BFS

Foundation Course in Banking
Foundation Course in Banking & Capital Markets
Version : 3.1
Date : 01-December-2005
Cognizant Technology Solutions

500 Glenpointe Centre West
Teaneck, NJ 07666
Ph: 201-801-0233
www.cognizant.com
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TABLE OF CONTENTS
1. BFS CONCEPTS 3
1.1. THE CONCEPT OF MONEY 4
1.2. FINANCIAL INSTRUMNETS 13
1.3. FINANCIAL MARKETS 24
1.4. FINANCIAL STATEMENTS 33
2. BANKING 47
2.1. INTRODUCTION TO BANKING 48
2.2. RETAIL BANKING 56
2.3. CONSUMER LENDING 68
2.4. COMMERCIAL AND WHOLESALE BANKING 81
2.5. CARDS AND PAYMENTS 115
2.6. INVESTMENT MANAGEMENT 126
2.7. INVESTMENT BANKING AND BROKERAGE 146
2.8. RISK MANAGEMENT 161
2.9. CUSTODY AND INVESTOR SERVICES 169
2.10. CLEARING AND SETLEMENT 177
2.11. CORPORATE SERVICES 183
3. RECENT DEVELOPMENTS 189
4. GLOSSARY 199
5. REFERENCES 207
Foundation Course in Banking Ver 2.1 Page 2 of 208

1. BFS CONCEPTS

1.1. THE CONCEPT OF MONEY

THE CONCEPT OF MONEY

DEFINING MONEY
“Money is a standardized unit of exchange”. The practical form of money is currency. It varies
across countries whereas money remains the same. For example, in India, the currency is the
Indian Rupee (INR) and in the US, it is the US Dollar (USD).
Due to various economic factors, the value of each country’s currency is not equal. For example,
if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70,
it implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken as
a benchmark against which to compare the value of each currency.
THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST

Interest is the amount earned on money; there is such an earning because present consumption
of the lender is being sacrificed for the future; you are letting somebody else use the money for
present consumption. Using an analogy, interest is the ‘rent’ charged for delaying present
consumption of money. Interest rates are not constant and will vary depending on different
economic factors
Simple interest
Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: P
is the Principal or the initial amount you are initially borrowing or depositing, to earn or charge
interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% interest on a beginning value of $100, the first year they would
get:
0.05*$100 = $5
If they continued to receive 5% interest on the original $100 amount, over five years the growth in
their investment would look like this:
Year 1: (5% of $100 = $5) + $100 = $105
Year 2: (5% of $100 = $5) + $105 = $110
Year 3: (5% of $100 = $5) + $110 = $115
Year 4: (5% of $100 = $5) + $115 = $120
Year 5: (5% of $100 = $5) + $120 = $125

Compound interest
With compound interest, interest is calculated not only on the beginning interest, but on any
interest accumulated with the initial principal in the meantime. Compound interest =
[P*(1+r/100)^t – P], where: P is the Principal or the initial amount you are initially borrowing or
depositing, to earn or charge interest on, r is the interest rate and t is the time period.
Example
If someone were to receive 5% compound interest on a beginning value of $100, the first year
they would get the same thing as if they were receiving simple interest on the $100, or $5. The
second year, though, their interest would be calculated on the beginning amount in year 2, which
would be $105. So their interest would be:
.05 x $105 = $5.25
If this were to continue for 5 years, the growth in the investment would look like this:
Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00
Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25
Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76
Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55
Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63

Note that in comparing growth graphs of simple and compound interest, investments with simple
interest grow in a linear fashion and compound interest results in geometric growth. So with
compound interest, the further in time and investment is held the more dramatic the growth
becomes.
INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For example, if
Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/(1+I) kgs. Of
groceries next year, where I refers to the rate of inflation beyond today.
Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply
and other market conditions hold), next year, you can only buy 5/(1.05) worth of groceries.
A quantitative estimate of inflation in a particular economy can be calculated by measuring the

ratio of Consumer Price Indices or CPI of two consecutive years. That’s right, the CPI that you
hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of

the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods,
over last year.
Inflation results in a decrease in the value of money over time. The link between the interest
rates, nominal and real, and inflation enables you to identify this impact.
Nominal Interest
Nominal rate of interest (N) refers to the stated interest rate in the economy. For example, if
counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal
rate of interest is 10%. This, as you see, includes the inflation rate.
Example
You’ve lent out 100 rupees, at 10%, for one year. On maturity, you get a profit, so you think, of 10
rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation!
Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year
ago, and it is less by the inflation rate. Thus the real interest you earned is less than 10%.
Real rate of Interest

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the nominal
rate of interest for economies having positive rate of inflation.
The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of
inflation) is as:
R= N-I
(This is a widely used approximation; the exact formula takes into account time value of inflation
etc.)
Why is it important to know the real rate of return? Take an example where a business is earning
a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is actually at
zero.
Example
Nominal rate (N) = 10%, Inflation (I) = 5%
Therefore, real interest is:

R = N – I = 5%
Therefore, the real rate of return is not 10% but 5%.
TIME VALUE CONCEPT OF MONEY

Time value of money, which serves as the foundation for many concepts in finance, arises from
the concept of interest. Because of interest, money on hand now is worth more than the same
money available at a later point of time. To understand time value of money and related concepts
like Present value and future value, we need to understand the basic concepts of simple and
compound interest described above.
Future Value
Future Value is the value that a sum of money invested at compound interest will have after a
specified period.
The formula for Future Value is:
FV = PV*(1 + i)n
Where:
FV : Future Value at the end of n time periods
PV : Beginning value OR Present Value
i : Interest rate per unit time period
n : Number of time periods
Example
If one were to receive 5% per annum compounded interest on $100 for five years,
FV = $100*(1.05)5 = $127.63
Intra-year compounding
If a cash flow is compounded more frequently than annually, then intra-year compounding is
being used. To adjust for intra-year compounding, an interest rate per compounding period must
be found as well as the total number of compounding periods.
The interest rate per compounding period is found by taking the annual rate and dividing it by the
number of times per year the cash flows are compounded. The total number of compounding
periods is found by multiplying the number of years by the number of times per year cash flows
are compounded.

Example
Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold it
for five years.,
Interest rate for compounding period = 8%/2 = 4%

Number of compounding periods = 5*2 = 10
Thus, the future value FV = 10,000*(1+0.04)^10 = $14,802.44
Present value
Present Value is the current value of a future cash flow or of a series of future cash flows. It is
computed by the process of discounting the future cash flows at a predetermined rate of interest.
If $10,000 were to be received in a year, the present value of the amount would not be $10,000
because we do not have it in our hand now, in the present. To find the present value of the future
$10,000, we need to find out how much we would have to invest today in order to receive that
$10,000 in the future. To calculate present value, or the amount that we would have to invest
today, we must subtract the (hypothetical) accumulated interest from the $10,000. To achieve
this, we can discount the future amount ($10,000) by the interest rate for the period. The future
value equation given above can be rearranged to give the Present Value equation:
PV = FV / (1+I)^n
In the above example, if interest rate is 5%, the present value of the $10,000 which we will
receive after one year, would be:
PV = 10,000/(1+0.05) = $ 9,523.81
Net Present Value (NPV)

Net Present Value (NPV) is a concept often used to evaluate projects/investments using the
Discounted Cash Flow (DCF) method. The DCF method simply uses the time value concept and
discounts future cash flows by the applicable interest rate factor to arrive at the present value of
the cash flows. NPV for a project is calculated by estimating net future cash flows from the
project, discounting these cash flows at an appropriate discount rate to arrive at the present value
of future cash flows, and then subtracting the initial outlay on the project.
NPV of a project/investment = Discounted value of net cash inflows – Initial cost/investment. The
project/investment is viable if NPV is positive while it is not viable if NPV is negative.

Example
An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of the
year. The after-tax net cash flows at the end of each year are forecast as follows:
Year Cash Flow

1 $9,000
2 8,500
3 8,000
4 8,000
5 8,000
6 8,000
7 8,000
8 7,000
9 4,500
10 51,000 (property sold at the end of the 10th year)
Assume that the required rate of return for similar investments is 15.00%.
NPV = - 50000 + 9000/(1+0.15)^1 + 8500/(1+0.15)^2 + ….. +51000/(1+0.15)^10 = $612.96
However, if we assume that the required rate of return is 16.00%,

NPV = - 50000 + 9000/(1+0.16)^1 + 8500/(1+0.16)^2 + ….. +51000/(1+0.16)^10 = ($1360.77)
Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:
• Increases with increase in future cash inflows for a given initial outlay
• Decreases with increase in initial outlay for a given set of future cash inflows
• Decreases with increase in required rate of return
Internal Rate of Return (IRR)

Internal Rate of Return (IRR), also referred to as ‘Yield’ is often used in capital budgeting. It is the
implied interest rate that makes net present value of all cash flows equal zero.
In the previous example, the IRR is that value of required rate of return that makes the NPV
equals zero.

IRR = r, where
NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + ….. +51000/(1+r)^10 = $0.00
IRR can be calculated using trial and error methods by using various values for r or
using the IRR formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is
the rate of return at which the project/investment becomes viable.
Cost of capital
You have seen how different entities such as individuals, corporations and governments raise
money. You would have also realized that there is a cost for raising money, known as cost of
capital. Costs will vary depending on the type of the financing such as equity or debt, who the
borrower is (their past record and repayment capacity), and finally the market timing of the
borrowings. In case of debt, additionally, the amount of collateral provided and how long the
capital is required is also considered.
The cost of capital includes interest payable in case of debt and expected returns including
dividends in case of equity, apart from the cost of raising such as investment banks’ fees,
regulatory fees and advertising. The tax factor is also considered while computing cost of capital
for debt capital since interest paid is a tax deductive expense. Computing cost for different means
of finance such as equity shares, preference shares, debentures or term loan is beyond the
purview of this learning program.
Since there is a limit to the amount of resources that corporations can raise from any source, they
use more than a single source for financing their needs. Also, funds will be raised at different
points in time depending on need, availability, and market timing etc. In such cases after
computing cost of each source, the firm arrives at a weighted average cost of capital, commonly
referred to as “cost of capital”. Let us take an example:
The Goodworks Company Inc. has Rs. 300 million through different means. The firm has raised
Rs. 107 mn. through equity, Rs. 13 mn through preference capital, Rs. 80 mn. by issuing
debentures and Rs. 100 mn. by taking a loan a financial institution.
Source of finance Cost (per cent) Weight Product of cost and weight
Equity capital 16.64 107/300 5.93
Preference capital 15.73 13/300 0.68
Debenture capital 11.08 80/300 2.95
Term loan 10.25 100/300 3.42
Average cost of capital 12.99 per cent

Looked at it with a different perspective, the cost of capital is the rate of return the firm must earn
on its investments in order to satisfy the expectations of investors who provide long-term funds to
it. It is an important concept for financing decisions.

1.2. FINANCIAL INSTRUMNETS

FINANCIAL INSTRUMENTS
RAISING CAPITAL
Corporations need capital to finance business operations. They raise money by issuing Securities
in the form of Equity and Debt. Equity represents ownership of the company and takes the form of
stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is
also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the
extent of a company’s leverage.
Investors choose between debt and equity securities based on their investment objectives.
Income is the main objective for a debt investor. This income is paid in the form of Interest,
usually as semi-annual payments. Capital Appreciation (the increase in the value of a security
over time) is only a secondary consideration for debt investors. Conversely, equity investors are
primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is
received in the form of Dividends.
Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It
also means that if the company ceases to do business and liquidate its assets, that the debt
holders have a senior claim to those assets.
SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a creditor
relationship with a corporation or government agency (a bond), or rights to ownership (an option).
Financial instruments can be classified into:
• Debt
• Equity
• Hybrids
• Derivatives
DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are
all examples of debt.
Bond
An investor loans money to an entity (company or government) that needs funds for a specified
period of time at a specified interest rate. In exchange for the money, the entity will issue a
certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date
(maturity date). Interest on bonds is usually paid every six months (semiannually).
Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only
and Fully Registered Bonds.
Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These
bonds are Unregistered because the owner’s name does not appear on the bond, and there is no
record of who is entitled to receive the interest payments. Attached to the bond are Coupons. The
bearer clips the coupons every six months and presents these coupons to the paying agent to
receive their interest. Then, at the bond’s Maturity, the bearer presents the bond with the last
coupon attached to the paying agent, and receives their principal and last interest payment.

Bonds that are registered as to principal only have the owner’s name on the bond certificate, but
since the interest is not registered these bonds still have coupons attached.
Bonds that are issued today are most likely to be issued fully registered as to both interest and
principal. The transfer agent now sends interest payments to owners of record on the interest
Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and
the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,
Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customer’s
Confirmation serves as proof of ownership.
Principal and Interest

Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The
annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond
certificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing
economic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the
credit rating, the lower the coupon). Bonds that are In Default are not paying interest.
Example
• IBM can issue 10 year bonds with a coupon of 5.5%.
• Priceline can issue similar 10 year bonds at 8%
• The difference in coupon is due to their credit rating!
The principal or par or Face amount of the bond is what the investor has loaned to the issuer. The
relative "safety" of the principal depends on the issuer’s credit rating and the type of bond that
was issued.
Corporate bond
A bond issued by a corporation. Corporations generally issue three types of bonds: Secured
Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.
All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond.
In contrast, unsecured bonds are backed by the general assets of the corporation only. There are
three basic types of Secured Bonds:
Mortgage Bonds are secured by real estate owned by the issuer
Equipment Trust Certificates are secured by equipment owned and used in the issuers business
Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (usually U.S. Government
securities)
Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they
are the first to be paid principal or interest and are thus the safest of an issuer’s securities.
Unsecured Bonds include debentures and subordinated debentures. Debentures have a general
creditor status and will be paid only after all secured creditors have been satisfied. Subordinated
debentures have a subordinate creditor status and will be paid after all senior and general
creditors have first been satisfied.

Case Study
• Enron set up power plant at Dabhol, India
• The cost of the project (Phase 1) was USD 920 Million
• Funding
o Equity USD 285 mio
o Bank of America/ABN Amro USD 150 mio
o IDBI & Indian Banks USD 95 mio
o US Govt – OPIC USD 100 mio
o US Exim Bank USD 290 mio
• Enron US declared bankruptcy in 2002
• Enron India’s assets are mortgaged to various banks as above.
• Due to interest payments and depreciation, assets are worth considerably less than
USD 920 mio.
• Who will get their money back? And how much?
Municipal bond (Munis)

A bond issued by a municipality. These are generally tax free, but the interest rate is usually
lower than a taxable bond.
Treasury Securities
Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to
pay off maturing debt and raise the cash needed to run the federal government. When an investor
buys one of these securities, he/she is lending money to the U.S. government.
Treasury bills are short-term obligations issued for one year or less. They are sold at a discount
from face value and don't pay interest before maturity. The interest is the difference between the
purchase price of the bill and the amount that is paid to the investor at maturity (face value) or at
the time of sale prior to maturity.
Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual
interest payments. Treasury notes have a term of more than one year, but not more than 10
years.
Treasury bonds are issued by the U.S. Government. These are considered safe investments
because they are backed by the taxing authority of the U.S. government, and the interest on
Treasury bonds is not subject to state income tax. T-bonds have maturities greater than ten
years, while notes and bills have lower maturities. Individually, they sometimes are called "T-
bills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at
prevailing market prices.
Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not
marketable and the owner of a Savings Bond cannot transfer his security to someone else.
Zero coupon bonds

Zeros generate no periodic interest payments but they are issued at a discount from face value.
The return is realized at maturity. Zeros sell at deep discounts from face value. The difference
between the purchase price of the zero and its face value when redeemed is the investor's return.
Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or
any government agency.

The higher rate of return the bond offers, the more risky the investment. There have been
instances of companies failing to pay back the bond (default), so, to entice investors, most
corporate bonds will offer a higher return than a government bond. It is important for investors to
research a bond just as they would a stock or mutual fund. The bond rating will help in
deciphering the default risk.
Commercial paper
An unsecured, short-term loan issued by a corporation, typically for financing accounts receivable
and inventories. It is usually issued at a discount to face value, reflecting prevailing market
interest rates. It is issued in the form of promissory notes, and sold by financial organizations as
an alternative to borrowing from banks or other institutions. The paper is usually sold to other
companies which invest in short-term money market instruments.
Since commercial paper maturities don't exceed nine months and proceeds typically are used
only for current transactions, the notes are exempt from registration as securities with the United
States Securities and Exchange Commission. Financial companies account for nearly 75 percent
of the commercial paper outstanding in the market.
There are two methods of marketing commercial paper. The issuer can sell the paper directly to
the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer
market for commercial paper involves large securities firms and subsidiaries of bank holding
companies. Direct issuers of commercial paper usually are financial companies which have
frequent and sizable borrowing needs, and find it more economical to place paper without the use
of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. This
savings compensates for the cost of maintaining a permanent sales staff to market the paper.
Interest rates on commercial paper often are lower than bank lending rates, and the differential,
when large enough, provides an advantage which makes issuing commercial paper an attractive
alternative to bank credit.
Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less
than 30 days. Paper usually is issued in denominations of $100,000 or more, although some
companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the
CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, bank
lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the
market.
Investors in the commercial paper market include private pension funds, money market mutual
funds, governmental units, bank trust departments, foreign banks and investment companies.
There is limited secondary market activity in commercial paper, since issuers can closely match
the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or
issuer usually will buy back the paper prior to maturity.
EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the
funds contributed by the owners (the stockholders) plus the retained earnings (or losses).

Common stock
Common stock represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of the
stock traded in the markets today is common. An individual with a majority shareholding or
controlling interest controls a company's decisions and can appoint anyone he/she wishes to the
board of directors or to the management team.
Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public
Offering (IPO). Before shares can be offered, or sold to the general public, they must first be
registered with the Securities and Exchange Commission (SEC). Once the shares have been
sold to investors, the shareholders are usually free to sell or trade their stock shares in the
Secondary Markets (such as the New York Stock Exchange – NYSE). From time to time, the
Issuer may choose to repurchase the stock they previously issued. Such repurchased stock
shares are referred to as Treasury Stock, and the shares that remain trading in the secondary
market are referred to as Shares Outstanding. Treasury Stock does not have voting rights and is
not entitled to any declared dividends. Corporations may use Treasury Stock to pay a stock
dividend, to offer to employees.

Stock Terminology
Public Offering Price (POP) – The price at which shares are offered to the public in a Primary
Offering. This price is fixed and must be maintained when Underwriters sell to customers.
Current Market Price – The price determined by Supply and Demand in the Secondary Markets.
Book Value – The theoretical liquidation value of a stock based on the company's Balance Sheet.
Par Value – An arbitrary price used to account for the shares in the firm’s balance sheet. This
value is meaningless for common shareholders, but is important to owners of Preferred Stock.
Example
When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ in
June 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split
twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current
Market Price stood at $46.26. However, if the stock-splits are taken into consideration the
actual market price would stand at 6 times the Current Market Price at whopping $253.56!!
Preferred Stock
Preference shares carry a stated dividend and they do not usually have voting rights. Preferred
shareholders have priority over common stockholders on earnings and assets in the event of
liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par
(always assumed to be $100) or a dollar amount.
Although preferred stock is equity and represents ownership, preferred stock investors are
primarily seeking income. The market price of income seeking securities (such as preferred stock
and debt securities) fluctuates as market interest rates change. Price and yield are inversely
related.
There are several different types of preferred stock including Straight, Cumulative, Convertible,
Callable, Participating and Variable. With straight preferred, the preference is for the current
year’s dividend only. Cumulative preferred is senior to straight preferred and has a first
preference for any dividends missed in previous periods.
Convertible preferred stock can be converted into shares of common stock either at a fixed
price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used
as a means for a risky company to obtain capital when neither debt nor equity works. It offers
considerable opportunity for capital appreciation.
Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.
Utilities represent the best example of nonconvertible preferred stock issuers.

American Depository Receipts (ADR)

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt
for a specified number of foreign shares owned by an American bank. ADRs trade like shares,
either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also
has the right to receive any declared dividends. An example would be Infosys ADRs that are
traded in NASDAQ.
HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.
Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of shares of
stock after a specified number of days. However, till the time of conversion the bonds continue to
pay coupons.
Case Study
Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond aggregating to
$100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue
was just 4% which was much lower than what it would have to pay if it raised the money in
India, where it is based out of. The company would use this money to pay-back existing loans
borrowed at much higher interest rates.
• Why doesn’t every company raise money abroad if it has to pay lower interest rates? Will
there is
• Will there be any effect on existing Tata Motors share-holders due to the convertible
issue? If ‘Yes’, when will this be?
Warrants
Warrants are call options – variants of equity. They are usually offered as bonus or sweetener,
attached to another security and sold as a Unit. For example, a company is planning to issue
bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so
they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire
worthless.
DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, foreign exchange, commodity or any other
item. For example, if the settlement price of a derivative is based on the stock price, which
changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence
derivative risks and positions must be monitored constantly.

Forward contract
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain
future time for a certain price. No cash is exchanged when the contract is entered into.
Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Index futures are all futures contracts where the underlying is the
stock index and helps a trader to take a view on the market as a whole.
Hedging involves protecting an existing asset position from future adverse price movements. In
order to hedge a position, a market player needs to take an equal and opposite position in the
futures market to the one held in the cash market.
Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can
earn risk less profits. When markets are imperfect, buying in one market and simultaneously
selling in other market gives risk less profit. Arbitrageurs are always in the look out for such
imperfections.
Options
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares
of the underlying security at a specific price on or before a specific date. There are two kinds of
options: Call Options and Put Options.
Call Options are options to buy a stock at a specific price on or before a certain date. Call
options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option premium, secures the investor the right to buy that certain stock at a specified
price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the
option premium. For call options, the option is said to be in-the-money if the share price is above
the strike price.
Example
The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24th, 2003
expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would
mean that to break-even the person buying the Call Option on the Infosys stock, the stock
price would have to cross Rs.5290 as of Dec 24th, 2003!!
Put Options are options to sell a stock at a specific price on or before a certain date. With a Put
Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor
can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no
need to use the insurance, and the only cost is the premium. A put option is in-the-money when
the share price is below the strike price. The amount by which an option is in-the-money is
referred to as intrinsic value.
The primary function of listed options is to allow investors ways to manage risk. Their price is
determined by factors like the underlying stock price, strike price, time remaining until expiration
(time value), and volatility. Because of all these factors, determining the premium of an option is
complicated.
Types of Options
There are two main types of options:

• American options can be exercised at any time between the date of purchase and the
expiration date. Most exchange-traded options are of this type.
• European options can only be exercised at the end of their life.
Long-Term Options are options with holding period of one or more years, and they are called
LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and
manage risk or even speculate, they are virtually identical to regular options. LEAPS, however,
provide these opportunities for much longer periods of time. LEAPS are available on most widely-
held issues.
Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-
standard options are called exotic options, which either are variations on the payoff profiles of the
plain vanilla options or are wholly different products with "optionality" embedded in them.
Open Interest is the number of options contracts that are open; these are contracts that have not
expired nor been exercised.
Swaps
Swaps are the exchange of cash flows or one security for another to change the maturity (bonds)
or quality of issues (stocks or bonds), or because investment objectives have changed. For
example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the lower rates.
Currency Swap involves the exchange of principal and interest in one currency for the same in
another currency.

Case Study
• The World Bank borrows funds internationally and loans those funds to developing
countries. It charges its borrowers a cost plus rate and hence needs to borrow at the
lowest cost.
• In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-
inflation tight monetary policy of the Fed. In West Germany the corresponding rate was 12
percent and Switzerland 8 percent.
• IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed
US companies. In contrast, the World Bank suffered from bad image since it had used
several times the Swiss market to finance risky third world countries. Hence, World Bank
had to pay an extra 20 basis points (0.2%) compared to IBM
• In addition, the problem for the World Bank was that the Swiss government imposed a
limit on the amount World Bank could borrow in Switzerland. The World Bank had
borrowed its allowed limit in Switzerland and West Germany
• At the same time, the World Bank, with an AAA rating, was a well established name in the
US and could get a lower financing rate (compared to IBM) in the US Dollar bond market
because of the backing of the US, German, Japanese and other governments. It would
have to pay the Treasury rate + 40 basis points.
• IBM had large amounts of Swiss franc and German deutsche mark debt and thus had
debt payments to pay in Swiss francs and deutsche marks.
• World Bank borrowed dollars in the U.S. market and swapped the dollar repayment
obligation with IBM in exchange for taking over IBM's SFR and DEM loans.
• It became very advantageous for IBM and the World Bank to borrow in the market in
which their comparative advantage was the greatest and swap their respective fixed-rate
funding.
Forward Swap agreements are created through the synthesis of two different swaps, differing in
duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes
swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example, if
an investor wants to hedge for a five-year duration beginning one year from today, they can enter
into both a one-year and six-year swap, creating the forward swap that meets the requirements
for their portfolio.
Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the option
to execute an interest rate swap on a future date, thereby locking in financing costs at a specified
fixed rate of interest. The seller of the swaption, usually a commercial or investment bank,
assumes the risk of interest rate changes, in exchange for payment of a swap premium.

1.3. FINANCIAL MARKETS

FINANCIAL MARKETS
WHAT ARE FINANCIAL MARKETS?

A financial transaction is one where a financial asset or instrument, such as cash, check, stock,
bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the
financial instruments come together and financial transactions take place.
TYPES OF FINANCIAL MARKETS

Primary Markets
Primary market is one where new financial instruments are issued for the first time. They provide
a standard institutionalized process to raise money. The public offerings are done through a
prospectus. A prospectus is a document that gives detailed information about the company, their
prospective plans, potential risks associated with the business plans and the financial instrument.
Secondary markets
Secondary Market is a place where primary market instruments, once issued, are bought and
sold. An investor may wish to sell the financial asset and encash the investment after some time
or the investor may wish to invest more, buy more of the same asset instead, the decision
influenced by a variety of possible reasons. They provide the investor with an easy way to buy or
sell.
The Different Financial Markets

A financial market is known by the type of financial asset or instrument traded in it. So there are
as many types of financial markets as there are of instruments. Typical examples of financial
markets are:
• Stock market
• Bond (or fixed income) market
• Money market
• Foreign exchange (Forex or FX for short) market (also called the currency market).
Stock and bond markets constitute the capital markets. Another big financial market is the
derivatives market.
CAPITAL MARKETS
Why businesses need capital?

All businesses need capital, to invest money upfront to produce and deliver the goods and
services. Office space, plant and machinery, network, servers and PCs, people, marketing,
licenses etc. are just some of the common items in which a company needs to invest before the
business can take off. Even after the business takes off, the cash or money generated from sales
may not be sufficient to finance expansion of capacity, infrastructure, and products / services
range or to diversify or expand geographically. Some financial services companies need to raise
additional capital periodically in order to satisfy capital adequacy norms.

What is the role of Capital Markets?

For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely
important. Capital markets have following functions:
1. Channeling funds from “savings pool” to “investment pool” - channeling funds from “those
who have money” to “those who need funds for business purpose”.
2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell financial
assets or instruments. Capital markets achieve this in a number of ways and it is particularly
important for institutional investors who trade in large quantities. Illiquid markets do not allow
them to trade large quantities because the orders may simply not get executed completely or
may cause drastic fluctuations in price.
3. Providing multitude of investment options to investors – this is important because the risk
profile, investment criteria and preferences may differ for each investor. Unless there are
many investment options, the capital markets may fail to attract them, thus affecting the
supply of capital.
4. Providing efficient price discovery mechanism – efficient because the price is determined by
the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers in
the market at any point. So the market price can be considered as a fair price for that
instrument.
STOCK MARKETS
Stock markets are the best known among all financial markets because of large participation of
the “retail investors”. The important stock exchanges are as follows:
• New York Stock Exchange (NYSE)
• National Association of Securities Dealers Automated Quotations (NASDAQ)
• London Stock Exchange (LSE)
• Bombay Stock Exchange (BSE),
• National Stock Exchange of India (NSE)
Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares
that are traded on that particular exchange. Exchanges then follow a mechanism to automatically
match these trades based on the quoted price, time, quantity, and the order type, thus resulting in
trades. The market information is transparent and available real-time to all, making the trading
efficient and reliable.
Earlier, before the proliferation of computers and networks, the trading usually took place in an
area called a “Trading Ring” or a “Pit” where all brokers would shout their quotes and find the
“counter-party”. The trading ring is now replaced in most exchanges by advanced computerized
and networked systems that allow online trading, so the members can log in from anywhere to
carry out trading. For example, BOLT of BSE and SuperDOT of NYSE.
What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of shares at each
price. The demand and supply vary primarily as the perceived value of the stock for different
investors varies. Investor will consider buying the stock if the market price is less than the
perceived value of the stock according to that investor and will consider selling if it is higher. A
large number of factors have a bearing on the perceived value. Some of them are:
• Performance of the company

• Performance of the industry to which it belongs

• State of the country’s economy where it operates as well as the global economy
• Market sentiment or mood relating to the stock and on the market as a whole
Apart from these, many other factors, including performance of other financial markets, affect the
demand and supply.
BOND MARKETS
As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in exchanges, most
of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations between
dealers. Lately there have been efforts to create computer-based market place for certain type of
bonds.
Participants in the Bond Market

Since Government is the biggest issuer of bonds, the central bank of the country such as Federal
Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like
stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the bond
issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid for
the bonds and the price is fixed based on the bids received. The dealers then sell these bonds in
the secondary market or directly to third parties, typically institutions and companies.
If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on the
direction of interest rates change. Remember, bond pays interest at a fixed coupon rate
determined at the time of issue, irrespective of the prevailing market interest rate. Market interest
rates are benchmark interest rates, such as Treasury bill rates, which are subject to change
because of various factors such as inflation, monetary policy change, etc. So when the prevailing
market interest rates change, price of the bond (and not the coupon) adjusts, so that the effective
yield for a buyer at the time (if the bond is held to maturity) matches the market interest rate on
other bonds of equal tenure and credit rating (risk).
So when the market interest rates go up, prices of bonds fall and vice-versa. Thus, since price of
bonds changes when market interest rate changes, all bonds have an interest rate risk. If the
market interest rates shoot up, then the bond price is affected negatively and an investor who
bought the bond at a high price (when interest rates were low) stands to lose money or at least
makes lesser returns than expected, unless the bond is held to maturity.

Example
Bond Price calculation can be summed by an easy formula:
where B represents the price of the bond and CFk represents the kth cash flow which is made
up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon
payment and the Principal.
• What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate
(i) is 10% and the Coupon payments are Rs.5 annually?
• Would the bond price increase/decrease if the coupon is reduced? What would be happen
to bond price if the interest rates came down?
FOREIGN EXCHANGE MARKET

Foreign exchange markets are where the foreign currencies are bought and sold. For example,
importers need foreign currency to pay for their imports. Government needs foreign currency to
pay for its imports such as defense equipment and to repay loans taken in foreign currency.
Foreign exchange rates express the value of one currency in terms of another. They involve a
fixed currency, which is the currency being priced and a variable currency, the currency used to
express the price of the fixed currency. For example, the price of a US Dollar can be expressed in
different currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound
(GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR,
GBP, Euro are the variable currencies.
US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currencies
worldwide, since maximum business transactions are carried out in these currencies.
The exchange rate at any time depends upon the demand – supply equation for the different
currencies, which in turn depends upon the relative strength of the economies with respect to the
other major economies and trading partners.
Participants
Only authorized foreign exchange dealers can participate in the foreign exchange market. Any
individual or company, who needs to sell or buy foreign currency, does so through an authorized
dealer. Currency trading is conducted in the over-the-counter (OTC) market.
The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of regulation
depends on the economic policies of the country. The central bank may also buy or sell their
currency to meet unusual demand – supply mismatches in the markets.
The foreign exchange rate and transactions are closely monitored because the fluctuations in
forex markets affects the profitability of imports and exports of domestic companies as well as

profitability of investments made by foreign companies in that country. Regulators try to ensure
that the fluctuations are not caused by any factor other than the market forces.
Example
The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange
rates to ensure that the importers/exporters are not hurt due to any exchange rate
fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world,
maintains a long-standing reputation of sharp increases in short-term volatilities.
MONEY MARKET
Money market is for short term financial instruments, usually a day to less than a year. The most
common instrument is a “repo”, short for repurchase agreement. A repo is a contract in which the
seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price.
Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also
considered as money market instruments.
Since the tenure of the money market instruments is very short, they are generally considered
safe. In fact they are also called cash instruments. Repos especially, since they are backed by a
Govt. security, are considered virtually the safest instrument. Therefore the interest rates on
repos are the lowest among all financial instruments.
Money market instruments are typically used by banks, institutions and companies to park extra
cash for a short period or to meet the regulatory reserve requirements. For short-term cash
requirements, money market instruments are the best way to borrow.
Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, the
minimum investment in bond and money markets runs into hundreds of thousands of Rupees or
Dollars. Hence the money market participants are mostly banks, institutions, companies and the
central bank. There are no formal exchanges for money market instruments and most of the
trading takes place using proprietary systems or shared trading platforms connecting the
participants.
REGULATION OF CAPITAL MARKETS

There are many reasons why the financial markets are regulated by governments:
• Since the capital markets are central to a thriving economy, Governments need to ensure
their smooth functioning.
• Governments also need to protect small or retail investors’ interests to ensure there is
participation by a large number of investors, leading to more efficient capital markets.
• Governments need to ensure that the companies or issuers declare all necessary information
that may affect the security prices and that the information is readily and easily available to all
participants at the same time.

Typically the government designates one or more agencies as regulator(s) and supervisor(s) for
the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US
has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and
norms for each activity and each category of participant. For example,
• Eligibility norms for a company to be allowed to issue stock or bonds,
• Rules regarding the amount of information that must be made available to prospective
investors,
• Rules regarding the issue process,
• Rules regarding periodic declaration of financial statements, etc.
Regulators also monitor the capital market activity continuously to ensure that any breach of laws
or rules does not go unnoticed. To help this function, all members and issuers have to submit
certain periodic reports to the regulator disclosing all relevant details on the transactions
undertaken.
FINANCIAL MARKET SYSTEMS

The demands of the capital market transactions, the need for tracking and managing risks, the
pressure to reduce total transaction costs and the obligation to meet compliance requirements
make it imperative that the functions be automated using advanced computer systems. Some of
the major types of systems in capital market firms are briefly described below.
Trading Systems
The volume of transactions in capital markets demands advanced systems to ensure speed and
reliability. Due to proliferation of Internet technology, the trading systems are also now accessible
online allowing even more participants from any part of the world to transact, helping to increase
efficiency and liquidity. The trading systems can be divided into front-end order entry and back-
end order processing systems.
Order entry systems also offer functions such as order tracking, calculation of profit and loss
based on real-time price movements and various tools to calculate and display risk to the value of
investments due to price movement and other factors.
Back-office systems validate orders, route them to the exchange(s), receive messages and
notifications from the exchanges, interface with external agencies such as clearing firm, generate
management, investor and compliance reports, keep track of member account balances etc.
Exchange systems
The core exchange system is the trading platform that accepts orders from members, displays
the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as
possible and sends status messages and trade notifications to the parties involved in each trade.
In addition, exchanges need systems to monitor the transactions, generate reports on
transactions, keep track of member accounts, etc.
Portfolio Management Systems

These systems allow the investment managers to choose the instruments to invest in, based on
the requirements or inputs such as amount to be invested, expected returns, duration (or tenure)
of investment, risk tolerance etc. and analysis of price and other data on the instruments and
issuers. The term “portfolio” refers to the basket of investments owned by an investor. A portfolio
of investments allows one to diversify risks over a limited number of instruments and issuers.

