (d) of sub-regulation (1) of regulation 21 and approvalof the Board of asset management company of which such person is a director,has been obtained;

b. the asset management company shall forthwith inform the Board of any materialchange in the information or particulars previously furnished, which have a bearingon the approval granted by it;

NOTES


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c. No appointment of a director of an asset management company shall be madewithout prior approval of the trustees;

d. The asset management company undertakes to comply with these regulations;e. no change in the controlling interest of the asset management company shall be

made unless,—

i. prior approval of the trustees and the Board is obtained;

ii. a written communication about the proposed change is sent to eachunitholder and an advertisement is given in one English daily newspaperhaving nationwide circulation and in a newspaper published in the languageof the region where the Head Office of the mutual fund is situated; and

a. the unitholders are given an option to exit on the prevailing Net Asset Value withoutany exit load;

b. The asset management company shall furnish such information and documents tothe trustees as and when required by the trustees.

Asset Management Company and its obligations as per SEBI (Mutual Fund)Regulations

1. The asset management company shall take all reasonable steps and exercise duediligence to ensure that the investment of funds pertaining to any scheme is notcontrary to the provisions of these regulations and the trust deed.

2. The asset management company shall exercise due diligence and care in all itsinvestment decisions as would be exercised by other persons engaged in the samebusiness.

3. The asset management company shall be responsible for the acts of commission oromission by its employees or the persons whose services have been procured bythe asset management company.

4. The asset management company shall submit to the trustee’s quarterly reports ofeach year on its activities and the compliance with these regulations.

5. The trustees at the request of the asset management company may terminate theassignment of the asset management company at any time.

Provided that such termination shall become effective only after the trustees have acceptedthe termination of assignment and communicated their decision in writing to the assetmanagement company.

6. Notwithstanding anything contained in any contract or agreement or termination,the asset management company or its directors or other officers shall not be absolvedof liability to the mutual fund for their acts of commission or omission, while holdingsuch position or office.

7. The Chief Executive Officer (whatever his designation may be) of the assetmanagement company shall ensure that the mutual fund complies with all theprovisions of these regulations and the guidelines or circulars issued in relationthereto from time to time and that the investments made by the fund managers are


NOTES


in the interest of the unit holders and shall also be responsible for the overall riskmanagement function of the mutual fund.

8. The fund managers (whatever the designation may be) shall ensure that the fundsof the schemes are invested to achieve the objectives of the scheme and in theinterest of the unit holders.

9. An asset management company shall not through any broker associated with thesponsor, purchase or sell securities, which is average of 5 per cent or more of theaggregate purchases and sale of securities made by the mutual fund in all its schemes

Provided that for the purpose of this sub-regulation, the aggregate purchase and saleof securities shall exclude sale and distribution of units issued by the mutual fund :

Provided further that the aforesaid limit of 5 per cent shall apply for a block of any threemonths.

An asset management company shall not purchase or sell securities through any broker[other than a broker referred to in clause (a) of sub-regulation (7)] which is average of 5per cent or more of the aggregate purchases and sale of securities made by the mutual fundin all its schemes, unless the asset management company has recorded in writing thejustification for exceeding the limit of 5 per cent and reports of all such investments are sentto the trustees on a quarterly basis:

Provided that the aforesaid limit shall apply for a block of three months.

10. An asset management company shall not utilise the services of the sponsor or anyof its associates, employees or their relatives, for the purpose of any securitiestransaction and distribution and sale of securities :

Provided that an asset management company may utilise such services if disclosure to thateffect is made to the unitholders and the brokerage or commission paid is also disclosed inthe half-yearly annual accounts of the mutual fund :

Provided further that the mutual funds shall disclose at the time of declaring half yearlyand yearly results :

i. any underwriting obligations undertaken by the schemes of the mutual funds withrespect to issue of securities associate companies,

ii. devolvement, if any,

iii. subscription by the schemes in the issues lead managed by associate companies,

iv. subscription to any issue of equity or debt on private placement basis where thesponsor or its associate companies have acted as arranger or manager.

NOTES


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11. The asset management company shall file with the trustees the details of transactionsin securities by the key personnel of the asset management company in their ownname or on behalf of the asset management company and shall also report to theBoard, as and when required by the Board.

12. In case the asset management company enters into any securities transactions withany of its associates a report to that effect shall be sent to the trustees at its nextmeeting.

13. In case any company has invested more than 5 per cent of the net asset value of ascheme, the investment made by that scheme or by any other scheme of the samemutual fund in that company or its subsidiaries shall be brought to the notice of thetrustees by the asset management company and be disclosed in the half-yearly andannual accounts of the respective schemes with justification for such investment[provided the latter investment has been made within one year of the date of theformer investment calculated on either side]

14. The asset management company shall file with the trustees and the Board—a. detailed bio-data of all its directors along with their interest in other

companies within fifteen days of their appointment;b. any change in the interests of directors every six months; andc. a quarterly report to the trustees giving details and adequate justification

about the purchase and sale of the securities of the group companies of thesponsor or the asset management company, as the case may be, by themutual fund during the said quarter.

15. Each director of the asset management company shall file the details of histransactions of dealing in securities with the trustees on a quarterly basis inaccordance with guidelines issued by the Board.

16. The asset management company shall not appoint any person as key personnelwho has been found guilty of any economic offence or involved in violation ofsecurities laws.

17. The asset management company shall appoint registrars and share transfer agentswho are registered with the Board :

Provided if the work relating to the transfer of units is processed in-house, the chargesat competitive market rates may be debited to the scheme and for rates higher than thecompetitive market rates, prior approval of the trustees shall be obtained and reasons forcharging higher rates shall be disclosed in the annual accounts.

