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Acropolis Institute of Management Studies and Research, Indore

BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Unit 1
What do you mean by Merchant Banking?
A Merchant bank is a financial institution primarily engaged in internal finance and long term
loans for multinational corporations and governments. It can also be used to describe the
private equity activities of banking. Merchant banks tend to advise corporations and wealthy
individuals on how to use their money. The advice varies from counsel on mergers and
acquisitions to recommendation on the type of credit needed. The job of generating loans and
initiating other complex financial transactions has been taken over by investment banks and
private equity firms. Thus, the function of merchant banking which originated, and grew in
Europe was enriched by American patronage, and these services are now being provided
throughout the world by both banking and Non-banking Institutions.
The word ―Merchant Banking - originated among the Dutch and the Scottish Traders, and
was later on developed and professionalized in Britain.
The first merchant bank was set up in 1969 by Grindlays Bank. Initially they were issue
mangers looking after the issue of shares and raising capital for the company. But
subsequently they expanded their activities such as working capital management; syndication
of project finance, global loans, mergers, capital restructuring, etc., initially the merchant
banker in India was in the form of management of public issue and providing financial
consultancy for foreign banks. In 1973, SBI started the merchant banking and it was followed
by ICICI. SBI capital market was set up in August 1986 as a full-fledged merchant banker.
Between 1974 and 1985, the merchant banker has promoted lot of companies. However they
were brought under the control of SEBI in 1992 through Securities Exchange Board of India
(Merchant Bankers) Regulations, 1992
Origination of Merchant Bankers in India
Merchant banking activity was formally initiated into the Indian capital Markets in 1967.
Registration started with various services like management of capital issues, Obligations &
production planning and system design to market research and management consulting
services to meet the requirements of small Responsibilities and medium sector rather than
large sector.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Citibank Setup its merchant banking division in 1970. The various Inspection tasks
performed by this division namely assisting new entrepreneur, evaluating new projects,
raising funds through borrowing and issuing Procedure for Action equity.
Indian banks Started banking Services as a part of multiple services they offer to their clients
from 1972.
State bank of India started the merchant banking division in 1972. In the Initial years the
SBI's objective was to render corporate advice And Assistance to small and medium
Definition of Merchant Banking:
Securities and Exchange Board of India (Merchant Bankers) Rules, 1992 ― A merchant
banker has been defined as any person who is engaged in the business of issue management
either by making arrangements regarding selling, buying or subscribing to securities or acting
as manager, consultant, adviser or rendering corporate advisory services in relation to such
issue management.
The Notification of the Ministry of finance defines A merchant banker as ,any person who is
engaged in the business of issue management either by making arrangements regarding
selling, buying or subscribing to the securities as manager, consultant, adviser or rendering
corporate advisory service in relation to such issue management.
Merchant banker
 A merchant banker is one who is a critical link between a company raising fund and
the investors.
 Merchant banker is one who underwrites corporate securities and advices clients on
issues like corporate mergers.
 The merchant banker may be in the form of a bank, a company, firm or even a
proprietary concern.
 Merchant Banker understands the requirements of the business concern and arranges
finance with the help of financial institutions, banks, stock exchanges and money
The Notification of the Ministry of Finance defines merchant banker as ―Any person who is
engaged in the business of issue management either by making arrangements regarding
selling, buying or subscribing to securities as manager-consultant, advisor or rendering
corporate advisory services in relation to such issue management‖

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

The Amendment Regulation specifies that issue management consist of Prospectus and other
information relating to issue, determining financial structure, tie-up of financiers and final
allotment and refund of the subscriptions, underwriting and portfolio management services.
Nature of Merchant Banking:
Merchant banking is skill based activities and involves serving every financial need of every
client. It requires focused skill-base to provide for the requirements of the client. SEBI has
made the quality of man-power as one of the criteria for registration as merchant banker.
These skills should not be concentrated in issue management and underwriting alone, which
may have an adverse impact on business.
Merchant bankers can turn to any of the activities mentioned above depending upon
resources, such as capital, foreign tie-ups for overseas activities and skills. The depth and
sophistication in merchant banking business are improving since the avenues for participating
in capital market activities have widened from issue management and underwriting to private
placement, bought out deals (BODS), buy-back of shares, merges and takeovers.
The services of merchant bank cover project counseling, pre investment activities, feasibility
studies, project reports, design of capital structure, issue management, underwriting, loan
syndication, mobilization of funds from Non-Resident Indians, foreign currency finance,
mergers, amalgamation, takeover, venture capital, buy back and public deposits. A Category-
1 merchant banker can undertake issue management only. Separate registration is not
necessary to carry on the activity as underwriter.
Characteristics of Merchant Banking:
 High proportion of decision makers as a percentage of total staff.
 Quick decision process.
 High density of information.
 Intense contact with the environment.
 Loose organizational structure.
 Concentration of short and medium term engagements.
 Emphasis on fee and commission income.
 Innovative instead of repetitive operations.
 Sophisticated services on a national and international level.
 Low rate of profit distribution.
 High liquidity ratio.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Channelizing the financial surplus of the general public into productive investments avenues
Co-coordinating the activities of various intermediaries like the registrar, bankers, advertising
agency, printers, underwriters, brokers, etc., to the share issue, ensuring the compliance with
rules and regulations governing the securities market.
Functions of merchant Banking:
Merchant banking functions in India is the same as merchant banks in UK and other
European countries. The following are the functions of merchant bankers in India.
 Corporate counseling
 Project Counseling
 Capital Structuring
 Portfolio Management
 Issue Management
 Credit Syndication
 Working capital
 Venture Capital
 Lease Finance
 Fixed Deposits
Corporate counseling:
Corporate counseling covers counseling in the form of project counseling, capital
restructuring, project management, public issue management, loan syndication, working
capital fixed deposit, lease financing, acceptance credit etc., The scope of corporate
counseling is limited to giving suggestions and opinions to the client and help taking actions
to solve their problems. It is provided to a corporate unit with a view to ensure better
performance, maintain steady growth and create better image among investors.
Project counseling:
Project counseling is a part of corporate counseling and relates to project finance. It broadly
covers the study of the project, offering advisory assistance on the viability and procedural
steps for its implementation.
 Identification of potential investment avenues.
 A general view of the project ideas or project profiles.
 Advising on procedural aspects of project implementation
 Reviewing the technical feasibility of the project