Accounting Systems
The accounting systems take care of present value calculations, profit & loss etc.- of investments
and funds and not the financial accounts of the firms.

SUMMARY
• Financial markets facilitate financial transactions, i.e. exchange of financial assets such
stocks, bonds, etc.
• Financial markets bring buyers and sellers in a financial instrument together, thus reducing
transaction costs, channeling funds, improving liquidity and provide a transparent price
discovery mechanism.
• Each financial market is segmented into a Primary market, where new instruments are issued
and a Secondary market, where the previously issued instruments are bought and sold by
investors.
• Stock markets, bond markets, money markets, foreign exchange markets and derivatives
markets are prominent examples of financial markets.
• Shares (stock) of a company are issued and traded in the stock markets.
• Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds, etc.
are traded.
• Money markets, like bonds markets, are also fixed income markets. Instruments traded in
money markets have very short tenure.
• Foreign exchange markets trade in currencies.
• Derivatives markets trade derivatives, which are complex financial instruments, whose
returns are based upon the returns from some other financial asset called as the underlying
asset.
• Price of any financial instrument depends basically on demand and supply, which in turn
depend upon multiple different factors for different markets.
• Each financial instrument has a differing level of inherent risk associated with it. Money
market instruments are considered the safest due to their very short tenure.
• Regulators play a very important role in the development and viability of financial markets.
Regulators try to ensure that the markets function in a smooth, transparent manner, that
there is sufficient and timely disclosure of information, that the interest of small investors is
not compromised by the large investors, and so on, which is critical for overall vibrancy,
efficiency and growth of the market and the economy.

1.4. Financial Statements

Financial Statements
Introduction to Financial Accounting
Why does the concept of Accounting and Financial Statements exist? Here are two main
reasons:
1. The managers of the business will want to know how things are going. They need
financial information in order to plan for the future; they need more up-to-date information
in order to check whether actual performance is on target. So accounting is the first step
in what we call management accounting.
2. There are several other groups of people who may have an interest in the finances of the
business (often referred to as 'stakeholders'). The law says that they have a legal right
to certain information. The whole process of providing this information (and of maintaining
a book-keeping system which is capable of providing it) is known as financial
accounting.
The stakeholders of any firm could be any or all of the following:
1. Shareholders
2. Employees
3. Management
4. Customers
5. Government
6. Trade Unions and others
Question: Who owns the firm - management or shareholders?

Answer: Shareholders of course, as they hold shares of the company. However Management
personnel/directors of a company are also encouraged to hold shares of the company to align the
interest of management and shareholders. )
For Accounting purpose, Company is considered as a Legal Entity – that is, a person or
organization that has the legal standing to enter into contracts and may be sued for failure to
perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a
corporation is a legal entity since it is a person in the eyes of the law.
In order that the stakeholders mentioned above understand the financial position of a company,
there are standardized financial statements that are prepared. The main ones are:
1. Balance Sheet
2. Income Statement or Profit and Loss Account
3. Cash-Flow statement
Now, let us study them one at a time (why do you need to do that? Well, one of the aims of this
course is to ensure that you are familiar with the basic concepts and terms used in Finance. And
the above statements are as basic as it gets. SO read on)

Balance Sheet
A Balance sheet is a statement that lists the total assets and the total liabilities of a given
business to portray its net worth at a given moment of time. Thus, if you look at any balance
sheet, it is “As on March 31st 200X” (Or whatever the financial year ending date)
So, it indicates the health of the firm at a point of time.
What are the individual items in a Balance Sheet?

First of all it’s called a balance sheet because the Asset and Liabilities in a Balance sheet
balance, meaning they equal each other – it’s as simple as that!
An Asset is anything owned by an individual or a business, which has commercial value. Claims
against others also qualify as Assets. (That is, if someone owes you something, then it is also an
asset, as it actually belongs to you and is of commercial value)
A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to
pay cash, or provide goods and services, in some future period. (Thus, if you buy a bike on
installments, Bike is of course an asset as it has capability to provide you service for next few
years, but the loan amount which you need to pay out in installments is a Liability you incur.)
The typical heads in a balance sheet are shown below with a sample:

Consolidated Statements of Financial Positions

(All number in thousands)
Assets Liabilities
Current Assets Current Liabilities
Cash and Cash Equivalents $100 Payables and Accrued Expenses $50
Short Term Investments 100 Short Term Loans 150
Receivables 200 Debt due in the next 1 year 100
Inventory 50 Other Current Liabilities 50
Other Current Assets 50
Total Current Assets 500 Total Current Liabilities 350
Long Term Assets Long term Liabilities
Net Fixed Assets (Land, 200 Long term debt 200

Properties and Equipments)
Intangible Assets 100 Deferred Liabilities 50
Goodwill 50 Other Liabilities 100
Other Assets 50 Total Liabilities 700
Shareholders’ Equity
Equity 100
Retained Earnings 100
Total Long Term Assets 400 Total Shareholder’s Equity 200
Total Assets 900 Total Liabilities and 900

Shareholders’ Equity
Lets look at each item closely:

ASSETS
Current Assets
Current Assets are those assets of a company that are reasonably expected to be realized in
cash, or sold, or consumed in the next one year. Some current assets are listed below:
Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which
can be converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts,
cash in bank accounts etc).
Short Term Investments: All investments, which will be converted in Cash in the next one
year. All the assets (bonds etc) with less than one year “time to maturity” will be accounted under
this item (E.g. short term securities).
Receivables: Also referred to as Account receivables. This indicates the money due to the firm,
for service rendered or goods sold on credit.
Inventory: Inventory for companies includes raw materials, items available for sale or in the
process of being made ready for sale (work in process). For a stockbroker, it will be the securities
bought and held by him, for resale.
Other Current Assets: Any thing else which could not be categorized in one of the items
above but we know that it’s a current asset can be accounted for here.
Long-Term Assets
Long-term assets are those assets that are not consumed during the normal course of business,
e.g. land, buildings and equipment, goodwill, etc. They include:
Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct
of a business, and which will not normally be converted into cash during the next fiscal period.
For example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all
property, plant, and equipment, net of depreciation.
Depreciation
We all understand that if we buy a car today, after 5 years of service the value of the car would
not be same. We will not be able to sell the car after 5 years at the same price at which we
bought the car. This means that assets lose their value as they provide service. This loss of
value, or spreading of cost, is called depreciation.
Calculating deprecation can get complex, but here’s one simple way of calculating depreciation.
Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the 3
years the asset will have a Zero value. What is the true value of the asset at the end of each
year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus:
Value of Asset End of Year
$ (3000-1000)=$ 2000 1
$1000 2
$0 3

Usually, instead of the value coming all the way down to zero, it is said to have a ‘scrap’ value:
say, $100. At this point, the asset is removed from the business’ books, or said to be “written off ‘.
Intangible Assets: Intangible Asset is an asset that is not physical in nature. Examples are
things like copyrights, patents, intellectual property, or goodwill. We can look at more details
through an example of Goodwill below.
Goodwill
Goodwill is that intangible possession which enables a business to continue to earn a profit that is
in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a
company such as Hindustan levers, has built up a lot of goodwill over the years. Customers
would prefer to buy their products versus an unknown brand. This is an intangible factor, yet
worth a lot of money!
Other Assets: Again, any other asset, which could not be classified under any of the categories
above, but one is sure its an asset, can be accounted for here.
LIABILITIES
Current Liabilities
Current Liabilities are amounts, or goods and services, to be paid or executed, within next one
year.
Payables and Accrued Expenses: A Company might have suppliers who supply on credit,
and this is an Account Payable. An accrued expense is an expense that the company has
already incurred but company has not paid for it so far.
Short Term Loans: All the loans that have to be paid in the next one year.
Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid
in installments every year, and so just the money that has to be paid in the next one year would
be accounted here.
Other Current Liabilities: Any liabilities, which cannot be categorized under any of the
headings above.
Long-term Liabilities
Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred
portions of long-term debt, and capital lease obligations. Please note that part of the loan that is
due only after next one year is indicated here.
Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or
liability is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this
case, one knows that there will be some expenses, but the exact amount and dates are not
known.
Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above.
Equity
This is basically equity share capital, which is capital raised by an entity through the sale of
common shares in the primary market. This is also called share capital.

Retained Earnings
Retained Earnings are profits of the business that have not been distributed to the owners as of
the balance sheet date. The earnings have been "retained" for planned activities such as
business expansion - so they actually belong to the owners (shareholders), but have been
retained.
Quiz: How do the three items above change when company declares dividend?
Answer: Nothing changes till the company pays out dividends.
Quiz: How do these items change when company pays out dividends?
Answer: Retained earnings go down by amount of dividend.
Advanced Quiz: Are stock options same as shares held by employees? Are these captured in
these statements?
Answer: A stock option is the right of an employee to buy company shares at a pre-specified
price, which may be above or below the market price, as on date of the exercising of option. If the
option price is below the market price, the employee may buy at the option price & sell at market
price & thus realize a profit. If option price is above the market price as on that date, obviously the
employee will not prefer to exercise the option. Hence, the options cannot be categorized as
‘shares’. However, in some balance sheets, provision may be made for these stock options under
the ‘liability’ head.
Income (P & L) Statements

Profit And Loss Statement (P&L) is also known as an income statement. It shows business
revenue and expenses for a specific period of time (such as the financial year – so if you look at
any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st
December 2003. The difference between the total revenue and the total expense is the business’
net income.
A key element of this statement, and one that distinguishes it from a balance sheet, is that the
amounts shown on this statement represent transactions over a period of time while the items
represented on the balance sheet show information as of a specific date (or point in time). So in
engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesn’t
have a memory.
It is important to understand that for a company “Profit” need not equal the “Cash” it has
generated during a period. It might so happen that company has provided the service but the
client has not yet paid and so company makes a Profit but not Cash. To account for cash
generated during a period, companies also report “Cash flow statement”.
A sample P&L statement is shown below.

P&L or Income Statement
Revenue A
Direct Cost B = (C+D)
Direct Material C
Direct Labor D
Gross Profit E = (A-B)
Operating Expenses (Based on the type of business, some F = (G+ H+I+J+K)

of these items would qualify as indirect Cost)
Administration G
R&D H
Marketing and Selling Expenses I
Any one time expenses (e.g. ex-gratia etc) J
Other Expenses K
Operating Income L = (E-F)
Other Income M
Other Expenses N
EBIT (Earnings Before Interest and Taxes) O = (L+M-N)
Interest Expenses P
Profit Before Tax (PBT) Q = (O-P)
Income Taxes R
Net Income or PAT (Profit after Tax) S= (Q-R)
EPS (Earnings Per Share) T = S/ Number of shares
P/E Ratio Market price/T

Let’s look at each item closely:

Revenue
Revenue is the inflows of assets (may be Cash or Receivables, Remember!) from selling goods
or providing services to customers. This is also referred to as the ‘Topline’ (as it is the top line in
the P& L statement!)
Direct Cost
Direct Cost is that portion of cost that is directly expended in providing a product or service for
sale e.g. material and labor.
Gross Profit
Gross Profit is one of the key performance indicators. Gross profit shows the relationship
between sales and the direct cost of products/services sold. It is measured as indicated in the
table above.
Indirect Cost
Indirect Cost is that portion of cost that is indirectly expended in providing a product or service for
sale (cannot be traced to a given project, in our case, in an economically feasible manner) e.g.
rent, utilities, equipment maintenance, etc.
Operating Expenses
Operating Expenses is all selling and general & administrative expenses. Includes depreciation,
but not interest expense.
Operating Income
Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related
operating expenses that are applied to the day-to-day operating activities of the company. It
excludes financial related items (i.e., interest income, dividend income, and interest expense),
and taxes.
EBIT (Earnings Before Interest and Taxes)
It’s the earnings before any interest or taxes.
Interest Expenses
Interest expense captures all the finance charges incurred on any borrowed capital.
Profit Before Tax (PBT)
Profit before accounting for Taxes.
Income Taxes
Amount of tax to be paid. This is a % of PBT.
Net Income or PAT (Profit after Tax)
This is the profit after all the obligations, which can be distributed to shareholders’. This is also
referred as the ‘Bottomline’ (as this is the bottom line in a P &L statement, or the final profit net of
expenses & tax.
EPS (Earnings Per Share)

Earnings Per Share (EPS) is the amount of net income (earnings) related to each share;
computed by dividing net income by the number of shares outstanding during the period.
P/E Ratio
Price To Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison
against other companies or within the stock's own historical performance. For instance, if a stock
has historically run at a P/E of 35 and the current P/E is 12, you may want to explore the reasons
for the drastic change. If you believe that the ratio is too low, you may want to buy the stock.
There are a number of other ratios that help analysts to analyze the financial statements of
companies to understand the current performance and future prospects; we are not
discussing those here.
Cash Flow Statement
Statement accounting for all the inflows and outflows of cash is captured in this statement.
Why do you need a separate Cash-flow statement?

Isn’t it covered in Balance sheet or Income statement?
All the accounting is done based on the method wherein, revenue and expenses are recorded in
the period in which they are earned or incurred regardless of whether cash is received or
disbursed in that period. So when a good is sold or some service rendered, it will show in
Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is
received for the same.
Quiz: How will you explain a scenario where company is reporting a large profit but company
doesn’t have the cash to pay salary to its employees? Where is the cash going or “did it come at
all”?
Answer: It means that the company is selling goods and also making profits but has not received
cash payments from its customers!
Exercise
1. Day 1: You borrow Rs 100 from a bank for a business to produce t-shirts. How would
your balance sheet look like at the end of the day?
2. Day 2: You purchase raw material for your products for Rs 50. How would your balance
sheet look like at the end of the day?
3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The
product is ready to be shipped to customer.
4. Day 30: You pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay
other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the day
the product is shipped to the customer. Customer has promised to pay you Rs 120 after
checking the quality, which will take 5 days. How would your balance sheet look like at
the end of the day? How would your Income statement look like?

5. Day 35: You get Rs 120 from customer. You also get admission in a Business School
and so you plan to wind up the business. Prepare all the financial statements (Balance
sheet and Profit and loss statement at the end of day 35).
Useful Information: Bank charges 12% simple interest rate. You need to pay tax @ 10% of the
net income. Inflation for the period was 5%.
Advanced Exercise
Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this
60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred in
rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US
infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is
incurred in rupees. By what percentage, will the profit increase/decrease if the rupee appreciates
by 1% from its current level of Rs. 50 per dollar?
Understanding Cognizant’s Financial Statements
Cognizant’s Balance Sheet


Cognizant’s Income Statement.

NOTES: FINANCIAL STATEMENTS

2. BANKING

2.1. INTRODUCTION TO BANKING

INTRODUCTION TO BANKING
WHAT IS A BANK?
The term ‘Bank’ is used generically to refer to any financial institution that is licensed to accept
deposits and issue credit through loans.
Banks are the backbone of any economy, as all monetary transactions end up touching banks.
The main functions of banks are to:
• Channelize Savings
• Provide credit facilities to borrower
• Provide investment avenues to investors
• Facilitate the trade and commerce dealings
• Provide financial backbone to support economic growth of the country
• Minimize Cash Transactions
• Provide Services
WHY DO WE NEED A BANK?

• They provide a return (pay interest) on our saving
• Safety of principal and interest
• Convenience of being able to write checks and use debit cards
• Raising funds when we need
From the business or economic point of view, however, banks are the primary source of finance.
Since the deposits of the small investors are protected, bank deposits are considered a low risk
investment avenue. Due to their access to a large source of funds at very low cost, owing largely
to the low interest rate on savings and term deposits, banks are in the best position to lend to
businesses and individuals at competitive interest rates.
WHAT IS THE CENTRAL BANK AND WHAT ARE ITS ROLES?

The Central bank of any country can be called the banker’s bank. It acts as a regulator for other
banks, while providing various facilities to facilitate their functioning. It also acts as the
Government’s bank. The Federal Reserve is the central bank of the United States, while Reserve
Bank of India is the central bank in India.
The main objective of a central bank is to provide the nation with a safer, more flexible, and more
stable monetary and financial system. They have the following responsibilities:
• Conducting the nation's monetary policy. Central banks define the monetary policy and then
take necessary actions to create an environment to make those policies feasible. E.g. if the
central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more
money in the economy.
• Supervising and regulating banking institutions and protecting the rights of consumers
• Maintaining the stability of the financial system, i.e. stability of interest rates and foreign
exchange rate.
• Ensuring that the interest rates remain at such a level as to make business viable
• Ensuring that sufficient funds are available for long term investment to businesses as well as
government, without causing inflation to rise

• Providing certain financial services to the government, the public, financial institutions, and
foreign official institutions
• Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow of
foreign currency
BANKS, ECONOMY AND AMOUNT OF MONEY

Banks facilitate the creation of money in the economy. The primary function of banks is to put
account holders' money to use by lending it out to others who can then use it to buy homes,
businesses etc.
Let’s look at an example as how banks do this. The amount of money that banks can lend is
directly affected by the reserve requirement set by the Central Bank. That is, every bank needs to
maintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserve
requirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of
$100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes
back into the economy, purchasing goods or services, and usually ends up deposited in another
bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to
purchase goods or services and ultimately is deposited into another bank that proceeds to lend
out a percentage of it. In this way, money grows and flows throughout the community in a much
greater amount than physically exists. This is also called multiplier effect. In the picture below, an
initial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate the
investing/spending of money that multiply funds through circulation and this is known as “Money
Multiplier” effect.

HOW DO BANKS MAKE MONEY?

Banks are like any other regulated business; the product they deal with is “Money”. So they
borrow money from individual or businesses “who have money”, and lend it to those “who need
money”, by adding a mark up, to pay for expenses and profit. The difference between the rates,
which banks offer to depositors and lenders, is generally referred to as “Spread”. Understandably,
the spread in this business is low; hence increasing the turnover (volume) is the key to making
profit. Hence, in practice, banks offer a number of options – often termed as “products” - to both
investors and borrowers to meet their different requirements and preferences and thus increase
business. They also provide fee-based services such as managing cash for corporate clients, to
increase business and improve profit margin.
SERVICE OFFERINGS OF BANKS

Service offerings of banks are organized along following divisions:
• Corporate Banking
o Trade Finance
o Cash Management
• Retail Banking
o Electronic Banking
o Credit Card services
o Retail Lending – Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans
o Private Banking
o Asset Management
• Investment Banking
o Private Equity
o Corporate Advisory
o Capital Raising
o Proprietary Trading
o Emerging Markets

o Sales, Trading & Research

§ Equity
§ Fixed Income
§ Derivatives
TOP 50 BANKS IN THE US BY ASSET SIZE

As of March 2004 ($ Million)
Si no. Company Name Total Assets Total Deposits
1 Citigroup, Inc. 1,317,877 499,189
2 J.P. Morgan Chase & Co. 1,120,668 502,826
3 Bank of America Corporation 1,016,247 573,356
4 Wachovia Corporation 410,991 232,338
5 Wells Fargo & Company 397,354 248,369
6 U.S. Bancorp 192,093 118,964
7 SunTrust Banks, Inc. 148,283 96,661
8 National City Corporation 128,400 77,122
9 ABN AMRO North America
Holding Company* 127,154 53,289
10 HSBC North America Inc.* 125,950 86,248
11 Citizens Financial Group, Inc.* 118,986 84,764
12 BB&T Corporation 94,282 64,125
13 Fifth Third Bancorp 93,732 55,250
14 State Street Corporation 92,896 53,512
15 Bank of New York Company, Inc. 92,693 55,961
16 KeyCorp 84,448 49,931
17 Regions Financial Corporation 80,275 54,170
18 PNC Financial Services Group,
Inc. 74,115 48,125
19 Merrill Lynch Bank USA* 66,643 53,208
20 MBNA Corporation* 59,126 31,861
21 Comerica Incorporated 54,468 43,523
22 SouthTrust Corporation 52,673 35,515
23 M&T Bank Corporation 50,832 33,341
24 AmSouth Bancorporation 47,415 31,545
25 UnionBanCal Corporation 46,102 39,006
26 BancWest Corporation* 43,814 30,794
27 Northern Trust Corporation 40,179 28,448
28 Bankmont Financial Corp.* 38,767 21,908
29 Popular, Inc. 38,102 18,603
30 Marshall & Ilsley Corporation 35,476 23,151
31 Mellon Financial Corporation 33,898 20,306
32 Huntington Bancshares
Incorporated 33,875 20,935
33 Zions Bancorporation 29,790 21,486
34 Compass Bancshares, Inc. 27,481 16,524
35 First Horizon National Corporation 27,084 17,712

Si no. Company Name Total Assets Total Deposits

36 Banknorth Group, Inc. 26,880 17,958
37 North Fork Bancorporation, Inc. 26,178 19,164
38 Commerce Bancorp, Inc. 24,955 22,883
39 Capital One Bank 24,515 12,213
40 Synovus Financial Corp. 22,286 16,214
41 American Express Centurion
Bank 20,413 8,858
42 Associated Banc-Corp 19,254 12,375
43 RBC Centura Banks, Inc. 19,232 9,347
44 Discover Bank 19,107 13,490
45 Hibernia Corporation 18,717 14,882
46 TD Waterhouse Group, Inc. 17,007 9,630
47 Colonial BancGroup, Inc. 16,499 10,050
48 Webster Financial Corporation 15,090 8,638
49 Commerce Bancshares, Inc. 14,485 10,253
50 Merrill Lynch Bank & Trust
Company 14,377 12,252

UNIVERSAL BANKING
The universal banking concept permits banks to provide commercial bank services, as well as
investment bank services at the same time.
Glass-Steagall Act of 1933, created a Chinese wall between commercial banking and securities
businesses in US. That act was intended to address the perceived causes of bank failures during
the Great Depression of 1929.
Today, Glass-Steagall restrictions have become outdated and unnecessary. It has become clear
that promoting stability and best practices cannot be done through artificially separating these
business areas. Over the years, banks and securities firms have been forced to find various
loopholes in the Glass-Steagall barriers. The restrictions undermined the ability of American
banks to compete with the other global banks which were not covered by such legislation.
Most of Glass-Steagall provisions have been repealed in the US in 1990s enabling the banks to
offer a full range of commercial and investment banking services to their customers.
Example
In the late 1990s, before legislation officially eradicated the Glass-Steagall Act’s restrictions,
the investment and commercial banking industries witnessed an abundance of commercial
banking firms making forays into the I-banking world. The mania reached a height in the
spring of 1998. In 1998, NationsBank bought Montgomery Securities, Société Génerale
bought Cowen & Co., First Union bought Wheat First and Bowles Hollowell Connor, Bank of
America bought Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought
Bankers Trust (which had bought Alex. Brown months before), and Citigroup was created in a
merger of Travelers Insurance and Citibank.
While some commercial banks have chosen to add I-banking capabilities through acquisitions,
some have tried to build their own investment banking business. J.P. Morgan stands as the
best example of a commercial bank that has entered the I-banking world through internal
growth. J.P. Morgan actually used to be both a securities firm and a commercial bank until
federal regulators forced the company to separate the divisions. The split resulted in J.P.
Morgan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan
has slowly and steadily clawed its way back into the securities business, and Morgan Stanley
has merged with Dean Witter to create one of the biggest I-banks on the Street.

SUMMARY
• Banks are an integral part of any economy channelizing savings from lenders to borrowers
• Bank deposits are low risk investments
• The Central bank is the “Bankers’ Bank” and it regulates other banks in an economy.
• Central banks define a nation’s monetary policy
• A bank makes a profit by investing or lending money that is earning a higher rate of interest
than it pays to its depositors.
• A bank is required to keep a certain amount of "cash reserves" by regulation to maintain
liquidity, i.e. to ensure that the banking system does not face a cash crunch due to higher
withdrawals, which can lead to panic among investors and a run on a bank.
• Banks create a “Money Multiplier” effect
• Banks are generally organized as corporate banking, investment banking, retail banking, and
private banking functions.
Universal banks provide commercial banking as well as investment bank services under one roof

2.2. RETAIL BANKING

RETAIL BANKING
RETAIL SERVICE
Banking Accounts
Banking account can classified as below based on their features, cost and usefulness.
Checking Accounts
• Quick, convenient and, frequent-access to the money.
• Checks are used to withdraw money, pay bills, purchasing, transfer money to another
accounts and many other common usage.
• Some banks pay interest while many do not.
• Institutions may impose fees on checking accounts, besides a charge for the checks ordered.
Any combination of the following three ways can be used by the banks:
o Flat fee regardless of the balance maintained or number of transactions.
o Additional fee if average balance goes down below a specified amount.
o A fee for every transaction conducted.
Money Market Deposit Accounts

• An interest-bearing account with checks writing facility, called a money market deposit
account (MMDA).
• Pays a higher rate of interest than a checking or savings account
• MMDAs often require a higher minimum balance to start earning interest
• Each month, numbers of transactions are limited to six transfers to another account or to
other people, and only three of these transfers can be by check.
• Most institutions impose fees on MMDAs.
Savings Account
• Allows making withdrawals, but checks writing facility is not there.
• Number of withdrawals or transfers one can make on the account each month is limited.
• Passbook savings – The pass book must be presented when you make deposits and
withdrawals
• Statement savings – Institution regularly mails a statement that shows withdrawals and
deposits for the account.
• Institutions may assess various fees on savings accounts, such as minimum balance fees.
Time Deposits (Certificates of Deposit)
• Guaranteed rate of interest for a term or length of time specified by the account holder.
• Once the term specified, one cannot withdraw the principal without attracting penalties.
• One can withdraw the interest earned on the principal.
• The rate of interest is often higher than savings or any other account

• CDs renew automatically, so if not notified before maturity, CDs will roll over for another term.
Most of the institutions notify the account holder before maturity.
Basic or No Frill Banking Accounts

• Checking accounts, but with a limit on the number of checks one can write and the number of
deposits and withdrawals one can make
• Interest is generally not paid.
• Fees is generally lower than checking accounts
Branch Banking
• A banking system in which there is a head office and interconnected branches providing
financial services in different parts of the country
• Today 70% of customers use more than one contact channel
o However, 51% of customers still prefer branch banking – branch loyalty
• Evidence from the trends of new branch openings
o 550 over three years at Bank of America
o 100 over five years at JPMorgan Chase
o 250 this year alone at Washington Mutual
• Branch networks have re-emerged as combined centers for advice-based product sales and
service, as well as more traditional banking transactions
• Customers are looking for a full-service center for all their needs -- from banking products to
brokerage services
• Branches are being transformed from transaction processing centers into customer-centric,
financial sales and service centers
• This transformation is helping Banks to achieve bottom line business benefits like
o Increased customer profitability
o Retention of most profitable customers
o Increased branch revenue
o Increased staff productivity
o Reduced operational costs
• A typical Retail branch at a Bank provides two primary functions
o Teller Operations - Accept and process customer transactions at the teller
window
o Sales and customer service Operations - Tasks, such as new account opening,
account maintenance and product sales
Teller Operations
• Teller functionality
o Cash advances
o Consumer /mortgage loan payments
o Currency and coin orders
o Deposits, including commercial deposits

o Fee collection
o Foreign currency exchange
o Payments
o Stop payments
o Transfers
o Wire transfers
o Withdrawals
Sales and Customer Service

• Sales and Service Platform Functions
o Account and contact histories
o Bank information and fee schedules
o Campaign management
o Complaint reporting and tracking
o Customer contact and event tracking and management
o Customer profile and relationships
o Decision tracking
o Lead generators
o Marketing and sales planners
o Profiling
o Referral processing
Multi-branch banking
It is a special facility that allows a customer to operate his SB or Current Account through a
network of branches of the bank where he has an account. All Multi Branch Banking account
holders are eligible for Multi City Cheque (Pay At par Cheque) facilities.
• Multi-branch banking functions
o Under this service, the customer of one branch is able to transact on her
account, from any other networked branch of the Bank.
o Typical services provided through “Multi Branch Banking” include
o Cash Deposits
o Cash Payments
o Transfer of funds
o Balance Inquiry
o Marking Stop Payment of a Check
ATM Banking
Banking enabled through a terminal used to make transactions without a human teller. In recent
years it has become one of the most popular banking media.
• ATM growth was 9.3 percent per year from 1983 to 1995 but increased to 15.5 percent from
1996 to 2002
o Off-premise ATMs account for nearly 60 percent of total U.S. ATMs
• Access to ATM by means of a card, typically a dual ATM/debit card

• Transaction directly linked to the consumer’s bank account - amount debited against the
funds in that account
• Typical Services
o Cash withdrawal – Limit per day restricted by respective bank guidelines
o Money Transfer between accounts
o Cash/ Check Deposits
o Utility Bill Payments
o Balance enquiry /Account Statements
Types of ATMs
• Proprietary System
o Operated by a financial institution that purchases or leases ATMs,
o Acquires the necessary software or develops it in-house, installs the system and
markets it, and issues cards of its own design
• Shared / Regional System
o A network that comes into being when customers of one or more financial
institutions have access to transaction services at ATMs owned or operated by
other financial institutions.
• National / International System
o A network which enables an ATM machine in New York to connect with another
in Los Angeles. Through service agreements with regional and proprietary
networks, national networks link ATM machines coast to coast.
ATM
Proprietary Shared/Regional National/International
Money Transfer
• Cheques/Checks
o Bearer Checks
o Account Payee Checks
o Travelers’ Checks
o Bankers Checks
• Debit Cards
• Demand Drafts
• Automated Clearing House (ACH)
• Standing Instructions
• Electronic Transfer

ELECTRONIC BANKING
Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic
technology as a substitute for checks and other paper transactions. EFTs are initiated through
devices like ATM cards or codes that let one to access your account. Many financial institutions
use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose. 1
The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
transactions. The Act does not cover “stored value” cards like prepaid telephone cards, mass
transit passes, and some gift cards. These "stored-value" cards, as well as transactions using
them, may not be covered by the EFT Act.
ELECTRONIC FUND TRANSFERS

EFT offers the following services to the customers:
Automated Teller Machines (ATMs)

ATMs are electronic terminals that let customers bank almost any time. The customer generally
inserts an ATM card and enters his/her PIN to withdraw cash, make deposits, or transfer funds
between accounts, Some financial institutions and ATM owners charge a fee, particularly to
customers who don't have accounts with them or on transactions at remote locations.
Direct Deposit
Customers can authorize specific deposits, such as paychecks and Social Security checks, to
their account on a regular basis.
Direct Debits/Electronic Bills Presentment

Customers can pre-authorize direct withdrawals (ECS under Indian context) so that recurring
bills, such as insurance premiums, mortgages, and utility bills, are paid automatically.
Pay-by-Phone Systems
They let customers call their financial institution with instructions to pay certain bills or to transfer
funds between accounts. For such transactions, customers need to have an explicit agreement
with their banks.
Personal Computer Banking

Customers do many banking transactions through their personal computer. For example,
customers can view their account balance, request transfers between accounts, and pay bills
electronically.
1
Excerpted from Federal Trade Commission website http://www.ftc.gov

Point-of-Sale Transfers
Customers can pay for their purchases with a debit card, which also may also double up as the
ATM card. Debit card purchase transfers money - fairly quickly - from the customer’s bank
account to the store's account. So the customer should have the required funds in his/her
account before the use of debit card.
Electronic Check Conversion

ECC converts a paper check into an electronic payment at the point of sale or elsewhere. In a
store, the customer can present a check to a store cashier. The check can be processed through
an electronic system that captures the banking information and the amount of the check. Once
the check is processed, the customer signs a receipt authorizing the store to present the check to
the bank electronically and deposit the funds into the store’s account. The customer gets a
receipt of the electronic transaction and the check is returned to the customer. It should be voided
or marked by the merchant so that it can't be used again.
EFT REGULATIONS
Disclosures
The documents (usually fine print) supplied by the issuer of the “access device” cover the legal
rights and responsibilities regarding an EFT account. Before using EFT services, the institution
must tell the customer the following information:
• A summary of customer’s liability for unauthorized transfers.
• The telephone number and address of the person to be notified in the event of an
unauthorized transfer, a list of the institution's "business days", and the number of days to
report suspected unauthorized transfers.
• The type of transfers, fees for transfers, and any limits on the frequency and dollar amount of
transfers.
• A summary of right to receive documentation of transfers, to stop payment on a pre-
authorized transfer, and the procedures to follow to stop payment.
• Procedures to report an error on a receipt for an EFT or periodic statement and to request
more information about a transfer listed on the statement, and the number of days to report.
• A summary of the institution's liability if it fails to make or stop certain transactions.
• Circumstances under which the institution will disclose information to third parties concerning
customer’s account.
• Charges for using ATMs where the customer does not have an account.
Receipts and Statements

The customers are entitled for terminal receipts and periodic statements. Customers are entitled
to a terminal receipt when they initiate an electronic transfer, whether it is an ATM or a point-of-
sale electronic transfer. The receipt must show the amount and date of the transfer, and its type,
such as "from savings to checking."
No terminal receipts would be issued for regularly occurring electronic payments that are pre-
authorized, like insurance premiums, mortgages, or utility bills. Instead, these transfers will
appear on your periodic statement.

Customers are also entitled to a periodic statement for each statement cycle in which an
electronic transfer is made. The statement must show the amount of any transfer, the date of
credit or debit to their account, the type of transfer and type of account(s) to or from which funds
were transferred, and the address and telephone number for inquiries.
Errors
Customers have 60 days from the date a statement is received to notify errors to the bank. The
best way is to notify the financial institution by way of a certified letter, return receipt requested.
Under US federal law, the institution has no obligation to conduct an investigation if the customer
missed out the 60-day deadline.
The financial institution has 10 business days to investigate the error. The institution has to
communicate the results of its investigation within three business days after completion and must
correct the error within one business day after detecting the error. If the institution needs more
time, it may take up to 45 days to complete the investigation - but only if the money in dispute is
returned to the customer’s account with due notification of the credit. At the end of the
investigation, if no error has been found, the institution may take the money back after sending a
written explanation.
Lost or Stolen ATM or Debit Cards

Unlike a credit card, if someone loses the ATM or debit card, customer can lose much more. If
the customer reports the loss of an ATM or debit card to the card issuer before it's used without
his/her permission, he/she can't be held responsible for any unauthorized withdrawals.
If unauthorized use occurs before reporting, the liability of the customer varies depending on the
delay in reporting the loss to the card issuer.
• Within two business days – Liability limited to $50 for unauthorized use.
• Between 2 - 60 days – Liability limited to $500 because of an unauthorized transfer.
• If the loss is not reported within 60 days, the liability has no limits.
If the customer failed to notify the institution within the time periods allowed because of
extenuating circumstances, such as lengthy travel or illness, the issuer must reasonably extend
the notification period. In addition, if state law or the individual contract imposes lower liability
limits, those lower limits apply instead of the EFT act limits.
Limited Stop-Payment Privileges

The EFT Act does not give the right to the customer to stop payment. If a purchase is defective or
an order is not delivered, it's up to the customer to resolve the problem with the seller.
The customer can stop payment only for regular payments out of his/her account to third parties,
such as insurance companies. The institution has to be notified at least three business days
before the scheduled transfer.
Although federal law provides only limited rights to stop payment, individual financial institutions
may offer more rights or state laws may require them.
ELECTRONIC BILLING PRESENTATION AND PAYMENT
Introduction

Electronic Billing Presentation and Payment (EBPP) is the use of electronic means, such as email
or a short message, for rending a bill.
Advantages
The advantage of EBPP over traditional means is primarily the savings to the operator in terms of
the cost to produce, distribute, and collect bills.
Use in Mobile Communications
EBPP may be used in lieu of a standard paper bill as a means to reduce operational costs. Some
operators may view EBPP as an alternative to prepay as some operators view prepay service
strictly as an alternative to traditional billing, but it usually has most value as an alternative
mechanism for billing post-paid customers. However, EBPP can also be used simply as an
informational tool to inform the customer of charges levied against the account.
Billing and Charging to Third Parties
EBPP is an efficient mechanism to bill or inform third parties of charges. For example, the father
of a son in college may want to know how much the child is spending on mobile phone service
prior to the bill becoming to high.
Paying the Bill
Some EBPP systems require software for payment while others require only standard browser
software for accesses a web site for secure payment. Alternatively, the billing arrangement can
be made in advance for funds to be automatically debited from a customer’s account with a
financial institution. However, the more attractive model for most will be to have control over when
the bill is actually paid, rather than have it be paid at a predetermined date.
Future of EBPP
EBPP is expected to become an increasingly attractive alternative as mobile operators continue

to search for ways to reduce operational costs. However, the extent to which EBPP is proliferated
will depend entirely on user acceptance and diligence to actually pay for bills in a timely and
(preferably) electronic fashion.

1. FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and more than 9,000 on-line and off-line depository institutions and thus
plays a key role in US payments mechanism. The system is available on-line depository
institutions with computers or terminals that communicate directly with the Fedwire network.
These users originate over 99 percent of total funds transfers. The remaining customers have off-
line access to Fedwire for a limited number of transactions.
Fedwire transfers U.S. government and agency securities in book-entry form. It plays a significant
role in the conduct of monetary policy and the government securities market by increasing the
efficiency of Federal Reserve open market operations and helping to keep the market for
government securities liquid.
Depository institutions use Fedwire mainly to move balances to correspondent banks and to send
funds to other institutions on behalf of customers. Transfers on behalf of bank customers include
funds used in the purchase or sale of government securities, deposits, and other large, time-
sensitive payments.
Fedwire and CHIPS, a private-sector funds transfer network specializing in international
transactions, handle most large-dollar transfers. In 2000, some 108 million funds transfers with a
total value of $380 trillion were made over Fedwire -- an average of $3.5 million per transaction.
All Fedwire transfers are completed on the day they are initiated, generally in a matter of minutes.
They are guaranteed to be final by the Fed as soon as the receiving institution is notified of the
credit to its account.
Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks.
However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required the
pricing of Fed services, including funds and securities transfers, and gave nonmember depository
institutions direct access to the transfer system. To encourage private-sector competition, the law
requires the Fed's fees to reflect the full cost of providing the services, including an implicit cost
for capital and profitability.
How Fedwire Works

Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a
private or government organization asks a bank to transfer funds. If the banks of the sender and
receiver are in different Federal Reserve districts, the sending bank debits the sender's account
and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the
receiver's bank. The two Reserve Banks settle with each other through the Inter-district
Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions.
Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the
transfer is received, it is final and the receiver may use the funds immediately. If the sending and
receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the
processing and accounting are done by one Reserve Bank.
2. CHIPS
CHIPS, Clearing House Interbank Payments System, is the premier bank-owned payments
system for clearing and settling large value payments. CHIPS is a real-time, final payments
system for U.S. dollars that use bi-lateral and multi-lateral netting for maximum liquidity efficiency.
CHIPS is the only large value system in the world that has the capability of carrying extensive
remittance information for commercial payments. CHIPS processes over 267,000 payments a

day with a gross value of over $1.37 trillion. It is a premier payments platform serving the largest
banks from around the world, representing 22 countries worldwide.
3. SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a worldwide
network by which messages concerning financial transactions are exchanged among banks and
other financial institutions. As of December 2001, it linked over 7000 financial institutions in 194
countries and estimates that it carried payments messages averaging more than six trillion US
dollars per day. SWIFT network is used for transfers across different countries and in all
currencies.
SWIFT is a co-operative society under Belgian law, owned by its member financial institutions
with offices around the world. SWIFT’s headquarters are located in La Hulpe near Brussels. It
was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish a
common language for financial for financial transactions and a shared data processing system
and worldwide communications network. Fundamental operating procedures, rules for liability,
etc. were established in 1975 and the first message was sent in 1977.
SUMMARY
• Retail banking is banking services provided for individuals. Common services include –

o Branch Banking
o Customer Care
o Teller Services
o Deposit and Loan Products
o Online Banking
o Financial Advisory
• ATM banking has become increasingly popular over the last few decades
• There are many types of Banking Accounts
o Checking Accounts
o Money Market Deposit Accounts
o Savings Account
o Time Deposits (Certificates of Deposit)
o Basic or No Frill Banking Accounts
• Electronic banking, also known as electronic fund transfer (EFT), uses computer and
electronic technology as a substitute for checks and other paper transactions.
• EFT’s are initiated through devices like ATM cards or codes that let one to access your
account. Many financial institutions use ATM or debit cards and Personal Identification
Numbers (PINs) for this purpose.
• The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
transactions.
• EFT offers the following services to the customers:
o Automated Teller Machines (ATMs)
o Direct Deposit
o Direct Debits/Electronic Bills Presentment
o Pay-by-Phone Systems
o Personal Computer Banking
o Point-of-Sale Transfers
o Electronic Check Conversion
• EBPP is an upcoming mode of transaction involving the use of electronic means, such as
email or a short message, for rending a bill.
• FedWire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and depository institutions and thus plays a key role in US payments
mechanism
• Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer
network mainly for international transactions. CHIPS transfers are settled on a net basis at
the end of the day, using Fedwire funds transfers to and from a special settlement account on
the books of the New York Fed.

2.3. CONSUMER LENDING

RETAIL LENDING
Retail Lending is one of the most important functions performed by a bank. It encompasses the
following:
• Personal loans, consumer loans
• Asset based loans - auto loans, home loans
• Open ended loans
• Lease, Hire Purchase
• Credit cards
Personal Loans / Consumer Loans

Personal loans are amount borrowed by individuals to cover their personal expenses. The details
of such expenses are never of any interest to the lenders.
• The financer is not interested in the intention of the loan.
• No security
• Short term loans
• Rate of interest is very steep.
• Ideally should be used only in case of an emergency
• All banks/finance companies offer these loans
• Loan amount is directly linked to borrower’s repayment capacity.
Asset Based Loans

Such loans are amount borrowed by individuals to buy some asset, which is hypothecated to the
lender. Thus the lender is fully aware of the purpose of the loan. The interest rate charged is
lower than personal loans because the loan is secured by the hypothecation of the asset to the
lender.
Two main types – auto loans, housing loans

• Interest rate is lower as compared to Personal loans
• Hypothecation of the Asset to the financer.
• Repayment through EMI’s.
• Thumb rules for calculation of Maximum loan amount
a. Not greater than 3 times the yearly income OR
b. The EMI should be less than 60 pct of the gross monthly income.
Loan against Securities

• Overdraft facility can be availed against pledge of equity Shares, Mutual Fund units.
• Drawing power is usually 60-70 % of the value of the pledged instruments.
Open Ended Loans

Open ended loan allow the borrower to borrow additional amount subject to the maximum amount
less then a set value.
• Similar to overdraft facilities provided by banks.
• Interest is calculated on the daily outstanding balance.
• Usually a card (similar to a Credit Card) is issued by the lending institution.
• The lending institution has tie-ups with various merchant establishments.
• Also allow you to withdraw Cash.
• Important Terms;
c. Limit (L) – max outstanding allowed
d. Margin (M) – percentage of limit that can be drawn
e. Asset value (AV) – value of underlying asset
f. Drawing Power (DP) - lower of L and (1-M)*AV
• Example:
Limit =$ 1000; Margin = 30%; Asset Value (initial) = $1000
Date Asset Value (AV) Drawing Power (DP)
1st Jan 2004 $1000 $700
1st Feb 2004 $1600 $1000
1st Mar 2004 $2000 $1000
1st Apr 2004 $500 $350
Lease / Hire Purchase

Lease is a long-term rental agreement for the asset, while Hire Purchase is allows the user to
own the asset after all the payments have been made to the lender.
Lease
• Two main types – operating, financial
• The Financier owns the asset.
• Depreciation is claimed by the financier.
• Tax deduction can be claimed for the full value of the rental paid.
• Financier takes care of maintenance, insurance etc.
Hire Purchase
• The asset is owned by the financier.

• Depreciation can be claimed by the borrower.

• Tax deduction can be claimed only to the extent of the interest repayment.
Retail Lending Cycle
1. Loan application management and processing

• Receipt of loan/card application
• Application Processing
o Duplicate check
o Negative list check
o Document Verification
o Calculate loan eligibility, IRR, processing fees
o Credit scoring
o Field Investigation
o Credit Approval
• Disbursement
o Cheque issuance
o Credit to account
o Payment to third party
• Formulating the repayment schedule.
2. Loan repayments and termination
• Post-Dated Cheques
o PDC’s are collected & their information captured.
o Cheques are presented in clearing on due dates
o Bounced/ hold cheques are marked for further action.
• Salary deductions
o Employer wise receipt batches are created.
o Employer cheque details are captured
o Payment receipt is marked for corresponding employees.
• Direct receipts
o Cash/Cheque information is captured
o Cheques are cleared in batches.
• Auto payments / Direct debits
o Bank wise receivable batches are created.
o Short receipts are marked.
o Release receipt batch to mark receipts
• Kinds of repayments
o EMI – same installment amount
o Fixed Principal – constant principal, decreasing interest amt
o Step-up – principal amount increases in steps
o Step-down – principal amount decreases in steps

o Balloon – notional amount initially, large last payment

o Bullet – interest payment initially, entire principal at one shot
o Random – schedule & amount of installments undecided
o Special products – combination of above
3. Delinquencies identification and collections

• Case Processing
o Categorization of cases based on predefined rules
o Allocation of cases to collectors
• Standard Cases
o Collector follow-up (desk/field)
o Repayment by customer
o Cheque issuance
• Exception Cases (death/fraud etc.)
o Initiate process based on case specifics (legal/other means)
o Track/follow up the case developments till repayment
o Case closed
Submit Proposal Scrutinize OK Appraisal
Repayment NO Follow-up/Action
Decision
Monitoring OK
Disbursement Compliance Conditions for borrower
Interest Rates
Fixed Rate of Interest
The rate of interest applicable is guaranteed not to change during the fixed rate period. Borrower
& bank protected from adverse interest rate movements.
Floating Rate of Interest

The rate of interest is linked to one of the rates prevailing in the market, for example it can be
linked to PLR (Prime Lending Rate) or LIBOR (London Interbank Offered Rate). Borrower
benefits from falling int. rate, exposed to upward movement of int. rate.
Important terms are; Cap, floor, collar, benchmark/base/anchor rate, mark-up/spread rate, reset
date & frequency

Cap
Current rate
Spread
Collar
Interest rate à
Base rate
Floor
Collateral
An asset than can be repossessed by the lender if the borrower defaults. They are of the
following types
• Primary (same asset for which finance is taken)
• Secondary (asset backing the loan different)
Charge Types
• Pledge – gold, bank has possession
• Hypothecation – vehicle, borrower has possession
• Lien – against bank deposits
• Assignment – insurance policies, rights get transferred to bank
• Shares - periodic drawing power calculation
• Mortgage – immovable property
MORTGAGES
A loan secured by the collateral of some specified real estate property that obliges the borrower
to make a predetermined series of payments. If the borrower doesn’t keep up the loan
repayments, the lender can repossess the real estate property and sell it in order to get the
money back.
The rate of interest applicable is lower than personal loans and comparable to other asset based
loans.

To compare the cost of different Mortgages deals one should look at the APR – Annual
Percentage Rates. All firms that quote an APR must calculate it in a standard way, so one can
compare like with like. The APR for a loan is a single figure, which takes into account:
• The amount of interest you are charged
• When and how often the interest must be paid
• Other charges – for example, an arrangement fee or compulsory payment protection
insurance – if they must be bought from the lender as a condition of the loan
• When and how often these charges must be paid
Kinds of Mortgages
Mortgages can be classified based on the interest rates deals:
Interest Rate Deal How it works
Standard variable The payments go up and down as the mortgage rate changes.
rate
Same as a standard variable rate loan - but one receive a substantial

Standard variable
cash sum (Example 3–5% of the amount borrowed) when you take up
rate with cash back
the loan.
Similar to a standard variable rate mortgage but the interest rate is

Base rate tracker guaranteed to be a set amount above the base rate and alters in line
with changes in that rate.
The payments are set at a certain level for a set period of time – for
example, one year, two years, or five years. At the end of the period,
Fixed interest rate
one is usually charged the lender’s standard variable rate (or
sometimes a new fixed rate is offered).
The payments are variable, but they are set at less than that lender’s
Discounted interest
going rate for a fixed period of time. At the end of the period, one is
rate
charged the lender’s standard variable rate.
The payments go up and down as the mortgage rate changes but are
guaranteed not to go above a set level (the ‘cap’) during the period of
the deal.
Capped rate
Sometimes, they cannot fall below a set minimum level either (the
‘collar’ or ‘floor’). At the end of the period, one is charged the lender’s
standard variable rate.
Repayment Methods

Repayment mortgage
• Monthly payments over the agreed number of years (Called the mortgage ‘term’) goes partly
towards the interest and partly towards the principal.
• If all the monthly payments agreed with the lender are made, the whole loan will be repaid by
the end of the term.
• Monthly payments could increase if interest rates rise.
Interest-only mortgage
• The monthly payments to the lender cover only the interest on the loan. They do not pay off
any amount one has borrowed.
• One usually makes separate payments into a savings scheme each month to build up a lump
sum, which is then used to pay off the whole amount one has borrowed, in one go at the end
of the mortgage term or sooner.
• This involves some investment risk in building up a sum of money to repay the loan.
• It is one’s responsibility to save enough money to repay the loan at the end of its term.

Endowment mortgage
• To repay an interest-only loan, one can take an endowment policy, which is designed to end
at the same time as the mortgage.
• The money one pays into an endowment policy is invested in stocks and shares and other
investments. At the end of a set number of years (the policy ‘term’), the policy ‘matures’ and
one gets a lump sum, which is used to repay the mortgage loan.
• An endowment policy provides life insurance and sometimes other insurance benefits too.
Interest-only mortgage combined with stakeholder pension

• Alongside an interest-only loan, one can make payments into a personal or stakeholder
pension. When one start to take the pension (between age 50 and 75), one can take part of
the pension fund as a tax-free lump sum, which is used to pay off the mortgage loan.
Important US Institutions in Mortgage Market
Freddie Mac, Ginnie Maes & Fannie Mae

Federal National Mortgage Association (FNMA or Fannie Mae), Government National Mortgage
Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or
Freddie Mac) are all "secondary market lenders".
Banks issue loans/mortgages with some collateral for security. These loans/mortgages are
bought by the “secondary market lenders” from the banks thus freeing them to turn around and
issue mortgage to new customers.
Their core business consists of mortgage loan securitization. They buy mortgages from banks
and pool them into bonds to be sold or held. These companies guarantee the creditworthiness of
these bonds, but not the interest-rate risk. They hedge their own exposure to interest-rate risk
through derivative contracts.
Often many retail lenders actually receive their funds from a secondary market lender. These
secondary lenders have assisted the national mortgage market by allowing money to move easily
from state-to-state. The movement of loan funds helps to avoid a situation where mortgages are
only available in certain areas or states. Also, the secondary lenders have established regulations
and guidelines that help the general public.
AUTO LOANS
Auto Loans is basically lending to the individual customers for a two or four wheeler or their
personal use. The following section describes the multiple mechanisms by which the financing for
auto loans is normally done.
Types of Financing Mechanism

• Direct Lending: The Bank or the finance company directly lends to the buyer or the borrower
in this case. A number of lending institutions are offering such loans on their websites.
• Dealer financing: This is a type of loan available through the dealer. The lending and
repayments are done by/to the dealer. Basically the dealer tells the customer how much

down payment and monthly Installment is to be paid against the vehicle. The effective cost to
the customer most of the times is generally more than the original price.
• Leasing : Vehicle/ Auto lease is a contract between the borrower and a auto leasing
company. The borrower agrees to pay the leasing company for the use of the vehicle for a
certain amount of time, usually 24 to 36 months. During that time the borrower agrees to
make monthly lease payments, keep the car in good repair, insure the car and not drive the
car more miles that stipulated in the contract.
The Key entities in a lease agreement are the lessee or the lessor.
Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee
is the consumer. The lessee is required to make payments and to meet other obligations
specified in the lease agreement.
Lessor or the lender or the lending institution is the original owner of the vehicle or property being
leased
The lease can be closed ended or open ended as defined below:
• Closed end lease - A lease agreement that establishes a non-negotiable residual value for
the leased auto and fee amounts due at the end of the lease term.
• Open End lease - A lease term that requires the lessee to pay the difference between
residual value and fair market value at the end of the lease term if the fair market value is
lower
In a lease, the factors such as the ownership, up front costs and monthly payments as against the
direct lending are:
• Ownership: You do not own the vehicle. You get to use it but must return it at the end of the
lease unless you choose to buy it.
• Up-front costs: Up-front costs may include the first month's payment, a refundable security
deposit, a capitalized cost reduction (like a down payment), taxes, registration and other fees,
and other charges.
• Monthly payments: Monthly lease payments are usually lower than monthly loan payments
because you are paying only for the vehicle's depreciation during the lease term, plus rent
charges (like interest), taxes, and fees.
The Key Entities in an Auto Loan system are:
• Borrower: is the one who needs to use/own the automobile and approaches a dealer/lender
for getting financing for the same
• Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the
vehicle to the buyer
• Lender: Provides capital to the borrower for buying the vehicle. This can be the bank or the
dealer or any financing institution.
• Credit bureau: Tracks and maintains credit history of borrowers and forward it to lenders
during new application processing. This is used for deciding whether the loan should be
provided to a customer or not.
• Appraiser: Assesses and establishes the fair market value of a collateral offered as
underlying security to the credit asked for.
• Insurer: The Insurance company insures the vehicle owner against specific liabilities caused
to and from the vehicle during the course of its use upon the payment of a premium and
signing of a contract

• Loan servicer: is the one who provides various services during the life cycle of a loan starting
from loan origination to loan closure.
STUDENT LOANS
Student Loans are Loans availed by eligible students to pursue graduate and post graduate
studies in US Schools/Colleges/Universities. These loans are usually provided by banks, Credit
Unions and other financial institutions which are guaranteed by state sponsored Guarantors
Types of Student Loans
Students Loans offered can be categorized broadly into two types:
• Federally sponsored loans – These loans are federally insured and provide protection against
default. The department of Education guarantees upto 98% and even 100% in some cases
• Non-federally sponsored loans – These are insured by the private sector and have no
government backing. The guarantee in this case is only from the private insurers or from the
reserves pledged to securitization
Federally sponsored loans are of two types
• Federal Family Education Loan Program (FFELP)- These loans are made by financial
institutions primarily with a floating rate that is adjusted once a year. The interest rate is
capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and the
rate cap through Special Allowance Payments(SAP). The rates are usually specified by
indexing them to the US Treasury bill rates.
• Federal Direct Loan (FDLP)- where the department of Education directly provides the loans
FFELP or the Federal Family Education Loan Program can further be divided into three types
• Federal Stafford –Federal Stafford loans are the most common source of education loan
funds in the US. This is available to both graduate and undergraduate students. This loan
could be either subsidized or unsubsidizedby the federal government. The interest rate is a
floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates of
during the year 2003-04 were
o 2.82% in school, grace and deferment
o 3.42% in repayment and forbearance

• Federal PLUS - PLUS loans are availed by the parents of a full- or half-time undergraduate
student .This requires a credit check and hence the parent must have a good credit history
and should have been a citizen or permanent resident of US. The loans don’t require any
collateral and the interest payments are tax deductible.
• Consolidation loans - A consolidation loan involves two or more existing federally sponsored
loans into one single loan. The interest rate for this is determined by the weighted average of
the loan rates prevailing at that time and capped at 8.25%
There are three principal advantages

• Convenience – By combining loans the borrower is able to focus on repaying one single loan
than handle multiple loans
• Interest rate – In a low rate scenario the borrower can reduce his cost of borrowing by taking
a new loan at the low prevailing low rates
• Repayment – The repayment period is extended to 30 years and this reduces the installment
to paid each month
The Key Entities in the Student Loan System are Federal government, Schools, Lenders
Servicers and guarantors and the borrower.
• Federal government: Sponsors and authorizes funds for grants and loan programs.
• School: The school is certified by the department of education as an eligible school to
participate in the FFELP or FDLP loan programs. Schools are responsible for determining
borrower’s eligibility, recommends and certifies loan amounts, monitors the enrollment status
• Lenders : are the institutions approved by the DOE for voluntary participation in any or all of
the FFELP student loan programs. Typical lenders are usually Banks, credit unions, S&L
institutions, insurance companies and other institutions.
• Servicer: is an entity who collects payments on a loan and performs other administrative
tasks associated with maintaining a loan portfolio. The normal functions include disburse
loans funds, monitor loans while the borrowers are in school, collect payments, process
deferments and forbearances, respond to borrower inquiries and ensuring regulatory
compliance.
• Guarantor is a state agency, which guarantees or insures the loan and is a not-for-profit
agency. It protects the lenders against loss due to borrower default, death of borrower, total
and permanent disability, bankruptcy, closed school, and ineligible borrower.
• Borrower : is the student who avails of the loan.

SUMMARY
• The loans given to retail customer come under Consumer Lending. There are four major
types of Consumer Lending –
o Personal loans
o Mortgages
o Auto Loans
o Student Loans
• Personal loans normally have the highest interest rates charge while mortgages have the
lowest.
• Retail lending cycle includes -
o Loan application management and processing
o Loan repayments and termination
o Delinquencies identification and collections
• Types of interest rates

o Fixed interest rate
o Flexible interest rate
o Hybrid interest rates
• Mortgages are Loans given to consumers for the purpose of purchase, construction or repair
of real estate.
• Auto loans are loans financed for vehicles for personal use
• Student loans are loans provided to eligible students to pursue graduate and post graduate
studies in US Schools/Colleges/Universities

2.4. COMMERCIAL AND WHOLESALE

BANKING

CORPORATE LENDING
CORPORATE LENDING
Corporate Lending refers to various forms of loans extended by banks to corporate bodies like
proprietorship, partnership, private limited companies or public limited companies. Banks lend to
such entities on the strength of their balance sheet and business cash flows. Corporate loans are
provided by banks for various purposes like new projects, capacity expansion or plant
modernization, daily cash flow requirements (working capital) etc. Depending on the nature of the
requirement, loans may be long-term or short-term in nature.
Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate
defaults on payment of principal or interest on the loan, the bank can take possession of the
security and sell off the same to meet principal or interest payment on the loan. Security is usually
in the form of land, buildings, plant and machinery, physical stock of the raw material, goods for
sale etc.
CORPORATE LENDING PROCESS
The following is the typical stages in a corporate lending process:

• Corporate approaches the relationship manager of the bank with a request for a loan. The
corporate provides details like: past financial statements, details of the loan requirement,
cash flow projection for the period of the loan, details of the security being provided etc.
Depending on the loan type and bank requirements, various other information would need to
be provided by the corporate.
• The concerned division of the bank prepares the detailed analysis of the corporate financial
statements. A detailed study is also done on the corporate’s products, market segment,
competitors etc to ascertain the strength of the corporate’s business. A report is prepared to
capture the above details.
• Based on the above report, the concerned division of the bank assigns a rating to the
corporate. The rating captures various factors like strength of business, financial state of the
corporate, ability to repay the loan based on cash flow projections, promoter background etc.
• A committee of the bank evaluates the loan proposal and decides to sanction/reject the
same.
• Once sanctioned, the bank provides a sanction letter to the corporate providing details of the
loan terms and conditions.
• After the corporate accepts the same, a loan agreement is signed between the bank and the
corporate. The loan agreement captures various conditions of the loan like repayment mode,
repayment period, interest payable, security provided, other conditions etc. The loan
becomes ‘committed’ at this stage.
• The bank disburses the required amount under the loan committed. This amount is called the
‘disbursed amount’ under the loan.
Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if
also payable on the committed amount of the loan. Also, in most cases, the corporate would have
to pay a certain amount as processing fees for the loan. This would cover the bank’s overhead
costs in the loan process.

CORPORATE CREDIT RATING

Before sanctioning a loan to a corporate, the bank does a detailed assessment of its financials
and business strength as discussed in the earlier section. This process ends with the bank
assigning a rating to the corporate for the loan facility.
Ratings are usually specified in alphanumeric terminologies. Rating levels might vary from AAA
(highest), AA+, AA- to default ratings like D. Rating terminologies might vary across banks and
across various loan tenures. The rating level specifies a certain probability of default of the loan. It
also takes in to account the protection offered by the security of the loan.
For corporates with higher ratings, banks provide loans at lower interest rates and vice versa. In
most cases, banks do a rating process for each of its corporate clients at the end of say, every
year or every quarter. This helps banks to continuously track the financials and market position of
the corporate.
Credit enhancements
Credit enhancement is a mechanism used to increase the original rating of a loan for a corporate.
Credit enhancements can be in the form of pledge of shares, cash collateral, corporate or bank
guarantees etc.
Example:
A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the
loan rating and thus reduce interest payable on the loan, the promoters pledges their share
holding in the company with the bank. Thus, whenever there is a default on repayment of the
loan, the bank has the right to sell the shares in the market. Based on the historic volatility of the
shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan to
BBB+.
TYPES OF LOANS
Term loans
These loans can either be short term loans or long term loans.
Long-term loans are extended for purposes like new projects, capacity expansion or plant
modernization. These loans are usually repayable over a 2-7 year period after an initial
moratorium period (period during which loan repayments are not required) to help the corporate
complete implementation of the project before revenue generation takes place.
Example
On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding their IT
modernization project across the nation. The loan is repayable in 16 quarterly installments
starting April 15, 2005, after an initial moratorium of 4 quarters. The interest payable would be
LIBOR+0.5% payable quarterly. The loans would be secured by AT&T equipment at their HQ,
worth USD 300 mn.
Short term loans are extended usually for meeting working capital requirements. The loans can
be repayable in various tenures starting from a week to as long as 1 year. The loans are either

repayable in fixed installments or in one bullet installment at the end of the period. In some cases,
short term loans are backed by promissory notes which are legal instruments that guarantee
payment of a certain amount on a specified due date.
Corporate bonds
Corporate bonds are used for the same purpose as term loans, but the loan is backed by a
transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who
receives the right to get payments from the corporate. Bonds are rated depending on the rating of
the corporate and depending on the rating, the market demands varying amounts of interest. A
certain class of bonds called junk bonds is issued by corporates with very low credit ratings and
carry very high rates of interest.
Working Capital
For any business, there would be current assets in the form of cash, receivables, raw material
inventory, goods for sale inventory etc while there would be current liabilities in the form of
payables and other short term liabilities. Part of the current assets would be funded through
current liabilities while the rest would have to be funded through a mixture of short term and long
term loans. As per norms, 25% of the working capital gap would have to be funded by long term
sources like equity or term loans while the rest 75% can be funded through short term loans and
overdraft limits.
Banks conduct a detailed assessment of the current assets and liabilities for a corporate and
arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include
only receivables which are less than 6 months old. Also within the specified limit, banks keep
reviewing the current asset and current liability position of a company to arrive at the drawing
power for each month. Corporates are allowed to borrow up to the working capital limit or the
drawing power, whichever is lower.
Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of the
business. The bank makes available a certain sum of money for a period of time (say, USD 20.0
million for a period of 1 year). There would be a separate account called the overdraft account
created to monitor withdrawals under this loan. Whenever the corporate has a deficit in its main
business account, it can draw money from the overdraft account (up to the limit of USD 20.0
million). It can also put back money in the overdraft account as and when they have surpluses in
the business account. Interest is calculated by the bank on the various end-of-day deficits in the
overdraft account and is usually payable by the corporate at the end of every month.
Lines of credit
These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw
the loan as and when required within the validity period and repay the loan after a certain period
(repayment period). Interest is either repayable in certain intervals or in one bullet installment at
the end of the repayment period. In many cases, the lines of credit are of a revolving nature. The
same is explained via the example provided below:

Example
Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within
the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative
outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with
interest at the end of 30 days from the date of borrowal. Since AT&T can thus ‘revolve’ the limit
any number of times within the specified limit and validity period, these are called revolving lines
of credit.
Bill discounting
Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial
instrument by which one party promises to pay the other party a certain amount of money on a
specified due date. This is transferable and the final holder of the bill holds the right to receive the
payment from the concerned party. The corporate would have bills of exchange which are drawn
on their dealers, which entitle the corporate to receive certain amounts of money from the dealer
after a pre-defined credit period. The corporate can then transfer the bill to the bank and get a
discounted amount upfront. The bank collects the interest on the bill amount for the specified
period upfront in this process called bill discounting. On the due date, the bank collects the
payment from the concerned party directly.
Commercial Paper
Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows
money from banks for short periods of time. A CP binds the corporate to make a payment equal
to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like
a short term unsecured loan. However, a CP is tradable in the market – the bank can sell the CP
to a third party. For this reason, banks charge lesser interest on CPs than normal short term
loans. However, since CPs are unsecured and are to be tradable in the market, banks provide CP
lending to only highly rated corporates.
Leasing
Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment,
or other fixed assets on behalf of the corporate and grants use of the same for a specified time to
the corporate in exchange for payment, usually in the form of rent. The owner of the leased
property is called the lessor, the user the lessee. Lease payments (which include principal and
interest payments usually) can be shown by corporates as operating expenses and hence leases
are used by some corporates as a substitute for loans to get better tax benefits.
Supplier and dealer loans

These are short term loans provided by banks to suppliers and dealers of large companies.
These loans usually have conditions which ensure that there is sufficient support from the
corporate in case the supplier or a dealer defaults. Thus, using the support from the corporate,
the suppliers/dealers can borrow money from the bank at a lower rate of interest than otherwise
possible. Such loans help the corporates to develop a stronger base of suppliers and dealers,
which often helps them in improving their business.

Asset Securitisation loans

Asset Securitisation loans are loans which are backed by specified future cash flows or other
assets of the corporate. These loans help corporates to release excess cash flows from existing
receivables or future receivables.
Example
Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from
future monthly sale of oil explored from its specified offshore rig. In this case, there would be a
mechanism to ensure that money from monthly sale of oil explored from the specified rig for the
period of the loan would be used to service payment of interest and principal of the loan to
Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices and
ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch Shell.
CLASSIFICATION OF LOANS BY THE BANK
1. Classification of Drawn Loans
Loans are classified and accounted for as follows:

Accrual—Loans that management has the intent and the ability to hold for the foreseeable future
or until maturity/loan payoff. Accrual loans are reported on the balance sheet at the principal
amount outstanding, net of charge-offs, allowance for loan losses, unearned income, and any net
deferred loan fees.
Held-for-sale—Loan or loan portfolios that management intends to sell or securitize.
Trading—Loans where management has the ability and intent to trade or make markets (i.e.,
sell/hedge the credit risk.) Loans held for trading purposes are included in Trading Assets and are
carried at fair value, with the gains and losses included in Trading Revenue provided that the
criteria outlined in this policy are met.
2. Classification of Undrawn Loan Commitments
Loan commitments are generally classified as accrual and recorded off-balance sheet.
Differences between loan and commitment are as follows; -

Loans are reflected in the asset side of the bank’s balance sheet. Commitments are
‘off-balance sheet’ items and are reflected in the contingent asset side of the balance
sheet.
• The amount of the loan that is disbursed is credited to the account of the borrower. In
case of a commitment, there is no disbursement or credit to a borrower’s account.
• The fee charged on a loan is a function of the disbursed amount. The fee charged on
commitment is a function of the amount of commitment that is not utilized.

CREDIT DERIVATIVES
Credit derivatives are financial contracts that transfer credit risk from one party to another,
facilitating greater efficiency in the pricing and distribution of credit risk among market players.
Example
The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer
whereby he will make periodic payments to the dealer in exchange for a lump sum payment in the
event of default by XYZ Corp. during the term of the derivatives contract. As a result of such a
contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer. In
market parlance, the corporate bond investor in this example is the buyer of protection, the dealer
is the protection seller, and the issuer of the corporate bond is called the reference entity.
Uses of Credit Derivatives

Like any other derivative instrument, credit derivatives can be used either to take on more risk or
to avoid (hedge) it. A market player who is exposed to the credit risk of a given corporation can
hedge such an exposure by buying protection in the credit derivatives market. Likewise, an
investor may be willing to take on that credit risk by selling protection and thus enhance the
expected return on his portfolio.
Credit derivatives can be used to create positions that can otherwise not easily be established in
the cash market. For instance, consider an investor who has a negative view on the future
prospects of a given corporation. One strategy for such an investor would be to short the bonds
issued by the corporation, but the corporate repo market for taking short positions in corporates is
not well developed. Instead, the investor can buy protection by way of credit default swap. If the
corporation defaults, the investor is able to buy the defaulted debt for its recovery value in the
open market and sell it to its credit derivatives counterparty for its face value.
Banks use credit derivatives both to diversify their credit risk exposures and to free up capital
from regulatory constraints. As an example, consider a bank that wants to diminish its exposure
to a given client, but does not want to incur the costs of transferring loans made to that client to
another bank. The bank can, without having to notify its client, buy protection against default by
the client in the credit derivatives market: Even though the loans remain on the bank's books, the
associated credit risk has been transferred to the bank's counterparty in the credit derivative
contract.
The above example can also be used to illustrate banks' usage of credit derivatives to reduce
their regulatory capital requirements. Under current Basle standards, for a corporate borrower,
the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve.
However, if its credit derivatives counterparty happens to be a bank located in an OECD country,
and the bank can demonstrate that the credit risk associated with the loans has been effectively
transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to
1.6 percent.

Example
Let us visualize a bank, say Bank A which has specialized itself in lending to the office
equipment segment. Out of experience of years, this bank has acquired a specialized
knowledge of the equipment industry. There is another bank, Bank B, which is, say,
specialized in the cotton textiles industry. Both these banks are specialized in their own
segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in the
office equipment segment and bank B is focused on the textiles segment. Understandably,
both the banks should diversify their portfolios to be safer.
One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say
textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office
equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know
enough of the textiles segment as bank A does not know anything of the office equipment
segment.
Here, credit derivatives offer an easy solution: both the banks, without transferring their
portfolio or reducing their portfolio concentration, could buy into the risks of each other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a fee.
Both continue to hold their portfolios, but both are now diversified. Both have diversified their
risks. And both have also diversified their returns, as the fees being earned by the derivative
contract is a return from the portfolio held by the other bank.
Types of Credit Derivatives

Credit derivatives can be classified in two main groups: Single name instruments are those that
involve protection against default by a single reference entity. Multi-name credit derivatives are
contracts that are contingent on default events in a pool of reference units.