18. The asset management company shall abide by the Code of Conduct as specifiedin the Fifth Schedule.

Custodian

As per the definition of the SEBI (Mutual Fund) Regulations “custodian” means aperson who has been granted a certificate of registration to carry on the business of custodianof securities under the Securities and Exchange Board of India (Custodian of Securities)Regulations, 1996.


NOTES


Appointment of custodian

1. The mutual fund shall appoint a Custodian to carry out the custodial services forthe schemes of the fund and sent intimation of the same to the Board within fifteendays of the appointment of the Custodian; in case of a gold exchange traded fundscheme, the assets of the scheme being gold or gold related instruments may bekept in custody of a bank which is registered as a custodian with the Board.

2. No custodian in which the sponsor or its associates hold 50 per cent or more ofthe voting rights of the share capital of the custodian or where 50 per cent ormore of the directors of the custodian represent the interest of the sponsor or itsassociates shall act as custodian for a mutual fund constituted by the same sponsoror any of its associates or subsidiary company.

Agreement with custodian

The mutual fund shall enter into a custodian agreement with the custodian, which shallcontain the clauses which are necessary for the efficient and orderly conduct of the affairsof the custodian:

Provided that the agreement, the service contract, terms and appointment of the

custodian shall be entered into with the prior approval of the trustees.

5.9 SEBI (MUTUAL FUND) REGULATIONS, 1996

General Obligations:

Some of the general obligations as per the SEBI (Mutual Fund)

Regulations, 1996 reproduced below.

(1) Proper books of account and records, etc.

Every asset management company for each scheme shall keep and maintain properbooks of account, records and documents, for each scheme so as to explain its transactionsand to disclose at any point of time the financial position of each scheme and in particulargive a true and fair view of the state of affairs of the fund and intimate to the Board theplace where such books of account, records and documents are maintained. Every assetmanagement company shall maintain and preserve for a period of Eight years its books ofaccount, records and documents.

(2) Restrictions on issue expenses

All expenses should be clearly identified and appropriated in the individual schemes.The Asset Management Company may charge the mutual fund with investment and advisoryfees which are fully disclosed in the offer document subject to the following namely:—

NOTES


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i. One and a quarter of one per cent of the weekly average net assets outstanding ineach accounting year for the scheme concerned, as long as the net assets do notexceed Rs. 100 crores, and

ii. One per cent of the excess amount over Rs. 100 crores, where net assets socalculated exceed Rs. 100 crores.

For schemes launched on a no load basis, the asset management company shall beentitled to collect an additional management fee not exceeding 1% of the weekly averagenet assets outstanding in each financial year.

In addition to the above, recurring expenses including:—i. marketing and selling expenses including agents’ commission, if any ;ii. brokerage and transaction cost ;iii. registrar services for transfer of units sold or redeemed ;iv. fees and expenses of trustees ;v. audit fees ;vi. custodian fees ;vii. costs related to investor communication ;viii. costs of fund transfer from location to location ;ix. costs of providing account statements and dividend/redemption cheques

and warrants ;x. Insurance premium paid by the fund;xi. Winding up costs for terminating a fund or a scheme;xii. Costs of statutory advertisements(xii.a) In case of a gold exchange traded fund scheme, recurring expenses incurred

towards storage and handling of gold;(xii.b) In case of a capital oriented scheme, rating fees; and(xiii) Such other costs as may be approved by the Board.

The total expenses of the scheme excluding issue or redemption expenses, whetherinitially borne by the mutual fund or by the asset management company, but including theinvestment management and advisory fee shall be subject to the following limits :—

i. On the first Rs. 100 crores of the average weekly net assets 2.5%;ii. On the next Rs. 300 crores of the average weekly net assets 2.25%;iii. On the next Rs. 300 crores of the average weekly net assets 2.0%;iv. On the balance of the assets 1.75%:

Provided that such recurring expenses shall be lesser by at least 0.25% of the weeklyaverage net assets outstanding in each financial year in respect of a scheme investing inbonds:

Provided further that in case of a fund of funds scheme, the total expenses of the schemeincluding the management fees shall not exceed 0.75% of the daily or weekly average net


NOTES


assets, depending upon whether the NAV of the scheme is calculated on daily or weeklybasis.

Any expenditure in excess of the limits specified in sub-regulation (6) shall be borneby the asset management company or by the trustee or sponsors.

(3) Declaration of dividends:

A mutual fund may declare dividends in accordance with the offer document andsubject to such Guidelines as may be specified by the Board.

(4) Despatch of warrants and proceeds:

Every mutual fund and asset management company shall,a. despatch to the unitholders the dividend warrants within 30 days of the declaration

of the dividend;b. despatch the redemption or repurchase proceeds within 10 working days from

the date of redemption or repurchase;c .in the event of failure to despatch the redemption or repurchase proceeds within

the period specified in sub-clause (b), the asset management company shall beliable to pay interest to the unitholders at such rate as may be specified by theBoard for the period of such delay;

d. otwithstanding payment of such interest to the unit-holders under sub-clause(c),the asset management company may be liable for penalty for failure todespatch the redemption or repurchase proceeds within the stipulated time.

(5) Annual Report:

Every mutual fund or the asset management company shall prepare in respect of eachfinancial year an annual report and annual statement of accounts of the schemes and thefund as specified in Eleventh Schedule.

(6) Auditor’s report:

Every mutual fund shall have the annual statement of accounts audited by an auditorwho is not in any way associated with the auditor of the asset management company.

