Financial System

Dr. Medha Joshi

What is System? What is Financial System? What is the role of Financial system? What are the components of financial system? What are the major roles that financial intermediaries performed?

Financial System


The word "system", in the term "financial system", implies a set of complex and closely connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance - the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments, financial intermediation and financial regulations.

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P a Sc na P a Sc na rimry eodry rimry eodry

Financial System
funds
Dep/Shares

Financial Institutions Banks/NBFCs, Ins. Cos., Mutual Funds, Provident Funds

Incomes & Financial Claims Savings

funds Loans

Suppliers of Funds Households Business Firms Government

funds
Securities

Seekers of Funds Business Firms Government Households

Financial Mkts. Money Market Capital Market

funds
Securities

Functions of Financial System



Provides a payment system for exchange of goods and services Enables the pooling of funds from wealth surplus units for undertaking large-scale enterprises i.e. wealth deficit units F.S. has to deal with information gathering


Transform unproductive wealth into productive

 

Appraisal of Project and borrower Creation of appropriate instruments : Convenient for ultimate lenders and ultimate borrowers To determine prices of financial instruments

FINANCIAL INTERMEDIARIES


These are firms that provide services and products that customers may not be able to get more efficiently by themselves in financial market. E.g. Mutual Funds Important products of Financial Intermediaries include  Savings / Current Accounts  Loans  Mortgages  Mutual Fund Schemes  Insurance Contracts

Some of the important intermediaries operating in the financial markets include;  Commercial Banks  Developmental Financial Institutions SFC, SIDC, SIDBI  Insurance Companies  Post Office Savings Bank  NABARD  Investment Bankers  National Housing Bank  Mutual Funds  Merchant Bankers  Venture Capital Firms  Information Services

        

Underwriters Stock Exchanges Registrars Depositories Custodians Portfolio Managers Mutual Funds Financial Advisers Portfolio Managers Primary Dealers

Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. Underwriter. However, the services offered by them vary from one market to another.

Overview of Financial System

Financial System

Financial Institutions

Financial Markets

Financial Instruments

Financial Services

Regulatory

Intermediaries

Non Intermediaries

Organized

Unorganized

Primary

Secondary

Banking

Primary

Secondary

Non Banking

Capital

Money

What are Markets?  What are Financial Markets?  Functions of Financial Markets  facilitate price discovery  provide liquidity to financial assets  Reduce the cost of transacting  Search Cost & Transaction Cost


Intermediary Stock Exchange Investment Bankers Underwriters

Market Capital Market

Role Secondary Market to securities

Capital & Credit Corporate advisory Market services, Issue of securities Capital & Subscribe to Money Market unsubscribed portion of securities Capital Market Issue securities to the investors on behalf of the company and handle share transfer activity

Registrars, Depositories, Custodians

Intermediary Primary Dealers Satellite Dealers Forex Dealers

Market Money Market

Role Market making in government securities Ensure exchange in currencies

Forex Market

Rationale for Financial Intermediaries Diversification  Lower Transaction Cost  Economies of Scale  Confidentiality  Signaling


Rationale for Financial Intermediaries



Diversification : The pool of funds mobilised by financial intermediaries is invested in a broadly diversified portfolio of assets (loans, stocks, bonds and so on). Diversified Portfolio reduces the risk Lower Transaction Cost : The transaction cost in percentage terms decreases as the transaction size increases. Higher the size of transaction lower will be the transaction cost Economies of Scale : Due to bigger size and professional resources they have a comparative advantage in information gathering and processing & regular monitoring of market

Rationale for financial intermediaries



Confidentiality : Information shared with financial intermediaries may be kept confidential whereas information disclosed to numerous individual investors is in public domain. Companies seeking funds share Confidential information with FIs Signaling : FIs can pick up and interpret signals and cues provided by companies and pass on the information to investing community. So they perform a signalling function for the investment community.

Financial Instruments


Financial instruments are intangible assets as they represent claims to future cash flows. The entity that offers future cash flows - Issuer of the financial instrument Owner of Financial instrument Investor Some examples of financial instruments A 10 year bond issued by the Government of India carrying an interest rate of 7% p.a. A 7 year non convertible debenture issued by Reliance Industries Limited carrying an interest rate 8% p.a. A 3 year car loan provided by City bank to an individual at an interest rate of 12% p.a. ordinary shares issued by GMR infra to public through IPO

Financial instruments are created by F.Is. which will be convenient for lenders to lend and borrowers to borrow. Lending Side  C/A SB/A Auto Sweep Facility F.D.  Return & Risk Borrowing Side  Cash Cr. O.D. Term loans (short /long)  Interest rate

Regulatory Infrastructure


As a maker and enforcer of laws in a society, the government has the responsibility for regulating the financial system 3 Major Regulatory bodies of the Government of India are  Reserve Bank of India (RBI) Banking & NBFCs  Security Exchange Board of India (SEBI) Capital Markets  Insurance Regulatory & Development Authority Insurance Companies

Duties & Responsibilities of Regulator

    

 