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

 Assisting in the selection of TCO‗s (Technical Consultancy Organizations) for

preparing project reports
 Assisting in the preparation of project report
 Assisting in obtaining approvals, licenses, grants, foreign collaboration etc., from
 Capital structuring
 Arranging and negotiating foreign collaborations, amalgamations, mergers and
 Assisting clients in preparing applications for financial assistance to various national
and state level institutions banks etc,
 Providing assistance to entrepreneurs coming to India in seeking approvals from the
Government of India.
Capital Structure:
Here the Capital Structure is worked out i.e., the capital required, raising of the capital, debt-
equity ratio, issue of shares and debentures, working capital, fixed capital requirements, etc.,
Portfolio Management:
It refers to the effective management of Securities i.e., the merchant banker helps the investor
in matters pertaining to investment decisions. Taxation and inflation are taken into account
while advising on investment in different securities. The merchant banker also undertakes the
function of buying and selling of securities on behalf of their client companies. Investments
are done in such a way that it ensures maximum returns and minimum risks.
Issue Management:
Management of issues refers to effective marketing of corporate securities viz., equity shares,
preference shares and debentures or bonds by offering them to public. Merchant banks act as
intermediary whose main job is to transfer capital from those who own it to those who need
it. The issue function may be broadly divided in to pre issue and post issue management.
 Issue through prospectus, offer for sale and private placement.
 Marketing and underwriting
 Pricing of issues
Credit Syndication:
Credit Syndication refers to obtaining of loans from single development finance institution or
a syndicate or consortium. Merchant Banks help corporate clients to raise syndicated loans
from commercials banks. Merchant banks helps in identifying which financial institution

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

should be approached for term loans. The merchant bankers follow certain steps before
assisting the clients approach the appropriate financial institutions. a. Merchant banker first
makes an appraisal of the project to satisfy that it is viable b. He ensures that the project
adheres to the guidelines for financing industrial projects. c. It helps in designing capital
structure, determining the promoter‗s contribution and arriving at a figure of approximate
amount of term loan to be raised. d. After verifications of the project, the Merchant Banker
arranges for a preliminary meeting with financial institution. e. If the financial institution
agrees to consider the proposal, the application is filled and submitted along with other
Working Capital:
The Companies are given Working Capital finance, depending upon their earning capacities
in relation to the interest rate prevailing in the market.
Venture Capital:
Venture Capital is a kind of capital requirement which carries more risks and hence only few
institutions come forward to finance. The merchant banker looks in to the technical
competency of the entrepreneur for venture capital finance.
Fixed Deposit:
Merchant bankers assist the companies to raise finance by way of fixed deposits from the
public. However such companies should fulfill credit rating requirements.
Other Functions
 Treasury Management- Management of short term fund requirements by client of
companies. Stock broking- helping the investors through a network of service units
 Servicing of issues- servicing the shareholders and debenture holders in distributing
dividends, debenture interest.
 Small Scale industry counseling- counseling SSI units on marketing and finance
 Equity research and investment counseling – merchant banker plays an important role
in providing equity research and investment counseling because the investor is not in
a position to take appropriate investment decision.
 Assistance to NRI investors - the NRI investors are brought to the notice of the
various investment opportunities in the country.
 Foreign Collaboration: Foreign collaboration arrangements are made by the Merchant

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Q. Describe role of Merchant Banking in India and Abroad?

Merchant Banking in India
A merchant bank may be considered as an institution which centers its operation on all or
most of the following activities.(1) Corporate financial advice, on such diverse matters as
new share and bond issues, capital reconstructions, mergers and acquisitions;(2) The taking
of deposits and currency, money market operations including foreign exchange dealing;(3)
Medium-term lending and syndication of loans;(4) Acceptance credits and all forms of export
finance;(5) The holding and dealing in quoted and unquoted investment; and(6) Fund
management on behalf of clients, most typically pension funds, unit trust, investment trusts
and wealthy individuals.
As planning and industrial policy envisaged the setting up of new industries and technology,
greater financial sophistication and financial services are required. According to Goldsmith,
there is a well proven link between economic growth and financial technology.
Economic development requires specialist financial skills: savings banks to marshal
individual savings; finance companies for consumer lending and mortgage finance; insurance
companies for life and property cover; agricultural banks for rural development; and a range
of specialized government or government sponsored institutions. As new units were set up
and businesses expanded, they required additional financial services which were then not
provided by the banking system. Like the local banking system and the trade before, the local
system of family enterprises was unsuited for raising large amounts of capital. A public
equity or debt issue was the logical source of funds.
Merchant banks serve a dual role within the financial sector. Through deposits or sales of
securities they obtain funds for lending to their clients (SEBI forbids lending by them): a
function similar to most institutions. Their other role is to act as agents in return for fee. SEBI
envisages a mandatory role for merchant banks in exercising due diligence apart from issue
management, in buy-backs and public offer in takeover bids. Their underwriting and
corporate financial services are all fee rather than fund based and their significance is not
reflected in their total assets of the industry. SEBI has been pressing for merchant banks to be
primarily fee based institutions.
Merchant banking, as the term has evolved in Europe from the 18th century to today,
pertained to an individual or a banking house whose primary function was to facilitate the
business process between a product and the financial requirements for its development.
Merchant banking abroad:

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Bank of Ireland's U.S. Merchant Banking Group was formed in 2002. We are committed to
building quality, long-term relationships by delivering comprehensive leveraged finance
solutions to support the acquisition activities of U.S. private equity firms focused on middle
market companies.
We are engaged in arranging and underwriting debt facilities in support of management
buyouts, leveraged buyouts, leverage corporate acquisitions, public to privates,
recapitalizations and capital expansions.
Financing products range from senior secured cash flow facilities to junior capital and
mezzanine facilities alongside global Syndications. This comprehensive offering allows us to
provide our clients with a "one-stop" option when financing transactions. Our U.S. Merchant
Banking Group has built a diversified portfolio of leveraged finance transactions, both
geographically and by sector.
We have significant experience across a wide range of industry sectors, with a key focus on
companies in the following sectors:
 Consumer Products
 Manufacturing
 Distribution
 Selected Business Service Companies
 Selective Retail
Q. Describe the Recent Developments in Merchant Banking.
Developments are:
1. Setting up of Bank subsidiaries: It meet out the needs of financial services from the
corporate sector. The Merchant banking divisions of the nationalized banks have started
forming their independent subsidiaries. These subsidiaries offer more specialized services
with professional expertise and skills.
2. Reorganization of Private firms: To face the competition from growing number of MB
subsidiary companies of nationalized banks, private merchant bankers have started
developing their activities.
3. Establishment of Stockbroker Underwriter Association: Established in 1984 and works in
coordination with MBs and take steps for promoting the capital market.
Recent Developments in Merchant Banking and Challenges Ahead: The recent developments
in Merchant banking are due to certain contributory factors in India. They are

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

The Merchant Banking was at its best during 1985-1992 being when there were many new
issues. It is expected that 2010 that it is going to be party time for merchant banks, as many
new issue are coming up.
The foreign investors – both in the form of portfolio investment and through foreign direct
investments are venturing in Indian Economy. It is increasing the scope of merchant bankers
in many ways.
Disinvestment in the government sector in the country gives a big scope to the merchant
banks to function as consultants.
New financial instruments are introduced in the market time and again. This basically
provides more and more opportunity to the merchant banks.
The mergers and corporate restructuring along with MOU and MOA are giving immense
opportunity to the merchant bankers for consultancy jobs.

Scope of merchant banking in India: Merchant banking activities help in channelizing the
financial surplus of the general public into productive investment avenues. They help to
coordinate the activities of various intermediaries to the share issue such as the registrar,
bankers, advertising agency, printers, underwriters, brokers, etc. and to ensure the compliance
with rules and regulations governing the securities market. This being the era where mergers
and acquisitions are hot, the scope of merchant banking has grown to a large extent.

Q. What are the challenges faced by merchant bankers in India?

The challenges faced by merchant bankers in India are:

1. SEBI guideline has restricted their operations to Issue Management and Portfolio
Management to some extent. So, the scope of work is limited.
2. In efficiency of the clients are often blamed on to the merchant banks, so they are into
trouble without any fault of their own.
3. The net worth requirement is very high in categories I and II specially, so many
professionally experienced person/ organizations cannot come into the picture.
4. Poor New issues market in India is drying up the business of the merchant bankers. Thus
the merchant bankers are those financial intermediary involved with the activity of
transferring capital funds to those borrowers who are interested in borrowing. The activities
of the merchant banking in India is very vast in the nature of

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

The management of the customers securities

The management of the portfolio
The management of projects and counseling as well as appraisal
The management of underwriting of shares and debentures
The circumvention of the syndication of loans
Management of the interest and dividend etc

Q. Explain the Regulatory framework of Merchant Banking?

Regulatory framework
The merchant banking activity in India is governed by SEBI (Merchant Bankers)
Regulations, 1992. Registration with SEBI is mandatory to carry out the business of merchant
banking in India. An applicant should comply with the following norms:
The applicant should be a corporate body.
The applicant should not carry on any business other than those connected with the securities
The applicant should have necessary infrastructure like office space, equipment, manpower,
The applicant must have at least two employees with prior experience in merchant banking.
Any associate company, group company, subsidiary or interconnected company of the
applicant should not have been a registered merchant banker.
The applicant should not have been involved in any securities scam or proved guilt for any
The applicant should have a minimum net worth Rs50 million.
Any person or body proposing to engage in the business of merchant banking would get
authorization by SEBI. The authorization is granted taking into account the professional
competence, personnel and other infrastructure, capital adequacy. The following are the
major terms and conditions of authorization.
All merchant bankers must have a minimum net worth of Rs. 1 crores.
Authorization will be for a initial period of three years.
All issues should be managed by at least one authorized merchant banker, functioning as the
sole manager on the lead manager. Or-dinarily, not more than two merchant bankers should

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

be associated as lead managers, advisors and consultants to a public issue. In is-sues of over
Rs. 10 crores, the number could go up to a maximum of four.
The specific responsibilities of each lead manager must be submit-ted to SEBI prior to the
Lead managers/merchant bankers would be responsible for ensuring timely refunds and
allotment of securities to the investors.
SEBI shall prepare and prescribe a code of conduct for merchant bankers which they should
adhere to.
Merchant bankers have to segregate their business from other ac-tivities and they cannot take
up any fund-based business.
SEBI may suspend/cancel the authorization of merchant bankers for a suitable duration in
case of isolations of the terms of authorization.
Capital adequacy norms: This has been expressed in terms of minimum net worth i.e. capital
contributed to the business plus free reserves. These are the norms made by