Explanation: For the purposes of this sub-regulation and regulation 66 “auditor”means a person who is qualified to audit the accounts of a company under section 224 ofthe Companies Act, 1956 (1 of 1956). An auditor shall be appointed by the trustees. Theauditor shall forward his report to the trustees and such report shall form part of the AnnualReport of the mutual fund.

The auditor’s report shall comprise the following: —

i. Auditor has obtained all information and explanations which, to the best of hisknowledge and belief, were necessary for the purpose of the audit ;

NOTES


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ii the balance sheet and the revenue account give a fair and true view of the scheme,state of affairs and surplus or deficit in the Fund for the accounting period to whichthe Balance Sheet or, as the case may be, the Revenue Account relates ;

iii. the statement of account has been prepared in accordance with accounting policiesand standards as specified in the Ninth Schedule.

(7) Annual Report to the investors:

The scheme wise Annual Report of a mutual fund or an abridged summary thereofshall be mailed to all unitholders as soon as may be but not later than six months from thedate of closure of the relevant accounting year. The Annual Report and abridged summarythereof shall contain details as specified in the Eleventh Schedule and such other details asare necessary for the purpose of providing a true and fair view of the operations of themutual fund:

Provided that the abridged scheme wise annual report mailed to unitholders need notcontain full portfolio disclosure but must contain details on group company investmentssuch as the name of the company, the amount of investment made in each company of thegroup by each scheme and the aggregate investments made by all schemes in the groupcompanies of the sponsor.

(8) Notice before inspection and investigation:

Without prejudice to the provisions of regulation 55, the Board shall have the powerto appoint an auditor to inspect or investigate, as the case may be, into the books ofaccount or the affairs of the mutual fund, trustee or asset management company: Providedthat the Auditor so appointed shall have the same powers of the inspecting officer as statedin regulation 61 and the obligation of the mutual fund, asset management company, trustee,and their respective employees in regulation 63, shall be applicable to the investigationunder this regulation.

(9) Show cause notice and order:

On receipt of the report from the enquiry officer, the Board shall consider the sameand issue to the mutual fund, trustees or Asset Management Company, a show-causenotice. The mutual fund, asset management company or trustee, shall within fourteen daysof the date of the receipt of the show-cause notice, send a reply to the Board.

The Board, after considering the reply of the mutual fund, trustees or asset managementcompany, if any, shall as soon as possible pass such order as it deems fit. The Board shallsend to the mutual fund, trustees, or Asset Management Company, a copy of the ordermade under regulations.


NOTES


(10) Effect of suspension or cancellation of certificate of registration

On and from the date of the suspension of the certificate or the approval, as the casemay be, the mutual fund, trustees or asset management company, shall cease to carry onany activity as a mutual fund, trustee or asset management company, during the period ofsuspension, and shall be subject to the directions of the Board with regard to any records,documents, or securities that may be in its custody or control, relating to its activities asmutual fund, trustees or asset management company.

(11) Action against intermediaries

The Board may initiate action for suspension or cancellation of registration of anintermediary holding a certificate of registration under section 12 of the Act who fails toexercise due diligence or to comply with the obligations under these regulations; Providedthat no such certificate of registration shall be suspended or cancelled unless the procedurespecified in regulations applicable to such intermediary is complied with.

Illustration 1: A mutual fund that had a net asset value of Rs 10 at the beginning of month-t made income and capital gain distribution of Re 0.05 and Re 0.04 per share respectivelyduring the month, and then ended the month with a net asset value of Rs 10.03. Calculatemonthly return.

Answer:Monthly Return on the Mutual Fund = r

(NAVt - NAV t-1) + Income at the time‘t’ + Capital Gainr = ———————————————————————

NAV t-1

(Rs 10.03 – Rs 10.00) + Re 0.05 + Re 0.04 = —————————————————————— = 0.012

Rs 10.00 = 1.20% per month or 14.40% per annum

Illustration 2: The unit price of TSS Scheme of a mutual fund is Rs 10. The public offerprice of the unit is Rs10.204 and the redemption price Rs 9.80. Calculate (i) Front – endload and (ii) Back – end Load.

Answer:(i) Calculation of Front-end Load

Net Asset ValuePublic offer price = —————————————————

1 – Front-end load

NOTES


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1010.204 = ——————————

1 – Front-end load

10.204 (1 – Front-end load) = 10

Front end load = 0.204 / 10.204 = Rs 0.01999 or 2%

(ii) Calculation of back end load

Net Asset ValueRedemption price = ———————————

1- back end load

109.80 = — ————————

1- Back end load

9.80 (1 - Back end load) = 10

Back end load = 0.20 / 9.80 = 2.04%

Illustration 3: Mr. A has invested in three Mutual Fund schemes as per detailed below:

Date of investment 01.12.2003 01.01.2004 01.03.2004

Amount of investment Rs 50,000 Rs 1,00,000 Rs 50,000

Net Asset Value at entry date Rs 10.50 Rs 10 Rs 10

Dividend received up to 31.03.2004 Rs 950 Rs 1,500 Rs Nil

NAV as at 31.03.2004 Rs 10.40 Rs 10.10 Rs 9.80

Required; what is the effective yield on per annum basis in respect of each of the threeschemes to Mr. A up to 31.03.2004.