Setting Entry and Licensing Norms Setting Capital Adequacy Norms Setting Market Conduct Regulations Supervision Off Site and On site of F.I. Creating Regulations for Distribution Channel and Agency Setting up Investor Protecting Mechanism Setting up Customer Grievance Redressal Mechanism Setting up Exit Norms Seizure, Closure and Exit

FINANCIAL INTERMEDIARIES
Reserve Bank of India

Commercial banks

Developmental financial institutions

Insurance companies

Other public sector financial institutions

Mutual funds

Non-banking financial corporations

Public sector banks

All India institutions

Life Insurance Corporation of India

POSB

Unit Trust of India

Public sector firms

Private sector insurance companies

NABARD

Private sector banks

State level institutions

General Insurance Corporation of India

NHB

Other mutual funds

Private sector firms

Financial Institutions
Banks Development Finance Insti. Investment Institutions Specialised Institutions Schedule Commercial Banks, Regional Rural Banks, Co-operative Banks IFCI SIDBI, IDFC, IDBI, ICICI (now Banks) Mutual Funds, LIC & Private sector Insurance Cos. GIC & GIPSA Cos. & Pvt. Sector Non life Cos. NHB, NABARD, EXIM, ECGC, DICGC, STCI, Discount and Finance House of India, Technical Development & Information Co. India State Industrial Development Corp. Industrial Reconstruction Bank of India

Some of the important intermediaries operating in the financial markets include;  Commercial Banks : PVT, PSU, Foreign, RRBs Cooperative, Post Office Savings Bank Special Developmental Financial Institutions  IFCI, ICICI, IDBI, IRBI, EXIM, NABARD, SCICI, TFCI, RCTFC, AFC, NCDC, CWC, SWC, REC, NIDC, NSIC, SFC, SIDC, SIDBI, SIIC, SSIDC, PFC, NHB, Housing Fin. Cos.  Others : DICGC, ECGC, TCO, SCHIL, CRISIL, ICRA DFHI, ILFS,TDIC, STCI  Money Lenders  Indigenous Bankers  Pension and Provident funds  Insurance Companies : LIC, GIC  Small Savings Organisations  Nidhi and Chit Companies

        

Investment Companies Mutual Funds Venture Capital Firms Hire Purchase Cos. Leasing Companies Information Services Factoring Companies Merchant Bankers Underwriters Stock Exchanges Registrars Depositories Custodians Portfolio Managers Primary Dealers

Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. Underwriter. However, the services offered by them vary from one market to another.


  

   

 

What do you mean by asset and liability? What kind of assets are financial assets? Why? How are they different from tangible assets? What is the role of financial assets? What is Financial System? What is the role of Financial system? What are the components of financial system? What are the major roles that financial intermediaries performed? What is the difference between Banks and NBFCs? What is Universal Bank? What type of services NBFCs offer?

Activities of Financial Institutions

 

 

Fee Based Activities Fund Based Activities  Deposit Based Intermediation  Risk Based Intermediation  Investment Based Intermediation What banks do? What is a Non-Banking Financial Company (NBFC)? What NBFCs do? What is the key difference in banks and NBFCs

A few differences between Banks & NBFCs



An NBFC cannot accept demand deposits; It is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and Deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks.

In terms of Section 45-IA of the RBI Act, 1934, it is mandatory that every NBFC should be registered with RBI to commence or carry on any business of non-banking financial institution as defined in clause (a) of Section 45 I of the RBI Act, 1934. However, to obviate dual regulation, certain category of NBFCs which are regulated by the other regulators are exempted from the requirement of registration with RBI viz.

  

Venture Capital Fund Merchant Banking companies Stock broking companies registered with SEBI, Insurance Company holding a valid Certificate of Registration issued by IRDA, Nidhi companies as notified under Section 620A of the Companies Act, 1956, Chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982 or Housing Finance Companies regulated by National Housing Bank.

Fee based Services

  

   

Agency Services Broking Services Merchant Banking  New issue management : Public Issue, Private Placement  Issue Underwriting Financial Consultancy Portfolio Management Services Loan Syndication Sell of Data

Fund Based Activities

     

Leasing Consumer Finance Hire Purchase Housing Finance Infrastructure Finance Portfolio Management Services

Merchant Banking


It is mandatory for a merchant banker to register with the SEBI. Without holding a certificate of registration granted by the Securities and Exchange Board of India, no person/Financial Institution can act as a merchant banker.

REGISTRAR + SHARE TRANSFER AGENTS (REGD.)