Q. State the advantages and disadvantages of Merchant Banking.

Merchant banks perform functions that cannot be carried out by businesses on their own.
Merchant banks have access to traders, financial institutions, and markets that companies or
individuals could not possibly reach.
By using their skills and contacts, merchant banks can get the best possible deals for their

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Merchant banks are really only for large corporate customers, or extremely wealthy smaller
businesses owned by individual clients.
Not all deals carried out by merchant banks meet with unqualified success.
There is always risk attached to the kinds of deal that merchant banks undertake
EBI stipulates high capital adequacy norms for authorization which prevents young,
specialised professionals into merchant banking business
Non co-operation of the issuing companies in timely allotment of securities and refund of
application of money etc.. is another problem
Yet merchant banking is vast but should develop adequate expertise to provide a full range of
merchant banking services
Q. Discuss the code of conduct of Merchant Bankers?
Merchant bankers code of conduct by SEBI
Integrity: Observance of high standards of integrity and fairness in all dealings with clients
and other merchant bankers.
Quality service: Rendering high standards of service, exercising due diligence, ensuring
proper care and exercising independent professional judgment, disclosing to the clients,
wherever necessary, possible sources of conflict of duties and interests, while providing
unbiased services.
Fair practice: Refraining from making any statement or becoming privy to any act , practice
or unfair competition , which is likely to be harmful to the interests of other merchant bankers
, or make merchant bankers in an disadvantageous position, while comforting for or
executing any assignment.
Responsible statement: Not to indulge in any exaggerated statement , oral or written , to the
client either about the qualification or the capability to render certain services , or
achievements in regard to services rendered to other clients
Best advice: Endeavoring to render the best possible advice to the clients keeping in mind the
client‘s needs and the merchant bankers own professional skills in order to ensure that all
professional dealings are effected in a prompt , efficient and cost effective manner.
Secrecy: Not to divulge to other clients, press or any other party any confidential information
about the client and deal in the securities of any client without disclosing to the board, as
required under the regulations.
Information: Making constant efforts to ensure that the investors are provided with true and
adequate information, without making any disguised or exaggerated claims in order to make
them aware of the attendant risks before they undertake any investment decision.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Prospectus: Making available copies of the prospectus, memorandum and related literature to
Allotment: Initiating adequate steps to ensure the fair allotment of securities and refund of
application money without delay.
True market: Not to be a party to the creation of false market, price rigging , passing on price
sensitive information to brokers , member of the stock exchanges and other player in the
capital market, or take any other action which is unethical and unfair to the investors.
Compliance: Abiding by the provisions of the act , rules and regulations which may be
applicable and relevant to the activities carried out by the merchant bankers.

Q. Explain the structure of Merchant Banking industry?


1. Industrial Securities Market: This is a market for industrial securities i.e. market for shares
and debentures of the existing and new corporate firms. Buying and selling of such
instruments take place in this market. This market is further classified into two types such as
the New Issues Market (Primary) and the Old (Existing) Issues Market (secondary). In
primary market fresh capital is raised by companies by issuing new shares, bonds, units of
mutual funds and debentures. However in the secondary market already existing i.e. old
shares and debentures are traded. This trading takes place through the registered stock

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

exchanges. In India we have three prominent stock exchanges. They are the Bombay Stock
Exchange (BSE), the National Stock Exchange (NSE) and Over the Counter Exchange of
India (OTCEI).
2. Development Financial Institutions (DFIs): This is yet another important segment of Indian
capital market. This comprises various financial institutions. These can be special purpose
institutions like IFCI, ICICI, SFCs, IDBI, IIBI, UTI, etc. These financial institutions provide
long term finance for those purposes for which they are set up.
Banks: Indian and foreign banks plays an important role in merchant banking. SBI was the
first bank which started this and is now established very well in this. After this many banks
like PNB , UCO bank set up their divisions at their offices.

Q. Explain the guidelines for Merchant Bankers given by SEBI.

Guidelines for Merchant Bankers

SEBI‘s authorization is a must to act as merchant bankers. Authorization criteria include
Professional qualification in finance, law or business management Infrastructure like office
space, equipment and man power Capital adequacy Past track of record, experience, general
reputation and fairness in all transactions Every merchant banker should maintain copies of
balance sheet, Profit and loss account, statement of financial position Half-yearly unaudited
result should be submitted to SEBI Merchant bankers are prohibited from buying securities
based on the unpublished price sensitive information of their clients
SEBI has been vested with the power to suspend or cancel the authorization in case of
violation of the guidelines Every merchant banker shall appoint a ‗Compliance Officer‗ to
monitor compliance of the Act SEBI has the right to send inspecting authority to inspect
books of accounts, records etc… of merchant bankers Inspections will be conducted by SEBI
to ensure that provisions of the regulations are properly complied An initial authorization fee,
an annual fee and renewal fee may be collected by SEBI A lead manager holding a certificate
under category I shall accept a minimum underwriting obligation of 5% of size of issue or
Rs.25 lakhs whichever is less
Q. Explain role of primary market in Merchant Banking?

Primary market
Primary market is the part of capital market where issue of new securities takes place. Public
sector institutions, companies and governments obtain funds for further growth of the

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

company after the sale of their securities or bonds in primary market. The selling process of
new issues in primary market is called as Underwriting and this process is done by a group of
people called underwriters or security dealers. From a retail investor‘s point of view,
investing in the primary market is the first step towards trading in stocks and shares.