Answer:

MF X MF Y MF ZRs Rs Rs

Investment 50,000 1,00,000 50,000No. of units 4,761.905 10,000 5,000Unit NAV on 31.3.2004 10.40 10.10 9.80Total NAV on 31.03.2004 49,523.81 1,01,000 49,000


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Increase or (decrease) of NAV (476.19) 1,000 (1,000)Dividend Received 950 1,500 NilTotal yield 473.81 2,500 (1,000)Number of days 122 91 31Effective yield per annum 2.835% 10.027% (24%)

5.10 MUTUAL FUNDS AND CREDIT RATING

Credit rating has occupied vital place in the modern and developed financial markets.The issuer of long term source of fund, long term debt, debentures, bonds, fixed depositand commercial paper, including mutual funds need to have the credit rating not only to getreliability from the others but also to fulfill the legal requirements such as SEBI and RBI.

The Benefits of credit rating to the mutual funds

For the Investor, the Ratings:• Facilitate informed investment decision making• Provide independent and reliable opinion on:

• the relative credit quality of the portfolio• the quality of the Fund’s management and operations

• Help meet specific investment objectives

For the Intermediaries, the Ratings help to:

• Provide informed advice to investors• Offer products matching the specific return-risk preferences of investors• Enhance the marketability of various schemes• Differentiate (using the ICRA Rating) the various Schemes from other Rated/

non-Rated Schemes

For the Fund Sponsors/AMCs, the Ratings:

• Provide an assessment made by an independent agency• Serve as a marketing tool to differentiate a scheme from other available schemes• Help meet investors’ rating requirements• Provide for benchmarking of performance

ICRA Mutual Fund Credit Risk Ratings: Scale and Definitions ICRA’s Long-Term Debt Fund Credit Risk Rating Scale: This scale is used to rate the underlyingcredit risk of debt funds portfolio on the long term rating scale

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Notes:

For the rating categories mfAA through to mfC the sign of + (plus) or - (minus)may be appended to the rating symbols to indicate their relative position within the ratingcategories concerned. Thus, the rating of mfAA+ is one notch higher than mfAA, whilemfAA- is one notch lower than mfAA.

ICRA’s Short-Term debt fund Credit Risk Rating Scale: This scale applies todebt funds with weighted average maturity up to one year. Such funds would generallyinclude liquid funds and cash funds. Benchmark maturity for this scale is 12 months.


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Notes:

For the short-term fund ratings of mfA1 through to mfA4, the sign of + (plus) maybe appended to the rating symbols to indicate their relatively stronger position within therating categories concerned. Thus, the rating of mfA2+ is one notch higher than mfA2.

5.11 INSURANCE

5.11.1 Introduction

Insurance basically are two types one is life insurance and other one is general insurance.Under Life Insurance policy the insurance covers the life o the insured up to the policyamounts. In other words in case of death of the policy holder, the nominee of the insuredcould get the policy value. Life insurance policy also facilitate for payment of the policyvalue either at maturity or by installments at an agreed bonus to the policy holder.

General Insurance means insurance other than the life insurance. As per the definitionof the Insurance Act “General Insurance Business” as fire, marine or miscellaneous insurance

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business whether carried on singly or in combination with one or more of them. For examplegeneral insurance can be viewed as exchange risk insurance, motor vehicle insurance,burglary insurance and workmen compensation insurance and so on.

History of the Insurance Companies in India:

The Indian Life Assurance Companies Act, 1912 was the first statutory measure toregulate life business in India. In 1928, the Indian Insurance Companies Act was enactedto enable the Government to collect statistical information about both life and non-lifebusiness transacted in India by Indian and foreign insurers including provident insurancesocieties. In 1938, with a view to protecting the interest of the Insurance public, the earlierlegislation was consolidated and amended by the Insurance Act, 1938 with comprehensiveprovisions for effective control over the activities of insurers.

There was large number of insurance companies and level of operations and unfairtrade practices during the period 1950’s. Therefore, the Government of India decided tonationalize insurance business in the same year. The Life Insurance Corporation of India(LIC) was formed by the Government of India in the in the year 1956 by an Ordinance.The LIC absorbed 154 Indian, 16 non-Indian insurers as also 75 provident societies.

Till the year 1990 the LIC was the only player in the life insurance business. Thissector is reopened to the private sector in the year 2000 based on the R N Malhotra (theformer insurance secretary and the RBI governor) committee report. The GeneralInsurance came to India as a legacy of British occupation. The general insurance companywas established in India for the first time in the year 1850 in Calcutta by the British. In theyear 1972 General Insurance Business (Nationalisation) Act, 1972 was brought by thegovernment of India.

The General Insurance Corporation is not meant to offer returns but is a protectionagainst contingencies like accidents, illness, fire, burglary etc. The General InsuranceCorporation has four subsidiaries namely (i) The National Insurance Company Limited (ii)New India Assurance Company Limited (iii) Oriental Insurance Company and (iv) UnitedIndia Insurance Company Limited.

In the year 1993, the committee under the chairmanship of R N Malhotra was stronglyrecommended the need of regulations for the insurance business. In this process the InsuranceRegulatory and Development Authority (IRDA) Act, 1999 was enacted by parliament inthe fiftieth year of the Republic of India to provide for the establishment of an authority toprotect the interest of holders of insurance policies.

At present the Indian Insurance industry is governed by the Insurance Act, 1978, theGeneral Insurance Business (Nationalisation) Act, 1972, Life Insurance Corporation Act,1956 apart from the IRDA regulations.


NOTES


The IRDA was incorporated as a statutory body with the objectives which includespromotion of competition so as to enhance customer satisfaction through increased consumerchoice and lower premiums, while ensuring the financial security of the insurance market.

The IRDA opened up the market in August 2000 with the invitation for application forregistrations. Foreign companies were allowed ownership of up to 26%. The Authorityhas the power to frame regulations under Section 114A of the Insurance Act, 1938 andframed various regulations ranging from registration of companies for carrying on insurancebusiness to protection of policyholders’ interests.