  

  

CATEGORY I : BOTH ROLES CATEROGY II : EITHER OF TWO ASSIST M/B : SELECT BANKERS, COLLECTION CENTRES / PROCESS DESIGN FORMS / CHECK / SCREEN INVALID APPLICATIONS PREPARE BASIS OF ALLOTTMENT SEBI APPROVAL / RETURN REFUNDS ASSIST FOR LISTING

Role of Merchant Bankers & Capital requirement for carrying on activity



Category I to carry on the activity of issue management and to act as adviser, consultant, manager, underwriter, portfolio manager. Cap. Requirement : 5 Cr Category II - to act as adviser, consultant, comanager, underwriter, portfolio manager. Cap. Requirement : 50 L Category III - to act as underwriter, adviser or consultant to an issue. Cap. Requirement: 20L Category IV to act only as adviser or consultant to an issue (Nil)

Merchant Bankers
Ensure correctness / sufficiency of information declared in offer document (SEBI)  Designing instrument / Price Band  Advising Time / Market  Registration of Offer documents  Coordinate with intermediaries

BANKERS : Collect Application Forms / Money Send Daily Reports & Arrange Refunds DEBENTURE TRUSTEES : Banks, FIs & Insurance Cos. Allowed To Act  Ensure That The Trust Property Is Intact  Receipt Of Interest + Principle As Promoter  Resolve Grievances  Dispose Of Property If Needed  Inform SEBI Of Any Irregularities

 

UNDERWRITERS : MB Or Member Of Stock Exchange Or Any Body Regd. Under SEBI Reg. (1993) Minimum Networth 20 Lakh Total U/w Obligations Should Not Exceed 20 Times Of Networth If Underwriter Lead Manager s Minimum 5% Or Rs. 25 Lakh Whichever Is Less the Lead Manager (LM) takes up the due diligence of company s operations/ management/ business plans/ legal etc. Other activities of the LM include drafting and design of Offer documents, Prospectus, statutory advertisements and memorandum containing salient features of the Prospectus.

 

  

BROKERS : NOT MANDATORY OFFER MARKETING SUPPORT IN SENDING FORMS INFORM INVESTORS / ADVANCE MKT INTELLIGENCE ON EXPECTD RESPONSE UNDERWRITE ALSO

AUDITORS : REPORT TO BE INCLUDED IN OFFER DOCUMENT CERTIFY PROMOTER S CONTRIBUTION BROUGHT BEFORE OPENING OF ISSUE, ETC. LEGAL ADVISORS : NOT MANDATORY CHECK SEBI, COMPANY S ACT AND OTHER MATTERS

 

OTHERS
PORTFOLIO MANAGERS  ADVISE INVESTMENT  UNDERTAKE MANAGEMENT & ADMINISTRATION OF SECURITIES AND FUNDS OF CLIENTS  SEBI REGISTRATION COMPULSORY MUTUAL FUNDS

CUSTODIAL SERVICES  SAFE KEEPING OF SECURITIES  INCIDENTAL SERVICES LIKE MAINTAINING ACCOUNTS  COLLECTION BENEFITS / RIGHTS  USED FOR GDR / ADR DEPOSITORIES :  NATIONAL SECURITIES DEPOSITORY LTD CENTRAL DEPOSITORY SERVICES LTD.  DELAY IN TRANSFER / BAD DELIVERIES/ STAMP DUTY EXEMPTIONS / PROBLEMS OF DUPLICATE CERTIFICATES/ NOMINATIONS

Fund Based Activities

     

Leasing Consumer Finance Hire Purchase Housing Finance Infrastructure Finance Portfolio Management Services

1.

2.

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Why are financial markets important to the health of economy? When interest rates rise, how might businesses and consumers change their economic behavior? How can change in interest affect the profitability of financial institutions? Is everybody worse off when interest rates rise? How does a decline in the value of the rupee affect Indian consumers? How does an increase in the value of the rupee affect American businesses? How can changes in foreign exchange rates affect the profitability of financial institutions?

1. 2.

3. 4.

5.

6.

7.

What is the basic activity of banks? What are the other important financial intermediaries in the economy besides banks? What types of risks do financial institutions face? Why do managers of financial institutions care so much about activities of the Reserve Bank of India? In which scenario will you plan visit to Nigara fall in Canada and in which scenario you will prefer to visit Kashmir and Leh? What effect might a fall in stock prices have on business investment? What effect might a rise in stock prices have on consumers decisions to spend?

What are Markets?  What are Financial Markets?  A Financial Market can be defined as the market in which financial assets are created or transferred. A financial transaction involves creation or transfer of a financial asset. Functions of Financial Markets  Financial markets facilitate price discovery  Financial Markets provide liquidity to financial assets  Reduce the cost of transacting  Search Cost & Transaction Cost


Financial Markets


Money Market- The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. Participants : Government, Banks and Financial Institutions. Capital Market - Designed to finance the long-term investments. Participants : Corporates, Banks and financial institutions, FII, Brokers, PMS, Investors

Forex Market  Deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market.  One of the most developed and integrated market across the globe. Credit Market In this market Banks, FIs and NBFCs provide short, medium and long-term loans to corporate and individuals.