Role of Primary Market

Capital formation - It provides attractive issue to the potential investors and with this
company can raise capital at lower costs.

Liquidity - As the securities issued in primary market can be immediately sold in secondary
market the rate of liquidity is higher.
Diversification - Many financial intermediaries invest in primary market; therefore there is
less risk if there is failure in investment as the company does not depend on a single investor.
The diversification of investment reduces the overall risk.
Reduction in cost - Prospectus containing all details about the securities are given to the
investors hence reducing the cost is searching and assessing the individual securities.
Features of Primary Market
It is the new issue market for the new long term capital.
Here the securities are issued by company directly to the investors and not through any
On receiving the money from the new issues, the company will issue the security certificates
to the investors.
The amount obtained by the company after the new issues are utilized for expansion of the
present business or for setting up new ventures.
External finance for longer term such as loans from financial institutions is not included in
primary market. There is an option called ‗going public‘ in which the borrowers in new issue
market raise capital for converting private capital into public capital.
Prerequisites for Investor to Participate in Primary market Activities:
PAN Number: Permanent Account Number (PAN) is a ten-digit alphanumeric number,
issued in the form of a laminated card, by the Income Tax Department. A typical PAN is
AABPS1205E.It is also compulsory to quote PAN in all documents pertaining to financial
transactions notified from time-to-time by the Central Board of Direct Taxes.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Bank Account: A bank account is a financial account between a bank customer and a
financial institution. A bank account can be a deposit account, a credit card, or any other type
of account offered by a financial institution. The financial transactions which have occurred
within a given period of time on a bank account are reported to the customer on a bank
statement and the balance of the account at any point in time is the financial position of the
customer with the institution. a fund that a customer has entrusted to a bank and from which
the customer can make withdrawals.
Demat Account: In India, shares and securities are held electronically in a Dematerialized
account, instead of the investor taking physical possession of certificates. A Dematerialized
account is opened by the investor while registering with an investment broker (or sub-
broker). The Dematerialized account number is quoted for all transactions to enable
electronic settlements of trades to take place. Every shareholder will have a Dematerialized
account for the purpose of transacting shares.
Types of issues
Public issues can be classified into 3 types:
Initial Public Offering (IPO) – Fresh issue of shares or selling existing securities by an
unlisted company for the first time is known as IPO. Listing and trading of securities of a
company takes place in IPO.
Rights Issue – Rights issue is when the listed company issues new securities and provides
special rights to its existing shareholders for buying the securities before issuing it to public.
The rights are issued on particular ratio based on the number of securities currently held by
the share holder.
Preferential Issue – It is the fresh issue of securities and shares by listed company. It is called
as preferential as the shareholders with preferential shares get the preference when it comes
to dividend disbursement.
Price manipulation is very less in primary market compared to secondary market.
There is no payment of brokerage, transaction fees, and stamp duty or service tax.
Investors get the shares at same prices so market fluctuations do not affect it.
The shares are allotted proportionately if there is over subscription which means, the small
investors may not get any allotment.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Money is locked in for longer time, as it is a long term investment. The shares allotment for
the investor takes few days in primary market compared to secondary market where it takes
only 3 days to allot the shares.
Unit 2 - Notes

Q. Explain the nature and scope of financial services.

Nature and scope of financial services
Meaning of financial services
In general, all activities which are of a financial nature can be brought under the term
'financial services'. The term financial services' in a broad, sense means "mobilizing and
allocating savings". Thus it includes all activities involved in the transformation of savings
into investment.
Financial services can also be called 'financial inter mediation'. Financial intermediation is a
process by which funds are mobilizing from a large number of savers and make them
available to all those who are in need of it and particularly to corporate customers.
Thus, financial services sector is a key area and it is very vital for industrial developments. A
well developed financial services industry is absolutely necessary to mobilize the savings and
to allocate them to various invest able channels and thereby to promote industrial
development in a country.
Classification of Financial Services Industry
The financial intermediaries in India can be traditionally classified into two :
i. Capital Market intermediaries and
ii. Money market intermediaries.
The capital market intermediaries consist of term lending institutions and investing
institutions which mainly provide long term funds. On the other hand, money market consists
of commercial banks, co-operative banks and other agencies which supply only short term
funds. Hence, the term 'financial services industry' includes all kinds of organizations which
intermediate .and facilitate financial transactions of both individuals and corporate customers.
Role of Financial Services in financial system
Financial services cover a wide range of activities. They can be broadly classified into two,
i. Traditional. Activities
ii. Modern activities.
Traditional Activities

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Traditionally, the financial intermediaries have been rendering a wide range of services
encompassing both capital and money market activities. They can be grouped under two
heads, viz.
a. Fund based activities and
b. Non-fund based activities.
Fund based activities
The traditional services which come under fund based activities are the following:
i. Underwriting or investment in shares, debentures, bonds, etc. of new issues (primary
market activities).
ii. Dealing in secondary market activities.
iii. Participating in money market instruments like commercial papers, certificate of
deposits, treasury bills, discounting of bills etc .
iv. Involving in equipment leasing, hire purchase, venture capital, seed capital,
v. Dealing in foreign exchange market activities. Non fund based activities
Non fund based activities
Financial intermediaries provide services on the basis of non-fund activities also. This can be
called 'fee based' activity. Today customers, whether individual or corporate, are not satisfied
with mere provisions of finance. They expect more from financial services companies. Hence
a wide variety of services, are being provided under this head. They include:
i. Managing die capital issue — i.e. management of pre-issue and post-issue activities relating
to the capital issue in accordance with the SEBI guidelines and thus enabling the promoters to
market their issue.
ii. Making arrangements for the placement of capital and debt instruments with investment
iii. Arrangement of funds from financial institutions for the clients' project cost or his
working capital requirements.
iv. Assisting in the process of getting all Government and other clearances.
Modern Activities
Beside the above traditional services, the financial intermediaries render innumerable
services in recent times. Most of them are in the nature of non-fund based activity. In view of
the importance, these activities have been in brief under the head 'New financial products and
However, some of the modern services provided by them are given in brief hereunder.