In December, 2000, the subsidiaries of the General Insurance Corporation of Indiawere restructured as independent companies and at the same time GIC was convertedinto a national re-insurer. Parliament passed a bill de-linking the four subsidiaries from GICin July, 2002. At present there are 15 general insurance companies including the ExportCredit Guarantee Corporation (ECGC), and Agriculture Insurance Corporation of Indiaand 16 life insurance companies operating in the country.

5.11.2 Life Insurance Businesses in India

There are 15 private sector companies and one in public sector was registered withthe IRDA up to the year ending 2006. They are as follows;

1. Life Insurance Corporation of India2. Birla Sun-life Insurance Company Limited3. Bajaj Allianz Life Insurance Company Limited4. HDFC Standard Life Insurance Company Limited5. ICICI Prudential Life Insurance Company Limited6. ING Vysya Life Insurance Company Limited7. Max New York Life Insurance Company Limited8. Metlife India Insurance Company Pvt. Limited9. Kotak Mahindra Old Mutual Life Insurance Limited10. SBI Life Insurance Company Limited11. TATA AIG Life Insurance Company Limited12. Reliance Life Insurance Company Limited13. Aviva Life Insurance Company India Pvt. Ltd14. Sahara India Life Insurance Company Limited15. Sriram Life Insurance Company Limited16. Bharti AXA Life Insurance Company Limited.

We have various types of life insurance products with which insurance companies aredealing with, namely Endowment Plan, Money back Policies, Whole-life policy, TermInsurance policy, Unit-linked Insurance polices and Group Insurance policies. These lifeinsurance products are occupying the major market share in terms of resource mobilization.

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As per the report of the IRDA till October 2006 the market share of Life InsurancePlayers are as follows

We have the following advantages in case of Life Insurance Business:

a. Financial protection to the insured family against unpredictable events.b. Income tax benefit under section 80C up to Rs 1,00,000 at presentc. It provides a very good source of income for the individuals who retired from the

services due to age factord. Insurance business helps us by providing certain periodic financial needs, either for

child’s education or marriage etc.

5.11.3 Type of products under Life Insurance Business:

As we said in the above we have following broad types of insurance policies for theinvestors according to their interest and choice to choose for investment.

(1) Endowment Policy:

Endowment policy means the sum assured together with bonus is payable on the dateof maturity or in the event of death of the insured, whichever is earlier. This is popularproduct mobilizes considerable market because it provides us long term savings facilitywith risk coverage.

(2) Money –back Policy:

Money-back policy means the sum assured is returned as lum-sum after defined periodof intervals. In this policy the policy holder receives a fixed sum at fixed intervals during theterm of the policy and at the end of the maturity. This policy is also popular because itmeets the needs of short term finance requirements of the investors.


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(3) Whole-life Policy:

Whole-life policy means the policy holder goes on paying the premium through outhis life and on account of his death, the money is handed over to his family. This policy isnot success due to non fulfillment of either short term or long term needs of the insured inaddition to heavy premium.

(4) Term Insurance Policy:

Term insurance policy means the policy holder goes on paying the premium for thedefined period of time with very low premium and the sum assured is payable only if thepolicy holder dies within the policy term. If the policy holder survives, he is not entitled toany payment on maturity.

(5) Unit Linked Insurance policy:

Unit linked insurance policies means a part of the premium is invested in a fund andthe return is linked to the performance of the fund. These are like mutual funds when wepay the premium, the insurance company after deducting some charges, invests the netamount in stock market instruments.

These are NAV based insurance policies few of them cover the risk few of the nonrisk coverage policies. For Example recently the LIC of India launched the two Unit LinkedInsurance policies one is Profit Plus and Market Plus, former one cover the insurance andlater one is non risk coverage policy.

(6) Group Insurance Policy:

Group insurance polices are generally taken by the corporate to cover the risk of thelife of their employees. Group gratuity and superannuation plans are come under this category.These are popular polices in India because of lower premium and group gratuity andsuperannuation plans are compulsory as a result of statutory compliance.

General Insurance Business

Basically the general insurance business is to provide the short term coverage ofinsurance risk usually for a period of 12 months. Since general insurance is non-life insuranceit covers the following types of insurance namely

a. Fire Insuranceb. Motor Vehicle Insurancec. Marine Insurance andd. Miscellaneous insurance.

The six public sector general insurance companies namely the Oriental InsuranceCompany Limited, The New India Assurance Company Limited, The National InsuranceCompany Limited and the United India Insurance Company Limited in addition to ECGC

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and Agriculture Insurance Company of India catering the services to cover the risk of fire,motor vehicles, marine and miscellaneous risk. Private sector companies also participate ingeneral insurance business as helping hand to the insured.

We have the following general insurance companies under private sector to providethe non-life insurance in India.

1. The Royal Sundaram Alliance Insurance Company Limited2. The Reliance General Insurance Company Limited3. IFFCO Tokio General Insurance Company Limited4. TATA AIG General Insurance Company Limited5. Bajaj Alianz General Insurance Company Limited6. ICICI Lombard General Insurance Company Limited7. Cholamandalam General Insurance Company Limited8. HDFC Chubb General Insurance Company Limited9. Star Health and Allied Insurance Company Limited

5.11.4 Types of general insurance policies:

(1) Fire Insurance Policies:

Fire Insurance policy can be described as an agreement whereby one party, for aconsideration, undertakes to indemnify the other party up to an agreed amount againstfinancial loss of goods or property which the latter may suffer because of fire. Fire insurancegenerally covers the building or flat, plant and machinery, furniture and fixtures, loss ofprofit and so on.