TREASURY SERVICES
The Treasury Services department is concerned with managing the financial risks of the bank.
Hence, the treasurer's job is to understand the nature of these risks, the way they interact with
the business, and to minimize or to offset them. In many cases, the treasury services department
also provides cash management solutions for customers of the bank. The Treasury services
department of a bank performs the following functions:
• Managing the cash position of the bank, managing liquidity and associated risks
• Forex services: provides forex services to corporates, enters in to deals with multiple
counterparties to maintain a risk-managed position for the bank.
• Risk management services: provides risk management products like swaps, options etc to
corporates and enters in to multiple deals with various counterparties to maintain a risk-
managed position for the bank.
• Conducts research on various market factors, monitors interest rate and economic scenario
etc
• Cash Management services for corporates – managing collections and payments
Typically, the treasury has a front office desk which enters in to trades (in forex, money markets,
equity, treasury securities etc) with various market participants and a middle office/back office
desk which monitors positions and provides operational support.
Most large investment banks provide Treasury Services to their clients. Treasury domain
includes
• Fixed Income : An investment that provides a return in the form of fixed periodic payments
and eventual return of principle at maturity. Unlike a variable-income security where
payments change based on some underlying measure, such as short-term interest rates,
fixed-income securities payments are known in advance.
• Money Markets : The money market is a subsection of the fixed income market. The
difference between the money market and the fixed income market is that the money market
specializes in very short-term debt securities (debt that matures in less than one year).
Money market investments are also called cash investments because of their short
maturities. Some of the popular money market instruments include Certificates of Deposit
(CD), Commercial Paper (CP), Treasury Bills (T-Bills)
• Foreign Exchange : The market for buying and selling of currencies is called the Foreign
Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded
include – The US Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great
Britain Pound (GBP), The Swiss Frank (CHF). FX rates express the value of one currency in
terms of another currency. They involve
o The commodity currency - the currency being priced, usually 1 unit or a fixed amount of
currency.
o The terms currency - the currency used to express the price of the commodity, in
varying amounts of
• OTC Derivatives : Over the counter (OTC) markets are a form of Secondary markets. World
over Secondary markets are classified as Listed and OTC. Listed markets typically are
exchanges where a security is listed and traded. A decentralized market of securities not
listed on a exchange where market participants trade over the telephone, facsimile or
electronic network instead of a physical trading floor or electronic order matching systems.
There is no central exchange or meeting place for this market. Typically Currency
instruments are traded OTC. A derivative contract derives its value based on the value of

some basic underlying. The underlying may be any instrument like a bond, a stock or a
market index, currency or interest rates. Some of the instruments traded OTC include
o Forward Rate Agreement (FRA) - A contract that determines the rate of interest,
or currency exchange rate, to be paid, or received, on an obligation beginning at a some
future start date. It is also referred to as Future Rate Agreement.
o Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch
floating-rate loans for fixed rate loans in another country. These can be either the same
or different currencies. The motive may be the competitive advantage of one company to
have access to lower fixed rates than another company. The other company may be
competitively placed to have access to lower floating rates. A swap would be beneficial
to both. The swap is measured by its notional principal.
• FX Options : Forex Options give the holder the right to buy or sell a currency in terms of
another currency at a particular rate on a particular date or within a period of time. The
option to buy is called as a Call Option and the option to sell is called as a Put Option.
• Equity Options – These are similar to FX options the only difference is the underlying. The
underlying in case of Equity Options are stocks or stock market indices. When the underlying
is a stock market index the term used is Index Option and the term used to refer options on
individual stocks is Stock Option
• Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage
their exposure to credit risk. Credit Derivatives are financial assets like forward contracts,
swaps, and options for which the price is driven by the credit risk of economic agents (private
investors or governments). For example, a bank concerned that one of its customers may not
be able to repay a loan can protect itself against loss by transferring the credit risk to another
party while keeping the loan on its books.
Functions of the Treasury Manager
• Ensure availability of funds – An integrated treasury typically would include debt market,
money market and forex transactions. Treasury manager needs to ensure that adequate
funds are available to cover the settlement obligations of the said transactions.
• Manage all foreign currency transactions for the bank
• Manage various risks:
o Liquidity – Risk of asset and liability cash flow mismatch. A bank may not have adequate
funds for the settlement of its transactions or to pay its customers because of
mismatches in the tenor of its receivables
o Interest rate – Risk due to volatility of interest rates. A bank may have borrowed at
floating rates of interest and lent at fixed rate of interest and the interest rates moves up
o Currency – Risk due to volatility in exchange rates. A bank may have its payment
obligations in a currency say USD and the rate to purchase the said currency goes up
• Commodity – Risk due to volatility in commodity prices. A bank may have an obligation to
deliver a commodity in the future and the price of the commodity moves up
• Cash Management Services - CMS is a service provided by banks to its corporate clients for
a fee to reduce the float on collections and to ease the bulk payment transactions of the
client. The three elements of CMS are:
o Receivables Management –Helps the company to manage collection of its sale proceeds
from remote upcountry regions
o Payables Management – Helps the company to manage its payments to its regular
suppliers without keeping numerous bank accounts for various locations and then
reconciles them periodically in a highly manual / paper-based environment

o Liquidity Management – Helps the company by ensuring direct and instant access to its
bank accounts. It should not happen that a company has excess funds in one bank
account and it needs to pay through another bank account where there are no funds
• Managing Liquidity & Interest Rate risks
o Asset Liability Management – A bank’s assets and liabilities need to necessarily match.
If they don’t the bank may have liquidity problems which would endanger its solvency.
The long term assets should not be financed by short term sources of funds. The bank
would not be able to serve its lenders if the timings of its inflows do not match its
outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find out
mismatches and take corrective actions
Example
• A bank borrows USD 100MM at 3.00% for one year

• The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%.
For simplicity, assume interest rates are annually compounded and all interest accumulates to the
maturity of the respective obligations. The net transaction appears profitable—the bank is earning
a 20 basis point spread—but it entails considerable risk.
At the end of one year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. Assume interest rates are at 4.00% at the end of the first year.
• The Bank will now have to pay a higher rate of interest (4.00%) on the new financing than the
fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying
4.00% on its financing.
The problem in this simple example was caused by a maturity mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to asset-
liability mismatches are small or trivial. However, in a period of volatile interest rates, the
mismatches would become serious.
The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks
have ALM committees comprised of senior managers to address the risk. Techniques for
assessing asset-liability risk came to include gap analysis, duration analysis and scenario
analysis. Gap analysis looks at amount of assets and liabilities in various maturity buckets while
Duration analysis looks at weighted average maturity of cash flows to compare assets and
liabilities. Since liquidity management is closely linked to asset-liability management, assessment
and management of liquidity risk is also a function of ALM departments and ALM committees.
ALM strategies often include securitization, which allows firms to directly address asset-liability
risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-
liability risk; it also frees up the balance sheet for new business.
• Interest rate risk management

o Manage risks due to volatility of interest rates - Demand and supply of money go on
changing from time to time making interests rates volatile. A bank may have accepted
deposits at a fixed rate of interest historically. However current market rates may be
lower when it wishes to lend. The bank’s portfolio value of investments in bonds and

treasury also varies inversely with the interest rates. A higher interest rate diminishes the
value of a bank’s portfolio and vice versa. Instruments like interest rate swaps and
currency swaps help to address Interest Rate risks
Causes of interest rate risk
The causes of interest rate risk might vary:
• Repricing risk: The primary form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-
balance-sheet (OBS) positions. For instance, a bank that funded a long-term fixed rate loan
with a short-term deposit could face a decline in both the future income arising from the
position and its underlying value if interest rates increase.
• Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of
investment yields against maturity periods) have adverse effects on a bank's income or
underlying economic value. Yield curves can shift parallel or change in steepness, posing
different risks. For instance, the underlying economic value of a long position in 10-year
government bonds hedged by a short position in 5-year government notes could decline
sharply if the yield curve steepens, even if the position is hedged against parallel movements
in the yield curve.
• Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates earned
and paid on different instruments with otherwise similar repricing characteristics. For
example, a strategy of funding a one year loan that reprices monthly based on the one month
U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one month
Libor, exposes the institution to the risk that the spread between the two index rates may
change unexpectedly.
• Optionality: An additional and increasingly important source of interest rate risk arises from
the options embedded in many bank assets, liabilities and OBS portfolios. Options may be
stand alone instruments such as exchange-traded options and over-the-counter (OTC)
contracts, or they may be embedded within otherwise standard instruments. They include
various types of bonds and notes with call or put provisions, loans which give borrowers the
right to prepay balances, and various types of non-maturity deposit instruments which give
depositors the right to withdraw funds at any time, often without any penalties. If not
adequately managed, the asymmetrical payoff characteristics of instruments with optionality
features can pose significant risk particularly to those who sell them, since the options held,
both explicit and embedded, are generally exercised to the advantage of the holder and the
disadvantage of the seller.
Managing interest rate risk

Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through
Duration analysis. Duration is a mathematical concept which can be used to measure the
sensitivity of a financial instrument’s price to changes in interest rate. On the basis of duration
analysis, banks can increase/decrease holdings of long term and short term securities in
response to anticipated changes in interest rate.
Banks also use derivative instruments like interest rate swaps and options to manage interest
rate risks (A derivative is a generic term often used to categorize a wide variety of financial
instruments whose value “depends on” or is “derived from” the value of an underlying asset,
reference rate or index). Some of them are:

o Interest Rate Swap: An agreement to exchange net future cash flows. In its
commonest form, the fixed-floating swap, one counterparty pays a fixed rate and
the other pays a floating rate based on a reference rate, such as Libor. There is
no exchange of principal. The interest rate payments are made on an agreed
notional amount.
o Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the
interest rate for a specified period in advance. One party pays fixed, the other an
agreed variable rate. Maturities are generally out to two years and are priced off
the underlying yield curve. The transaction is done in respect of an agreed
nominal amount and only the difference between contracted and actual rates is
paid.
o Interest Rate Guarantee: An option on a forward rate agreement (FRA), also
known as a FRAtion. Purchasers have the right, but not the obligation, to
purchase a FRA at a predetermined strike. Caps and Floors are strips of interest
rate guarantees.
o Swaption: An option to enter an interest rate swap. A payer swaption gives the
purchaser the right to pay fixed (receive floating), a receiver swaption gives the
purchaser the right to receive fixed (pay floating).
• Forex Management – Similar to interest rates, the forex rates of countries who have not
pegged their currencies vary from time to time. This exposes its market participants to risk of
adverse movements of exchange rates. FX Forwards and Forex Options provide a means of
reducing exchange rate risks by entering into contracts at fixed rates thereby making the
outcome predictable
Foreign exchange is essentially about exchanging one currency for another. Forex rates between
two currencies at any point of time are influenced by a variety of factors like state of the economy,
interest rates & inflation rate, exchange rate systems (fixed/floating), temporary demand-supply
mismatches, foreign trade position etc.
Foreign exchange exposures for a financial entity arise from many different activities. A company
which borrows money in a foreign currency is at risk when the local currency depreciates vis-à-vis
the foreign currency. An exporter who sells its product in foreign currency has the risk that if the
value of that foreign currency falls then the revenues in the exporter's home currency will be
lower. An importer who buys goods priced in foreign currency has the risk that the foreign
currency will appreciate thereby making the cost in local currency greater than expected.
Generally the aim of foreign exchange risk management is to stabilise the cash flows and reduce
uncertainty from financial forecasts.
Since a bank is usually a counter party to the above transactions, it faces similar forex Risk when
the reverse happens.
Basics of forex
Currencies are quoted in one of the two ways:
• Direct Quotation (1 USD = INR 45.26) &
• Indirect Quotation (INR 100 = USD 2.21).
‘Direct’ or ‘Indirect’ are always vis-à-vis the US dollar perceptive. In practice, all currencies except
the British Pound are quoted in the direct quotation method. Since rates for all currencies are
quoted vis-à-vis the US dollar, cross currency rates (example: INR/Euro) would be obtained by
combining the two primary currency quotes vis-à-vis the US dollar.

Also, quotes usually have two parts: the bid rate (rate at which the bank will purchase US dollars
against home currency in case of direct quotes) and the ask rate (rate at which the bank will sell
US dollars against home currency in case of direct quotes). The bid rate will always be lesser
than the ask rate to cover for operational charges and profit margins of the banks. Examples are:
• INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one ‘pip’)
• EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as one ‘pip’)
While the derived cross currency rate would be:
INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51
Foreign currency deals in a particular currency necessary have to be settled in the home nation of
the currency. Hence, banks taking part in international transactions need to maintain accounts in
various countries to enable transacting in those currencies. These accounts are of multiple types:
• Nostro (Our/my account with you): Current account maintained by one bank with another
bank abroad in the latter’s home currency
• Vostro (Their account with me/us): Current account maintained in the home currency by one
bank in the name of another bank based abroad
Typically, banks have vostro/nostro accounts with multiple foreign banks.
Spot and Forward Foreign Exchange Contracts

The most basics tools of forex risk management are 'spot' and 'forward' contracts. These are
contracts between end users and financial institutions that specify the terms of an exchange of
two currencies. In any forex contract there are a number of variables that need to be agreed upon
and they are:
• The currencies to be bought and sold - in every contract there are two currencies the one that
is bought and the one that is sold
• The amount of currency to be bought or sold
• The date at which the contract matures
• The rate at which the exchange of currencies will occur
The exchange rates advertised either in the newspapers (and that mentioned above) or on the
various information services assume a deal with a maturity of two business days ahead - a deal
done on this basis is called a spot deal. In a spot transaction the currency that is bought will be
receivable in two days whilst the currency that is sold will be payable in two days. This applies to
all major currencies with the exception of the Canadian Dollar.
Most market participants want to exchange the currencies at a time other than two days in
advance but would like to know the rate of exchange now. This is done through a forward
contract to exchange the currencies at a specified exchange rate at a specified date. In
determining the rate of exchange in six months time there are two components:
• the current spot rate
• the forward rate adjustment
The spot rate is simply the current market rate as determined by supply and demand. The
forward rate adjustment is a slightly more complicated calculation that involves the interest rates
of the currencies involved.
Forward rate (Local currency/USD) = Spot rate *(1+ interest rate in US) / (1+ local interest rate),
with interest rates adjusted for the period of the forward rate. The concept behind this equation is

that if you defer the value date of a spot transaction each party will have the funds that they would
have paid to invest. The difference between a forex spot rate and the forward rate for a particular
tenure is called the forward premium for that tenure. Currencies can have forward premiums or
forward discounts vis-à-vis the US dollar.
Forex risk can also be covered through forex future contracts. Futures are exactly similar to
forwards, except for the fact that these deals are brokered through an exchange, non-
customizable (only standard deals available) and hence, not prone to counter-party risk.
Bifurcation of All major markets (Equities, Bond, FX, Derivatives)

• Small and Larger Orders – Equity markets are characterized by smaller orders as compared
to the markets for other financial instruments because of more retail participation
• Liquidity – Exchange traded instruments are more liquid
• Investor Profile – Equity markets have a more retail investor profile as compared to markets
for other financial instruments
• Routing – Deals in the Equity markets are routed to multiple destinations where as deals in
forex as well as debt markets are “matched” internally
• Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC
Treasury applications segments & vendors
Treasury Management Systems – Inter-bank

Cross-Asset Trading and Risk
• Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales,
trading and risk management, operations and distribution across multiple asset classes. Its
rich functionality enables traders to make critical decisions with assurance. It is flexible
across a range of business areas gives which gives traders a competitive edge in trading
activities.
• Summit - Summit is a core solution for treasury management for both financial and corporate
institutions. Summit’s trading applications interact with operations and risk management
platforms to provide a straight-through-processing solution. This allows front to back
management of all products within four primary business areas viz Treasury, Fixed Income,
Derivatives and Commercial lending
• Calypso - Calypso Technologies the world’s leading software provider of credit derivatives,
cross
asset trading, risk management, and processing. It offers a front-to-back office system that
allows traders flexibility to plug in their own products.
• Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions to
the world's leading financial institutions and corporations The Wall Street System financial
trading and treasury engine provides a multi-entity, multi-currency, multi-asset class
environment which supports all front, middle and back office operations.
Treasury Sales – Bank to Customer

Single-bank platform

• Cognotec – Cognotec is the world's leading provider of automated trading solutions to

financial enterprises across the globe. They provide forex dealing solutions. They have
partnered with world-leading technology providers, multi-bank platforms and industry
organizations.
• Integral - Integral is at the forefront of the eFX market in developing new, highly innovative
products. Integral is the provider of integrated electronic trading systems, offering intuitive
and innovative products that automate and streamline the entire trading cycle.
Multi-bank platform
• Reuters RET - Reuters Electronic Trading provides a comprehensive FX and money markets
trading solution for banks.. It includes Automated Dealing, an internet based FX and money
market automated dealing capability, to enable the Bank's dealing room to price, execute,
confirm and manage FX and money market trading.

CASH MANAGEMENT
Cash Management Service (CMS) is a service provided by banks to its clients for a fee to reduce
the float on collections and to ease the bulk payment transactions of the client. Large
Corporations like GM or Ford need to manage cash well since they have:
• Payments to multiple parties at various locations – Payments need to be made to suppliers
across the country. Typically these have suppliers across the country to reduce dependence
on one or a few suppliers
• Collections from multiple parties at various locations - How does a company collect its sale
proceeds from remote upcountry regions?
• Multiple banking accounts at various locations
o Ensure local deficits and surpluses are managed – A corporate may be paying its
employees salaries out of one bank account whereas it may be banking its receivables in
another bank account another location leading to surpluses and deficits in their bank
accounts
o Ensure net surplus is invested properly – If a corporate is unable to identify surpluses, a
corporate may risk keeping money idle leading to loss of interest income if it does not
prudently invest its net surpluses leading to
o Reduce operational costs associated with payments & collections – A CMS would help
optimize wasted operational cost on payments and collections
• Cash Management solutions help corporations:
o Devise an effective account & investment strategy to manage surpluses and deficits –
Pooling, Netting, Zero-balance structures
o Automate collections and payments process flows
o Outsource collections and payments administration & reconciliation
Example
Consider a consumer goods company in Mid-west US, with dealerships spread through 12 states.
The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio, Michigan,
Illinois and Texas. The company transports goods to the 4 depots which serves the respective
local dealers and in some cases dealers in neighboring states. All the depots are treated as
independent cost centers, with sales from respective regions and salaries and general expenses
for these regions marked to the depot concerned. Collections from dealers in various locations
are managed by local sales teams, one team for each state. The company wants to:
• Ensure daily monitoring of collections from various states
• Sweep all local collections daily to a central bank account at Michigan
• Ensure that local accounts do not remain in debit when the central account is in credit.
• Provide facility for temporary intra-day overdraft for the local accounts
• Ensure that surplus money in the central account is invested in an optimal fashion while
allowing sufficient liquidity
• All payments from local accounts above $10,000 require an approval from the CFO sitting in
Michigan

This is a typical case where the company needs the services of a bank to manage its cash
collections and payments. The company needs both cash management facilities and MIS of
collections and payments that can allow it to track revenue and expenses in the manner required.
Companies rarely fail because they are insolvent. They do fail because they are illiquid.
Companies must focus on precise working capital management as a critical component of
treasury strategy. Companies require:
• rich information, to parallel the company’s cash flow cycle
• global cash concentration, through pooling mechanisms
• automated internal funding mechanisms for deficit positions
• Investment options to match individual profiles for liquidity, risk and return.
Some of the offerings in Cash Management Services are -

Payment / Disbursement Offerings
• Payment service for corporations/retail customers
o Banks process payments on behalf of corporations – CMS provides its customers the
payment processing services which help corporations to reduce administrative hassles
and costs in doing so.
o Instruments - Checks/demand drafts/ Electronic Fund Transfer (EFT) help in processing
payments
• Payment Initiation
o Manual instruction – Banks can act on manual instructions given by the corporations to
their bankers for processing payments. They typically take the form of cheques or drafts
o Floppy/Electronic media instructions – A list of beneficiaries and the corresponding
amounts are given in either a floppy or an other electronic media to their banks in the
required formats which are used by the banks for processing payments
o Electronic banking applications – Electronic applications like ECS / EFT or individual
bank specific software packages can be made use of by corporations to effect transfers
• Bulk payments
CMS is very beneficial for processing repetitive / bulk payments in the nature listed below.
Economies of scale and reduction of administrative and related costs can be gained by
corporations
o Payroll processing
o Dividend warrants
o Redemptions
Collections Services
• Collect funds around the globe – CMS provides accurate and timely collection of receivables
worldwide
• Funds are credited to the cash management account
o Local collections – Refer to collections from suppliers / debtors who issue local cheques
o Outstation collections - Refer to collections from customers not in the base location of
the corporation

Banks have responded to the call for evolved cash management concepts. Accelerating accounts
receivable and streamlining accounts payable via a single banking system interface provide the
stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash
management with liquidity and investment offerings. They do so by:
• developing optimal account structures
• applying cash concentration techniques like pooling and sweeping
• providing investment vehicles to maximize cash flows
• implementing foreign exchange and interest rate exposure netting systems
• Establishing regional treasury and shared service centers.
The final objective of most of these cash management solutions is to effectively outsource the
corporate’s receivables and payables process and ensure the best possible liquidity and short
term investment management strategy. Moreover, increasingly, cash management (both
payments and collections) are moving over to a web-based environment where the corporate can
manage his receivables, payables and liquidity position online. In many cases, there is almost-
complete integration between the bank and the company’s supply chain/ERP system which
manages collection and payments data internally. Some of the common methods used for cash
management are described below.
Cheque Collections – Lock Box service
There are possibilities for optimizing and streamlining a company’s incoming payment flows. The
most common collection mechanism is a Cheques lock box service – a collecting service which
enables companies to collect and settle cheques locally (In a typical case, each of the corporate’s
debtors would send cheques along with accepted invoices to a designated post box, hence the
lock box name). Banks undertake to collect cheques at various pre-defined locations on behalf of
the customer, send them for clearing and credit the amount s to a specified customer account.
Once the cheques are collected by the bank through person, courier or delivered by the company
representative:
• the cheques are sorted and batched
• post dated cheques are kept for processing on the value date
• the image of the cheques and the remittance advices are captured and sent to the corporate
• cheques are sent for clearing, if required
• realized cheques are tallied and amounts credited to the corporate’s bank account
• the information on cheques collected is transmitted to the corporate for electronic
reconciliation
In enhanced versions of this facility, the bank manage the receivable books of the corporate -
managing collections, monitoring receivables ageing and providing reconciled collection reports
which can be directly uploaded to corporate information/supply chain systems.
Zero balance structure - Pooling

Pooling allows a company or several companies belonging to the same group profit from efficient
liquidity management, centralized treasury and credit-line management and optimization of
interest results. Banks offer both domestic and cross border zero balancing whereby all value
balances of a set of 'participating' accounts are centralized at the end of each day in one central
account. Thus the participating accounts will not bear any credit or debit interest, and all balances
are concentrated in the central account enabling optimal management of your cash position.

Netting
Netting is the fundamental method for centralising and offsetting intra company and third party
payments. Netting not only significantly reduces payment flows and costs, but also provides
invaluable management information. Banks offer both domestic and cross-border netting
solutions.
Clearing services
Banks offer clearing services to other banks. In such cases, a bank with strong local branch
coverage offers to participate in clearing arrangements on behalf of other banks with no physical
presence at these locations. Also clubbed under correspondent banking services, this facility
primarily helps use the branch networks of various banks on a complimentary basis.
New Act - Check 21

The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28,
2003, and became effective on October 28, 2004. The law facilitates check truncation by
creating a new negotiable instrument called a substitute check, which permits banks to
truncate original checks, to process check information electronically, and to deliver substitute
checks to banks that want to continue receiving paper checks. A substitute check is the legal
equivalent of the original check and includes all the information contained on the original
check. The law does not require banks to accept checks in electronic form nor does it require
banks to use the new authority granted by the Act to create substitute checks.
o Electronic transmission of cheques by Check imaging - Banks find that exchanging
electronic images of checks with other banks is faster and more efficient than physically
transporting paper checks. To address this need, Check 21 allows a bank to create and
send a substitute check that is made from an electronic image of the original check.
o Faster / efficient cheque realization – Since the electronic image of the cheque can be
quickly transmitted electronically, time required for transporting the physical paper
cheques is greatly reduced thereby effecting faster cheque realizations
DEVELOPMENTS IN TREASURY & CASH MANAGEMENT
Asset Securitisation
Financial institutions and banks need to raise fresh capital to fund continuous asset growth and
portfolio management. This has become a major challenge for many financial institutions and
banks due to tough capital market conditions and other market related factors. Asset
securitisation can offer an alternative cost efficient financing tool, enabling them to better manage
liquidity and funding requirements.
Asset securitisation transactions have one basic concept: the identification and isolation of a
separable pool of assets that generate revenue streams independently from the originating entity.
The securities issued on these assets are then sold to investors who base their returns
exclusively on the underlying assets’ performance. The structure is illustrated below:

All these entities need not be present in every transaction. The number of entities depends on the
complexity of the transaction. An example would help understand the concept better.
Example
Bank of America (Originator) has 5000 home loans totaling more than $600 million. The individual
loans are of various credit profiles and various repayment periods. Bank of America is
constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to
‘sell’ about 2000 home loans totaling $200 million. The steps followed are shown below:
• Bank of America conducts an internal study of the portfolio and ascertains that the average
maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It
realizes that historically 10% of the total home loan owners default. So it would only realize
$180 million instead of $200 million.
• Bank of America wants to enhance the rating so that it can ‘sell’ the loans at a better price. It
decides to provide a cash security of $10 million (Credit enhancement) in the scenario of any
repayment default by home loan borrowers.
• Bank of America appoints Credit rating agency X which analyses the pool of loans, and
taking into account the cash security provided rates it AA+.
• Bank of America ‘sells’ the pool of housing loans amounting to $200 million to a independent
firm, Plexus SPV Ltd.
• Backed by these home loan’s future cash flows, Plexus SPV Ltd. issues debt certificates for
$200 million to investors. Plexus pays back the investors the money from the repayments
done by the home loan borrowers.
• Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to
cover operational costs.
• From now on, all EMI repayments on these home loans made by retail investors would flow
through Plexus SPV Ltd and then reaches the investors.

The above example captures the gist of any securitisation transaction, but there are a lot of
structuring issues and legal and regulatory challenges involved in any such transaction.
Fannie Mae and Ginnie Mae are examples of institutions specializing in securitisation
transactions of mortgage loans for US banks. They help US banks in having enough fresh funds
for home loan disbursements.
Real Time Gross Settlement (RTGS)

The current payment system involves settlement of payments on a ‘settlement day’ and interest is
invariably computed to accrue on a daily basis. Even in the wholesale markets for foreign
exchange and money markets contracts, ‘spot’ transactions mean two-business days. Settlement
for clearing cheques presented to the clearing houses takes place on a netting basis at a
particular time either same day or on the next day. This system gives rise to risks such as credit
risk, liquidity risk, legal risk, operational risk and systemic risk.
RTGS is a system provides online settlement of payments between financial institutions. In this
system payment instructions between banks are processed and settled individually and
continuously throughout the day. This is in contrast to net settlements where payment instructions
are processed throughout the day but inter-bank settlement takes place only afterwards typically
at the end of the day. Participant banks will have to maintain a dedicated RTGS settlement
account with the central bank for outward and inward RTGS payments.
RTGS systems do not create credit risk for the receiving participant because they settle each
payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because participants need
sufficient liquidity to cover their outgoing payments.
Continuous Linked Settlement (CLS)

The average daily turnover in global forex transactions stand at almost USD 2 trillion, with
participants in the market spread across various geographies and time zones. However, the
difference in time zones and hence lack of synchronization of transactions has resulted in
considerable amount of systematic risk. Typically, one leg of a forex trade is affected at one point
of time and there would be a delay before the other leg is executed because of time-zone
differences. In such a situation, there is a heightened risk of one party defaulting.
CLS eliminates this ‘temporal’ settlement risk, making same-day settlement both possible and
final. This is made possible by leveraging on the fact that there are significant overlaps between
the main time zones. CLS provides a specific time window in which various settlement time zones
can interact and pass settlement messages. The CLS system consists of the following entities:
• CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned by
nearly 70 of the world’s largest financial groups throughout the US, Europe and Asia Pacific,
who are responsible for more than half the value transferred in the world's FX market.
• Settlement Members: They are shareholders of the CLS bank, who can each submit
settlement instructions directly to CLS Bank and receive information on the status of their
instructions. Each Settlement Member has a multi-currency account with CLS Bank, with the
ability to move funds. Settlement Members have direct access and input deals on their own
behalf and on behalf of their customers. They can provide a branded CLS service to their
third-party customers as part of their agreement with CLS Bank.

• User Members: User Members can submit settlement instructions for themselves and their
customers. However, User Members do not have an account with CLS Bank. Instead they
are sponsored by a Settlement Member who acts on their behalf. Each instruction submitted
by a user member must be authorized by a designated Settlement Member. The instruction is
then eligible for settlement through the Settlement Member's account.
• Third parties: Third parties are customers of settlement and user members and have no
direct access to CLS. Settlement or user members must handle all instructions and financial
flows, which are consolidated in CLS.
• Nostro agents: These agents receive payment instructions from Settlement Members and
provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank. They
receive funds from CLS Bank, User Members, third parties and others for credit to the
Settlement Member account.
The benefits of the CLS system are many:

• Traders can expand their FX business with counterparty banks without increasing limits.
• Treasury managers have more certainty about intraday and end-of-day cash positions.
• Global settlement can rationalize nostro accounts and leverage multi-currency accounts.
• The volume and overall value of payments is reduced, as are cash-clearing costs.
• Costly errors are minimized and any problems can be resolved fast.
Automated Clearing House facilities (ACH)

ACH transactions are electronic clearing transactions in which information about debits and
credits are passed across the clearing system through electronic data files rather than physical
instruments like cheques, drafts etc. ACH electronic transactions are distinguished from wire
transfers in that they are high volume, regularly scheduled, usually between the same parties,
and are initiated via specifically formatted electronic files. Such transactions must usually be
initiated one to two days prior to the settlement date, since they are batch processed and not for
immediate payment. The most common ACH payment applications are:
• Direct deposit of payroll, where the bank debits the corporate account and credits employee
accounts on the basis of a electronic file transmitted/provided by the corporate
• Corporate Disbursement Service, where the bank debits a client's account to initiate
payments to vendors on their behalf
• Corporate Collection Service, where the bank enables it’s clients to collect payments and
remittance data from vendors or trading partners.
• Collection of consumer payments over the telephone, through the Internet or via check-to-
ACH conversion.
• ACH Accounts Receivable Check Conversion enables converting checks collected at a
lockbox or remittance-processing center to ACH electronic debits, speeding payment
collections and improving funds availability.
These services allow the customer to increase transaction speed and improve accuracy and ease
of reconciliation by electronic means and avoidance of physical instruments and clearing delays.
ACH has been an area of very strong growth, with over 8.5 billion transactions being effected
through this route in 2002. However, several security issues remain to be resolved in this area.

TRADE FINANCE
The main objective of trade finance is to facilitate transactions. There are many financing options
available to facilitate international trade such as pre-shipment finance to produce or purchase a
product, and post-shipment finance of the receivables.
PRE SHIPMENT LOANS

Banks provide Pre-shipment finance - working capital for purchase of raw materials, processing
and packaging of the export commodities.
POST SHIPMENT LOANS

Post-shipment financing assists exporters to bridge their liquidity needs where exports are made
under deferred payment basis. A typical example of post-shipment financing is bills discounting.
Bills discounting facility serves to provide liquidity to an exporter by advancing him/her a portion
of the face value of a trade bill drawn by the exporter, accepted by the buyer and endorsed to the
Bank.
In competitive supply situations, favorable terms of payment often ensure that the order is
won. An exporter usually wants to get paid as quickly as possible and an importer will want to pay
as late as possible – preferably after they have sold the goods. Trade finance is often required to
bridge these two disparate objectives.
Question
Pre-shipment finance is liquidated only through realizations of export bills or amounts received
through export incentives. Pre shipment finance should not normally remain outstanding
beyond the original stipulated shipment date. In case it remains outstanding, can the non-
adjusted amount be then transferred as post shipment finance?
FACTORS IN CHOOSING THE MODE OF FINANCING

• Costs: The cost of different financing methods can vary, both in terms of interest rates and
fees. These costs will impact the viability of a transaction
• Time Frame: Depending on the need, short, medium and long-term finance facilities may be
available. The different possibilities should be explored with the finance provider prior to
concluding a transaction. Long-term requirements should also be considered to ensure fees
are not being paid out on a revolving facility that could be saved by using a different financing
structure
• Risk Factors: The nature of the product or service, the buyers’ credit rating and
country/political risks can all affect the security of a trading transaction. In some cases it will
be necessary to obtain export insurance or a confirmed letter of credit. Increased risks will
normally correspond to increased cost in a transaction and will normally make the funding of
a particular transaction, harder to obtain

• Government Guarantee Programs: These can sometimes be obtained where there is some
question over the exporter’s ability to perform or where increased credit is needed. If
obtained, these may enable a lender to provide more finance than their usual underwriting
limits would permit.
• Exporters’ Funds: If the exporter has sufficient resources, he/she may be able to extend
credit without the need for third party financing. However, an established trade finance
provider, offers other benefits like expert credit verification and risk assessment as well as an
international network of offices and staff to ensure that the transaction is completed safely
and satisfactorily
BILL OF LADING
A bill of lading or BOL is:
• A contract between a carrier and a shipper for the transportation of goods.
• A receipt issued by a carrier to a shipper for goods received for transportation.
• Evidence of title to the goods in case of a dispute.
The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind a
shipper even if it meant that the shipper's goods could be detained and sold by the sub-
contractor.
CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his representative,
performs ‘due diligence’ or a reasonable assessment of the risks posed by the potential buyer.
The sources of information include:
• Chambers of commerce, Business Bureaus or their equivalents
• Credit rating services such as TRW and Dun & Bradstreet which have international affiliates
• Trade associations and trade promotion organizations
• Freight forwarders, brokers, and banks
• Direct references from the buyer
PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment method can be
selected. The most common payment methods are described below:
• Cash in advance
• Letter of credit
• Documentary collection
• Open account or credit
• Counter-trade or Barter

CASH IN ADVANCE
Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is
usually a wire transfer or a check. Although an international wire transfer is more expensive, it is
often preferred because it is speedy and does not bear the danger of the check not being
honored. The check can be at a disadvantage if the exchange rate has changed significantly by
the time it arrives, clears and is credited. On the other hand, the check can make it easier to shop
for a better exchange rate between different financial institutions.
For wire transfers the seller must provide clear routing instructions in writing to the buyer or the
buyer’s agent. These include:
• Full name, address, telephone, and telex of the seller’s bank
• Bank’s SWIFT and/or ABA numbers
• Seller’s full name, address, telephone, type of bank account, and account number.
COMMERCIAL LETTER OF CREDIT

The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a bank)
that will guarantee full payment to the seller provided that he has shipped the goods and
complied with the terms of the agreement.
Features
• The LC serves to evenly distribute risk between buyer and seller. The seller is assured of
payment when the conditions of the LC are met and the buyer is reasonably assured of
receiving the goods ordered. This is a common form of payment, especially when the
contracting parties are unfamiliar with each other.
• Since banks deal with documents and not with products, they must pay an LC if the
documents are presented by the seller in full compliance with the terms, even if the buyer
never receives the goods. Goods lost during shipment or embargoed are some examples.
Iraq for example, never received goods that were shipped before its embargo but the LCs
had to be paid anyway.
• LCs are typically irrevocable, which means that once the LC is established it cannot be
changed without the consent of both parties. Therefore the seller, especially when
inexperienced, ought to present the agreement for an LC to an experienced bank or freight
forwarder so that they can verify if the LC is legitimate and if all the terms can be reasonably
met. A trusted bank, other than the issuing or buyer’s bank can guarantee the authenticity of
the document for a fee.
Disadvantages
• If there are discrepancies in the timing, documents or other requirements of the LC the buyer
can reject the shipment. A rejected shipment means that the seller must quickly find a new
buyer, usually at a lower price, or pay for the shipment to be returned or disposed.
• One of the most costly forms of payment guarantee – Usual cost is 0.5% to 1%. Sometimes,
the costs can go up to 5 percent of the total value.