Broad Classifications of Financial Markets

 

Size of transactions Wholesale Market and Retail Market Place of Transactions Exchange Traded Market (ETM) & Over The Counter Market (OTC)

 

Classification of Financial Markets

Nature of Claim Debt Market Equity Market Maturity of Claim Money Market Capital Market Seasoning of Claim Primary Market Secondary Market Timing of Delivery Cash/ Spot Market Forward/ Future Market Organisational Structure Exchange Traded Market OTC Market

Debt & Equity Markets What is debt instrument?  It is contract between Lender & borrower  Lender lends money on predetermined terms with regard to  rate of interest,  Periodicity of interest payment,  Repayment of principal amount

Lenders : Institutional Investors, Banks, FIs, MFs, PFs, Insurance Cos & Corporates Borrowers : Central and State Govts, Public Sector Undertakings (PSU) large sized trades predominantly wholesale market with dominant institutional investors participation Bonds are issued by State/Central Govts and SEBs, local bodies like municipal corporations, PSUs Government bonds are not tax free while some PSU bonds are tax free

 

Debentures are issued by Private corporates. Structured to suit the requirements of investors and issuing corporates Debentures have variety of features w.r.t. payments, term to maturity and redemption. Requires credit rating Safer the instrument lower the interest

Features Debt Instruments



Maturity of Bond : The date on which a bond matures Term to maturity : No. of years remaining for a bond to mature. Term to maturity changes everyday Term to maturity can be calculated on any date as the difference between such a date and the date of maturity.

Principal/ Par/ Face Value  Amount that has been borrowed  Central Government bond face value is Rs. 100

Coupon : Periodic interest payments made by borrowers The rate at which interest is paid usually % of par value of bond Generally paid half yearly

The name of bond itself conveys key features of bond eg. GS CG2008 11.40%

Government Securities


 

Maturity of all securities is greater than 1 year. It may be 5, 7 or 20 years. Sold by auction. Default risk is minimum due to which induced heavy trading Central and State govt. raise money to finance the creation of new infrastructure as well as to meet their current cash needs Commercial banks invest in G secs to meet the regulatory requirement to maintain Statutory Liquidity Ratio

The Govt security with face value Rs. 100 duration of security is 5 years and carrying coupon 10% p.a. Coupon is paid half yearly so every 6 months holder of security will get Rs. 5 therefore for 5 years he will get 9 coupons and he will receive 45. At maturity he will get 105 There is a secondary market for G secs. If market rate = Coupon rate Then MP = FV If market rate < Coupon rate Then MP > FV

  

Industrial Securities


Industries are interested in raising loans to finance their long term and working capital needs Sometimes raising loans from NBFCs are financially very heavy then they come up with these securities When credit rating for Industrial security is low then investors expect higher rate of return Secondary market is not well developed.

Major Instruments in Industrial Security Market Debentures  Fixed Maturity and Pay fixed or variable rate of interest  The company has to pay interest and principal amount on due dates regardless of it s profitability position  These instruments carry predetermined rate of return hence there is no scope for any major capital appreciation.  In case of fixed rate debentures market price moves in the opposite direction of interest rates  Credit Rating is essential

There are number of variations in debentures  Zero coupon bonds are issued at discount to their face value and redeemed at full face value  Convertible Debentures : It can be converted at the option of holder in to ordinary shares of the company under specified terms and conditions  Partly Convertible Debentures : Part of debenture will be converted in to ordinary shares and part will be buy back by the issuing company at the time of maturity i.e. 5 years

Equity Shares


It represents the form of fractional ownership in a business venture Total equity capital of a company divided into equal units of small denomination each called a share Suppose equity capital of a company is 1 crore. It is divided into 10 lakh units of Rs. 10 each. Then 10 is called face value. On share certificate the original cost of stock i.e. face value is shown. The face value of equity shares in India varies from Re 1 to Rs. 100

When securities are issued above the face value it is called at premium and when they are issued below the face value it is called at discount.
It does not have much bearing on the price of share which may quote higher in the stock market.

 

Equity shareholders have voting rights They do not carry fixed return and have no maturity period

It bears high risk , the investor can participate in the earnings and wealth of the company without any limit The major component of returns is dividend income and capital gain In the period of inflation, value of holdings increases and equity shares hedged against inflation It is not mandatory for company to pay dividends on ordinary shares Investment is permanent but not illiquid due to existence of secondary market

Preference Shares  Carry fixed dividend. Equity shareholders cannot be paid any dividend unless preference dividend is paid  carries preferential right to dividend over equity shareholders  At the time of winding up of company the preference shareholders get back their capital before equity shareholders  Preferential Issue : Select group, Promoters  Faster way to raise the capital  Cumulative Preference shares and  Convertible preference shares

Rights Shares


Issue of new securities to existing shareholders in proportion to their existing holdings Best suitable to companies who want to raise capital without diluting stake of existing shareholders as on record date Offered generally in a particular ratio at a price. For e.g. 2:3 rights issue at Rs. 125 For every 3 shares, a shareholder will receive 2 shares @ Rs. 125/Suppose a shareholder holds 90 shares he will receive 60 shares

Bonus Shares


Fresh shares are offered to existing shareholders free of cost on the number of shares shareholder holds. It is also in proportion to existing holding. E.g. 1:1; 2:1 or 1:5 When company has accumulated large amount of accumulated reserves as retained earnings

Primary Markets


Provides channel for sale of new securities to issuer in domestic as well as International market Provides opportunities to issuer of securities to raise resources to meet their requirements of investment or discharge some obligations Transactions mobilize savings and supply fresh capital to corporate and other entities Debt and equity securities are traded in the market

Primary Market or New Issue Market



Initial Public Offering Equity or Debentures Unlisted company makes fresh issue or offer for sale of its existing securities or both for the first time to pubic When an issue is open to general public or any other investor at large and is not made only for select individual. As per Companies Act 1956 an issue become if allotment is made to more than 50 people Players : Corporate, Government, Public

What is the difference between public issue and private placement



Private Placement is generally made to Insurance Companies, Pension Funds A Follow on Public Offering : Listed company wishes to raise fresh capital and made offer to the public

Why companies go public?