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i. Rendering project advisory services right from the preparation of the project report rill the
raising of funds for starting the project with necessary Government approvals.
ii. Planning for M&A and assisting for their smooth carry out.
iii. Guiding corporate customers in capital restructuring
iv. Acting as trustees to the debenture holders.
v. Recommending suitable changes in the management structure and management style
with a view to achieving better results.
vii. Rehabilitating and restructuring sick companies through appropriate scheme of
reconstruction and facilitating the implementation of the scheme.
viii. Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political
risk by using swaps and other derivative products.
ix. Managing portfolio of large Public Sector Corporations.
x. Undertaking risk management services like insurance services, buy-hack options etc.
xi. Advising the clients on the questions of selecting the best source of funds taking into
consideration the quantum of funds required, their cost, lending period etc.
xii. Guiding the clients in the minimization of the cost of debt and in the determination of the
optimum debt-equity mix.
xiii. Undertaking services relating to the capital market, such as
Clearing services
Registration and transfers
Safe custody of securities
Collection of income on securities

xiv. Promoting credit rating agencies for the purpose of rating companies which want to go
public by the issue of debt instrument.
Q. What are the Causes for Financial services Innovation?
Causes for Financial services Innovation
Financial intermediaries have to perform the task of financial innovation to meet the
dynamically changing needs of the economy and to help the investors cope with the
increasingly volatile and uncertain market place. There is a dire necessity for the financial
intermediaries to go for innovation due to the following reasons:
Low profitability: The profitability of the major FI, namely (he banks has been very much
affected in recent times. There is a decline, in the profitability of traditional banking products.
So, (hey have been compelled to seek out new products which may fetch high returns.

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Keen competition: The entry of many FIs in the financial sector has led to severe competition
among them. This keen competition has paved the way for the entry of varied nature of
innovative financial products so ns to meet the varied requirements of the investors.
Economic Liberalization: Reform of the financial sector constitutes the most important
component of India's programme towards economic liberalization. The recent economic
liberalization measures have opened the door foreign competitors to enter into our domestic
market. Deregulation in the form of elimination of exchange controls and interest rate
ceilings have made the market more competitive. Innovation has become a must for survival.
Improved communication technology: The communication technology has become so
advanced that even the world's issuers can be linked with the investors i the global financial
market without any difficulty by mean of offering so many options and opportunities.
Customer Service:
Nowadays, the customer's expectations are very great. They want newer products at lower
cost or at lower credit risk to replace the existing one. To meet this increased customer
sophistication, the financial intermediaries are constantly undertaking research in order to
invent a new product which may suit to the requirement of the investing public.
Global impact: Many of the providers and users of capital have changed their roles all over
the world. FI have come out of their traditional approach and they arc ready to assume more
credit risks.
Investor Awareness: With a growing awareness amongst the investing public, there has been
a distinct shift from investing the savings in physical assets like gold, silver, land etc. to
financial assets like shares, debentures, mutual funds, etc. Again, within the financial assets,
they go from 'risk free bank deposits to risky investments in shares. To meet the growing
awareness of the public, innovations has become the need of the hour.
New Financial Products and Services
In these days of complex finances, people expect a financial service company to play a very
dynamic role not only as a provider of finance but also as a departmental store of finance.
With the opening of the economy to multinationals, the free market concept has assumed
much significance. As a result, the clients both corporate and individuals are exposed to the
phenomena of volatility and uncertainty and hence the)' expect the financial services
company to innovate new products and services so as to meet their varied requirements.
As a result of innovations, new instruments and new products are emerging in the capital
market. The capital market and the money market are getting widened and deepened.

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Moreover, there has been a structured change in the international capital market with the
emergence of new products and innovative techniques of operation in the capital market.
Many financial intermediaries including banks have already started expanding [heir activities
in the financial services sector by offering a variety of new products. As result, sophistication
and innovations have appeared in the arena of financial intermediations. Some of them are
briefly explained hereunder :
Q. What are the major types of financial services available in financial market?
There are two categories of sources of income for a financial services company, namely: (i)
Fund based and (ii) Fee — based.
Fund based income
Fund based income comes mainly from interest spread (the difference between the interest
earned and interest paid), lease rentals, income from investments in capital market and real
estate. On the other hand, fee based income has its sources in merchant banking, advisory
services, custodial services, loan syndication, etc. In fact, a major part of the income is earned
through fund-based activities. At the same time, it involves a large share of expenditure also
in the form of interest and brokerage. In recent times, a number of private financial
companies have started accepting deposits by offering a very high rate of interest. When the
cost of deposit resources goes up, tin" (ending rate should also go up. It means that such
companies have to compromise the quality of its investments.
Fee based income
Fee based income, on the other hand, does not involve much risk, but, it requires a lot of
expertise on the part of a financial company to offer such fee-based services.
Q. What is leasing? Explain its evolution and features?
Leasing, as a financing concept, is an arrangement between two parties, the leasing company
or lessor and the user or lessee, whereby the former arranges to buy capital equipment for the
use of the latter for an agreed period of time in return for the payment of rent.
Equipment leasing association of UK: ―Lease is a contract whereby the owner of an asset
grants to another party the exclusive right to use the asset usually for an agreed period of time
in return for the payment of rent.‖
Leasing as a source of finance:-
Modernization of business
Balancing equipment

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Assets which are not being financed by banks or institutions.