• LCs take time to draw up and usually tie up the buyer’s working capital or credit line from the
date it is accepted until final payment, rejection for noncompliance, expiration or cancellation
(requiring the approval of both parties)
• The terms of an LC are very specific and binding. Statistics show that approximately 50% of
submissions for LC payment are rejected for failure to comply with terms. For example, if one
of the required documents is incomplete or delivered late, then payment will be withheld even
if all other conditions are fulfilled and the shipment received in perfect order. The buyer can
sometimes approve the release of payment if a condition is not fulfilled; but changing terms
after the fact is costly, time consuming and sometimes impossible.
The mechanism
Usually, four parties are involved in any transaction using an LC:
1. Buyer or Applicant
The buyer applies to his bank for the issuance of an LC. If the buyer does not have a credit
arrangement with this issuing bank then he must pay in cash or other negotiable securities.
2. Issuing bank
The issuing or applicant’s bank issues the LC in favor of the beneficiary (Seller) and routes
the document to the beneficiary’s bank. The applicant’s bank later verifies that all the terms,
conditions, and documents comply with the LC, and pays the seller through his bank.
3. Beneficiary’s bank
The seller’s or beneficiary’s bank verifies that the LC is authentic and notifies the beneficiary.
It, or another trusted bank, can act as an advising bank. The advising bank is used as a
trusted bridge between the applicant’s bank and the beneficiary’s bank when they do not
have an active relationship. It also forwards the beneficiary’s proof of performance and
documentation back to the issuing bank. However, the advising bank has no liability for
payment of the LC. The beneficiary, or his bank, can ask an advising bank to confirm the LC.
The confirming bank charges a fee to ensure that the beneficiary is paid when he is in
compliance with the terms and conditions of the LC.
4. Beneficiary or Seller
The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.

Letter Of Credit Diagram2
1. Buyer and seller agree on a commercial transaction.

2. Buyer applies for a letter of credit.
3. Issuing bank issues the letter of credit (LC)
4. Advising bank advises seller than an LC has been opened in his or her favor. Seller sends
merchandise and documents to the freight forwarder.
5. Seller sends copies of documents to the buyer.
6. Freight forwarder sends merchandise to the buyer’s agent (customs broker).
7. Freight forwarder sends documents to the advising bank.
8. Issuing bank arranges for advising bank to make payment.
9. Advising bank makes payment available to the seller.
10. Advising bank sends documents to the issuing bank.
11. Buyer pays or takes loan from the issuing bank.
12. Issuing bank sends bill of lading and other documents to the customs broker.
13. Customs broker forwards merchandise to the buyer.
2
Letter of Credit Diagram and the 14 steps have been reproduced from www.web.worldbank.org

Letters of credit can be flexible. Some LC variations include: Revolving, Negotiable, Straight, Red
Clause, Transferable, and Restricted. But perhaps the safest type of letter of credit from the
seller’s point of view, is the Standby letter of credit.
Example
An Asian Buyer from a Swedish Exporting company stated when he convinced the Exporter to
sell to them on open account terms. The Asian Buyer obtained 60 days credit, which was to be
calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods
were dispatched and invoiced by the Swedish Exporter on the 15th July 2003.
The payment from Asia was due on the 14th Sept 2003. The payment eventually arrived on the
21st Nov 2003, over two months late. The delay in payment cost the Exporter USD 1700 as it
resulted in his account being overdrawn by this amount for 68 days at 9% per annum.
What if confirmed Letter of Credit had been required?

If Swedish Exporter had insisted on receiving a confirmed Letter of Credit through Allied Swedish
Banks plc. The following costs (approximations) would have applied:
Confirmation Fee USD $250

Acceptance Commission (@ 1.5% pa for 60 days) USD $250
Negotiation / Payment Fee USD $150
Out of Pocket Expenses (estimate) USD $60
Total Letter of Credit Cost USD $710
Interest Cost as a result of late payment USD ($1,700)
Benefit of using Letter of Credit USD $990
Advantages of Letter of Credit

• A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms
and conditions of the Letter of Credit were complied with).
• A definitive date for the receipt of funds, particularly important for devising proper currency
hedging strategies.
• The opportunity to receive the payment in advance of the due date through non-recourse
discounting of the receivable.

Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have incurred a
further cost in canceling or rearranging the forward contract. Letters of Credit provide real and
tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course if
the Asian buyer had not paid at all they would have lost the whole USD 100,000
The standby LC is like a bank guarantee. It is not used as the primary payment method but as a
fail safe method or guarantee for long-term projects. This LC promises payment only if the buyer
fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should
the buyer default, the seller must then apply to the bank for payment - a relatively simple process
without complicated documentation. Since the standby LC can remain valid for years (Evergreen
Clause) it eliminates the cost of separate LCs for each transaction with a regular client.
Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank
to open his own LC to buy inputs necessary to fill his buyer’s order.
DOCUMENTARY COLLECTION
The seller sends a draft for payment with the related shipping documents through bank channels
to the buyer’s bank. The bank releases the documents to the buyer upon receipt of payment or
promise of payment. The banks involved in facilitating this collection process have no
responsibility to pay the seller should the buyer default unless the draft bears the aval (ad
valutem) of the buyer’s bank. It is generally safer for exporters to require that bills of lading be
“made out to shipper’s order and endorsed in blank” to allow them and the banks more flexible
control of the merchandise.
Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon
receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new
buyer or pay for return shipment. Documentary collections are viable only for ocean shipments,
as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document
whereas the comparable airway bill is not negotiable as an ownership title.
Drafts
A draft (sometimes called a bill of exchange) is a written order by one party directing a second
party to pay a third party. Drafts are negotiable instruments that facilitate international payments
through respected intermediaries such as banks but do not involve the intermediaries in
guaranteeing performance. Such drafts offer more flexibility than LCs and are transferable from
one party to another. There are two basic types of drafts: sight drafts and time drafts.
Sight Draft
After making the shipment the seller sends a sight draft, through his bank to the buyer’s bank,
accompanied by agreed documentation such as the original bill of lading, invoice, certificate of
origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees it
and thereby receive the documentation that gives him ownership title to the goods that were
shipped. There are no guarantees made about the goods other than the information about
quantities, date of shipment, etc. which appears in the documentation. The buyer can refuse to
accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to a
destination without a buyer. There is no recourse with the banks since their responsibility ends
with the exchange of money for documents.

Time Drafts/Bankers' acceptances

Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the export,
import, domestic shipment or storage of goods. It demands payment after a specified time or on a
certain date after the buyer accepts the draft and receives the goods. A bankers' acceptance is
"accepted" when a bank writes on the draft its agreement to pay it at maturity. A bank may accept
the draft for either the drawer or the holder.
An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of money at
a specified time. A draft may be drawn on individuals, businesses or financial institutions.
An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by selling the
acceptance. Nevertheless, the acceptance is an outstanding liability of the bank and is subject to
the reserve requirement unless it is of a type eligible for discount by the Federal Reserve Bank.
Example
Banker’s Acceptances sell at a discount from the face value:
Face value of Bankers Acceptance $1,000,000
Minus 2% per annum commission for one year -$20,000
Amount received by exporter in one year $980,000
HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied. Frequently,
trading partners will use a combination of payment methods. For example: the seller may require
that 50% payment be made in advance using a wire transfer and that the remaining 50% be
made by documentary collection and a sight draft.
OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one of the
most common methods of payment in international trade and many large companies will only buy
on open account. Payment is usually made by wire transfer or check. This can be a very risky
method for the seller, unless he has a long and favorable relationship with the buyer or the buyer
has an excellent credit rating. Still, there are no guarantees and collecting delinquent payments is
difficult and costly in foreign countries especially considering that this method utilizes few legally
binding documents. Contracts, invoices, and shipping documents will only be useful in securing
payment from a recalcitrant buyer when his country’s legal system recognizes them and allows
for reasonable settlement of such disputes.
OTHER PAYMENT METHODS
Consignment

The consignment method requires that the seller ship the goods to the buyer, broker or distributor
but not receive payment until the goods are sold or transferred to another buyer. Sometimes even
the price is not pre-fixed and while the seller can verify market prices for the sale date or hire an
inspector to verify the standard and condition of the product, he ultimately has very little recourse.
Credit Card
Some banks offer buyers special lines of credit that are accessible via credit card to facilitate
even substantial purchases. It is convenient for both parties - but the seller should confirm the
bank charges and also bear in mind that the laws that govern domestic credit card transactions
differ from those govern international use.
Counter-trade and Barter

Counter-trade or barter is most often used when the buyer lacks access to convertible currency or
finds that rates are unfavorable or can exchange for products or services desirable to the seller.
Counter-trade indicates that the buyer will compensate the seller in a manner other than transfer
or money or products.
Factoring
Factoring is a discounting method without recourse. It is an outright sale of export accounts
receivable to a third party, (the factor) who assumes the credit risk. The factor may be a factoring
house or a department of a bank. The advantage to the exporter is the removal of contingent
liabilities from its balance sheet, improved cash flow and elimination of bad debt risk.
Factoring is for short-term receivables (under 90 days) and is more related to receivables against
commodity sales.
Forfaiting
The exporter sells accounts receivables to a forfaiter on a “non-recourse discount” basis, and the
exporter effectively passes all risks associated with the foreign debt to the forfaiter. The forfaiter
may be a forfaiting house or a department of a bank. The benefits are same as factoring -
maximize cash flow and eliminate the payment risk. It is a flexible finance tool that can be used in
short, medium and long-term contracts.
Forfaiting can be for receivables against which payments are due over a longer term, over 90
days and even up to 5 years.

Example
An Asian Importer wants to purchase machinery that he is unwilling or unable to pay for in
cash until that machinery begins to generate income.
At the same time, the exporter wants immediate payment in full in order to meet his on-going
business commitments
Forfaiting solution works as follows
1. Commercial contracts are negotiated subject to finance;
2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a series of
Promissory Notes or Bills of Exchange to be drawn in favour of the exporter which the
importer arranges to have guaranteed by his local bank;
3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount which
is then agreed;
4. The goods are shipped;
5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without recourse"
to the order of the discounting bank);
6. The discounting bank purchases the guaranteed notes or bills from the exporter at the
agreed rate.
Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his goods
and can pay for them in installments over time; and the forfaiter has title to an asset which
he may retain as an investment.
FOREIGN CREDIT INSURANCE UNDERWRITERS AND BROKERS

The purpose of foreign credit insurance is to insure repayment of export credit against
nonpayment due to political and/or commercial causes. It insures commercial risks of
nonpayment by importers because of insolvency or other business factors and political risks of
war, expropriation, confiscation, currency inconvertibility, civil commotion, or cancellation of
import permits.
THE BANKERS ASSOCIATION FOR FOREIGN TRADE (BAFT)

The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions,
dedicated to promoting American exports, international trade, and finance and investment
between U.S. firms and their trading partners. BAFT has set up a trade finance database with a
grant from the U.S. Department of Commerce. The database serves as an essential resource for
assisting exporters seeking trade finance and banks that provide financial services.

INTERNATIONAL PAYMENT INSTRUMENTS COMPARISON CHART3
3
The above “International Payments Comparison Chart” is reproduced from US Department of
Agriculture website - www.ams.usda.gov/ Pub.

2.5. CARDS AND PAYMENTS

CREDIT CARDS
The U.S. payments industry has undergone a significant shift in recent years. Check usage is
declining while the adoption of electronic payment forms is growing. During calendar year 2003,
44.5 billion electronic payments were originated in the United States with a value of $27.4 trillion.
This represents a CAGR of 3.8% since 2000, which is twice the real GDP growth (1.9%).
Non-cash Payment instruments in the US can be classified as follows:
Check-based Payments
Until recently, checks were the most used payment instrument in the US. Towards the end of
2004, Cards-based payment instruments have overtaken them. Their popularity has been due to
their ease of use at the point of sale, for bill payments, and for person-to-person payments. The
latest development in this payment instrument is the introduction of Check 21 Act, which is
related to the truncation of checks to electronic form. A recent study by Federal Reserve indicates
that while checks paid decreased by over 5 billion from 2000 to 2003, the number of electronic
payment transactions increased by over 13 billion. It is estimated that before the end of the
decade credit cards and debit cards will individually exceed the number of paid checks.
Cards-based Payments
Debit
Debit cards enable the holder to make purchases and to charge those purchases directly to a
current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based)
or off-line (Signature-based). On-line debit cards have been available for several decades and
have seen tremendous growth since the early 1990’s. Off-line debit cards are a more recent
innovation and consumers are increasingly using them at merchant locations that accept
bankcards. Of all cards-based payments, debit has seen the highest growth.
ATM
Financial institutions issue ATM cards to consumers to provide on-line access to account
information and to allow consumers to make withdrawals and deposits at ATMs. Many financial
institutions now offer ATM cards that can also be used as debit cards for POS transactions at
participating retailers.
Credit
These include general-purpose credit cards and private-label credit cards (discussed later).
Compared to other electronic payment instruments, credit cards have shown a relatively
moderate growth since 2000.
Chip Cards
These cards have the capability to store funds electronically in an embedded chip, which updates
the funds available data as transactions are made. While Prepaid cards are best known for their
use as a gift card, they are increasingly used for payroll, incentives, insurance, refunds and other
purposes. Some stored value cards may also be smart cards if they contain an integrated
microchip. The integrated chip can store value and perform other functions, such as consumer
authentication, health care programs, government-funded benefits programs, transportation
services, etc. The chip might also contain consumer preferences and loyalty program information
for marketing purposes.
Automated Clearing House (ACH)

An ACH transaction is a batch-processed, value-dated electronic funds transfer between

originating and receiving financial institutions. ACH payments are used in a variety of payment
environments. Originally, consumers primarily used the ACH for paycheck direct deposit. Now,
they increasingly use the ACH for bill payments (often referred to as direct payments), corporate
payments (business-to-business), and government payments (e.g., tax refunds), and electronic
check presentment. There are two national ACH operators – Electronic Payment Networks, a
private processor with a 30% market share while the rest of the market is served by the Federal
Reserve Banks.
Emerging Payments
Online Bill Pay (EBPP, EIPP)
Online services that enable customers to receive, review, and execute payment of their bills over
the Internet.
Person-to-Person Payments (P2P)
On-line P2P payments, or e-mail payments, use existing retail payment networks to provide an
electronically initiated transfer of value from one individual to another.
Internet Currencies / Digital Cash / e-Wallets
Similar to P2P payments, individuals can transfer electronic cash value to other individuals or
businesses. Most electronic cash applications exist on the Internet. Consumers can use the cash
payment instruments for purchases at retailers’ Web sites or they can transfer cash to other
individuals through e-mail. Individuals use a credit card or signature-based debit card number to
pre-fund the Web certificate or electronic account, and recipients redeem the value with the
Issuer.
Electronic Benefits Transfer (EBT)
Electronic system that allows a recipient to authorize transfer of his/her government benefits from
a Federal account to a retailer account to pay for products received. EBT is currently used to
issue food stamps and other benefits in the US.
Generic Framework for Payment Instruments
The diagram below depicts the common model on which most payment systems are based..
Four Corner Payment System Model
Payer Payee
Present Non-cash Payment instrument
Goods / Services
Network
Financial Institution Financial Institution

or Third party or Third party
Solid line indicates flow of information

While the flow of funds, information, and data are different, in most cases, the set of participants
are similar. The initiator of the payment (payer) is typically a consumer and the recipient of the
payment (payee), typically a merchant. The payer and the payee are shown to have a
relationship with their respective financial institutions. The payment network routes the
transactions between the financial institutions
Credit Card Market Overview
Credit card activities in the US represent more than 25 billion individual transactions purchasing
$1.7 trillion dollars in products and services equaling more than 10% of GDP. There are 1.2 billion
credit cards (including store and gas credit cards) in circulation in the US held by over 160 million
individuals. The average household possesses 14.27 credit cards with an average household
credit balance of $9,450 in 20034. Credit card fees paid by consumers exceed $15 billion.
A Credit card is a type of a payment card product. A payment card product is a set of
entitlements. It allows the client to access the features the provider (e.g., financial institution)
attaches to the card.
A sample of possible payment card entitlements is shown below:
Access Convenience Affordability
Credit Worldwide acceptance Interest rate
Deposits 24 hour availability Fees
Merchants Portability Benefits
ATMs Monthly statements Payment terms
To create an actual payment card product, these entitlements are grouped together to appeal to a
target segment – consumer or business. A card is issued to a cardholder and usually displays
cardholder name, account number, expiration date, location acceptance logos (e.g.,
Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some
of the new cards contain chips that store information such as additional customer information and
stored value. A card usually is linked to some type of financial account (e.g., credit card to a credit
line and a debit card to a checking/savings account).
Credit Cards
A credit card indicates that the holder has been granted a line of credit enabling the cardholder to
make purchases and/or draw cash up to a pre-arranged amount. Interest is charged on the
amount of the unpaid credit balance and cardholders are often charged an annual user fee.
The dominant payment card types that are in use at this time in developed banking environments
are those employing the use of “magnetic stripe” technology. Part of the reason for this is the
relatively lower cost of Points-of-Sale (POS) terminals and the formation of well-established
specifications that allows these magnetic-stripe cards to be used in virtually any card-based POS
device worldwide. The production costs of the stripe card are also low. Additionally, administrative
support requirements are well developed.
However, smart cards, introduced a decade ago, are making significant inroads in some countries
where, in addition to, regulated pilots being undertaken some significant schemes are already in
place. These plastic cards, which are embedded with a computer chip, offer a number of
significant benefits to financial institutions, retailers, and cardholders—ranging from improved
security to a host of innovative new features.
But while smart card usage has been rapidly increasing thanks to a diverse set of applications
from wireless telephones to loyalty programs, the predicted mass migration of payment
applications from conventional magnetic-stripe cards to smart cards has not yet materialized. One
4
Source: Nilson Report

of the biggest hurdles, until now, has been the lack of universally accepted specifications for
smart card based payments; however, consensus on EMV (Europay / MasterCard / Visa)
specifications for smart cards is now set to change this situation and smart cards are poised to
challenge the 2+ billion magnetic-stripe cards in circulation around the globe.
Credit Card Market – Major Business Entities and their Activities

Issuer: Holds contractual agreements with and issues cards to cardholders. The key
activities of an issuer can be represented in the following manner –
Acquirer: Does business with merchants enabling them to accept credit cards. Acquirers buy
(acquire) the merchant's sales slips and credit the tickets' value to the merchant's account.
Acquirer’s key activities can be summarized as –
Due to high factors such as high volumes and low profit margins, most US banks have sold
their acquirer businesses to non-banking entities that specialize in this field. Following are the
Income and Expense sources in an Acquirer business –

q Income:
§ Merchant discount (1–4% of transaction value)
§ Processing fees ($ 0.20 – $ 0.40 per transaction)
§ Monthly minimum fees
§ Customer service fees
§ POS Equipment sales/service
q Expense:
§ Interchange fees paid to Issuer
§ ISO/MSP fees
§ Data processing & Communications expenses
§ Risk Management
§ Losses on Merchant Chargebacks & Fraud
Processor (Third Party Entities): Provides credit card processing, billing, reporting and
settlement, and operational services to the Issuer/Acquirer. The Card Processing market is a
highly concentrated market with players like First Data and TSYS processing more than half
of all US card transactions. The two main services that the Third Party Processors offer are
Issuing Services and Acquiring Services -
q Issuing services
§ Functions: Most activities of card Issuers
§ Income = Transaction Processing fees + Software Licensing & Maintenance
§ Expense = Data processing & Communications expense
q Acquiring services
§ Functions: Most activities of card Acquirers
§ Income = Merchant fees + Processing fees + ISO/MSP fees
§ Expense = Data processing & Communications expense + Losses on
Chargebacks + Depreciation
Independent Sales Organization (ISO): An outside company (not MasterCard/VISA
member, non-bank) that offers merchant accounts and may process credit card transactions
for a transaction fee. ISOs enter into a contract with Acquiring banks to offer bankcard
acquiring services, through registered or unregistered sales agents or employees
Association: An organization owned by members, which services and obtains processing
services for members. Members include commercial/retail banks, credit unions etc. Following
are few main characteristics of Association -
q License members (Issuers, Acquirers) to issue & accept payment cards
§ However, associations themselves do NOT issue cards / set card fees / set credit
limits / set interest rates, or solicit merchants / set discount rates
q Serve as the nerve center connecting the issuing & acquiring sides
§ Provide the interchange systems to transfer data and funds between members
(transaction processing – VisaNet, BankNet)
q Offer a variety of product programs and services to improve member profitability and
minimize member risk
§ E.g. ‘Verified by Visa’, SET

q Implement rules and regulations that govern the interchange of transactions between
members
q Undertake brand advertising and promotional campaigns
A card Association -
Provide These Functions Do Not Provide These Functions

• Recommend, monitor & provide support services • Issue cards
o Bylaws • Set credit limits
o Operating rules & regulations • Set card fees
• Brand advertising & promotional campaigns • Set interest rates
• Authorization & settlement systems • Solicit merchants
• Security/Risk management • Set discount rates
• Assessment & fee based services
• Develop new products & services
Merchant: A retailer, or any other person, firm, or corporation that, according to a Merchant
Agreement, agrees to accept credit cards, debit cards, or both, when properly presented.
Cardholder: The person to whom a financial transaction card is issued or an additional
person authorized to use the card
The following diagram depicts typical activities in transaction processing using a card
involving all the entities described above -

The following table shows lists the description of the various entities involved in a Credit card
processing
Entity Description
This is a bank / financial institution that issues a credit product
Issuing Bank
Cardholder portfolio account is created when a credit application is approved.
Cardholder Account
This defines the processing rules for all the accounts under a business venture of
Business Portfolio the same card offering type. This entity may hold billing rules, auth limits, collection
Account strategies, and other properties that can be defined at this level. Examples of
Business portfolio account may include Chase Visa Classic, Chase Visa Gold, etc
Identifies the different card types that the Credit system supports. Examples may
Card Product be proprietary cards, Visa, MasterCard
Authorization engines are used to authorize credit transactions. The authorization
Authorization Engine engine uses the account information, merchant information, and other related
information to approve / decline / refer an authorization transaction. There can be
more than one authorization engines for a business portfolio.
Provides credit scores that are used by Issuers to process card applications
Credit Bureau
Third party to whom Issuer outsources the cardholder collection activities
Collection Agency
An outside company with which the Issuer contracts to provide cardholder
Issuer Processor transaction processing activities.
Bank designated by the Issuer to receive the Issuer’s daily net settlement
Issuer Clearing Bank advisement. The clearing bank (may be the Issuer itself) will also conduct funds
transfer activities with the net settlement bank and maintain the Issuer’s clearing
account.
This is a bank / financial institution that acquires merchant transactions
Acquirer
Bank designated by Acquirer to receive the Acquirer’s daily net settlement
Acquirer Clearing advisement. The clearing bank (may be the Acquirer itself) will also conduct funds
Bank transfer activities with the net settlement bank and maintain the Acquirer’s clearing
account.
An outside company with whom the Acquirer contracts to provide merchant
Acquirer Processor processing services
A merchant account is created when a merchant application is approved. A
Merchant Account merchant account is necessary for a merchant to accept payment by credit card
Contains presentments and other financial messages that need to be matched with
Clearing file corresponding authorizations
This file is for enabling member settlement
Funding file

Transaction Types
Entity Transaction Type Remarks

• Purchase
Cardholder • Authorization/Verification Triggered by the cardholder.
transactions • Preauthorization Authorization/Verification is the default
• Merchandise return transaction type. If no type is indicated when
submitting transactions to the
gateway, the gateway will assume that the

transaction is of the type
• Reversal
System Generated This transaction is an action on a previous
Transactions transaction and is used to cancel the previous
transaction and ensure it does not get sent for
settlement.
• Adjustment
Exception • Chargeback & Chargeback Used to correct errors that occur at point of
Transactions Reversal transaction or in a participant’s system
• Representment
• Administrative
Others • Network These are routine transactional activities to
• Reconciliation ensure completion of the various activities
• File Maintenance involved in a transaction processing cycle
• Fee transactions
Chargeback & Chargeback Reversals –

At any time (currently limited to 60 days after statement date), cardholder may contact the Issuer
to question whether a transaction is legitimate and request a copy of the transaction from the
merchant. If the cardholder does not receive a copy of transaction, she may request a
chargeback – a financial reversal of the transaction. Even if the retrieval request is fulfilled,
cardholder still may request the Issuer to initiate a chargeback. However, if the merchant disputes
the chargeback, the disputed transaction is dealt with through a defined dispute process.
Following diagram depicts the process of chargeback and chargeback reversal

Major Players
The following table shows some of the leading US card organizations and their respective roles in
the Credit card industry:
Leading US Market Card Organizations
Banks Non-Banks Association /

Organization
• Citigroup • First Data Corp (Processor) • Visa
(Issuer) (Card
• TSYS (Processor) Association,
• MBNA America Processor)
(Issuer) • Vital (Acquirer & Processor)
• American Express (Acquirer, Card • MasterCard
• JPMorgan Chase / (Card
Bank One Organization & Issuer)
Association,
(Acquirer & Issuer) • Discover (Acquirer, Card Organization & Processor)
• Bank of America Issuer)
• JCB (Card
(Acquirer & Issuer) • Diners Club (Card Organization & Issuer) Association)
• Capital One • Equifax (Processor)
(Issuer)
• Sears ( Acquirer, Card Organization &
• Wells Fargo Issuer)
(Acquirer & Issuer)
• GE Card Services (Processor)
• Wachovia
(Issuer) • US Government (Acquirer & Issuer)

SUMMARY
• Cards are one of the most widely used mechanisms for transactions world wide. There are
several types of cards used –
o Debit cards
o ATM cards
o Credit cards
o Chip cards
o Smart cards
• ACH enables batch-processed, value-dated electronic funds transfer between originating and
receiving financial institutions.
• Emerging payments systems are –
o Online Bill Payment (EBPP, EIPP)
o Person to Person Payments (P2P)
o Internet currencies, digital cash, e-Wallet
o Electronic Benefit Transfer (EBT)
• There are various entities involved in the credit card transaction processing cycle -
o Issuer
o Acquirer
o Third party Processor
o Independent Sales organization
o Association
o Merchant
o Card holder
• Chargeback and Chargeback reversals are legitimate ways to cancel the credit card
transactions within a limited time frame

2.6. INVESTMENT MANAGEMENT

PRIVATE BANKING / WEALTH MANAGEMENT
Private Banking covers banking services, including lending and investment management, Private
banking primarily is a credit service, and is less dependent on accepting deposits than retail
banking.
The Federal Reserve Supervisory Letter defines private banking as personalized services such
as money management, financial advice, and investment services for high net worth clients.
Although high net worth is not defined, it is generally taken at a household income of at least
$100,000 or net worth greater than $500,000. Larger private banks often require even higher
thresholds - Several now require their new clients to have at least $1 million of investable assets.
As per the World Wealth Report 2001 by Merrill Lynch / Cap Gemini, there are currently over 7.2
million millionaires in the world with a combined asset base exceeding US$ 27 trillion which is
projected to grow to over US$ 45 trillion by the end of 2005.
CLIENT SERVICES
A typical private banking division of a large bank would offer the following financial services to its
Private clients:
Investment Management and Advice

A client relationship Manager understands the client’s liquidity, capital and investment needs. He
strives to develop an integrated approach to manage client investments and capital markets
trading. Access to specialist advice and extensive research is a key feature of private banking.
Self-directed or non-discretionary: This is largely investment advisory in which the bank offers
investment recommendations based on the Client’s approval. The client may choose to ignore
this.
Discretionary: In this case, the bank’s portfolio managers make investment decisions on behalf
of the customer.
Risk Management
Strives to reduce exposures for its clients across the world through a variety of hedging tools,
taking positions in derivative markets etc
Liquidity
Management of a Client’s liquidity (cash etc) needs through short-tem credit facilities, flexible
cash management services etc. An exclusive cash management service with "sweep" facility is a
Private Banking feature. The sweep automatically transfers excess funds over a pre-determined
limit out of your current account into a higher yielding reserve account, optimizing your return on
short-term cash. Funds are on call so they remain easy to access.
Structured Lending
Provides tailored lending to provide long-term liquidity to clients, or investment capital

Enhanced banking facilities

Private clients enjoy a variety of exclusive banking services such as:
• Insurance
• Foreign exchange transactions
• Automatic credit entitlements etc
Issuer Capital formation

Providing clients with access to investment banking and other institutional services
Private Bankers are high-end relationship managers, as well as money managers and advisors.
Private clients trade in larger volumes, the fees and commissions are larger.
Changes in the regulatory environment have redefined the competitive landscape of wealth
management by allowing involvement of banks in insurance activities. A successful wealth
manager must harness and deploy not just the standard activities of equity and fixed income
investment management, but a plethora of other products and services: tax and estate planning,
insurance products, 401(k) rollovers, and more.
Most private banks segregate their clients based on net worth, investible assets, age etc. For
example, one classification could be between young affluent and retired affluent.
Private banking clients typically demand higher returns on their investment, and as a result banks
offering these services are heavily dependent on efficient Portfolio Analysis and Asset Allocation
techniques to achieve this. The consequent investment in technology is also very high.
Private banking is a fee-driven business. Banks offering these services charge anything between
1-4 % for their service, depending on the nature of the service rendered. Return on equity for
banks offering these services could be as high as 25%.
COMMON PRIVATE BANKING PRODUCTS
Personal Investment Companies (PICs)

A PIC is a shell company set up by a Private Bank’s offshore division (e.g. trust division) for a
client, usually in a tax haven like the Cayman Islands. The PIC has its own legal entity and the
investor enjoys confidentiality as well as tax benefits. There is substantial startup fee involved for
these, and banks charge annual administration fees.
Payable Through Account (PTA)

PTAs are transaction deposit accounts that allow banks in one country to offer their foreign clients
of a foreign bank, such services as check-writing. The foreign bank in this case plays the role of a
correspondent bank. These accounts usually have a high transaction volume and attract dollar
deposits from the foreign customers.

Hedge Funds
This is a private investment partnership, and is usually run by Private Banks. Hedge funds are
highly speculative and they use a variety of techniques such as leverage, short-selling, and use of
derivatives. Several hedge funds also utilize some form of arbitrage, such as those where they
can take advantage of movements expected to occur in the stock price of two companies
undergoing a merger or other similar event. In most cases, investors in a hedge fund need to be
duly accredited.
How have average hedge fund returns performed vis-a-vis market levels?
“Multibillion dollar Quantum Fund managed by the legendary George Soros, for instance,
boasted compound annual returns exceeding 30% for more than a decade.”
“Off Shore Hedge Funds: Survival and Performance: 1989-1995," a study by Yale and NYU
Stern economists, indicates that, during that six-year period, the average annual return for
offshore hedge funds was 13.6%, whereas the average annual gain for the S&P 500 was
16.5%. Even worse, the rate of closure for funds rose to over 20% per year, so choosing a
long-term hedge fund is trickier even than choosing a stock investment.
Are hedge funds not immune to risk?
Led by Wall Street trader John Meriwether and a team of finance wizards and Ph.Ds, Long
Term Capital Management imploded in the late 1990s. It nearly sank the global financial
system and had to be bailed out by Wall Street's biggest banks. In 2000 George Soros shut
down his Quantum Fund after sustaining stupendous losses.
WHO OFFERS PRIVATE BANKING SERVICES?

Most Banks have separate divisions offering dedicated private banking services. There may be
Edge Corporations or Foreign subsidiaries of large national banks as well, which offer these
services.
The large European banks like UBS, Credit Suisse are industry leaders. There are a number of
standalone Private Banks as well. In banks such as Mellon and Bank One, Private Banking takes
place in the Trust or Investment Management division. Many banks offer Private Client
Services (PCS) to clients in other countries as well, through foreign subsidiaries, or even
affiliated banks.
WHY GROW PRIVATE BANKING BUSINESS?

• Most private banks target return on equity of at least 25% which is considerably higher than
that of the average commercial bank.
• Opportunities for off-balance sheet income are an additional incentive. Unlike depository
accounts, securities and other instruments held in the clients’ investment accounts are not
reflected on the balance sheet of the institution because they belong to the client.
• However, the institution can earn substantial fees for managing client assets or performing
other cash management and custodial services. To grow, private banks need to lure new

wealthy investors away from direct investing or from investing with major mutual funds such
as Fidelity or Merrill Lynch.
CORE FUNCTIONS IN PRIVATE BANKING

• Sales and Marketing / Client Prospecting
• Client Management, Servicing and delivery
• Financial Planning
• Portfolio Analysis and Optimization
• Market Activities
• Research
• Compliance controls.
PRIVATE BANKING WORKFLOW

The high-level process flow for private banking is shown below. The roles and responsibilities of
the various players are outlined below:
• Client Representative:
• Servicing specialist
• Middle office
• Back office


The diagram below shows the various departments in the Private Banking division of a bank.

INVESTMENT MANAGEMENT
Investment Management can be defined as the process of managing money, which includes
investments such as real estate, financial instruments such as stock, mutual fund, bonds or
equipment that has monetary value that could be realized if sold. Very often, terms such as
money management, asset management etc. are used interchangeably.
INVESTMENT MANAGEMENT GOALS

Investment Management aims at the following goals:
• Manage investors money efficiently and cost effectively
• Generate superior investment returns
• Investing Goal Ultimate objective is to deliver equity type returns with lesser volatility risk
and achieve capital preservation
In achieving the above goals, an Investment Manager uses the following approaches/principles:
• Asset Mix is the primary determinant of portfolio return, optimum portfolios are designed
using asset allocation tools
• International Diversification - Investment in world wide stocks reduces risk and improves
returns
• Screens/Filters - Variety of quantitative and qualitative screens to identify candidate
investments, interviews with fund managers prior to investing and continuous due diligence.
• Capital preservation - Preserve the wealth of investors and ensure erosion free investment
• Alternative Investments - Investing in hedge fund and futures to have strong returns. These
assets generally earn returns consistent with those of equities. By combining alternative
investments with equities, the asset manager can generate superior returns while reducing
the ups and downs of the portfolio.
Investment management services are usually offered by firms that specialize in managing an
investor’s money. These firms employ individuals known as portfolio managers who are
responsible for taking the decision on which type of assets to invest it to best suit the investors
needs.
THE INVESTMENT PROCESS
Making investment decisions is not an easy task and requires specialized skills and services and
involves a number of business processes.
The diagram below depicts some of the key steps/process involved in the investment
management life-cycle.