 

Most companies started by promoters Promoters capital and borrowing from banks and FIs is insufficient for setting up and running the business over a long period. To raise high quantum of funds for Capex acquisition, debt refinance, VC Exit

Advantages  Image & Visibility  Enable Valuation  Liquidity of existing shareholders  Protection in Dealing

  

Disadvantages Diluting Owners stake Mandatory Disclosures/ Regulations : SEBI Costly (15%) Investor s Relations Take Management s Time

 

Issue Price : The price at which companies are offered initially in the primary market Who decides Price of an issue? Issuer in consultation with Merchant Banker. SEBI does not play any role in pricing of issue. No formula is stipulated by SEBI Market Capitalisation : Market Price of a share X Total No. of Shares

Secondary Markets


It provides platform for trading existing financial securities Active market impart liquidity to financial securities. An Investor need not hold securities till maturity For companies it serves as a monitoring and control conduit by facilitating value enhancing control activities and aggregating information that guides management decisions Operations through Stock Exchanges

What is Index?


 

It is a basket of securities and the average price movement of Basket of securities indicates the upward and downward movement of index Sensex : 30 scrips NIFTY 50 scrips

What is depository?


Depository is like a bank wherein deposits are securities in electronic form. National Securities Depository Ltd, Central Securities Depository Ltd are 2 depositories in India Depository provides their services to general public through its agents called Depository Participants (DP) DPs are appointed by depositories with the approval of SEBI. DPs are classified in 3 categories : Banks, Financial Institutions and SEBI Registered Trading Members

Benefits of participation in Depository

  

Immediate transfer of securities No stamp duty on transfer of securities Elimination of risks associated with physical certificates such as fake securities Change in address recorded with DP gets registered electronically with all companies in which investor holds securities eliminating the need to correspond with each of them separately

  

Reduction in transaction cost Ease of nomination facility Convenient method of consolidation of folios/accounts Holding investments in equity, debt instruments and government securities in a single account , automatic credit into DEMAT a/c of shares, arising out of split/ consolidation / merger etc.

How is a depository similar to Bank

  

Banks  Holds funds in a/c  Transfers funds  between a/c on the  instruction of the a/c holder Facilitates transfers without having to  handle money Facilitates safekeeping of money

Depository Hold securities Transfer securities Facilitates transfers of ownership without having to handle securities Facilitate safekeeping of shares

 

What is dematerialisation? The process by which physical certificates of investors are converted to equivalent number of securities in electronic form and credited to investor s account with his DP

Classification of Financial Markets Primary Markets & Secondary Markets

Primary Market or New Issue Market Initial Public Offering ordinary or Debentures Private Placement to Insurance Companies, Pension Funds Players : Corporate and Government Transactions mobilize savings and supply fresh capital to corporate and other entities

 

Secondary Markets


Where the existing financial securities are traded Active market impart liquidity to financial securities An Investor need not hold securities till maturity Operations through Stock Exchanges

Classification of Financial Markets



 

MONEY MARKETS Short Term Instruments <=1 Year Maturity E.g. Call Money, Notice Money , Treasury Bills Manage Short Term Liquidity Banks, Insurance Cos. Cooperative Banks, Mutual Funds, Corporates, NBFCs RBI

 

CAPITAL MARKETS Long Term Instruments >1 Year Maturity E.g. Shares, debentures, Govt. Securities, Converting savings of economy into long term investments Creation of new productive capacities thus Capital Formation of the country

Same set of players operate in the both markets

Money Market Instruments



Some of the important money market instruments are : 1. 2. 3. 4. 5. Call/Notice Money Treasury Bills Inter Bank Term Money Certificate of Deposit Commercial Papers

Call Money Market  Period to Maturity : 1 day  Use : Manage daily liquidity

Notice Money Market  Period to Maturity : 2 days to 15 days  Use : Manage short term liquidity

No collateral security is required to cover these transactions.

How the market arise?

Participants in the market Borrowers : Banks Lenders : Insurance Cos., Mutual Funds, DFHI, STCI, NABARD

Call Money Rates In India

Year 1990 1995 2000 2002 2007 2009 2011 Call Rate 11.49 17.73 9.15 5.89 5.8 2.25 to 4.75 6.75-7.25 Bank Rate 10.00 12.00 7.00 6.25 6.0 6.0 6.0

Location of Call Money Market Mumbai, Chennai, Kolkata, Delhi, Ahmedabad

Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the Money supply. Repo rate: Whenever the banks have any shortage of funds they can borrow it from the central bank. Repo rate is the rate at which our banks borrow currency from the central bank. A reduction in the repo rate will help banks to get Money at a cheaper rate. When the repo rate increases borrowing from the central bank becomes more expensive. It is more applicable when there is a liquidity crunch in the market. In order to increase the liquidity in the market, the central bank does it.