Cars, scooters and other vehicles and durables
Evolution of Indian Leasing Industry
Leasing activity was initiated in India in 1973. The first leasing company of India, named
First Leasing Company of India Ltd. was set up in that year by Farouk Irani, with industrialist
A C Muthiah. For several years, this company remained the only company in the country
until 20th Century Finance Corporation was set up - this was around 1980.
By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and
Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game.
The last three names, already involved with hire-purchase of commercial vehicles, were
looking for a tax break and leasing seemed to be the ideal choice.
The industry entered the third stage in the growth phase in late 1982, when numerous
financial institutions and commercial banks either started leasing or announced plans to do
so. ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost
to the concept of leasing.
Thereafter, the trickle soon developed into flood, and leasing became the new gold mine.
This was also the time when the profit-performance of the two doyen companies, First
Leasing and 20th Century had been made public, which contained all the fascination for
many more companies to join the industry.
In the meantime, International Finance Corporation announced its decision to open four
leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced
strict measures for enlistment of investment companies on stock-exchanges, which made
many investment companies to turn overnight into leasing companies.
As per RBI's records by 31st March, 1986, there were 339 equipment leasing companies in
India whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number -
from merely 2 in 1980 to 339 in 6 years.
Subsequent swings in the leasing cycle have always been associated with the capital market -
whenever the capital markets were more permissive, leasing companies have flocked the
market. There has been appreciable entry of first generation entrepreneurs into leasing, and in
retrospect it is possible to say that specialized leasing firms have done better than diversified
industrial groups opening a leasing division.
Another significant phase in the development of Indian leasing was the Dahotre Committee's
recommendations based on which the RBI formed guidelines on commercial bank funding to

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leasing companies. The growth of leasing in India has distinctively been assisted by funding
from banks and financial institutions.
Banks themselves were allowed to offer leasing facilities much later - in 1994. However,
even to date, commercial banking machinery has not been able to gear up to make any
remarkable difference to the leasing scenario.
The post-liberalization era has been witnessing the slow but sure increase in foreign
investment into Indian leasing. Starting with GE Capital's entry, an increasing number of
foreign-owned financial firms and banks are currently engaged or interested in leasing in
The Lease Purchase Agreement is a type of real estate contract by which a buyer first
becomes the tenant and the seller first becomes the landlord. The Homeowner gives his home
to the tenant for the time period mentioned in the contract papers. The tenant takes the home
on lease and pays to seller in form of rent. The tenant is allowed to live in home till the
contract period is not expired and at time of contract expiry the tenant has pay the balance
payment to the homeowner and take ownership of the property.
If you need to buy equipment for your business, but don‘t have the cash to pay for it upfront,
you have probably considered financing options like bank loans, vendor credit or equipment
lease. While a loan or vendor credit may be easy to understand because it works like any
other loan, an equipment lease comes with various terms, structures and tax consequences.
An equipment lease can be a great way to finance your purchases, whether it‘s computer
equipment, kitchen equipment for your restaurant or heavy equipment for your construction
business. However, you should make sure that you fully understand how it works and what
you are signing up for.
Leasing Company in India: Reliance Industries Limited, Tata Consultancy Services (TCS),
Infosys Technologies Ltd, Wipro Limited, Bharti Tele-Ventures Limited, etc.
Q. What Are Equipment Leases?
Leasing is a process by which you can use certain fixed assets, such as equipment, in
exchange for a series of payments. In other words, it is a form of financing where you can use
equipment without actually coming up with the cash to purchase it outright. The company
that uses the equipment under a lease is called the lessee, and the company that provides the
equipment under a lease agreement is called the lessor.
Equipment leases can be an easy way for small businesses to get access to equipment that is
needed to expand or run the business, without committing cash up front for the purchase.

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Documentation Requirements for Equipment Leases

The documentation required by leasing companies varies depending on the transaction size
and whether the lease is being made based on personal credit rather than credit of the
business. Most leasing companies will ask for the Social Security number of the person
guaranteeing the lease in order to perform a credit check. In addition, the company‘s Federal
Employment Identification Number (FEIN) will also be required.
For medium to big-ticket leases (leases generally over $100,000), equipment lease companies
may require the company to have been in operation for over 2-3 years and will generally
require financial statements as well. Personal credit checks and guarantees might still be
Legal Aspects of Leasing: present Legislative Framework.
As there is no separate statue for equipment leasing in India, the provisions relating to
bailment in the Indian Contract Act govern equipment leasing agreements as well section 148
of the Indian Contract Act defines bailment as:
―The delivery of goods by one person to another, for some purpose, upon a contract that they
shall, when the purpose is accomplished, be returned or otherwise disposed off according to
the directions of the person delivering them. The person delivering the goods is called the
‗bailor‘ and the person to whom they are delivered is called the ‗bailee‘.
Since an equipment lease transaction is regarded as a contract of bailment, the obligations of
the lessor and the lessee are similar to those of the bailor and the bailee (other than those
expressly specified in the least contract) as defined by the provisions of sections 150 and 168
of the Indian Contract Act. Essentially these provisions have the following implications for
the lessor and the lessee.
The lessor has the duty to deliver the asset to the lessee, to legally authorize the lessee to use
the asset, and to leave the asset in peaceful possession of the lessee during the currency of the
The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to
protect the lessor‘s title, to take reasonable care of the asset, and to return the leased asset on
the expiry of the lease period.
Q. Describe the contents of a lease agreement?
Contents of a lease agreement:
The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It
typically contains terms relating to the following:
Description of the lessor, the lessee, and the equipment.