INVESTMENT MANAGEMENT CYCLE
Market and Analytical Portfolio Brokers and

Trade Orders
Data Management Trading
Networks
Research
and
Analysis Trading
Clearing and
Settlement
Data
External
Trading
Information
Providers
Monitoring Custodians
Trades Investment
Prices and Settlements Operations
Reporting

RESEARCH
Research is one of the primary inputs towards deciding what kind of asset or financial instrument
to invest in. It involves performing a variety of qualitative and quantitative analysis to determine
the ideal portfolio mix. His includes an in depth analysis about the institution issuing the
instrument, estimating future growth, industry analysis, trend analysis of historical prices etc.
Some of the pre-requisites for performing meaningful research to aid investment decision making
are as follows:
Research team
The first step is to put together a dedicated research team. It is critical that the team members not
only understand the financial market dynamics but also have knowledge on Model building and
Econometrics. The success of the research team is usually evaluated relative to a benchmark
return.
Data
The research team must have easy access to a variety of data. The collection and maintenance
of the database is very important. Tactical decisions need to be made quickly as new data keeps
pouring in. It is best to invest in a database system that takes the new data and automatically
runs the quantitative analyses.
Computing
While most top-down data management exercises can be handled within Excel, the bottom up
projects are not feasible within a spreadsheet. The bottom-up projects may include up to 10,000
securities along with vectors of attributes for each security.
ASSET ALLOCATION
Passive Approach
The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns
subject to the risk and cash flow constraints. Thus the investor’s characteristics determine the
right mix for the portfolio. In coming up with the mix, the asset manager uses diversification
strategies; asset classes tend to be influenced differently by macro economic events such as
recessions or inflation. Diversifying across asset classes will yield better trade offs between risk
and return than investing in any one risk class. The same observation can be made about
expanding portfolios to include both domestic and foreign assets.
Active Approach
Portfolio managers often deviate from the passive mix by using “Market timing”. To the extent that
portfolio managers believe that they can determine which markets are likely to go up more than
expected and which less than expected, they will alter the active-passive mix accordingly. Thus, a
portfolio manager who believes that the stock market is over valued and is ripe for a correction,
while real estate is under valued, may reduce the proportion of the portfolio that is allocated to
equities and increase the proportion allocated to real estate. Market strategists at all of the major
investment firms influence the asset allocation decision.

There have been fewer successful market timers than successful stock pickers. This can be
attributed to the fact that it is far more difficult to gain a differential advantage at market timing
than it is at stock selection. For instance, it is unlikely that one can acquire an informational
advantage over other investors at timing markets. But it is still possible, with sufficient research
and private information, to get an informational advantage at picking stocks. Market timers
contend that they can take existing information and use it more creatively or in better models to
arrive at predictions for markets, but such approaches can be easily imitated.
APPROACHES TO ASSET ALLOCATION

Fund managers generally adopt an individual investment management style. The following are
the two quantitative approaches to tactical global asset management:
Top Down Approach

The "top down" investor begins by looking at the “big picture” - economy or broad trends in
society to identify individual countries and then sectors that will benefit from the prevailing
conditions. For example, a "top down" investor might say that since the huge baby-boomer
generation is aging and moving toward retirement, companies that provide products and services
to older people should benefit from that trend. This might lead to buying pharmaceutical stocks or
health care shares or, stocks of insurers that provide retirement annuities.
A "top down" investor may also make investments based on what he or she thinks lies ahead for
the economy. So, for example, if a "top down" investor believed that a resurgent economy might
re-ignite inflation fears, then he or she might consider buying gold or natural resource stocks, or
jettisoning long-term bonds in favor of Treasury bills. So a "top down" investor starts with a
concept and then looks for stocks that are compatible with it.
Then they work systematically down from this very broad perspective translating these top-down
views into more specific economic and market forecasts. This is an analytical process; trying to
identify those profound structural changes in global economies and societies, seeing what effects
are likely to filter down and in time affect the value of ordinary investments.
An illustrative model of “top down” approach will look as follows:
• Build country-by-country forecasting models based on benchmark return
• Validation of models
• Forecast out of sample returns
• Sort country returns
• Invest in portfolio of highest expected return countries
• Information in both the volatility and correlation is used in determining optimal portfolio
weights
"Hedge" strategies are also possible. This involves taking long positions in the highest expected
returns countries and short positions in the lowest expected returns countries.
Bottom Up Approach
The idea is to select individual securities. From a variety of methods, forecasted winners are
purchased and forecasted losers are sold. “Bottom up" investor would try to find investments that

are attractive because of something particular to them -- i.e., their terrific growth potential, say, or
the fact that their assets are selling for less than their intrinsic worth. So an investor who practices
the "bottom up" approach might screen through a long list of stocks to find ones that look like a
buy on the basis of their fundamentals.
PORTFOLIO EXECUTION
There are many individual strategies that may show promise in terms of beating the market.
However, very few portfolio managers actually accomplish the same objective. One very
important reason is the failure on the part of most studies to factor in both the difficulties and the
costs associated with executing strategies.
There are three dimensions to portfolio execution:

Cost of execution
There are three components to this cost.
Bid-ask spread, which leads investors to buy at a high price and sell at a lower price. For low-
priced stocks, this cost can be as high as 20% of the price of the stock.
Price impact that investors have when they trade, pushing the price up as they buy and down as
they sell. In illiquid markets, this cost can be significant especially for large trades.
Tax impact associated with trading, which becomes a factor when we consider the objective in
portfolio management is maximizing after-tax returns.
When considered in aggregate, the trading costs will work out to be high. The trading costs will
vary widely across different investment strategies, depending upon the trading frequency and
urgency associated with each strategy.
Trading speed
The need to trade fast and the desire to keep transactions costs low will come into conflict.
Investors who are willing to accept trades spread out over longer periods will generally be able to
have much lower trading costs than investors who need to trade quickly. Long term value
investors will be less affected by trading costs than short term investors trading on information.
Portfolio Risk Management

Portfolio risk characteristics change over time and it is the portfolio manager’s job to keep the
portfolio risk at desired levels at minimum costs. The derivatives markets provide portfolio
managers with additional tools that can be used to hedge risk and add to returns over time.
INVESTMENT PHILOSOPHIES
Portfolio Managers follow different investment philosophies. Some examples are:
Passive Diversification
Some Portfolio Managers believe that markets are efficient; even if they are inefficient, the cost of
exploiting the inefficiency is more the returns that can be earned. Hence, they are willing to

accept market returns. They try to construct portfolios that resemble the market index, often
indexing to broadest possible indices.
Passive Value Investing

Markets systematically undervalue certain companies. Portfolio Managers identify such
companies with parameters like low PE, High dividend yield, low Price to Book Value, low
Price/Replacement Value etc. The leading examples are the likes of Peter Lynch and Warren
Buffet. Such Portfolio Managers have long time horizons, low turnover (i.e.) buying and selling,
and transactions costs
Momentum Investing
Markets tend to stay in trends: if prices have gone up (down) quickly, they will tend to keep going
up (down). Portfolio Managers who subscribe to this school, use price momentum indicators,
relative strength indicators and charts. They have short time horizons and speedy execution
styles.
Market Timing
It is possible to forecast the direction of markets (i.e. to time markets) using identified variables
like market timing models/indicators. Such Portfolio Managers usually take large bets on the
market (in either direction), attempt tactical Asset Allocation in sectors, and use Hedge funds
(selling overvalued and buying undervalued asset classes). An example would be George Soros
and his Quantum Fund.
Contrarian Investing
Markets tend to correct themselves; if prices have gone up (down) quickly, they will tend to go
down (up). If investors are too bullish (bearish), stocks are more likely to go down (up). Such
Portfolio Managers have usually short time horizons, are willing to hold unpopular investments
and use specialist short sales.
Example: In the middle of March this year, the war with Iraq was just starting. The SARS
epidemic was raging across Asia. Travellers, whether for business or pleasure, were staying
at home in fear of terrorism – whether in the guise of chemical or biological warfare, or old
fashioned high explosives. The airline, tourism, and hotel industries were warning of the worst
conditions in living memory. The FTSE 100 index fell to an eight-year low of 3,300.
The contrarians, meanwhile, were rubbing their hands with glee.
Guess what? If you had invested then, at the pit of misery you would have made 27 per cent
in around three months to the middle of June.

INVESTMENT MANAGEMENT VARIANTS

Although we have seen the generic definition and a typical investment management process flow
there are a number of variants in investment management that have evolved over the years to
address specific needs of Investors. This section focuses on some of the investment options that
are available to investors.
INSTITUTIONAL ASSET MANAGEMENT

Institutional money managers are independent financial advisory firms organized and licensed
under the Security and Exchange Commission or Banking Laws' oversight agency of the country.
Institutional Asset Management service can be both Advisory or Fund handling and investing on
behalf of the customer.
Institutional money managers are distinguished by the fact that:
• They are under greater regulatory scrutiny from both state and federal authorities
• They provide exclusive service to their clientele who are typically institutions having portfolios
in excess of several million dollars.
• They are very selective in the clientele they service and first do an independent analysis of
that client's financial needs, goals, objectives, and risk tolerance.
• They charge competitive fees due to the fact that their clients entrust millions of dollars to
them for investing. Accordingly they are under greater scrutiny to provide attractive
performance returns.
All major international banks offer asset management services. Some key players include:
• Morgan Stanley
• Bankers Trust
• Boston Partners
• Pacific Investment Management Co. (PIMCO)
MUTUAL FUNDS
A mutual fund is a fund that pools together money from many investors and invests it on behalf of
the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling
shares of the fund to investors that includes individuals and institutions, much like any other
company can sell stock in itself to the public. These funds take the proceeds of the money from
the sale of the shares and invest it in other instruments like bonds, stocks etc. In return for the
money they give to the fund when purchasing shares, shareholders receive an equity position in
the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders
are free to sell their shares at any time, although the price of a share in a mutual fund will
fluctuate daily, depending upon the performance of the securities held by the fund.
Now you must be wondering that why do people buy mutual funds when they can directly buy the
instruments that these mutual funds invest in. after all what is the need of having a middleman?
There are numerous reasons for investing in the mutual fund. They are:
• Diversification: With a mutual fund one can diversify the investment both across companies
and across asset classes. When some assets are falling in price, others are likely to be rising,
so diversification results in less risk than if you purchased just one or two investments.

• Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.
• Low Investment Minimums: One doesn’t need to be wealthy to invest in mutual funds. Most
mutual funds will allow you to buy into the fund with as little $1,000 or $2,000.
• Convenience: When you own a mutual fund, you don't need to worry about tracking the
dozens of different securities in which the fund invests; rather, all you need to do is to keep
track of the fund's performance.
• Low Transaction Costs: Mutual funds are able to keep transaction costs low because they
benefit from reduced brokerage commissions for buying and selling large quantities of
investments at a single time.
• Regulation: Mutual funds are regulated stringently by the government. Thus this reduces the
risk for the end investor.
• Professional Management: Mutual funds are managed by a team of professionals, which
usually includes one mutual fund manager and several analysts.
So mutual funds are full of benefits. Now you must be wondering if the mutual fund what the
disadvantages of mutual funds are. There are plenty of disadvantages:
• Fees and Expenses: Most mutual funds charge management and operating fees that pay for
the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few
mutual funds charge high sales commissions.
• Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average
more than half of the mutual funds fail to do better than the market returns.
• Loss of Control: The mutual fund managers are the people who decide upon the strategy to
invest. Thus the investor loses the control of his money to the fund manager.
• Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to
provide protection against simultaneous withdrawals. This provides investors with liquidity,
but due to the large cash reserve the mutual funds do not invest all cash in asset and thus
provide investor with lowered returns.
Types of mutual funds

Mutual funds come in many varieties. For example, there are index funds, stock funds, bond
funds, money market funds.
Index funds
"Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment
objective typically is to achieve the same return as a particular market index, such as the S&P
500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market
Index.
Stock funds
"Stock fund" and "equity fund" describe a type of investment company (mutual fund, closed-end
fund, Unit Investment Trust (UIT)) that invests primarily in stocks or "equities". The types of
stocks in which a stock fund will invest will depend upon the fund’s investment objectives,
policies, and strategies. For example, one stock fund may invest in mostly established, "blue
chip" companies that pay regular dividends whereas another stock fund may invest in newer,
technology companies that pay no dividends but that may have more potential for growth.
Bond funds

"Bond fund" and "income fund" are terms used to describe a type of investment company (mutual
fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or other
types of debt securities. The securities that bond funds hold will vary in terms of risk, return,
duration, volatility, and other features.
Money market funds
A money market fund is a type of mutual fund that is required by law to invest in low-risk
securities. These funds have relatively low risks compared to other mutual funds and pay
dividends that generally reflect short-term interest rates. Unlike a "money market deposit account"
at a bank, money market funds are not federally insured.
Money market funds typically invest in government securities, certificates of deposits, commercial
paper of companies, and other highly liquid and low-risk securities. While investor losses in
money market funds have been rare, they are possible.
Net Asset Value

Net asset value," or "NAV," of an investment company or a mutual fund is the company/fund’s
total assets minus its total liabilities. For example, if an investment company has securities and
other assets worth $100 million and has liabilities of $10 million, the investment company’s NAV
will be $90 million. Because an investment company’s assets and liabilities change daily, NAV will
also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the
day after.
The investment company/fund calculates the NAV of a single share (or the "per share NAV") by
dividing its NAV by the number of shares that are outstanding.
Some of the leading companies that offer mutual funds are:

• Fidelity Investments
• Vangaurd
• ING Direct
• Mellon
SEPARATELY MANAGED ACCOUNTS

A separately managed account is a portfolio of securities owned directly by the investor and
managed by professional money manager in lieu of an asset-based fee. SMA or the separately
managed accounts provides the individual investors the same quality of service as offered to
institutional investors.
Separately managed accounts help investors build and manage their wealth by focusing on the
investor's individual investment goals, time horizon, and risk tolerance. To determine these, a risk
profile questionnaire is used. Clients receive a personalized Investment Policy Statement that
outlines goals and the investment vehicles necessary to help achieve them. From there, the
financial consultant chooses an asset allocation strategy that is used as a road map to achieve
objectives. The financial consultant then recommends the investment managers best suited to
manage the overall portfolio. Lastly, ongoing monitoring and review of the portfolio takes place at
both the financial consultant and investment manager level.
Key Features
The key features of SMA are -:

• Direct ownership: The portfolio is held in a personal account rather than held as a part of
fund, thereby giving direct control to the investors.
• Exclusivity: The arrangement gives exclusivity to the investor as investment preference,
objectives and tax liability are not necessarily shared across a pool of investors
• Customization: The security to be held and the investment pattern can be customized to
individual needs. e.g. a customer may not want to invest in those companies that are in
tobacco business. The portfolio can be customized to cater to his individual needs and
preferences.
• Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue.
However, in case of SMA tax advantages to investor results from tax loss harvesting strategy
Advantages and Disadvantages

• Separately managed accounts provide the client with the following benefits:
• The investors get access to top Investment managers at an affordable rate that they would
have been difficult otherwise.
• The fee structure is asset based and not commission based which offer a significant value to
the customer.
• The client is relieved of portfolio management functionality and he can concentrate on other
matters.
• The client gets better tax planning because of the tax-harvesting element in SMA.
• The transactions and the operations are more transparent to the customer as compared to
traditional mutual fund.
• The client gets customized reports about his portfolio.
Disadvantages
• There is no requirement for the reporting of the holding and there is no specific governing
regulation unlike the mutual funds
• There is no board in case of SMA, one hires the manager to manage the asset and there is
no board to sue if something goes wrong
• Closing an SMA would require moving the individual’s security to another manager, which is
a complicated and time consuming exercise.
• It is difficult to find an appropriate comparable to benchmark the performance of SMA.
Difference between SMA and Mutual Funds

The key difference between a mutual fund and an SMA is that an SMA offers investors a
customized approach to investing, rather than a generic product. Usually, the process begins with
an assessment by an adviser of the individual’s financial needs and goals. The adviser can then
recommend a variety of portfolio strategy options, which are customized to meet each investor’s
needs. Once the strategy has been agreed, a professional portfolio manager buys and sells
stocks and bonds in the portfolio on the investor’s behalf. The financial adviser then keeps a
close eye on the portfolio’s performance.
As the portfolio is tailored to meet both long- and short-term cash needs, an SMA, unlike a mutual
fund, can take into account personal investment preferences, such as not investing in particular

stocks for personal, social or environmental reasons. For e.g. an investor may specify that his/her
portfolio should not contain any stock belonging to TOBACCO companies.
Also unlike mutual funds, the investor has direct ownership of the stocks and bonds within the
portfolio. This can facilitate tax management strategies.
Some of the leading investment managers offering SMA services are:

• Merrill Lynch Investment Management
• Brandes Investment Partners
• Nuveen Investments
• Alliance Capital
• Morgan Stanley Investment Management
HEDGE FUNDS
Hedge funds are very similar to mutual funds except that they are targeted at High Networth
individuals as explained in the previous chapter. Hedge funds are exempt from many of the rules
and regulations governing other mutual fund which allows them to accomplish aggressive
investing goals. They are restricted by law to no more than 100 investors per fund, and as a result
most hedge funds set extremely high minimum investment amounts, ranging anywhere from
$250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a
management fee; however, hedge funds also collect a percentage of the profits (usually 20%).
PENSION FUNDS (401k, IRA)

Pension funds are the funds launched to meet retirement savings of individuals so as to provide a
steady income to them after retirement. Since conservation of income is of utmost importance for
a pension fund their investment strategy focuses on long term, safer instruments. Investment in
pension funds also offers tax benefits.

SUMMARY
• Private Banking covers personalized services such as money management, financial advice,
and investment services for high net worth clients. High net worth is generally taken at a
household income of at least $100,000 or net worth greater than $500,000. Larger private
banks often require even higher thresholds of at least $1 million of investable assets
• A typical private banking division of a large bank would offer financial services like:
o Investment Management and Advice
o Risk Management
o Liquidity Management
o Structured Lending
o Enhanced banking facilities
o Issuer Capital formation
• Core functions in private banking include the following:
o Sales and Marketing / Client Prospecting
o Client Management, Servicing and delivery
o Financial Planning
o Portfolio Analysis and Optimization
o Market Activities
o Research
o Compliance controls
• Private Banking Front Office covers functions like Sales & Client prospecting, Contact
Management, Account Aggregation and Financial Advisory services.
• Private Banking Middle/Back Office covers functions like Asset Allocation, Research, Portfolio
Analysis, Risk Management, Trade Processing, Compliance and Documentation
•
• Investment Management aims at managing investors’ money efficiently and cost effectively to
generate superior investment returns. The ultimate objective is to deliver equity type returns
with lesser volatility risk and achieve capital preservation
• An Asset Manager uses the following approaches/principles:
o Asset Mix
o International Diversification
o Screens/Filters
o Capital preservation
o Alternative Investments
• Asset Allocation can be done passively or actively.
o Passive Approach - The portfolio manager has to decide on the mix of assets that
maximizes the after-tax returns subject to the risk and cash flow constraints. Thus the
investor’s characteristics determine the right mix for the portfolio.
o Active Approach - Portfolio managers often deviate from the passive mix by using
“Market timing”. To the extent that portfolio managers believe that they can determine
which markets are likely to go up more than expected and which less than expected,
they will alter the active-passive mix accordingly.
• Fund managers generally adopt an individual "investment philosophy" which
overlays their investment management style. The following are the two quantitative
approaches to tactical global asset management.

• The "top down" investor begins by looking at the “big picture” - economy or broad trends in
society to identify individual countries and then sectors that will benefit from the prevailing
conditions.
• The “bottom up” investor selects individual securities. From a variety of methods, forecasted
winners are purchased and forecasted losers are sold. “Bottom up" investor would try to find
investments that are attractive because of something special to the security.
• Portfolio Managers follow different investment philosophies. Some examples are:
o Passive Diversification
o Passive Value Investing
o Momentum Investing
o Market Timing
o Contrarian Investing
• There are several variants of investment management that have manifested in terms of firms
offering products to suit specific needs of investors. Some of them are
o Institutional Asset Management
o Mutual Funds
o Separately Managed Accounts
o Hedge Funds
o Pension Funds

2.7. INVESTMENT BANKING AND

BROKERAGE

INVESTMENT BANKING
Investment Banks assist clients in raising money in order to grow and expand their businesses.
Their activities include:
• Originating and managing issues of securities
• Underwriting
• Market Making
• Principal buying or selling securities on a spread basis
The top-tier investment banks are:

• Goldman Sachs
• Merrill Lynch
• Morgan Stanley Dean Witter
• Credit Suisse First Boston
• UBS
• Salomon Smith Barney
• J.P. Morgan
• Lehman Brothers
Generally, the breakdown of an investment bank includes the following areas:
CORPORATE FINANCE
The bread and butter of a traditional investment bank, corporate finance generally performs two
different functions:
• Mergers and acquisitions advisory - Banks assist in negotiating and structuring a merger
between two companies. If, for example, a company wants to buy another firm, then an
investment bank will help finalize the purchase price, structure the deal, and generally ensure
a smooth transaction.
• Underwriting - The process by which investment bankers raise investment capital from
investors on behalf of corporations and governments that are issuing securities (both equity
and debt).An Underwriter guarantees that the capital issue will be subscribed to the extent of
his underwritten amount. He will make good of any shortfall.
SALES
Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson, or 3) the
private client service representative. Brokers develop relationships with individual investors and
sell stocks and stock advice.
Institutional salespeople develop business relationships with large institutional investors.
Institutional investors are those who manage large groups of assets, for example pension funds
or mutual funds.

Private Client Service (PCS) representatives lie somewhere between retail brokers and
institutional salespeople, providing brokerage and money management services for high net
worth individuals.
Salespeople make money through commissions on trades made through their firms.
TRADING
Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies,
either by carrying an inventory of securities for sale or by executing a given trade for a client.
Traders deal with transactions large and small and provide liquidity (the ability to buy and sell
securities) for the market. (This is often called making a market.) Traders make money by
purchasing securities and selling them at a slightly higher price. This price differential is called the
"bid ask spread."
RESEARCH
Research analysts follow stocks and bonds and make recommendations on whether to buy, sell,
or hold those securities. Stock analysts typically focus on one industry and will cover up to 20
companies' stocks at any given time. Some research analysts work on the fixed income side and
will cover a particular segment, such as high yield bonds or U.S. Treasury bonds.
Corporate finance bankers rely on research analysts to be experts in the industry in which they
are working. Salespeople within the I-bank utilize research published by analysts to convince their
clients to buy or sell securities through their firm.
Reputed research analysts can generate substantial corporate finance business as well as
substantial trading activity, and thus are an integral part of any investment bank.
SYNDICATE
The hub of the investment banking wheel, syndicate provides a vital link between salespeople
and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a
knock-down drag-out affair between and among buyers of offerings and the investment banks
managing the process. In a corporate or municipal debt deal, syndicate also determines the
allocation of bonds.
INITIAL PUBLIC OFFERINGS

An initial public offering (IPO) is the process by which a private company transforms itself into a
public company. The company offers, for the first time, shares of its equity (ownership) to the
investing public. These shares subsequently trade on a public stock exchange like the New York
Stock Exchange (NYSE) or the Nasdaq. The primary reason for going through the rigors of an
IPO is to raise cash to fund the growth of a company. Often, the owners of a company may
simply wish to cash out either partially or entirely by selling their ownership in the firm in the
offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm.
The IPO process consists of these three major phases:

Hiring the Managers

This choosing of an investment bank is often referred to as a "beauty contest." Typically, this
process involves meeting and interviewing investment bankers from different firms, discussing the
firm's reasons for going public, and ultimately nailing down a valuation. In making a valuation, I-
bankers, pitch to the company wishing to go public what they believe the firm is worth, and
therefore how much stock it can realistically sell. Perhaps understandably, companies often
choose the bank that provides the highest valuation during this beauty contest phase instead of
the best-qualified manager. Almost all IPO candidates select two or more investment banks to
manage the IPO process.
Due Diligence and Drafting

This phase involves understanding the company's business as well as possible scenarios (called
due diligence), and then filing the legal documents as required by the SEC. The SEC legal form
used by a company issuing new public securities is called the S-1 (or prospectus) and Lawyers,
accountants, I-bankers, and of course company management must all toil to complete the S-1 in
a timely manner.
Marketing
Once the SEC has approved the prospectus, the company embarks on a road show to sell the
deal. A road show involves flying the company's management coast to coast (and often to
Europe) to visit institutional investors potentially interested in buying shares in the offering.
Typical road shows last from two to three weeks, and involve meeting literally hundreds of
investors, who listen to the company's presentations, and then ask scrutinizing questions. Often,
money managers decide whether or not to invest thousands of dollars in a company within just a
few minutes of a presentation. The marketing phase ends abruptly with the placement of the
stock, which results in a new security trading in the market.
Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the
course of the next few quarters.
THE CHINESE WALL

Between corporate finance and research, firms build what is known as a Chinese Wall separating
research analysts from both bankers and Sales & Trading. Often, bankers are privy to inside
information at a company because of ongoing or potential M&A business, or because they know
that a public company is in registration to file a follow-on offering. Either transaction is considered
material non-public information and research analysts, privy to such information cannot change
ratings or mention it, as doing so would effectively enable clients to benefit from inside
information at the expense of existing shareholders. When it comes to certain information, a
Chinese Wall also separates salespeople and traders from research analysts. The reason should
be obvious. Analyst reports often move stock prices - sometimes dramatically.
Thus, a salesperson with access to research information prior to it being published would give
clients an unfair advantage over other investors. Research analysts even disguise the name of
the company on a report until immediately before it is published. This way, if the report falls into
the wrong hands, the information remains somewhat confidential.
Insiders of the company cannot sell any shares for a specified period of time, this is
known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)

UNDERWRITING
An Underwriter is a broker/dealer or an investment bank. He guarantees that the capital issue will
be subscribed to the extent of his underwritten amount. He will make good of any shortfall. The
contract between the issuer and the Lead or Managing Underwriter is the Underwriting Agreement.
The agreement states the terms and conditions of the offering, such as, the Underwriting Spread
(the amount the underwriters make on sales), the Public Offering Price (POP), and the amount of
proceeds from the offering that will go to the issuer.
Three different levels of broker/dealers handle the underwriting process:
Managing Underwriters - The Manager (lead underwriter) is the broker/dealer awarded the
issue, who generally handles the relationship with the issuer and oversees the underwriting
process.
Syndicate - To share the risk, and more efficiently distribute the offering to the public,
broker/dealers will join together in a Joint Trading Account. The syndicate profits by selling the
securities and earning a Spread (i.e., the POP less the amount paid to the issuer). Syndicate
members share the risk and are responsible for any unsold securities.
Selling Group - comprises of broker/dealers chosen to assist the syndicate in marketing the
issue in a broker (agency) capacity. Selling Group firms are not members of the syndicate, and
are not at risk for the securities. All broker/dealers involved in the underwriting of non-exempt
securities must be NASD member firms.
Underwriters earn 3 types of Underwriting Spread:

• Manager's fee - The lead underwriter receives this fee on all securities sold.
• Underwriter's Allowance is the total spread minus the Manager's fee. This fee is shared by
syndicate members based on the type of syndicate account.
• Concession - It is typically the largest part of the spread and is paid to the broker/dealer that
actually took the client’s order.

Types of Underwriting
There are two basic types of commitments made by underwriters to issuers:

1. Firm commitment - The issue is purchased from the issuer, marked-up and sold to the
public. The underwriter here is acting as a dealer and is at risk for the unsold securities;
whatever securities are not sold will remain in the underwriter’s inventory. Standby
Underwriting is always used in a subsequent primary offering of stock that is preceded by a
subscription or pre-emptive rights offering. During the rights offering, the underwriter “stands
by”. After the rights offering period has ended and all rights have been either exercised or
expired, the underwriters must take any unsubscribed securities on a firm commitment basis.
2. Best-efforts underwriting - The underwriters act as agents or brokers for the issuer, and
attempt to sell all the securities in the market. The best efforts underwriter is not at risk, and
any unsold securities remain with the issuer. Two sub-types of best efforts are All-or-None
and Mini-max. An all-or-none underwriting may be canceled by the issuer if the entire issue is
not sold in a given time period. A mini-max underwriting requires a minimum amount to be
sold. If the underwriter sells the minimum, they may then attempt to sell the maximum
(usually being the entire issue). However, if the minimum is not sold, the issuer may cancel
the underwriting.
What is an agreement in which the underwriter is legally bound only to attempt to sell the
securities in a public offering for the firm?
When the investment banker bears the risk of not being able to sell a new security at the
established price, what is this is known as?
On the day that a lock-up period expires, the market value of the stock will most likely
________. (Increase/decrease/remain same.)
SECONDARY MARKET TRADING

The trading of outstanding issues takes place in the Secondary Markets. The secondary markets
are broken down into four market types:
1. Listed Market – Exchanges where an Auction method is used at a physical location.
Specialists provide liquidity on the floor of an exchange. (Eg) The New York Stock Exchange
(NYSE)
2. Over-the-Counter Market (OTC, Second Market, Unlisted) – A negotiated market without a

physical location where transactions are done via telecommunications. Broker/dealers acting
as Market Makers provide the liquidity.
3. Third Market – Where listed securities are traded OTC (over-the-counter), and
broker/dealers acting as market markers offer an alternative to trading on the exchange itself.
An example would be a broker/dealer that maintained an inventory of IBM stock (which

trades on the NYSE), and buys and sells that stock to other brokers and customers using a
negotiated, over-the-counter method of trading.
4. Fourth Market – The Instinet, a system for direct over-the-counter institutional trading that
bypasses broker/dealers and thus reduces the cost of large institutional Block Trades.
All the stock exchanges are registered with the SEC, and they have a “self regulation”
mechanism. The Maloney Act of1938 enabled the NASD to be the SRO for the second, third and
fourth markets.
THE FLOOR OF THE EXCHANGE

NYSE (partially) and London are the only major exchanges which still use a trading floor. When
an investor customer calls their broker to place a trade, the following sequence of activities
happen:
• Brokerage Firm checks the customer's account for cash balance, restrictions etc
• Enter the order in its Order Match System. The rep notifies the broker/dealer’s Order or Wire
Room to execute the trade.
• The Order room then wires the order to the Commission House Broker (CHB), an employee of
the broker/dealer who trades on the floor of the exchange for that broker/dealer.
• The CHB makes their way over to the respective Trading Post.
• At the post, the CHB encounters other folks who want to trade IBM stock.
• Transaction Report Is sent to the originating brokerage firms (buying and selling). A market
order through SuperDot to the specialist takes an average 15 seconds to complete.
• Reports are also sent to Consolidated Tape Displays world-wide, and to the Clearing
operations.
• Post Trade Processing Matching of buyers and sellers -- the Comparison process -- takes
place almost immediately.
• This is followed by a 3-day Clearing and Settlement cycle at which time transfer of ownership
(shares for dollars or vice versa) is completed via electronic record keeping in the Depository.
• Brokerage Firm The transaction is processed electronically, crediting or debiting the
customer's account for the number of shares bought or sold.
• Investor Receives a trade confirmation from his/her firm. If shares were purchased, the
investor submits payment. If shares were sold, the investor's account is credited with the
proceeds.
Specialist
Specialists conduct the auction as a broker or dealer and maintain a fair and orderly market by
matching up buyers and sellers. The specialist is not an employee of the exchange and may
trade for their own account, as well as trading as an agent for CHB orders.
Broker Dealer
Executes orders for others Executes orders for themselves
Acts as an Agent Acts as a Principal (i.e., a market maker)
Charges Commission Charges Mark-up and Mark-down

An individual firm could act as a broker on one trade and a dealer on another. When acting as a
broker, the firm is taking customer orders and acting as their agent to buy or sell the security. For
this service, the broker charges a commission. A firm acting as a dealer is the actual buyer or
seller, taking the other side of a trade. The price at which market makers will buy or sell a
particular security is known as the Bid or Ask Price.
Market Maker
• Provide continuous bid and offer prices within a prescribed percentage spread for shares
designated to them
• 4 to 40 (or more) market makers for a particular stock depending on the average daily
volume.
• Play an important role in the secondary market as catalysts, particularly for enhancing stock
liquidity
Registered Representatives
• An individual who has passed the NASD's registration process and is licensed to work in the
securities industry
• Usually a brokerage firm employee acting as an account executive for clients
• Sell to the public; they do not work on exchange floors
Order Types (Based on Price)

There are four basic order types.
1. Market Orders is executed at once, "at the market." A market order guarantees execution,
but does not guarantee a price. The final price is determined by supply and demand.
2. Limit Orders - Some investors may want to buy or sell, but only at a specific price. A Limit
order is executed at a set price or better and will not be executed if that price is not met. For
example, a customer owns XYZ stock, which is currently trading at $50/share. They would
like to sell the stock, but only if they can get a price of $55 or more. The investors would
place a Sell Limit at $55/share, an order that will be executed only if a price of $55 or better is
available. Similarly an investor who seeks to buy, but only at a certain price or better, might
enter a Buy Limit at $45/share.
3. Stop order - If the market price hits or passes through the stop price (Trigger), a market
order is Elected. For example, an investor bought stock at $50/share. The investor wants the
price of the stock to go up, but wishes to limit the losses if the stock price falls. Such an
investor might place a Sell Stop order at $45, and now if the market price falls to $45 or
below, the stop is triggered and a market order is elected. Another example might be a
Technical Trader who believes that if the stock goes up to a certain price, it is signaling the
beginning of a Bullish run. This investor might enter a Buy Stop at $51, for example. Now, if
the stock rises to $51 or above, a market order is triggered to buy the stock. A potential
problem with a stop order is that it triggers a market order, which does not guarantee a

purchase or sale price. A stop order must be triggered (activated or elected) before execution
as a market order.
4. Stop Limit order - If the investors placed an order for $51 Stop, $52 Limit, the order would
be elected at $51, but would not be filled (executed) unless a price of $52 or better was
available. Now, the investor has eliminated the risk of buying the stock without guaranteeing
the price. A stop limit order, once triggered, becomes a limit order.
5. Do-not-reduce Order - Indicates that the order price should not be adjusted in the case of a
stock split or a dividend payout.
A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at 21.07 & you
can be filled at 21.06? True/False
If you want to limit your risk on a long position you can place a sell stop order? True/false
If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at 15.01 if
you place a market order? True/False
Order Types (Based on Time)

Day Order – The order is valid till end of day and if it is unfilled at days end, it gets cancelled.
Open Order or Good Till Cancelled (GTC) – The order can remain open for up to six months. It
is the responsibility of the registered representative to cancel at the customer’s direction. In
addition, at the end of April and the end of October, all GTC orders must be reconfirmed or
eliminated.
Order Types (Based on Volume)

Fill or Kill (FOK) – The order must be immediately filled in one trade or canceled completely.
All or None (AON) - The entire order must be filled or canceled completely, but unlike FOK, AON
can remain good till cancelled.
Immediate or Cancel (IOC) must immediately be filled for as much of the order as possible in
one trade, with the remainder being cancelled.
Market Not Held order – The floor broker has the discretion concerning time and price. A key
point is that Market Not Held orders are never on the Specialist's Book.
THE OVER-THE-COUNTER (OTC) MARKET

Unlike listed securities that trade on an exchange, unlisted securities trade Over the Counter
(OTC). Most securities actually trade OTC, since U.S. government, Municipal and most corporate
securities trade OTC. Since there is no specialist book and no post to record transactions, OTC
price information is either published periodically in paper form, disseminated over telephone lines,
or displayed real-time electronically.

Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who maintain an
inventory of a particular stock, and buy and sell the stock from and to customers).
The largest system for displaying OTC market quotes is Nasdaq (The NASD’s Automated
Quotation system). Broker/Dealers subscribe to various levels of the Nasdaq system depending on
their functional needs. Level 1 service (i.e., the Inside Quote or Representative Quote) is the
highest bid and lowest ask prices of all market makers, and is used by registered reps. Level 2
service is for traders, and lists all market makers' firm quotes on price and size. Level 3 service also
displays all quotes, and is used by market makers to enter quotes.
The quotes look like the following:

Bid Ask
Dealer A 9 9.5
Dealer B 8.75 9.25
Dealer C 9.1 9.8
Dealer D 9 9.5
If you were selling stock, to whom would you sell? Dealer C has the highest bid of 9.1, while a
buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote, therefore, would be
9.1 – 9.25, the highest bid and the lowest ask.
HOW DOES A BROKERAGE FIRM LOOK LIKE?