Treasury Bills Market



Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). Treasury bills are issued by RBI through primary dealers on behalf of the government of India. All major banks are primary dealers They are issued at a discount to the face value, and on maturity the face value is paid to the holder. TBs are highly liquid, absence of risk of default, Assured yield, Low transaction cost,

Treasury Bills Market



The rate of discount and the corresponding issue price are determined at each auction. Participants in the Market : Banks, Insurance Companies, Cooperative Banks, Mutual Funds, NBFCs Prices of T bills will fluctuate  upon demand and supply of liquidity  On movement in the short term rate of interest

Inter-bank market for deposits

Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days.

Commercial Paper


 

It is zero coupon instrument issued at discount and redeemed at par. These are issued for short term maturities These are unsecured and therefore only those companies who have a good credit standing are able to access the funds through this instrument The Rate of interest is market driven and depends upon current liquidity position and creditworthiness of issuing company Corporate issue it for raising working capital finance

Certificate of Deposits


CDs are issued by banks at discount and redeemed at par They are transferable, negotiable, short term, fixed interest bearing, maturity dated, highly liquid and risk less money market instrument CDs have slightly higher rates than fixed deposits Maturity period varies between 3 months to 1 year The size of CD market is much bigger than CP market in India

Call Money Purpose Manage Short term liquidity mismatch of the banks, maintain CRR, discounting bills.. call-overnight short term - 1 to 14 days(at 2 or 3 days notice) very short term unsecured Loan Market Driven

Treasury Bills Manage cash flow mismatch of Govt. of India 91 and 364 days only

Maturity period Liquidity Risk Form Yield

Highly liquid, active secondary market. Transferable Govt sec. risk free Promissory notes or credit to sundry general ledger ( SGL ) account - Govt. decided / Auction Based - Issued at discount - Benchmark rate RBI issues it on behalf of Government India. Individuals, Corporates, FIs etc.( on competitive & non competitive basis ) - PF, State govt and Nepal Rastriya bank can only on Non competitive basis. Min. 25,000, & multiples of 25,000

Eligible issuers Eligible Investors

SCBs, DFHI, STCI and other Primary Dealers ( PDs) - These can borrow and lend as well Following can lend only. FIs , MFs , LIC , NABARD , UTI , GIC , IDBI. ( NBFCs can neither borrow nor lend ) 20 crores plus - RBI intervenes when rates turn volatile. - Non bank entities not going to be allowed to lend.

Size of Instrument Others aspects

Govt. Sec Purpose Maturity period Liquidity Investment needs of Central and state govt.s etc. 1 yr. onwards to 10 years. Very liquid, active secondary market. Transferable. Govt sec. risk free Stock certificate or credit to SGL account. - issued at Fixed coupon / Floating / at discount. - govt. decided rate or auction based. - Benchmark rate Central / State Govt. / Mpl. Corp. / Port trusts / State Ele. Boards / IDBI / STC / SIDC and NABARD. Individuals, Corporates, FIs, State govt., PFs , NBFCs, Insurance Cos. ( NRI, OCB and FII with RBI approval ) Min. 10,000 & multiples of 10,000

Comm. Paper Short term needs of Corporates Min 15 days, Max. 365 days very liquid, can be traded in secondary market , Negotiable. Unsecured Promissory Notes ( Only Dmat form ) - Negotiated - Higher than bank deposit rates but lower than lending rates of Bank -Issued at discount Pvt and Public companies, NBFCs - Tan NW. 4 cr. - W/C from banks -Standard asset Individuals, Firms, Companies and Banks. Min. 25 lacs & multiples of Rs. 5 lacs

Risk Form Yield

Eligible issuers

Size of Instrument Others aspects

Cert. of Deposit Purpose Resource mobilisation of Banks

Maturity period SCBs - 3m to 1 yr. FIs - 1 yr. to 3 yr. Liquidity very liquid, can be traded in secondary market. Negotiable Unsecured Promissory Notes. - Negotiated - Normally higher than public deposit rates. - Issued at Discount SCBs, RRB, and six others i.e. IDBI, ICICI, IFCI, SIDBI, IRBI and EXIM. Individuals, Firms, Companies and Banks.

Risk Form Yield

Eligible issuers Size of Instrument

Others aspects Min. Rs 5 lac & multiples of Rs 1 lac.