Fire insurance policy is a comprehensive policy which covers loss on account of fire,earthquake, riots floods, strikes, and malicious intent etc. Owner of the premises are onlyallowed to take this type of policy, a tenant if not allowed to insure the rental premises,however he is allowed to insure the contents of the premises.

(2) Motor Vehicle Insurance:

Motor vehicle insurance covers generally two types of risks one is the risk of damageby an accident or loss by theft and other one is the risk of liability arising from an injury ordeath of any person in an accident caused by a vehicle, commonly known as Third partyInsurance. Therefore as per the Indian Motor Vehicles Act the owner of the vehicle iscompulsorily required to get third party insurance.

(3) Marine Insurance:

Marine Insurance is one of the oldest insurance. It means the insurance company orthe underwriter agrees to indemnify the owner of a ship or cargo against risks which areincidental to marine adventure such as sinking or burning of the ship and its contents,stranding of the ship, collision of ship, jettison etc.


NOTES


We have the common sub- types of marine insurance which are as follows: Cargoinsurance, Hull Insurance and Freight Insurance. Cargo insurance means it is type ofinsurance which covers risks to the cargo on the ship. The cargo on the ship is exposed torisk arising from any act of God, enemies, fire etc. Marine Hull Insurance means the shipis also exposed to the perils described in the cargo insurance. Therefore the owner of theship may effect ‘hull’ insurance to cover the risk arising from the act of God, enemies, fireetc.

(4) Miscellaneous Insurance:

In addition to the above general insurance there are a number of other insurancepolicies which cover various other types of risks which includes Fidelity insurance, Creditinsurance, Workmen’s Compensation Insurance, Potential liability insurance and so on.

Reinsurance Business

Reinsurance plays a vital role in the insurance business. The services provided by thereinsurance company is almost same as provided by the insurance companies to theirpolicy holders. In case of general insurance business the risk is huge due to their magnitudeor nature, hence, one insurance company can not afford to cover entire risk for exampleaviation insurance.

Therefore, the reinsurance business can be defined as an agreement between a cedingcompany and a reinsurer whereby the former agrees to cede and the latter agrees toaccept a certain specified share of risk or liability upon terms and condition as set out in theagreement.

A ceding company means the original insurance company which has accepted therisk and has agreed cede or pass on that risk to another insurance company or a reinsurancecompany. We further classify the reinsurance into two sub classification one is FacultativeReinsurance and other one is the Treaty Reinsurance.

5.11.5 Insurance Regulatory and Development Authority Act, 1999

The IRDA is the supreme body to regulate the entire insurance business in India. TheInsurance Regulatory and Development Authority is empowered to issue the regulations,guidelines and clarifications along with the promotional and development role. Thepromotional and development role includes promoting competition so as to enhancecustomer satisfaction through increased consumer choice and lower premium, while ensuringthe financial security of the insurance market.

Duties, Powers and Functions of Authority.

As per section 14 of the IRDA Act, 1999 relating to the duties, powers and functionsof the authority is reproduced below.

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1. Subject to the provisions of this Act and any other law for the time being in force, theAuthority shall have the duty to regulate, promote and ensure orderly growth of theinsurance business and re-insurance business.

2. Without prejudice to the generality of the provisions contained in sub-section (1), thepowers and functions of the Authority shall include, -

a. issue to the applicant a certificate of registration, renew, modify, withdraw, suspendor cancel such registration;

b. protection of the interests of the policy holders in matters concerning assigning ofpolicy, nomination by policy holders, insurable interest, settlement of insuranceclaim, surrender value of policy and other terms and conditions of contracts ofinsurance;

c. specifying requisite qualifications, code of conduct and practical training forintermediary or insurance intermediaries and agents;

d. specifying the code of conduct for surveyors and loss assessors;

e. promoting efficiency in the conduct of insurance business;

f. promoting and regulating professional organisations connected with the insuranceand re-insurance business;

g. levying fees and other charges for carrying out the purposes of this Act;

h. calling for information from, undertaking inspection of, conducting enquiries andinvestigations including audit of the insurers, intermediaries, insuranceintermediaries and other organisations connected with the insurance business;

i. control and regulation of the rates, advantages, terms and conditions that may beoffered by insurers in respect of general insurance business not so controlled andregulated by the Tariff Advisory Committee under section 64U of the InsuranceAct, 1938 (4 of 1938);

j. specifying the form and manner in which books of account shall be maintainedand statement of accounts shall be rendered by insurers and other insuranceintermediaries;

k. regulating investment of funds by insurance companies;

1. regulating maintenance of margin of solvency;

m. adjudication of disputes between insurers and intermediaries or insuranceintermediaries;

n. supervising the functioning of the Tariff Advisory Committee;

o. specifying the percentage of premium income of the insurer to finance schemesfor promoting and regulating professional organizations referred to in clause (f);


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p. specifying the percentage of life insurance business and general insurance businessto be undertaken by the insurer in the rural or social sector; and

q. exercising such other powers as may be prescribed.

Registration Procedure

To carry insurance business in India should be registered with the IRDA. Theregistration procedure explained under Insurance Regulatory and Development Authority(Registration of Indian Insurance Companies) Regulations, 2000 is produced below:

1. An applicant desiring to carry on insurance business in India shall make a requisitionfor registration application in Form IRDA/R1.