A brokerage firm has the following departments:
• Sales
• New Accounts
• Order Room
• Purchase and Sales
• Cashiering
• Margin
• Corporate Actions
• Accounting
• Compliance
Sales
Sales team is responsible for canvassing business. They are staffed with Account
Executives/Account Managers who solicit business from retail and wholesale customers.

New Accounts
New Account department is responsible for receiving customer account opening applications and
documenting the customer data. They are the custodians for various documents like New account
form, Signature cards, Margin Agreements, Lending Agreements and Option Trading
Agreements. Only when the required documents are received, the account can legally operate.
New accounts can be of one of the following types:

• Individual Cash Account – Only cash transactions are permitted. No margin trading is
permitted.
• Margin Account
• Joint Account
• Power of Attorney Accounts
Order Room
Orders are taken by dealers in order room and they are executed in the best possible manner.
Every order has detailed instructions like:
• Buy/Sell
• Quantity
• Limit/Market
• Security details etc.
We have covered the different order types in the earlier pages.

The relationships among the various departments can be pictorially represented as below:
Sales Name Accounts (Name & Address)

Account executive • Open Accounts
(Home or Branch office • Executing Changes
Reports Order Tickets
Order Room
OTC Market Exchanges
• Execution recording
Execution • Confirming GTC orders
Reports • Pending Orders
Contra Brokers
Purchase & Sales (P&S)

Confirmation
Clearing Corp • Recording Clients
(CNS) • Figuration (including accrued interest)
• Comparison (reconcilement)
• Booking
Depository
Cashiers Margin
• Receive & Deliver • Account Maintenance
Banks • Vaulting • Sales support
• Bank Loan • Issue checks
• Stock Loan/borrow • Items due
• Transfer • Extensions
• Reorganization • Close – Outs
Brokerages • Delivery of securities
Transfer Stock Record Accounting

Agent • Account numbering & coding • Bookkeeping
• Audits • Daily cash record
• Security Movements • Adjusted trail balance
• Trail Balance
• P & L Statement
Dividend Proxy
• Cash Dividends • Proxy voting
• Stock splits • Information flow to customers
• Due bills
• Bond Interest

Purchase and Sales

This department is responsible for the following activities:
• Recording the trade with a unique number using codes and tickets.
• Figuration to calculate the monetary value of the transaction
• Reconciliation of customer trades with counter-party transactions
• Customer Confirmation in a legally binding form.
Margin
Margin or Credit Department monitors the status of the customer accounts. As explained in the
previous pages, they are also responsible for margin calls. The typical activities of this
department are:
• Account Maintenance
• Sales Support
• Clearing Checks
• Items pending (Money due, stocks due)
• Closing out
Cashiering
They are responsible for movement of securities and funds within the brokerage firm. They take
care of the following functions:
• Receiving and delivering
• Vaulting
• Hypothecations
• Security Transfers
• Stock Lending
Corporate Action
Corporate Action refers to dividend declarations, stock splits etc. The Corporate Action
department makes sure that the rightful owners (as on the Record Date) receive the dividends,
Splits etc.
Accounting
The Accounting department records, processes and balances the movement of money in the
brokerage firm. They produce the Daily Cash Records and Trial Balance, Balance Sheet and
Profit & Loss statements on a periodic basis.

Compliance
The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide Self
Regulatory Organizations. The compliance department is responsible for ensuring that all the
rules and regulations are complied with and reported on time.
They also make sure that the newer regulations like Anti Money Laundering Act are implemented
inside the firm.
Questions
1. All of these are different types of brokerage accounts except?
a) Margin Account b) Cash Account c) IRA Account d) Nostro Account
2. A market order that executes after a specified price level has been reached is called?
a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order
3. A brokerage or analyst report will contain all of the following except?
a) a detailed description of the company, and its industry.
b) an opinionated thesis on why the analyst believes the company will succeed or
fail.
c) a recommendation to buy, sell, or hold the company.
d) a target price or performance prediction for the stock in a year.
e) a track record of the analyst writing the report.

MARKET INDICES
Index of market prices of a particular group of stocks.
Index Types
Value Weighted Index is a stock index in which each stock affects the index in proportion to its
market value. Examples include Nasdaq Composite Index, S&P 500, Hang Seng Index, and
EAFE Index. They are also called capitalization weighted index.
Price Weighted Index is a stock index in which each stock affects the index in proportion to its
price per share. (Eg) Dow Jones Industrial Average
Key Market Indices

The important markets and the indices used are presented below:
US Diversified market Dow Jones Industrial Average (Dow)

US Technology NASDAQ 100
UK (London) Financial Times Stock Exchange Index (FTSE)
Germany (Frankfurt) DAX
France (Paris) CAC
Switzerland (Zurich) SMI
Japan (Tokyo) Nikkei
Hong Kong Hang Seng
Singapore Strait Times Index (STI)
Dow Jones Industrial Average (DJIA)

The Dow is made up of 30 large companies from various industries. The stocks in the following
chart comprise the index.
3M Alcoa
AlliedSignal American Express
AT&T Boeing
Caterpillar Chevron
Citigroup Coca-Cola
DuPont Eastman Kodak
Exxon General Electric
General Motors Goodyear
Hewlett-Packard IBM
International Paper J.P. Morgan
Johnson & Johnson McDonald
Merck Philip Morris
Procter & Gamble Sears
Union Carbide United Technology
Wal-Mart Walt Disney

2.8. RISK MANAGEMENT

RISK MANAGEMENT
A ship is safe in the harbor…But that is not what ships are built for!
Risk is any element of the operating environment that can cause loss or failure. Risks are difficult
to define and they keep changing constantly. For example, if we ask two derivative traders to
identify the biggest risks faced by them, we may get different answers.
Let us look at an example of an Export Oriented Unit. Most or all of their revenue is earned in
foreign exchange where as costs are in domestic currency. Expenses like cost of raw material,
salaries, are paid out in Indian Rupees. If rupee appreciates significantly, the exporter’s profits
may be significantly affected. This is summarized with a numerical example in the following table:
Scenario 1 Scenario 2
INR/USD 50 45
Revenues in USD 100 million 100 million
Revenues in INR 5000 million 4500 million
Costs 4000 million 4000 million
Net Profit 1000 million 500 million
A 10% appreciation in rupee resulted in a 50% drop in profits. This is a case of exchange rate
risk. Of course, in times of dollar appreciation, the firm will end up making pots of money!
THE RISK REWARD PRINCIPLE

The higher the risk you take, the higher is the potential reward and the lower the risk, the
lower is the potential reward. The lower the credit rating of the borrower, the higher is the risk
of lending money but higher also is the interest rate that can be charged! Note that the word used
here is “potential reward”. There is no set formula to say how much reward will justify a certain
amount of risk. Also, sometimes the reward may depend upon the person’s or the organization’s
ability to take advantage. However, the risk-reward principle should be the guiding principle while
deciding on a risk management strategy.

THREE PILLARS OF RISK MANAGEMENT
Define
What are the risks?
Measure Manage
How to estimate the risk? Set tolerance limits and act
DEFINING RISKS
The following are some of the possible risk types.

Credit risk is the possibility of loss as a result of default, such as when a customer defaults on a
loan, or more generally, any type of financial contract.
Liquidity risk is the possibility that a firm will be unable to generate funds to meet contractual
obligations as they fall due.
Operational risk is the possibility of loss resulting from errors in instructing payments or settling
transactions.
Legal risk is the possibility of loss when a contract cannot be enforced -- for example, because
the customer had no authority to enter into the contract or the contract turns out to be
unenforceable in a bankruptcy.
Market risk is the possibility of loss over a given period of time related to uncertain movements in
market factors, such as interest rates, currencies, equities, and commodities.
MEASURING RISKS
Once the risks have been identified, the next step is to choose the quantitative and qualitative
measures of those risks. Risk is essentially measured in terms of the following factors:
a. The probability of an unfavorable event occurring (expressed as a number between 0 and 1)
b. The estimated monetary impact on organization because of the event
The unfavorable events differ for different types of risk. For example, in case of market risk, future
events refer to market scenarios. These scenarios impact each portfolio prices differently
depending on its composition.
Risk measurement is a combination of management, quantitative analysis and information
technology. Serious technology investment is required for accurate measurement and reporting.
One of the commonly used methodologies for market risk is “Value At Risk”
Value at Risk (VaR)

Value at Risk is an estimate of the worst expected loss on a portfolio under normal market
conditions over a specific time interval at a given confidence level. It is also a forecast of a given
percentile, usually in the lower tail, of the distribution of returns on a portfolio over some period.
VaR answers the question: how much one can lose.
Another way of expressing this is that VaR is the lowest quantile of the potential losses that can
occur within a given portfolio during a specified time period. For an internal risk management
model, the typical number is around 5%. Suppose that a portfolio manager has a daily VaR equal
to $1 million at 1%. This means that there is only one chance in 100 that a daily loss bigger than
$1 million occurs under normal market conditions.
Suppose portfolio manager manages a portfolio which consists of a single asset. The return of
the asset is normally distributed with annual mean return 10% and annual standard deviation
30%. The value of the portfolio today is $100 million. We want to answer various simple questions
about the end-of-year distribution of portfolio value:
1. What is the distribution of the end-of-year portfolio value?
2. What is the probability of a loss of more than $20 million dollars by year end?
3. With 1% probability what is the maximum loss at the end of the year? This is the VaR at 1%.

Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and to
combine all of the factors into a single number which is a good indicator of the overall risk level.
VaR Calculation
A generic step-wise approach to calculate would be:
• Get price data for you portfolio holdings.
• Convert price data in to log return data. (Log Return: ui = ln (Si / Si-1) where Si is the price of
the asset on day i)
• Calculate standard deviations of each instrument or each proxy.
• Calculate preferred confidence level. 99% = 2.33 * standard deviation.
• Multiply position holdings by their respective Standard Deviation at a 99% confidence level.
This results in a position VaR at a 99% confidence level.
Example VaR Calculation
Assume that you have a holding in IBM Stock worth $10 million. You have calculated the
standard deviation (SD) of change over one day in IBM is $ 0.20.
Therefore for the entire position, SD of change over 1 day = $200,000

The SD of change over 10 days = $200,000 * √(10) = $632,456
The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621
A. Monte-Carlo Simulation
It is a simulation technique. First, some assumptions about the distribution of changes in market
prices and rates (for example, by assuming they are normally distributed) are made, followed by
data collection to estimate the parameters of the distribution. The Monte Carlo then uses those
assumptions to give successive sets of possible future realizations of changes in those rates. For
each set, the portfolio is revalued. When done, you've got a set of portfolio revaluations
corresponding to the set of possible realizations of rates. From that distribution you take the 99th
percentile loss as the VaR.

Example Monte-Carlo Simulation

Monte-Carlo simulation is a computation process that utilizes random numbers to derive an
outcome. So instead of having fixed inputs, probability distributions are assigned to some or
all of the inputs. This will generate a probability distribution for the output after the simulation
is ran. Here is an example.
A firm that sells product X under a pure/perfect competition market* wants to know the
probability distribution for the profit of this product and the probability that the firm will loss
money when marketing it.
The equation for the profit is: TP = TR - TC = (Q*P) - (Q*VC+FC)
Assumptions:
• The Quantity Demanded (Q) fluctuates between 8,000 and 12,000 units
• All other similar Output factors are also simulated to reflect the change.
A simple simulation worksheet is prepared to with 50000 iterations for Q. It shows the profit
number (with frequency) under various scenarios of quantity sold. This translates into a near
Normal Curve with a Mean and Standard Deviation.
Using the required confidence interval from the normal curve and the standard deviation, a
VaR limit is generated from this distribution.

B. Historical Simulation
Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions about
the distribution of changes in market prices and rates. Instead, it assumes that whatever the
realizations of those changes in prices and rates were in the past is the best indicator for the
future.
It takes those actual changes, applies them to the current set of rates and then uses those to
revalue the portfolio. When done, you've got a set of portfolio revaluations corresponding to the
set of possible realizations of rates. From that distribution, we can calculate the standard
deviation and take the 99th percentile loss as the VaR.
C. Variance-Covariance method
This is a very simplified and speedy approach to VaR computation. It is so, because it assumes a
particular distribution for both the changes in market prices and rates and the changes in portfolio
value. It incorporates the covariance matrix (correlation effects between each asset classes)
primarily developed by JP Morgan Risk Management Advisory Group in 1996. It is often called
Risk Metrics Methodology. It is reasonably good method for portfolio with no option type products.
Thus far, it is the computationally fastest method known today. But this method is not suited for
portfolio with major option type financial products.
MANAGING RISKS
There are multiple strategies to manage risks. Some of the commonly followed ones are:
1. Diversification
2. Hedging or Insurance
3. Setting Risk Limits
4. Ignore the risk!
All the above strategies will reduce the risk – but may not eliminate them. The top management
will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will be
responsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to day
basis and take action whenever the limits are breached.

SUMMARY
• Risk, defined as the deviation from expectation, is an extremely important concept for
financial services industry.
• The nature of banking business gives rise to many different risks in this business. Credit risk,
Liquidity risk, Operational risk, Legal risk, Market risk are some examples.
• Risk management is a 3-step process: Defining, Measuring and Managing risks. Risk is
measured in terms of the probability and the potential monetary impact should the adverse
event occur.
• Risk measurement is a combination of management, quantitative analysis and information
technology. Serious technology investment is required for accurate measurement and
reporting. One of the commonly used methodologies for market risk is “Value at Risk”
• There are multiple ways of managing risks. Rejecting credit if the credit rating is bad is one
operational measure to avoid high risk. Diversification spreads the total risk to the business
over multiple markets, thus reducing the impact of risk from any one market on the overall
business. Another way to reduce risk is to transfer or trade the risk, for example by buying
insurance.
• However, any risk reduction measure has its own cost. Therefore, one has to achieve a
balance between the cost of risk management and the benefit of those risk reduction
measures.
• Risk managers aim to reduce the risk to a manageable and known level through various risk
reduction measures. They use risk management systems to track and analyze the risks.
• A good risk management system not only calculates the risk based on a set of parameters,
but also allows the risk managers to drill down the risk to lowest components, carry out
sensitivity, what-if analyses, generates customizable reports and sends alerts automatically
when the risk crosses a defined tolerance limit.
• The Risk Manager in a bank will be responsible for identifying the risks, setting up tolerance
limits, measuring the risk on a day to day basis and take action whenever the limits are
breached.

2.9. CUSTODY AND INVESTOR SERVICES

CUSTODY SERVICES
Introduction
The custody service business evolved from safekeeping and settlement services provided by
banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping
services to their customers. The banks routinely settled trades and processed income for their
own investments. Their customers kept and took their securities out of safekeeping to settle
trades or for bond maturities. As time evolved, the banks realized that their expertise in securities
processing and their image as a safe repository would be valuable to their customers and they
began to promote their securities processing ability as an enhanced value-added service.
Services offered by Custodians
Services provided by a bank custodian are typically the settlement, safekeeping, and reporting of
customers’ marketable securities and cash. A custody relationship is contractual, and services
performed for a customer may vary.
Core Custody Services
A custodian providing core domestic custody services typically settles trades, invests cash
balances as directed, collects income, processes corporate actions, prices securities positions,
and provides record keeping and reporting services.
Global Custody Services
A global custodian provides custody services for cross-border securities transactions. In addition
to providing core custody services in a number of foreign markets, a global custodian typically
provides services such as executing foreign exchange transactions and processing tax reclaims.
A global custodian typically has a sub-custodian, or agent bank, in each local market to help
provide custody services in the foreign country. The volume of global assets under custody has
grown rapidly in recent years as investors have looked to foreign countries for additional
investment opportunities.
Users of Custody Services

Banks provide custody services to a variety of customers, including mutual funds and investment
managers, retirement plans, bank fiduciary and agency accounts, bank marketable securities
accounts, insurance companies, corporations, endowments and foundations, and private banking
clients. Banks that are not major custodians may provide custody services for their customers
through an arrangement with a large custodian bank. Institutional investors, money managers
and broker/dealers are the primary customers for custodians and other market participants for the
efficient handling of their worldwide securities portfolios.
Assets held under Custody
Custodians hold a range of assets on behalf of their customers. These include equities,
government bonds, corporate bonds, other debt instruments, mutual fund investments, warrants
and derivatives.

Business Drivers of Custody Services
The following are the key drivers in the growth of custody services:
• The wide range of financial instruments and the emerging markets spreading across
geographies resulted in growing interest of investors. The potential benefits associated with
the investments resulted in growth of custody services.
• The increasing use of global custodians to replace their own networks of local custodians by
Investment managers and banks.
• The state withdrawing from its role of primary pension provider, causing citizens to invest in
defined contribution pensions and mutual funds in record numbers - with custody banks
serving the pension funds and mutual funds, their money managers and the banks acting for
high net worth individuals.
• The introduction of floating exchange rates and lifting of exchange controls in many major
economies resulted in rapid development of the market for international debt instruments.
• The specialist fund managers running dedicated portfolios of foreign equities have increased
in recent time.
• The gradual increase in equities and cross-border investments.
INVESTOR SERVICES
The need of institutional investors now require a range of new services, including securities
lending, cash and short-term investment products, outsourcing and distribution solutions and
information delivery. These value added services are now offered under a broader package titled
Investor Services.
Investor Services fall under 3 major areas:

• Investment Management
• Trading
• Asset Servicing
INVESTMENT MANAGEMENT
Investment Management is the process of managing money, including investments, budgeting,

banking, and taxes. The following services fall under this purview:
• Asset/Liability Analysis
• Asset Allocation
• Asset Manager Solutions
• Cash Projection
• Compliance Reporting
• Securities Lending
• Fund Administration
• Information Products & Services
• Investment Manager Universe
• Local Fund Servicing

• Performance Measurement
Asset/Liability Analysis
Asset Liability analysis helps clients understand the required rate of return and the effect of return
volatility in minimizing the present value of future contributions to the investment plans. A
quantitative and probability based approach is used to establish a link between asset returns and
the future economic wealth of the plan. Future contributions are linked to future returns by
actuarial methods. These results can be used to develop investment objectives and investment
policy.
Example
An insurer might use asset-liability analysis to analyze its portfolio of single premium deferred
annuities (SPDAs) and the assets supporting that liability. A scenario might project paths over
the next ten years for swap interest rates, policy surrender rates and, if the assets include
mortgage-backed securities, mortgage prepayment rates. Likely, the scenario would reflect
reasonable relationships between these variables—if the scenario assumed interest rates
were to drop, it would probably also assume that prepayment rates would rise over the same
period.
A sophisticated analysis might make other assumptions as to how the insurer would alter its
investment portfolio in response to changing market conditions, or specify how new SPDA
sales might be affected by the changing level of interest rates.
Asset Allocation
Once an asset/liability analysis is completed, the next step is appropriate asset allocation to
generate the required rate of return. Proposed strategies may involve the use of options,
immunization, dynamic hedging, tactical asset allocation, and the potential for superior
management performance. Additional asset classes such as emerging market equities, venture
capital, real estate and managed futures may also be included. The asset allocation process
results in an investment policy designed to meet plan objectives.
Example
Fidelity Portfolio Selector Cash Projections
Global Balanced Fund is
managed with a more This aims at consolidating all known client portfolio events
conservative approach worldwide and gets up-to-the-minute data by currency.
towards providing capital Information can be obtained on-line, via proprietary network
growth primarily through interface such as
investment in a combination S.W.I.F.T., or transmitted directly to client portfolio systems.
of equities and bonds. This Real-time, interactive updates provide clients with the
fund will appeal to investors knowledge required to take advantage of the best short-term
seeking capital growth but investment opportunities.
who would prefer a lower

Compliance Reporting
Compliance reporting provides covers automatic exception-based information highlighting

potential violations of pre-agreed investment guidelines, external regulations and internal risk
exposure limits. They should be fully integrated with fund accounting system, this and if required
should accept data feeds from clients' in-house or third-party accounting platforms. The rules
library will incorporate client-specific requirements for compliance with regulations relating to the
U.S. Securities Act of 1940, UK unit trusts, and Open Ended Investment Contracts (OEICs). The
service covers a wide range of investment compliance categories, including:
• prohibited investments
• asset, currency, geographical, industry and security concentration limits
• shareholding, self-investment and credit-rating restrictions
• caps on holdings in non-listed securities
• weighted-average analytics
• derivative exposure monitoring, including hedging and gearing reports
Securities Lending
Institutional investors earn incremental income on their portfolios by lending their securities to
broker dealers. Securities lending experts specialize by combining market information, individual
expertise and solid negotiation skills to maximize profitability for lenders while managing credit
and interest rate risk.
Bank custodians have traditionally acted as the lending agent for customers’ securities lending
activities. However, because the market is extremely competitive, third-party intermediaries have
emerged. Wholesale intermediaries conduct transactions directly with the lender and the
borrower, becoming a principal to the transaction. Niche intermediaries may specialize in
particular types of securities loaned or aggressive cash collateral reinvestment programs.
Third-party intermediaries may target clients that are dissatisfied with the performance of their
custody banks. Internet auction systems for securities lending, which bring lenders and borrowers
together, may eliminate custodian and third party intermediaries.
In the 1970s, U.S. custodian banks first began lending securities to brokers on behalf of their
clients. Demand for securities lending increased as new trading strategies emerged. In 1982, the
collapse of a U.S. securities dealer led to a number of reforms, including standardized
agreements and collateral margins. The 1980s also saw a dramatic increase in the size of
government securities markets in the US and many other countries. Growth of securities lending
in some foreign markets was hampered by concerns about the legalities of transactions,
unfavorable tax treatment, and assorted regulatory restrictions. This resulted in the development
of “offshore” securities lending markets, where securities lending transactions were settled on the
books of foreign sub-custodians. In the 1990s securities lending expanded into emerging
markets.
Fund Administration
Fund admin covers the administrative and legal services to meet the needs of funds on items like
fund development, board meeting preparation and administration, compliance, financial reporting,
tax services and legal administration, portfolio evaluation, transfer agency and shareholder
record-keeping for both institutional and retail accounts, domiciliary administration services in the
offshore location, and fiduciary and compliance monitoring.

Information Products and Services
Includes value-added information products and decision support tools to the investment
community like global market data, analysis and information tools to help customers make better
decisions, increase productivity and achieve superior financial results.
Investment Manager Universe
Comparison of manager performance to a standard universe of fund managers to track results

against a plan's investment objectives.
Performance Measurement
Analytics such as risk-adjusted returns, information ratio, up/down market analysis, style map
scores, covariance matrices, Betas, standard deviation, country and currency exposure can be
analyzed by security, account, combination of accounts, composite, asset class, industry,
economic sector, country or security type for any time period.
TRADING
The following services fall under the Trading purview:

• Brokerage Services
• Cash & Short-Term Investments
• Commission Recapture
• Corporate Stock Repurchase
• Foreign Exchange
• Futures & Options Clearing and Execution
• Transition Management
Brokerage Services are offered by Banks to buy and sell securities for their customers. For the
bank, brokerage services and custody operations will operate under the same umbrella and thus
reduce the cost of operations.
Cash and Short-Term Investment services are provided by Banks to help clients improve cash
management by providing them with coordinated, seamless access to an entire spectrum of USD
and multi-currency cash and short-term fixed income products and services.
The commission recapture involves returning a portion of the clients’ commission expenses. It
helps institutional investors reduce their trading costs
The corporate stock repurchase program allows clients to buy and sell their own company's
stock in an efficient, cost-effective manner.
Foreign Exchange services support custody clients' cross-border investment activities in both
freely traded and exotic currencies and third-party foreign exchange transactions.
Futures & Options Execution and Clearing for full trade execution and clearing capabilities on
all major exchanges worldwide with multi-currency collateral management and reporting.
Transition management streamlines portfolio liquidation and transition processes, leveraging

client service and brokerage capabilities to minimize costs and maximize efficiency.

ASSET SERVICING
Asset servicing is a ”core“ ongoing service provided by custodians. This service includes
collecting dividends and interest payments, processing corporate actions and applying for tax
relief from foreign governments on behalf of customers.
An illustrative list of services under the asset servicing umbrella is given below:
Alternative Asset Servicing
Alternative investments include:

• hedge funds
• investment-grade and non-investment grade credit structures
• private equity
• real estate
• distressed debt
• leveraged buyouts
• venture and mezzanine capital
Consulting
Consulting services targets plan sponsors, investment managers and consultants to thoroughly
assess each client's needs and develop individualized solutions.
Corporate Actions
24-hour customer service center provides responses to all client inquiries on active corporate
events using the latest SWIFT 15022 corporate action messaging standards.
Custody
Custody service handles trade processing and settlement, asset servicing and electronic
information delivery in multiple time zones and languages on a fully integrated platform.
Financial Reporting
Fund companies meet their financial reporting requirements to shareholders and regulators using
real-time financial accounting systems.
Income Processing
Receiving global income payments on due dates in the client-specified currency. Daily on-line
reports keep clients informed of conditional dividend projection as well as the status of
provisional, confirmed and credited income payments.
Pricing/Holdings Valuation
The financial institutions provide timely and accurate pricing, ratings, tranche types for various
securities of clients they hold on behalf of their clients. These holding may include government
securities, equities, certificates of deposit, banker’s acceptances and certificates of participation.

Tax Information Services
Changes in the world's various tax codes and tax treaty statuses create opportunities and
challenges for global investors. Tax information service integrates portfolio details with the
consequences of tax developments in multiple countries and enables clients to understand
entitlements of various statutory or treaty benefits as beneficial owners.
Tax Processing
To manage clients' investment-related tax issues, pursue tax relief at the source and to make
reclamations for client accounts with minimal intrusion.
Trade Instruction and Settlement
Custody clients' trade instructions are typically communicated through the S.W.I.F.T. network,
through mainframe-to-mainframe links supporting multiple data formats through links to
depositories.
Transfer Agency and Distribution Solutions Services
These services offer a single source for comprehensive mutual fund servicing, integrating global
transfer agency and distribution solutions with fund accounting, fund administration, cash
management and custody, depending on client needs.
Cash Sweep
Cash sweep is a value added service provided by custodian banks to its customers. This service
ensures that the surplus cash in customers’ accounts are effectively invested in short-term
investment funds i.e. STIF (may be as short as an overnight fund) to generate additional returns.
The sweep can be done intra-day based on projected earnings of the particular account or end-
of-day based on actual surplus cash in the account. The STIFs invest money in money market or
euro dollar Deposit.
Risks Associated with Custody Services
Many banks currently offer custodian services. The primary risks associated with custody
services are: transaction, compliance, credit strategic and reputation.
• Transaction Risk
• Compliance Risk
• Credit Risk
• Strategic Risk
• Reputation Risk

2.10. CLEARING AND SETLEMENT

Clearing and Settlement

Trading
What is an exchange?
An exchange is a regulated market place, where buyers and sellers come together to exchange
what they want. Finding a buyer or seller for a trade by oneself will be difficult and expensive. The
exchange facilitates the process of buying and selling. Thus, like any other market, exchanges
reduce transaction cost and provide liquidity.
In simple terms, if you want to buy/sell something, you can place an order with an exchange.
Exchange receives buy/sell orders from multiple parties and tries to match them, based on the
price quoted and quantity available/desired. If exchange is able to find a counter-party for your
trade, it will bring together both the parties for transaction to happen.
Examples: Stock Exchanges: NYSE, AMEX
We have different exchanges that deal with different asset types (stocks, commodities, futures,
etc.).
Over the Counter Market

Over The Counter (OTC) market is different from the exchanges in the sense that there is no
single physical location for members, and members (generally called market makers in OTC
markets) negotiate price to finalize deals rather than use any auction mechanism to derive prices.
In OTC markets, traders/dealers negotiate with each other through computer networks or simply
over the phone to strike deals. So traders/dealers assume the responsibility of exchanges too, to
find a counter-party for a trade.
NASDAQ is a good example of OTC market.
Certain other asset types trade in markets that are typically not regulated (e.g., currencies).
How does a typical trade cycle look?

Decision
to trade
Security/Fund Place an
Transfer Order
Market Participants (e.g.

Exchange, Brokers/Dealers,
Custodians, Depositories,
Clearing Corporation etc)
Settlement Trade
of Trades Matching
Clearing Trade
of Trades Execution
Based on the market news, risk analysis and investment philosophy, a customer decides to place
an order to buy 100 IBM shares at the market price.
Customer calls his broker (or goes to the online trading interface provided by the broker), and
places the order with the broker dealer. Broker dealer in turn forwards the order to an exchange.
Exchange gets multiple orders from different broker dealers. They maintain all the orders in an
order book and use a matching system to find a counter-party for an order. In this case, this order
lies in the order book of the exchange until someone places a Sell order for 100 IBM shares
(please note that even partial fill is possible, in case somebody places an order to sell 50 shares).
At this point in time, exchange finds a match between two trades.
Exchange matches these two orders to register a trade and informs the trade details to all the
associated parties.
At the end of the day, obligation for each participant is determined by the exchange and
communicated to each participant.
As per the settlement cycle, broker dealer provide the funds or security to the clearing house by a
particular date and time.
Clearinghouse transfers the security and funds to the appropriate party.

What is clearing? What is netting?

Clearing is the process of determination of obligations, i.e. who owes what, to whom and how
much. Lets look at the following example of stock trades. Following table captures the activity of a
broker on 06/02/2003 at NYSE.
Time Buy/Sell Quantity Sock Price
10:00 Buy 100 IBM $10.00
10:30 Sell 50 IBM $10.50
11:00 Buy 100 MSFT $20.00
11:30 Sell 20 IBM $11.00
12:00 Sell 10 MSFT $20.50
3:30 Sell 30 IBM $9.00
Broker has completed 6 transactions on that particular date but exchange would not settle these
transactions individually and would apply the concept of “netting” to determine the obligation of
broker. Deals executed during a particular trading period (in this case one trading day) are netted
at the end of that trading period and settlement obligations are computed.
In the example above:
Net position for IBM: +100 – 50-20-30 = 0
Net position for MSFT: +100 – 10 = 90
So broker would not receive any IBM shares from the exchange as he sold all the shares that he
bought during the day. But exchange will need to deliver 90 MSFT shares to the broker.
This was what exchange owes to broker.

Now lets look at what does broker owe to exchange?
Buy/Sell Quantity Price Amount
Buy 100 $10.00 ($1,000.00)
Sell 50 $10.50 $525.00
Buy 100 $20.00 ($2,000.00)
Sell 20 $11.00 $220.00
Sell 10 $20.50 $205.00
Sell 30 $9.00 $270.00
Total ($1,780.00)
So the broker has to pay $1780 only and he gets 90 MSFT shares from the exchange. It is
important to understand that netting across stocks is not possible, similarly netting across
different market (for examples trades executed at NASDAQ and NYSE) is not possible. Each
market would have its own rule to determine the “period”, for which transactions need to be
netted.
This concept of clearing based on netting is true for most financial transactions, and I have taken
the example of stock exchange just as an illustrative example. Even when you submit a check
issued by ICICI Bank in your HDFC bank account, it means that ICICI pays money to HDFC
bank, which in turn deposits the money in your HDFC bank account. But HDFC and ICICI have
millions of bank holders and so it doesn’t make sense to settle the individual transactions, instead
ICICI would aggregate (for different customers) its entire obligation to different banks and then
reduce it by amount that ICICI has to get from these banks and only the “net amount” would be
settled by the banks. Clearing house facilitates the whole process.
It is worth understanding that, we have some markets where settlement happens on a gross
basis, meaning no netting is done and all the transactions need to be settled individually. This is
prevalent in Fixed Income markets in the US and the settlement mechanism is known as Real
Time Gross Settlement (RTGS).

What are the benefits of “Netting”?

Settlement on “net” basis reduces the number of transactions to be settled drastically reducing
the overall transaction cost for everyone. As per an estimate, netting reduces the number of
settlements needed by more than 95%.
Role of Clearinghouses
We understand that there are two parties to a trade, one who buys something and the other one
who sells something. Now imagine a situation where one party (who had to deliver securities)
defaults on its obligation, what impact would it have on the other party? Other party would not like
to suffer because of this, as it’s the exchange that found a match. So clearing house comes into
the picture. To mitigate any counter-party risk (risk that a party involved in the trading doesn’t
meet its commitment), clearing house positions itself as the counter-party for both the legs of the
trade. Thus, buyer buys it from the clearinghouse and seller sells it to clearing house. This way
buyer and seller both are shielded from any “counter-party” risk, as clearing house stands to meet
its commitment to a trading party irrespective of whether the other party meets its commitment or
not.
This process of transferring obligation from one party to the other is also known as “Novation”.
What is Settlement?
As you can see that multiple parties are involved in settlement of a trade. Various parties perform
numbers of activities before funds/securities are finally transferred to your account. This process
of movement of funds/securities (or any other underlying asset) is called settlement.
Role of IT Systems in settlement of securities transactions

The trade cycle as shown previously involves multiple parties and activities before a trade is
settled. Increasing use of IT systems and networking among the transaction participants is
helping to reduce the processing time, effort and the delay in settlement. Reduction in cycle time
means reduced costs and increased liquidity as well as efficiency. Most of the financial industry
participants are spending fortunes in integrating their existing systems to achieve Straight
Through Processing (STP), i.e. processing of financial transactions with minimum or no manual
intervention.
Cognizant offers straight through processing solution to the securities industry and has built order
management and processing systems. Cognizant also offers payment processing solutions for
both check and credit card payments.

2.11. CORPORATE SERVICES

BENEFITS ADMINISTRATION
Employee benefit plans are established or maintained by an employer or by an employee

organization (such as a union), or both, that provides retirement income or defers income until
termination of covered employment or beyond. There are a number of types of retirement plans,
including the 401(k) plan and the traditional pension plan, known as a defined benefit plan.
The Employee Retirement Income Security Act (ERISA) covers most private sector pension
plans. Among other things, ERISA provides protections for participants and beneficiaries in
employee benefit plans, including providing access to plan information. Also, those individuals
who manage plans (and other fiduciaries) must meet certain standards of conduct under the
fiduciary responsibilities specified in the law.
The Employee Benefits Security Administration (EBSA) of the Department of Labor is responsible
for Administering and enforcing these provisions of ERISA. As part of carrying out its
responsibilities, the agency provides consumer information on pension plans, as well as
compliance assistance for employers; plan service providers, and others to help them comply
with ERISA.
The primary employee benefits are

• Defined Benefits
• Defined Contribution
• Health and Welfare
DEFINED BENEFITS
Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They
promise to pay a specified benefit at retirement age. They define the amount of retirement income
to be paid. The actual monthly (or annual) benefit is calculated using a specific formula stated in
the plan document. The benefit is usually paid at a specified time such as attainment of age 65.
A Defined Benefit Plan is an employer-sponsored retirement plan in which retirement benefits are
based on a formula indicating the exact benefit that one can expect upon retiring. Investment risk
is borne by the employer and portfolio management is entirely under the control of the company.
There are restrictions on when and how participant can withdraw these funds without penalties.
A private defined benefit plan is typically not contributory i.e. there are usually no employees
contributions, no individual accounts are maintained for each employee. The employer makes
regular contributions to the entire plan to fund the future benefits of the entire cohort of
participants. The employer, rather than the participant, bears the investment risk. Usually, the
promised benefit is tied to the employee's earnings, length of service, or both.
A Defined Benefit plan provides a guaranteed level of benefits on retirement and the cost is
unknown for the employer. If the plan assets earn less than expected, the employer must make
larger contributions to ensure that the plan will have sufficient funds to pay promised benefits. If
the plan assets earn more than expected, the employer's contributions will decrease.