Capital Markets
There are broadly 3 types of markets  Government Securities Market  Industrial Securities Market  Stock Related Instruments Market

Government Securities


 

 

Maturity of all securities is greater than 1 year. It may be 5, 7 or 20 years. Sold by auction just like Treasury Bills Central and State govt. raise money to finance the creation of new infrastructure as well as to meet their current cash needs Default risk is minimum E.g. The security with face value Rs. 1000 duration 5 years and carrying coupon 10% p.a. Commercial banks invest in G secs to meet the regulatory requirement to maintain Statutory Liquidity Ratio

   

There is a secondary market for G secs. If market rate = Coupon rate Then MP = FV If market rate < Coupon rate Then MP > FV Govt Backed Securities are of two types Central / State Govt. Backed In addition to these  Municipal Corporation bonds  State Electricity Board Bonds  Water supply and Sanitation Dept. also raise funds Default risk free due to which induced heavy trading Participants in the market  Banks, Mutual Funds, Insurance Companies, NBFCs

Industrial Securities


Industries are interested in raising loans to finance their long term and working capital needs Sometimes raising loans from NBFCs are financially very heavy then they come up with these securities When credit rating for Industrial security is low then investors expect higher rate of return Secondary market is not well developed.

Major Instruments in Industrial Security Market Debentures  Fixed Maturity and Pay fixed or variable rate of interest  Interest obligation on company  predetermined rate of return & no scope for any major capital appreciation.  Market Price Movement : fixed rate debentures opposite direction of interest rates  Credit Rating is essential

There are number of variations in debentures  Zero coupon bonds are issued at discount to their face value and redeemed at full face value  Convertible Debentures : It can be converted at the option of holder in to ordinary shares of the company under specified terms and conditions  Partly Convertible Debentures : Part of debenture will be converted in to ordinary shares and part will be buy back by the issuing company at the time of maturity i.e. 5 years

Preference Shares Hybrid Instrument : Partakes some characteristics of ordinary and some of debt  Carry fixed dividend. ordinary shareholders cannot be paid any dividend unless preference dividend is paid  carries preferential right to dividend over ordinary shareholders  At the time of winding up of company the preference shareholders get back their capital before ordinary shareholders

Ordinary shares


  

 

These are ownership securities which have certain advantages in favour of the issuing company and investors depending on their attitude of risk taking. ordinary shareholders have voting rights have residual claim to the income of the firm. do not carry fixed return and have no maturity period It bears high risk and major component of returns is dividend income and capital gain ordinary shares hedged against inflation It is not mandatory for company to pay dividends on ordinary shares Investment is permanent but not illiquid due to existence of secondary market The face value of ordinary shares in India varies from Re 1 to Rs. 1000

 

Preferential Issue : Select group, Promoters, Employees Faster way to raise the capital Right Issue : Existing shareholders in proportion to their existing holdings Not to dilute stake of existing shareholders Bonus Issue : fresh shares are offered to existing shareholders free of cost. When company has accumulated large amount of accumulated reserves as retained earnings

Financial Market Returns



Interest Rate depends on Unit of account, Maturity, Default Risk Return on Risky asset : Cash Dividend and Capital gain/loss

Cash Dividend Ending Price - Beginning Price r!  Beginning Price Beginning Price


Inflation & Real Interest Rate Nominal Rate  Inflation Real Rate ! 1  Inflation Rate Rate

Determinants of Rate of Return



Expected Productivity Capital : Higher the expected productivity of capital, the higher the level of interest rates in the economy and vice versa Degree of Uncertainty characterizing the productivity of capital : Higher the degree of uncertainty about the productivity of capital, the higher the risk premium required by ordinary investors and vice versa Time Preferences of People : Greater the preference of society for current consumption greater will be the interest rate in the economy Degree of Risk Aversion : Higher the degree of risk aversion of the population, the higher will be the risk premium

Sources of Short Term Financing

Dr. Medha Joshi

Short Term Finance by Banks

   

Cash Credit Account / Overdraft Term loans Bill Discounting/ Purchase Letter of Credit

Cash credit Account

 

Primary method in which Banks lend money against the security of commodities and debt. It runs like a current account except that the money that can be withdrawn from this account is not restricted to the amount deposited in the account. Instead, the account holder is permitted to withdraw a certain sum called "limit" or "credit facility" in excess of the amount deposited in the account. Cash Credits are, in theory, payable on demand. These are, therefore, counter part of demand deposits of the Bank.

Cash Credit Limit = Rs. 100000 @ 14% p.a. Calculate interest on CC for November
Date 1/11 3/11 5/11 11/11 18/11 26/11 30/11 Particulars Cash Deposit To Chq Payment To Chq Payment By Chq Deposit By Cash Deposit By Chq. Payment Calculate Interest 10000 30000 35000 Dr Cr Balance 2 6 7 8 5

25000 25000 -5000 -40000 15000 -25000 20000 - 5000 -15000

Overdraft


The word overdraft means the act of overdrawing from a Bank account. The account holder withdraws more money from a Bank Account than has been deposited in it.

How does Overdraft account then differ from a Cash Credit Account?


The difference is very subtle and relates to the operation of the account. In the case of Cash Credit, a proper limit is sanctioned which normally is a certain percentage of the value of the commodities/debts pledged by the account holder with the Bank. Overdraft, is allowed against a host of other securities including financial instruments like shares, units of mutual funds, surrender value of LIC policy and debentures etc. Some overdrafts are even granted against the perceived "worth" of an individual. Such overdrafts are called clean overdrafts.