2. Every requisition for registration application shall be accompanied by

a. a certified copy of the memorandum of association and articles of association, where the applicant is a company and incorporated under Companies Act,1956 (1 of 1956);b. the name, address and the occupation of the directors and principal officer;c. a statement of the class of insurance business proposed to be carried on;d. a statement indicating the sources that will contribute the share capital required under section 6 of the Act;

3. An affidavit must be submitted by the principal officer of the insurer that therequirement of paid up capital of Rs 100 crore in case of insurance business andRs 200 crore in case of general and reinsurance business have been compliedwith.

4. The insurance companies are required to deposit with the RBI, on behalf of theGovernment of India in cash or approved securities in case of Life Insurancebusiness a sum equivalent to 1% of total gross premium not exceeding Rs 10crore within India in any financial year, in case of general insurance business asum equivalent to 3% of total gross premium not exceeding Rs 10 crore, withinIndia in any financial year.

5. The fee of rupees fifty thousand for each class of business for registration shallbe remitted by a bank draft issued by any scheduled bank in favour of theInsurance Regulatory and Development Authority payable at New Delhi.

6. A certificate from a practising chartered accountant or a practising companysecretary certifying that all the requirements relating to registration fees, sharecapital, deposits, and other requirements of the Act have been complied with bythe applicant; has to enclosed.

7. A certificate copy of the published prospectus if any and standard policy forms ofthe insurer and statements of the assured rates, advertisements, terms and conditionsto be offered in connection with insurance policies, together with a certificate in

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connection with life business by an actuary that such rates or advantages or termsand conditions are workable and sound.

8. Any such other documents required by the IRDA need to be submitted.

On submission of all the relevant documents the IRDA may register the applicantname and grant a certificate of registration.

5.12 SECURITISATION AND ASSETS RECONSTRUCTION COMPANIES

For the past 10 years it is evident that Indian economy has faced many times financialcrises. In most cases, crises arises mainly due to financial sector culminate into non-performingassets namely NPA’s. A higher rate of NPA’s in the banking system can severely affect theeconomy in many ways for any given country.

In addition to the existing non-performing assets the banks tend to become risk aversein making new loans, particularly to small and medium sized companies. Thus large scaleNPA’s when left untouched, cause continued economic and financial degradation of thecountry.

Non-Performing Asset:

It means an asset, including a leased asset, becomes non-performing when it ceasesto generate income for the bank. NPA can be defined as a credit facility or advance whose(i) interest and installment of principal remain overdue for more than 90 days in respect ofa term loan, (ii) account remains out of order for more than 90 days in respect of anoverdraft or cash credit, (iii) bill remains overdue for more than 90 days in case of billspurchased or discounted, (iv) interest and or installment of principal remain overdue fortwo harvest seasons but for a period not exceeding two half years in case of advancesgranted for agricultural purposes and (v) amount to be viewed remain overdue for morethan 90 days in respect of other accounts.

The Government of India came to know the importance of recovery of non-performingassets only when the Narasimhan Committee was highlighted this in the year 1997. TheNarasimhan Committee report mentioned that an importance aspect of the continuing reformprocess was to reduce the high level of non-performing assets as means of banking sectorreform.

With this it was expected that with a combination of policy and institutionaldevelopment, new NPA’s in future could be lower, however our problem is with the hugebacklog of existing NPA’s. Of course, there is no doubt the higher rate of NPA’s impingedseverely on the banks performance and their profitability. The Report envisaged creationof an “Asset Recovery Fund” to take the NPAs off the lender’s books at a discount.


NOTES


Asset Reconstruction Company (ARC) is a company which is set up with the objectiveof taking over distressed assets (Non performing assets) from banks or financial institutionsand to reconstruct or redress these assets to make those assets saleable. In this context theNarasimham Committee in its first report had suggested formation of Asset ReconstructionCompanies (ARC) with a view to clean the balance sheet of banks.

These Asset Reconstruction Companies are generally public or government ownedcompanies. ARC’s functions as debt aggregators and engage in acquisition of NPA’s.Thus ARC’s take away the distraction by isolating NPA’s from the banking system andfucntion as ‘Bad Bank’. ARC’s facilitate the banking system free from NPA’s and allowto act as ‘Good Bank’. In fact the Government of India encourages transfer of assets toARC’s through creation of supportive environment.

Therefore, ARC’s will purchase the non performing assets from banks and financialinstitutions at a discount which will clear their balance sheets of sticky loans. NPA’s can beassigned by banks and Financial Institutions. In turn these assets will be reconstructed orrebuilt and then sold in the market in various forms or recovered through securitization andreconstruction of enforcement of security.

In this process the Government of India proactively initiated certain measures to controlNPA’s by setting up Debt Recovery Tribunals and Debt Appellate Tribunals under the‘Recovery of Debts Due to Banks and Financial Institutions Act, 1993. To expedite theprocess of recovery from NPA’s, the Government of India also set up the Securitisationand Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

In India The Asset Reconstruction Company Limited, is the first ARC with an initialequity capital of Rs 10 Crore out of which ICICI bank, IDBI and SBI contribution is up to24.50%, and balance to be shared by HDFC and UTI Bank. These ARC’s will need to beregistered with RBI before they take up any activity.

The banks and financial institutions make their balance sheets cleaner after sellingtheir impaired assets to ARC’s and they also find time to develop their business. AssetReconstruction Companies may be able to mix up their assets (ie. good and bad) in suchmanner to make them saleable. There is possibility of securitization resulting in funding ofthese assets through capital instruments. Securitisation is a process of transformation ofilliquid asset into security which may be traded later in the open market.

The Reserve Bank of India framed guidelines for Asset Reconstruction Companies,banks and financial institutions for transfer of assets to ARC’s by defining prudential guidelinesfor ARC’s and permitting Indian banks and financial institutions to participate in papers(certificates) issued by ARC’s.