Defined Contribution
A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of
money each year for an employee. The amount to be contributed to each participant's account
under the plan each year is defined (by either a fixed formula or by giving the employer the
discretion to decide how much to contribute each year). The size of a participant's benefit will
depend on:
• The amounts of money contributed to the individual's account by the employer and, perhaps,
by the employee as well;
• The rate of investment growth on the principal;
• How long the money remains in the plan (in most cases, the employee, upon retirement, has
the option of either receiving the payment in a lump sum or by taking partial payments on a
regular basis while the balance continues to earn interest); and
• Whether the forfeitures of participants who leave before they are fully vested can be shared
among the remaining participants as a reward to long-term employees.
Since benefits accumulate on an individual basis, these plans are sometimes referred to as
"individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward) of
investment experience is borne by the participant. Defined contribution plans can permit, and
sometimes require, that employees make contributions to the plan on either a pre-tax basis (as in
a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to,
permit employees to decide how the monies contributed into their accounts will be invested.
Defined contribution plans have gained popularity as employers have begun to ask their
employees to share responsibility for their retirement. The main purpose of a defined contribution
plan is to provide an investment vehicle for employees to accumulate retirement income.
Defined Benefit Plan Defined Contribution Plan

The employer funds it. Employee and employer contributions are allocated to
individual participants
The employer bears the investment risk (the The participant bears the investment risk.
potential for investment gain or loss).
It is generally difficult to communicate. It is easier to communicate.
The final benefit is defined as it is formula driven The final retirement benefit is unknown as it is decided
taking definite parameters (like salary, number of by the performance of participant selected investment
years of service etc.) as input data funds.
The benefit is expressed as an annuity (a specified The benefit is expressed as an account balance.
annual or monthly payment to a pensioner over a
specified period of time or based on life
expectancy) payable at normal retirement age,
usually age 65.

The following plans are designated as defined contribution plans:

• Profit Sharing Plans
• Cash Or Deferred Arrangements Or 401(k) Plans
• Stock Bonus Plans And Employee Stock Ownership Plans
• Simplified employee pensions (SEP)
• Tax Sheltered Annuities Or 403(b) Arrangements
Business entities involved in the Defined Contribution Pension Administration process have
strong interdependency in-terms of flow of information, fund and assets (stocks).
The diagram below depicts the main entities in the plan administration business and their
relations with each other.
Fig 2.1
• Sponsor delegates responsibilities to plan administrator

• Participant contributes for the plan to the sponsor.
• Trust owns the funds of the plan contributed by the sponsor and the participants and
delegates management of the same to Investment Manager
• Trust and plan administrator submit compliance reports to Federal Agencies which in turn
would qualify the plan.

• Participants direct the Investment manager on their investment preferences.

• Record Keepers provide information on Participant, plan and account information to Plan
Administrators, trustee, Sponsor and Participant.
Following diagram explains the basic processes involved in benefits administration

HEALTH AND WELFARE

In the early days when the Social Security was adopted, Health insurance was taken care by
private sectors. Later the escalating health costs and wage freezes of the post WW II era,
prompted many companies to offer non-cash rewards in the form of Health care benefits. The
challenges due to competitive benefits for maintaining the fiscal responsibility and changes in tax
code made the employers to offer greater benefit choices with certain tax incentives.
Health and Welfare benefit plans can be either Defined-Benefit or Defined Contribution plans.
Defined Benefit health and welfare plans specify a determinable benefit, which may be in the form
of reimbursement to the covered plan participant or a direct payment to providers or third party
insurers for the cost of specified services. Even when a plan is funded pursuant to agreements
that specify a fixed rate of employer contribution, it cannot be a Defined benefit health and
welfare plan.
Defined Contribution health and welfare plans on the other hand maintain an individual account
for each plan participant. The benefits a plan participant will receive are limited to the amount
contributed to the participant’s account, experience, expenses etc. Health and Welfare plans
generally are subject to certain fiduciary, reporting and other requirements of the ERISA
(Employee Retirement Income Security Act, 1974).
Categories of health and welfare plans

• Health Care
o Medical
o Prescription drug
o Behavioral health
o Dental
o Vision
o Long-term care
• Disability Income
o Sick leave
o Short-term disability
o Long term disability
• Survivor Benefits
o Term life

3. RECENT DEVELOPMENTS

RECENT DEVELOPMENTS
USA PATRIOT ACT‡‡‡

US Government passed the Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism (USA PATRIOT Act) in response to the terrorists’
attacks of September 11, 2001. The key features are:
• The Act gives federal officials greater authority to track and intercept communications, both
for law enforcement and foreign intelligence gathering.
• It vests the Secretary of the Treasury with regulatory powers to combat corruption of U.S.
financial institutions for foreign money laundering purposes.
• It seeks to further close our borders to foreign terrorists and to detain and remove those
within US borders.
• It creates new crimes, new penalties, and new procedural efficiencies for use against
domestic and international terrorists.
The anti money laundering rules are very important from a banking point of view. They are
described in greater detail later in the chapter.
Criminal Investigations: Tracking and Gathering Communications

Federal communications privacy law currently features a three tiered system, erected for the dual
purpose of protecting the confidentiality of communications while enabling authorities to identify
and intercept criminal communications. The first level prohibits electronic eavesdropping on
telephone conversations, face-to-face conversations, or computer and other forms of electronic
communications in most instances. However, in serious criminal cases, law enforcement officers
may seek a court order authorizing them to secretly capture conversations on a statutory list of
offenses for the permitted duration.
The next tier of privacy protection covers telephone records, e-mail held in third party storage,
and the like. The law permits law enforcement access, ordinarily pursuant to a warrant or court
order or under a subpoena in some cases. There is also a procedure that governs court orders
approving the government’s use of trap and trace devices and pen registers, a secret “caller id”,
which identify the source and destination of calls made to and from a particular telephone.
Foreign Intelligence Investigations

The Act eases some of the restrictions on foreign intelligence gathering within the United States,
and affords the U.S. intelligence community greater access to information unearthed during a
criminal investigation, but it also establishes and expands safeguards against official abuse. It
permits “roving” surveillance (court orders omitting the identification of the particular instrument,
facilities, or place where the surveillance is to occur when the court finds the target is likely to
thwart identification).
‡‡‡
Extracted from Congressional Research Service, US and Federation of American Scientists -
www.fas.org

Money Laundering
In federal law, money laundering is the flow of cash or other valuables derived from, or intended
to facilitate, the commission of a criminal offence. Federal authorities attack money laundering
through regulations, criminal sanctions, and forfeiture. The Act bolsters federal efforts in each
area.
The Act expands the authority of the Secretary of the Treasury to regulate the activities of U.S.
financial institutions, particularly their relations with foreign individuals and entities. Regulations
have been promulgated covering the following areas:
• Securities brokers and dealers as well as commodity merchants, advisors and pool operators
must file suspicious activity reports (SARs);
• Requiring businesses, which were only to report cash transactions involving more than
$10,000 to the IRS, to file SARs as well;
• Imposing additional “special measures” and “due diligence” requirements to combat foreign
money laundering;
• Prohibiting U.S. financial institutions from maintaining correspondent accounts for foreign
shell banks;
• Preventing financial institutions from allowing their customers to conceal their financial
activities by taking advantage of the institutions’ concentration account practices;
• Establishing minimum new customer identification standards and record-keeping and
recommending an effective means to verify the identity of foreign customers;
• Encouraging financial institutions and law enforcement agencies to share information
concerning suspected money laundering and terrorist activities; and
• Requiring financial institutions to maintain anti-money laundering programs which must
include at least a compliance officer; an employee training program; the development of
internal policies, procedures and controls; and an independent audit feature.
Crimes: The Act contains a number of new money laundering crimes, as well as amendments
and increased penalties for earlier crimes.
• Outlaws laundering the proceeds from foreign crimes of violence or political corruption;
• Prohibits laundering the proceeds from cybercrime or supporting a terrorist organization;
• Increases the penalties for counterfeiting;
• Seeks to overcome a Supreme Court decision finding that the confiscation of over $300,000
for attempt to leave the country without reporting it to customs
• Provides explicit authority to prosecute overseas fraud involving American credit cards; and
• Permit prosecution of money laundering in the place where the predicate offence occurs.
Forfeiture: The act allows confiscation of all of the property of participants in or plans an act of
domestic or international terrorism; it also permits confiscation of any property derived from or
used to facilitate domestic or international terrorism. Procedurally, the Act:
• Allows confiscation of property located in this country for a wider range of crimes committed
in violation of foreign law;
• Permits U.S. enforcement of foreign forfeiture orders;
• Calls for the seizure of correspondent accounts held in U.S. financial institutions for foreign
banks who are in turn holding forfeitable assets overseas; and
• Denies corporate entities the right to contest if their principal shareholder is a fugitive.

Alien Terrorists and Victims

The Act contains provisions designed to prevent alien terrorists from entering the US, to enable
authorities to detain and deport alien terrorists and those who support them; and to provide
humanitarian immigration relief for foreign victims of the September 11.
Other Crimes, Penalties, & Procedures

New crimes: The Act creates new federal crimes, for terrorist attacks on mass transportation
facilities, for biological weapons offenses, for harboring terrorists, for affording terrorists material
support, for money laundering, and for fraudulent charitable solicitation.
New Penalties: The Act increases the penalties for acts of terrorism and for crimes which
terrorists might commit.
Other Procedural Adjustments: The Act increases the rewards for information in terrorism
cases, authorizes “sneak and peek” search warrants etc
Anti Money Laundering GUIDELINES

Treasury expects all financial institutions covered by the customer identification regulations to
have their customer identification program drafted and approved by October 1, 2003 as
scheduled.
Foreign issued identification documents:
• An effective program for identifying new customers must allow financial institutions the
flexibility to use methods of identifying and verifying the identity of their customers
appropriate to their individual circumstances. For example, some financial institutions open
accounts via the Internet, never meeting customers face-to-face.
• Rather than dictating which forms of identification documents financial institutions may
accept, the final rule employs a risk-based approach that allows financial institutions
flexibility, within certain parameters, to determine which forms of identification they will accept
and under what circumstances.
• However, with this flexibility comes responsibility. When an institution decides to accept a
particular form of identification, they must assess risks associated with that document and
take whatever reasonable steps may be required to minimize that risk.
• Federal regulators will hold financial institutions accountable for the effectiveness of their
customer identification programs.
• Additionally, federal regulators have the ability to notify financial institutions of problems with
specific identification documents allowing financial institutions to take appropriate steps to
address those problems.
Customer Identification Program

The rule requires that financial institutions develop a Customer Identification Program (CIP) that
implements reasonable procedures to:
1. Collect identifying information about customers opening an account
2. Verify that the customers are who they say they are

3. Maintain records of the information used to verify their identity

4. Determine whether the customer appears on any list of suspected terrorists or terrorist
organizations
Collecting information:
As part of a Customer Identification Program (CIP), financial institutions will be required to
develop procedures to collect relevant identifying information including a customer’s name,
address, date of birth, and a taxpayer identification number – for individuals, this will likely be a
Social Security number. Foreign nationals without a U.S. taxpayer identification number could
provide a similar government-issued identification number, such as a passport number.
Verifying identity:
A CIP is also required to include procedures to verify the identity of customers opening accounts.
Most financial institutions will use traditional documentation such as a driver’s license or passport.
However, the final rule recognizes that in some instances institutions cannot readily verify identity
through more traditional means, and allows them the flexibility to utilize alternate methods to
effectively verify the identity of customers.
Maintaining records:
As part of a CIP, financial institutions must maintain records including customer information and
methods taken to verify the customer’s identity.
Checking terrorist lists:

Institutions must also implement procedures to check customers against lists of suspected
terrorists and terrorist organizations when such lists are identified by Treasury in consultation with
the federal functional regulators.
Reliance on other financial institutions:

The final rule also contains a provision that permits a financial institution to rely on another
regulated U.S. financial institution to perform any part of the financial institution’s CIP. For
example, in the securities industry it is common to have an introducing broker – who has opened
an account for a customer – conduct securities trades on behalf of the customer through a
clearing broker. Under this regulation, the introducing broker is required to identify and verify the
identity of their customers and the clearing broker can rely on that information without having to
conduct a second redundant verification provided certain criteria are met.
The following financial institutions are covered under the rule:

• Banks and trust companies
• Savings associations
• Credit unions
• Securities brokers and dealers
• Mutual funds
• Futures commission merchants and futures introducing brokers

SARBANES OXLEY ACT§§§
The Sarbanes-Oxley Act was signed into law on 30th July 2002, and introduced significant
legislative changes to financial practice and corporate governance regulation. The act is named
after its main architects, Senator Paul Sarbanes and Representative Michael Oxley, and of
course followed a series of very high profile scandals, such as Enron. It is also intended to "deter
and punish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and
protect the interests of workers and shareholders"
It introduced stringent new rules with the stated objective: "to protect investors by improving the
accuracy and reliability of corporate disclosures made pursuant to the securities laws". It also
introduced a number of deadlines, the prime ones being:
- Most public companies must meet the financial reporting and certification mandates for any end
of year financial statements filed after June 15th 2004
- smaller companies and foreign companies must meet these mandates for any statements filed
after 15th April 2005.
The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404, 401,
409, 802 and 906 are the most significant with respect to compliance. In addition, the Act also
created a public company accounting board, to oversee the audit of public companies that are
subject to the securities laws, and related matters, in order to protect the interests of investors
and further the public interest in the preparation of informative, accurate, and independent audit
reports for companies the securities of which are sold to, and held by and for, public investors.
Section 201 prohibits non audit services like bookkeeping, financial information systems design
and implementation, actuarial services, management services etc from the scope of practice of
auditors. They can however be taken up with the pre approval of the audit committee on a case
by case basis.
Section 401 specifies enhanced financial disclosures specifically:

• Accuracy of financial reports
• Off-balance sheet transactions
• Commission rules on pro forma figures
Section 501 seeks to improve objectivity of research by recommending rules designed to address
conflicts of interest that can arise when securities analysts recommend equity securities in
research reports. These rules are designed to foster greater public confidence in securities
research, and to protect the objectivity and independence of securities analysts.
§§§
Extracted from Sarbanes-Oxley forum

BASEL 2 CAPITAL ADEQUACY NORMS****

Bank for International Settlements (BIS), headquartered in Basel, Switzerland represents the
Central Banks of 55 member countries.. The first Basel Capital Accord was instituted in 1988 to
coordinate global regulatory efforts and institute minimum capital requirements to eliminate the
threat posed by undercapitalized banks.
The 1988 Capital Accord prescribed a single, standard measure of risk to determine minimal
capital requirements. The accord aimed, primarily to reverse the steady erosion of bank capital
ratios. As a basis for determining aggregate capital requirements, it has performed reasonably
well. However, this led to offsetting of over and under assessed assets across a bank’s portfolio.
The classification of obligors into sovereigns, banks and others (further divided between OECD
and non-OECD) bears only a tenuous connection to comparative credit risk.
Post 1988, to address growing complexity, volatility, and interdependence among international
financial markets, and heightened institutional and systemic threats, a new Capital Accord was
proposed by the Basel Committee on Banking Supervision. The new Accord was aimed at
establishing a more sophisticated framework for banks to measure risk and ensure sufficient
capital to cover losses from market, credit, and operational risk. The aim of Basel II is to
promote safety and soundness in the financial system by allocating capital in organizations to
reflect risk more accurately.
Basel II will apply to all financial services providers in the 110 countries that have signed the new
Capital Accord, including security firms and asset managers with operations in banking and
Capital markets. EU member states will require all domestic and foreign financial services
providers to comply, and the G-10 countries are including it into their regulatory environments in
order to meet the Basel II implementation deadline of December 2006. Many of the over 25,000
banks around the world are expected to adopt Basel II as well, in order to maintain their
competitiveness.
The coverage of Basel II is likely to be as wide as the Y2K effort. Analysts’ estimate that IT spend
would be around $22.5 billion to address Basel II requirements. A significant portion of this cost
would comprise of the new technological developments and enhancements to the existing
systems.
Three Pillars
The underlying principle for the Accord is that Safety and soundness in today’s dynamic and
complex financial system can be attained only by the combination of effective bank-level
management, market discipline, and supervision.
The New Accord proposal is based on three mutually reinforcing pillars that allow banks and
supervisors to evaluate the various risks that banks face.
****
Extracted from Bank of International Settlements’ documents – www.bis.org

Pillar 1 Pillar 2 Pillar 3

“Quantitative” “Qualitative” “Market Forces”
Minimum Capital Supervisory Market Discipline

Requirements Review
• Calculation of • Overview of • Disclosure

capital supervisory requirements
requirements review • Capital
• Credit risk • Supervisory
Key principles Market Discipline
structure
• Operational • Review
Capital • Risk
risk management
Supervisory exposures
Market Discipline
• Trading book processes
Review • Capital
changes • Interest rate adequacy
(market risk) risk in the
banking book
• )
Pillar 1: Minimum Capital Requirements

The first pillar sets out minimum capital requirements. The New Accord has focused on
improvements in the measurement of risks. The credit risk measurement methods are more
elaborate than those in the current Accord. The new framework proposes for the first time a
measure for operational risk, while the market risk measure remains unchanged.
Credit Risk: There is a choice between three increasingly sophisticated methods: the
Standardized, the Foundation Internal Ratings Based (‘IRB’) and the Advanced IRB Approaches.
The Standardized Approach

The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and
produces a sum of risk-weighted asset values.
Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks
or corporates). The risk weights are to be refined by reference to a rating provided by an external
credit assessment institution.
The Internal Ratings based Approach (IRB)

Under the IRB approach, banks will be allowed to use their internal estimates of borrower
creditworthiness to assess credit risk in their portfolios, subject to strict methodological and
disclosure standards. Distinct analytical frameworks will be provided for different types of loan
exposures, for example corporate and retail lending, whose loss characteristics are different.

Under both the foundation and advanced IRB approaches, the range of risk weights will be far
more diverse than those in the standardized approach, resulting in greater risk sensitivity. A more
complex approach (and therefore a more sophisticated risk management process) should lead to
a lower capital charge.
Operational Risk: Broadly, Operational Risk (OR) is defined as the risk of monetary losses
resulting from inadequate or failed internal processes, people, and systems or from external
events. The events characterize the inherent risks in doing business and are mostly managed by
putting in place controls. Some times controls may be ineffective or also fail because of weakness
in people, processes, systems or external events. Some times inherent risks themselves may
change because of the events in the external environment. Thus,
Operational risks = Inherent risks for which controls are not in place + Control risks
There is again a choice of approach: between a standardized and a more sophisticated Internal
Measurement Approach (‘IMA’).
Basic Indicator Approach

This approach links the capital charge for operational risk to a single risk indicator for the whole
bank. Gross income is proposed as the indicator, with each bank holding capital for operational
risk equal to the amount of a fixed percentage, alpha. The Basic Indicator Approach can be
applied for any bank regardless of its complexity or sophistication.
The Standardized Approach

In this Approach, a bank’s activities are divided into a number of standardized business units and
business lines. Within each business line, the capital charge is calculated by multiplying a bank’s
broad financial indicator by a ‘beta’ factor. The capital charge would continue to be standardized
by the supervisor. Now, for each business line gross income is taken to calculate the capital
charge.
The Internal Measurement Approach

This approach strives to incorporate an individual bank’s internal loss data into the calculation of
its required capital. Under the Internal Measurement Approach, a capital charge for the
operational risk of a bank would be determined using an Exposure Indicator (EI) within each
business line / loss type combination, Probability of loss Event (PE), based on the banks’ internal
loss data and Loss Given that Event (LGE) within each business line / loss type combination.

CHECK 21
The Check Clearing for the 21st Century Act (Check Truncation Act, Check 21) promotes check
imaging through the introduction of a new payment instrument known as the substitute check
(also referred to as the Image Replacement Document or IRD). The substitute check, which
contains an image of the check, will be the legal equivalent of the original. Check 21 also
abolishes the paying bank's right to demand presentment of the original paper check as a
condition of payment, which allows the bank of first deposit to truncate the check upon image
capture. The Act is expected to speed the transition from traditional processing to imaged
processing and encourage the use of electronic check clearing.
Check 21 will reduce paper flow resulting from 45- 50 billion paper checks processed each year,
and, in many cases, will eliminate labor- and cost-intensive paper check handling, transportation,
and storage issues. Banks that convert to check imaging will realize many other benefits,
including:
• Savings associated with lower transit costs and courier charges
• Lower risk of lost items and/or transit delays
• Lower check processing errors resulting from reduced handling and automated data capture
from check images
• Fully automated Day 2 (return) processing enabled by image exception item processing
• Compressed processing windows to enable later branch cutoff times
• Improved collection float due to faster clearing processes
Check 21 will lead to additional payment system efficiency industry-wide. It will allow financial
institutions to further leverage their investment in check imaging technologies.
Check 21 – Technology challenges for banks

Banks would require substantial technology investments in migrating to a Check 21 environment.
Analyzing from a process flow perspective, the following are the main systems required:
• Check image capture (with verification and receipt generation if required)
• Check image storage, archival & exchange
• Check image processing, pattern matching & signature verification
• CRM integration – check research and adjustment
Some of the investments can be avoided by going in for an ASP-based solution whereby all
processes like check image storage & archival, image exchange and processing workflow can be
managed by a third party service provider on a subscription basis. However, the decision on
outsourcing these activities have to be taken by banks after considerable research on as-is
process flow and technology analysis, capacity planning, security analysis and benchmarking.
Investments for check capture and image processing would be incremental, whereas there would
be significant investment required for storage, archival and exchange of check images in a secure
environment. This would be a major hurdle for most of the banks. Banks will also have to cope
with multiple technology vendors and architectural solutions while ensuring that they stick to
implementation time lines.

4. GLOSSARY

Agency bonds: Agencies represent all bonds issued by the federal government, except for those
issued by the Treasury (i.e. bonds issued by other agencies of the federal government).
Examples include the Federal National Mortgage Association (FNMA), and the Guaranteed
National Mortgage Association (GNMA).
Arbitrage: The trading of securities to profit from a temporary difference between the price of
security in one market and the price in another. This temporary difference is often called market
inefficiency.
Annualized Percentage or Return: The periodic rate times the number of periods in a year. For
example, a 5% quarterly return has an A.P.R. of 20%. It depends on the following:
• How much repayment
• How frequently
• Which component of loan – interest or principal
Authorization (Credit Cards): The act of ensuring that the cardholder has adequate funds
available against their line of credit. A positive authorization results in an authorization code being
generated, and a hold being placed on those funds. A "hold" means that the cardholder's
available credit limit is reduced by the authorized amount.
Beauty contest: The informal term for the process by which clients choose an investment bank.
Some of the typical selling points when competing with other investment banks for deals are:
"Look how strong our research department is in this industry. Our analyst in the industry is a real
market mover, so if you go public with us, you'll be sure to get a lot of attention from her."
Bloomberg: Computer terminals providing real time quotes, news, and analytical tools, often
used by traders and investment bankers.
Bond spreads: The difference between the yield of a corporate bond and a U.S. Treasury
security of similar time to maturity.
Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman Sachs,
Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman Brothers, Credit
Suisse First Boston.
Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the stocks,
bonds and securities sold by the investment banks. (The investment banks that sell these
products to investors are known as the sell-side.)

Capitalized Loan: A loan in which the interest due and not paid is added to the principal balance
of the loan. Capitalized interest becomes part of the principle of the loans; therefore, it increases
the total cost of repaying the loan because interest will accumulate on the new, higher principle.
Capture (Credit Cards): Converting the authorization amount into a billable transaction record.
Transactions cannot be captured unless previously authorized.
Commercial bank: A bank that lends, rather than raises money. For example, if a company
wants $30 million to open a new production plant, it can approach a commercial bank for a loan.
Commercial paper: Short-term corporate debt, typically maturing in nine months or less.
Commodities: Assets (usually agricultural products or metals) that are generally interchangeable
with one another and therefore share a common price. For example, corn, wheat, and rubber
generally trade at one price on commodity markets worldwide.
Comparable company analysis (Comps): The primary tool of the corporate finance analyst.
Comps include a list of financial data, valuation data and ratio data on a set of companies in an
industry. Comps are used to value private companies or better understand a how the market
values and industry or particular player in the industry.
Consumer Price Index: The CPI measure the percentage increase in a standard basket of
goods and services. CPI is a measure of inflation for consumers.
Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each year, until
maturity. In Thailand the coupon is usually paid semi-annually or annually.
Discount rate: The rate at which federal banks lend money to each other on overnight loans. A
widely followed interest rate set by the Federal Reserve to cause market interest rates to rise or
fall, thereby causing the U.S. economy to grow more quickly or less quickly.
Discount Rate for Credit Cards: A small percentage of each transaction that is withheld by the
Acquiring Bank or ISO. This fee is basically what the merchant pays to be able to accept credit
cards. The fee goes to the ISO (if applicable), the Acquiring Bank, and the Associations.
Dividend: A payment by a company to shareholders of its stock, usually as a way to distribute

profits to shareholders.
Fed: The Federal Reserve, which manages the country's economy by setting interest rates.

Federal funds rate: The rate domestic banks charge one another on overnight loans to meet
Federal Reserve requirements. This rate tracks very closely to the discount rate, but is usually
slightly higher.
Fixed income: Bonds and other securities that earn a fixed rate of return. Bonds are typically
issued by governments, corporations and municipalities.
Float: The number of shares available for trade in the market. Generally speaking, the bigger the
float, the greater the stock's liquidity.
Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid on U.S.
Treasuries), allowing the interest rate to change as market conditions change.
Glass-Steagall Act: Passed in 1933 during the “Depression” to help prevent future bank failures.
The Glass-Steagall Act split America's investment banking (issuing and trading securities)
operations from commercial banking (lending). For example, J.P. Morgan was forced to spin off
its securities unit as Morgan Stanley. Since the late 1980s, the Federal Reserve has steadily
weakened the act, allowing commercial banks such as NationsBank and Bank of America to buy
investment banks like Montgomery Securities and Robertson Stephens. In 1999, Glass-Steagall
was effectively repealed by the Graham-Leach-Bliley Act.
Graham-Leach-Biley Act: Also known as the Financial Services Modernization Act of 1999.
Essentially repealed many of the restrictions of the Glass-Steagall Act and made possible the
current trend of consolidation in the financial services industry. Allows commercial banks,
investment banks, and insurance companies to affiliate under a holding company structure.
Gross Domestic Product: GDP measures the total domestic output of goods and services in the
United States. For reference, the GDP grew at a 4.2 percent rate in 1999. Generally, when the
GDP grows at a rate of less than 2 percent, the economy is considered to be in recession.
Hedge: To balance a position in the market in order to reduce risk. Hedges work like insurance: a
small position pays off large amounts with a slight move in the market.
High grade corporate bond: A corporate bond with a rating above BB. Also called investment
grade debt.
High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to
compensate investors for high risk of default. Credit rating agencies such as Standard & Poor's
rate a company's (or a municipality's) bonds based on default risk. Junk bonds rate below BB.
Institutional clients or investors: Large investors, such as pension funds or municipalities (as
opposed to retail investors or individual investors).

Lead manager: The primary investment bank managing a securities offering. An investment
bank may share this responsibility with one or more co-managers.
League tables: Tables that rank investment banks based on underwriting volume in numerous
categories, such as stocks, bonds, high yield debt, convertible debt, etc. High rankings in league
tables are key selling points used by investment banks when trying to land a client engagement.
Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using that
company's own assets as collateral. LBOs were common in 1980s, when successful LBO firms
such as Kohlberg Kravis Roberts made a practice of buying up companies, restructuring them,
and reselling them or taking them public at a significant profit
LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR
represents the rate banks in England charge one another on overnight loans or loans up to five
years. LIBOR is often used by banks to quote floating rate loan interest rates. Typically the
benchmark LIBOR is the three-month rate.
Liquidity: The amount of a particular stock or bond available for trading in the market. For
commonly traded securities, such as big cap stocks and U.S. government bonds, they are said to
be highly liquid instruments. Small cap stocks and smaller fixed income issues often are called
illiquid (as they are not actively traded) and suffer a liquidity discount, i.e. they trade at lower
valuations to similar, but more liquid, securities.
Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting point for
pricing many other bonds, because Treasury bonds are assumed to have zero credit risk taking
into account factors such as inflation. For example, a company will issue a bond that trades "40
over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage point).
Making markets: A function performed by investment banks to provide liquidity for their clients in
a particular security, often for a security that the investment bank has underwritten. The
investment bank stands willing to buy the security, if necessary, when the investor later decides
to sell it.
Market Capitalization: The total value of a company in the stock market (total shares
outstanding x price per share).
Merchant Account: A special business account set up to process credit card transactions. A
merchant account is not a bank account (even though a bank may issue it). Rather, it is designed
to 1) process credit card payments and 2) deposit the funds into your (business) checking
account (minus transaction fees).

Money market securities: This term is generally used to represent the market for securities
maturing within one year. These include short-term CDs, repurchase agreements, commercial
paper (low-risk corporate issues), among others. These are low risk, short-term securities that
have yields similar to Treasuries.
Mortgage-backed bonds: Bonds collateralized by a pool of mortgages. Interest and principal

payments are based on the individual homeowners making their mortgage payments. The more
diverse the pool of mortgages backing the bond, the less risky they are.
Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a. municipalities.
Municipal bonds are structured as tax-free for the investor, which means investors in muni's earn
interest payments without having to pay federal taxes. Sometimes investors are exempt from
state and local taxes, too. Consequently, municipalities can pay lower interest rates on muni
bonds than other bonds of similar risk.
Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for their
services. This generally includes a monthly fee and a small flat fee per transaction. These fees
may be consolidated into a single bill by the acquiring bank or ISO, along with their fees.
Pitchbook: The book of exhibits, graphs, and initial recommendations presented by bankers to a
prospective client when trying to land an engagement.
Pit traders: Traders who are positioned on the floor of stock and commodity exchanges (as
opposed to floor traders, situated in investment bank offices).
P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its earnings-
per-share. The higher the P/E ratio, the more expensive a stock is (and also the faster investors
believe the company will grow). Stocks in fast-growing industries tend to have higher P/E ratios.
Prime rate: The average rate U.S. banks charge to companies for loans.
Producer Price Index: The PPI measure the percentage increase in a standard basket of goods
and services. PPI is a measure of inflation for producers and manufacturers.
Proprietary trading: Trading of the firm's own assets (as opposed to trading client assets).
Prospectus: A report issued by a company (filed with and approved by the SEC) that wishes to
sell securities to investors. Distributed to prospective investors, the prospectus discloses the
company's financial position, business description, and risk factors.
Red herring: Also known as a preliminary prospectus. A financial report printed by the issuer of a
security that can be used to generate interest from prospective investors before the securities are

legally available to be sold. Based on final SEC comments, the information reported in a red
herring may change slightly by the time the securities are actually issued.
Retail clients: Individual investors (as opposed to institutional clients).
Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity, or ROE,
is a commonly used measure of how well an investment bank is doing, because it measures how
efficiently and profitably the firm is using its capital.
Risk arbitrage: When an investment bank invests in the stock of a company it believes will be
purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.)
Road-show: The series of presentations to investors that a company undergoing an IPO usually
gives in the weeks preceding the offering. Here's how it works: Several weeks before the IPO is
issued, the company and its investment bank will travel to major cities throughout the country. In
each city, the company's top executives make a presentation to analysts, mutual fund managers,
and others attendees and also answer questions.
Sales memo: Short reports written by the corporate finance bankers and distributed to the bank's
salespeople. The sales memo provides salespeople with points to emphasize when hawking the
stocks and bonds the firm is underwriting.
Securities and Exchange Commission (SEC): A federal agency that, like the Glass-Steagall
Act, was established as a result of the stock market crash of 1929 and the ensuing depression.
The SEC monitors disclosure of financial information to stockholders, and protects against fraud.
Publicly traded securities must first be approved by the SEC prior to trading.
Securitize: To convert an asset into a security that can then be sold to investors. Nearly any
income generating asset can be turned into a security. For example, a 20-year mortgage on a
home can be packaged with other mortgages just like it, and shares in this pool of mortgages can
then be sold to investors.
Short-term debt: A bond that matures in nine months or less. Also called commercial paper.
Syndicate: A group of investment banks that will together underwrite a particular stock or debt
offering. Usually the lead manager will underwrite the bulk of a deal, while other members of the
syndicate will each underwrite a small portion.
Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This fee is
collected by the acquiring bank or ISO and pays for the toll-free dial out number and the
processing network.

T-Bill Yields: The yield or internal rate of return an investor would receive at any given moment
on a 90-120 government treasury bill.
Tombstone: The advertisements that appear in publications like Financial Times or The Wall
Street Journal announcing the issuance of a new security. The tombstone ad is placed by the
investment bank as information that it has completed a major deal.
Yield: The annual return on investment. A high yield bond, for example, pays a high rate of
interest.

5. REFERENCES

WEBSITES
WWW.BIS.ORG
WWW.IBRD.COM
WWW.SIAINVESTOR.COM
WWW.SIAC.COM
WWW.CNBC.COM
WWW.STOCKCHARTS.COM
WWW.MONEYCENTRAL.COM
WWW.MSNMONEY.COM
WWW.NYSE.COM
WWW.NASDAQ.COM
WWW.AMERITRADE.COM
WWW.ESCHWAB.COM
HTTP://FINANCE.YAHOO.COM
WWW.INVESTOPEDIA.COM
WWW.FT.COM
WWW.BLOOMBERG.COM
WWW.VANGUARD.COM
BOOKS
• The Bank Credit Card Business – American Bankers Association
• Value At Risk – Phillipe Jorions
• Principles of Corporate Finance – Brearley Myers
• Securities Operations – Michael T Reddy – New York Institute of Finance
• After the Trade is Made – David M Weiss – New York Institute of Finance
• Investment Analysis & Portfolio Management - Frank K. Reilly &
• Keith C. Brown
• The Warren Buffet Way – Robert Hagstrom Jr
• One Up on the Wall Street – Peter Lynch

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Foundation Course in Banking

Foundation Course in Banking & Capital Markets

Cognizant Technology Solutions

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Foundation Course in Banking Ver 2.1 Page 2 of 208

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1.1. THE CONCEPT OF MONEY

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THE CONCEPT OF MONEY

THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTEREST

Year 2: (5% of $100 = $5) + $105 = $110

Year 3: (5% of $100 = $5) + $110 = $115

Year 4: (5% of $100 = $5) + $115 = $120

Year 5: (5% of $100 = $5) + $120 = $125

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Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25

Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76

Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55

Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63

A quantitative estimate of inflation in a particular economy can be calculated by measuring the

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Real rate of Interest

Nominal rate (N) = 10%, Inflation (I) = 5%

Therefore, real interest is:

TIME VALUE CONCEPT OF MONEY

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Interest rate for compounding period = 8%/2 = 4%

Net Present Value (NPV)

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Year Cash Flow

However, if we assume that the required rate of return is 16.00%,

Internal Rate of Return (IRR)

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Equity capital 16.64 107/300 5.93

Preference capital 15.73 13/300 0.68

Debenture capital 11.08 80/300 2.95

Term loan 10.25 100/300 3.42

Average cost of capital 12.99 per cent

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1.2. FINANCIAL INSTRUMNETS

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Principal and Interest

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Municipal bond (Munis)

Zero coupon bonds

Foundation Course in Banking Ver 2.1 Page 16 of 208