Term Loans
 

Counter parts of Fixed Deposits in the Bank. Banks lend money in this mode when the repayment is sought to be made in fixed, pre-determined installments. This type of loan is normally given to the borrowers for acquiring long term assets i.e. assets which will benefit the borrower over a long period (exceeding at least one year). Purchases of plant and machinery, Constructing building for factory, setting up new projects. Financing for purchase of automobiles, consumer durables, real estate and creation of infra structure

Letter of Credit (L/C)



A binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be transferred to the seller. L/C gives the seller reassurance that he will receive the payment for the goods. In order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the delivery of goods within a given time frame. It is often used in International Trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political instability.

Deferred Credit


Many times the supplier of machinery provide deferred credit facility under which payment for the purchase of machinery is made over a period of time Interest rate on deferred credit and the period of payment vary widely Supplier insists that the bank guarantee should be furnished by the buyer

Leasing


A lease is an agreement conveying the right to use property, plant, or equipment usually for a stated period of time. The owner of the property is referred to as the lessor, and the renter is the lessee.

Lease Transaction
 

 

Lesee selects equipment Lessee approaches the lessor with a proposal Lessor decides term of lease and lease rental. If it is acceptable to lessee Lessor sanctions the payment and pays the price of equipment to equipment supplier(ES) ES delivers the equipment to lessor On paying final lease rental lessee is supposed to return the equipment to lessor

Classification of leases


On the basis of Functionality : Financial Lease & Operational lease Financial Lease : If it transfers substantial part of risk and rewards associated with ownership from lessor to lessee. Such transfer is supposed to exist if  Lease term is for more than 75% of useful life  PV of minimum lease rentals is greater than 90% or equal to fair market price of the equipment at the start of the lease

Exercise :  Cost of equipment is 400 Lacs  Lease term 5 years  Lease rentals Rs. 300 / 1000 p.a.  Useful life 3 years  Cost of borrowing for lessee 18% p.a. Will you choose this leasing option?

Responsibility of suitability of equipment and its obsolescence is with lessee Lessee to arrange for repair, maintenance and insurance Lease is cancelled only when heavy costs to lessee Lease agreement does not contain any clauses for transfer of ownership of equipment at the end of lease period

Operational Lease  Lease Term less than useful life of equipment  Lessor lessee cancel the lease at short notice  Lessor may provide only operational know-how and insurance  Lessor carries risk of obsolescence Sale and Lease Back : Owner of equipment sells it to leasing company who leases back to owner Advantages : Unlock investment in low yield generating asset and continue use of asset Tax authorities do not accept value of asset more than its book value

 

Bipartite : 2 parties ES cum lessor and Lessee Operating lease Tri Partite : 3 parties ES, Lessor, Lessee No. of Financiers : Single Investor Entire finance is raised by Leasing Co. Leveraged Lease Lessor contributes 10% of equipment price Lender 90% Lessor creates a charge of equipment in favour of lender and assigns the lease rental in his favour. On payment of entire price equipment is supplied to Lessee. Lender after taking instalment of interest and repayment remaining amount transfers to Lessor s account.

Types of Leases


Operating lease (rental) lessee rents the property. Lessee accrues rent expense. Capital lease -(purchase) lessee essentially owns the property. Lessee records the leased asset in the balance sheet (i.e. capitalized) together with the corresponding lease obligation.

Operational advantages to the lessee



Firstly there is no down-payment. Equity capital is released for other purposes. Documentation & period of lease sanction can be as small as 3 days whereas for a bank loan, it will be a very lengthy process. Leasing ready-to-use equipment may be more attractive if the asset requires lengthy preparation and set-up. Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically. Leasing for short periods provides protection against obsolescence.

Financial advantages to the lessee:  Lease payments can be tailored to suit the lessee's cash flows (up to 100% financing, instead of the 80% limit by banks).  Properly structured leases may be off-balance sheet , avoiding restrictions set by bondholders that prevent firm from taking on additional debt.  Leasing provides tax advantages from interest expense.

Disadvantages to the lessee:  Leased ready-to-use equipment may be of lower quality than custom built, resulting in lower quality products and lower sales.  Seasonal leasing may affect equipment availability and pricing. Premium must be paid for the protection against obsolescence. Disadvantages to financial statement users:  Off-balance sheet financing hides the true leverage of the firm.

Advantages for Lessor



It is very easy for lesser to take charge of the asset. Bank is usually at disadvantage. In case of default on repayment, taking charge of asset is not easy they have to approach to the Court of Law. All financial advantages such as charging interest, depreciation are claimed by the lesser during the lease period. Starting a leasing company permits the company to raise debt three & half times of its own capital. This is called advantage of leverage. Starting a leasing company enables the company to access capital market at lower rates of interest.

Difference in Leasing & HP



Lease Lessee cannot claim depreciation Entire lease rental is tax deductible expense for lessee Lessee not being the owner of the asset does not enjoy the salvage value of the asset

Hire Purchase Hirer can claim depreciation Only interest component of HP installment is a tax deductible expense for hirer Hirer being owner of the asset enjoys the salvage value of the asset