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5.12.1 Guidelines: Issued by the RBI has been reproduced which are in the natureof recommendatory

(1) Acquisition of Financial Assets:

a. The Asset Acquisition Policy shall provide that the transactions take place in atransparent manner and at a true price in a well informed market, and thetransactions are executed at arm’s length in exercise of due diligence;

b. The Policy so framed should provide for checks in the matter of acquiring assetsfrom a single Bank/FI, own sponsors and any single entity upto a desirable levelof ceiling so that possible departures from desirable practices are avoided;

c. The percentage of financial assets to be acquired should be appropriately andobjectively worked out keeping in view the fact that the percentage of ownershipstake has a bearing on the speed with which security interest rights can be enforcedin accordance with the provisions of the Ordinance;

d. For easy and faster realisability, financial assets due from a single debtor to variousbanks / FIs may be considered for acquisition. Similarly, financial assets havinglinkages to the same collateral may be considered for acquisition to ensure relativelyfaster and easy realisation ;

e. Both fund and non-fund based financial assets may be included in the list of assetsfor acquisition. Standard Assets likely to face distress prospectively may also beacquired ;Acquisition of funded assets

f. should not include takeover of outstanding commitments, if any, of bank / FI tolend further. Terms of acquisition of security interest in non-fund transactions,should provide for the relative commitments to continue with bank/FI, till demandfor funding arises;

g. Loans not backed by proper documentation should be avoided;

h. The valuation process should be uniform for assets of same profile and a standardvaluation method should be adopted to ensure that the valuation of the financialassets is done in scientific and objective manner. Valuation may be done internallyand or by engaging an independent agency, depending upon the value of the assets.Ideally, valuation may be entrusted to an asset acquisition committee, which shallcarry out the task in line with an Asset Acquisition Policy laid down by the Boardin this regard;

i. A record indicating therein the details of deviations made from the prescriptions ofthe Board in the matter of asset acquisition, pricing, etc. should be maintained;

j. To ensure functioning of Securitisation Companies/ Reconstruction Companies onhealthy lines, the operations and activities of such companies may be subjected toperiodic audit and checks by internal / external agencies.


NOTES


(2) Engagement of Outside Agency:

Securitisation Companies/ Reconstruction Companies may engage the services ofreputed specialised external agencies to handle the task of taking possession of securedassets in pursuance of its right to enforce security interest.

(3) Sale Committee:

It is desirable that the Sale Committee authorises in case of joint / consortium financing,the secured creditor with the highest outstanding, or more preferably, the SecuritisationCompany/ Reconstruction Company as the designated secured creditor to arrange for thesale of secured assets.

(4) Issue of security receipts:

i. The parties in question may finalize the price at which security receipt will be issuedas per the mutually agreed terms and on assessment of the risks involved;

ii. In cases where security receipts are issued involving transfer of risks to the fullextent and rewards to a limited extent, there could be a possibility of sharing ofsurplus between the issuer and the investors;

iii. The issuer may consider obtaining credit rating from any of recognized credit ratingagencies.

iv. The matters relating to charging of ‘management fee’ by the Securitisation Company/Reconstruction Company, for managing schemes floated by it, may be as per themutually agreed terms.

Summary

A mutual fund is a group of investors operating through a fund manager to purchase adiverse portfolio of stocks or bonds. Mutual funds are highly cost efficient and very easyto invest in. One of the most advantageous factor in the mutual fund is, it reduce the risk bydiversification and maximize the returns due to professional expertise of fund managersemployed by it.

Institutional Set up of the Mutual fund can be described as a set up in the form of atrust, which has Sponsor, Trustees, Asset Management Company (AMC), and Custodian.Thus why, our elders use to say “put not your trust in money, put your money in trust”.

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As per the definition of the SEBI (Mutual Fund) Regulations “asset managementcompany” means a company formed and registered under the Companies Act, 1956 (1 of1956) and approved as such by the SEBI under its regulations.

Insurance basically are two types one is life insurance and other one is general insurance.Under Life Insurance policy the insurance covers the life o the insured up to the policyamounts. In other words in case of death of the policy holder, the nominee of the insuredcould get the policy value. Life insurance policy also facilitate for payment of the policyvalue either at maturity or by installments at an agreed bonus to the policy holder.

General Insurance means insurance other than the life insurance. As per the definitionof the Insurance Act “General Insurance Business” as fire, marine or miscellaneous insurancebusiness whether carried on singly or in combination with one or more of them. For examplegeneral insurance can be viewed as exchange risk insurance, motor vehicle insurance,burglary insurance and workmen compensation insurance and so on.

The Government of India came to know the importance of recovery of non-performingassets only when the Narasimhan Committee was highlighted this in the year 1997. TheNarasimhan Committee report mentioned that an importance aspect of the continuing reformprocess was to reduce the high level of non-performing assets as means of banking sectorreform.

Asset Reconstruction Company (ARC) is a company which is set up with the objectiveof taking over distressed assets (Non performing assets) from banks or financial institutionsand to reconstruct or redress these assets to make those assets saleable. In this context theNarasimham Committee in its first report had suggested formation of Asset ReconstructionCompanies (ARC) with a view to clean the balance sheet of banks.


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Self Examination Questions:

1. Explain the various types of mutual funds available in the Indian Financial Market.

2. Explain the advantages and disadvantages in case of investments in Mutual Funds

3. Explain SEBI regulations with respect to mutual funds

4. Explain the concept of insurance and types of insurance

5. Please list out few points from the IRDA regulations with respect to insurancecompanies.

6. What do you mean by securitisation?

7. Explain the concept of Assets Reconstruction companies.

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