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Amount, time and place of lease rentals payments.

Time and place of equipment delivery.
Lessee‘s responsibility for taking delivery and possession of the leased equipment.
Lessee‘s responsibility for maintenance, repairs, registration, etc. and the lessor‘s right in
case of default by the lessee.
Lessee‘s right to enjoy the benefits of the warranties provided by the equipment
Insurance to be taken by the lessee on behalf of the lessor.
Variation in lease rentals if there is a change in certain external factors like bank interest
rates, depreciation rates, and fiscal incentives.
Options of lease renewal for the lessee.
Return of equipment on expiry of the lease period.
Q. Explain types of Lease.
Types of lease
Financial and operating lease
Sale And Lease Back
Leveraged Lease
Domestic and International Lease
Financial lease
Finance lease, also known as Full Payout Lease or capital lease, is a type of lease wherein the
lessor transfers substantially all the risks and rewards related to the asset to the lessee.
Generally, the ownership is transferred to the lessee at the end of the economic life of the
asset. Lease term is spread over the major part of the asset life. Here, lessor is only a
financier. Long-term, non-cancellable lease contracts are known as financial leases.
The essential point - it contains a condition whereby the lessor agrees to transfer the title for
the asset at the end of the lease period at a nominal cost. At lease it must give an option to the
lessee to purchase the asset he has used at the expiry of the lease. High cost high tech
equipment .The lease agreement is irrevocable.
All the risks incidental to the asset ownership are transferred to the lessee who bears the cost
of maintenance, insurance and repairs. Only title deeds remain with the lessor.
Financial lease is very popular in India as in other countries like USA, UK, and Japan. On an
all-India basis, at present approximately leases worth Rs. 75 to Rs. 100 crores are transacted
as a tax planning device.

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High cost equipment such as office equipment, diesel generators, machine tools, and textile
machinery, etc. are leased under financial lease.
Operating Lease
Operating Lease also known as service lease, or short term lease. In this lease the contractual
period between lessor and lessee is less than the full expected economic life of equipment.
This means that the lease is for the limited period.
In this risk and rewards are not transferred completely to the lessee. The term of lease is very
small compared to finance lease. The lessor depends on many different lessees for recovering
his cost.
Ownership along with its risks and rewards lies with the lessor. Here, lessor is not only acting
as a financier but he also provides additional services required in the course of using the asset
or equipment. It is in Contrast to the financial lease
A lease agreement gives to the lessee only a limited right to use the asset. The lessor is
responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to
purchase the asset at the end of the lease period.
The rate of lease would be fixed based on the kind of lease, the period of lease, periodicity of
rent payment and the rate of depreciation and other tax benefits available. The lease company
also charges nominal service charges to cover legal and other costs.
Leveraged lease
A leveraged lease is a lease in which the lessor puts up some of the money required to
purchase the asset and borrows the rest from a lender. The lender is given a senior secured
interest on the asset and an assignment of the lease and lease payments. The lessee makes
payments to the lessor, who makes payments to the lender. The term may also refer to a lease
agreement wherein the lessor, by borrowing funds from a lending institution, finances the
purchase of the asset being leased.
Sale and lease back
A sale and lease back transaction involves the sale of a property to the leasing company,
which then leases it back to the previous owner. This type of leasing is used primarily to
increase a company‘s liquidity, make use of undisclosed reserves or optimize the balance
Explain the difference between an operating lease and a finance lease.
Difference between an operating lease and a finance lease

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While financial lease is a long term arrangement between the lessee (user of the asset) and the
owner of the asset, whereas operating lease is a relatively short term arrangement between the
lessee and the owner of asset.
Under financial lease all expenses such as taxes, insurance are paid by the lessee while under
operating lease all expenses are paid by the owner of the asset.
The lease term under financial lease covers the entire economic life of the asset which is not
the case under operating lease.
Under financial lease the lessee cannot terminate or end the lease unless otherwise provided
in the contract which is not the case with operating lease where lessee can end the lease
anytime before expiration date of lease.
While the rent which is paid by the lessee under financial lease is enough to fully amortize
the asset, which is not the case under operating lease.
Aircrafts, land and building and heavy machinery are leased in financial lease and computers,
office equipment, automobiles, truck, etc. are leased in operating lease.
The lessor fulfills financial function in financial lease and in operating lease lessor fulfills
service function.
The risk of obsolescence is assumed by the lessee in financial lease. Leasing companies
assumes risk of obsolescence in operating lease.
Q. What are the advantages and disadvantages of Leasing?
Advantages of Leasing
Leases often require much less equity investment than bank financing.
Since leases are contracts between two willing parties, their terms can be structured in any
way to meet their respective needs.
Faster and cheaper credit i.e. it allows firms to acquire new equipment without going through
formal scrutiny procedure
Taxes may be reduced by leasing.
The lease contract may reduce certain types of uncertainty.
Transactions costs can be higher for buying an asset and financing it with debt or equity than
for leasing the asset.
Disadvantages of Leasing
Not suitable mode of project finance.
Certain tax benefit or incentives such as subsidy may not be available on leased equipment.
The cost of financing is generally higher than that of debt financing.
The value of real assets such as land and building may increase during lease period.

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1If the lessee is not able to pay rentals regularly, the lessor would suffer a loss.
In case of lease agreement, it is lessor who has purchased the asset from the supplier and not
the lessee. Hence the lessee by himself is not entitled to any protection in case the supplier
commits breach of warranties in respect of the leased assets.
Q. Define Hire Purchase and its feature.
Hire purchase is a type of installment credit under which the hire purchaser, called the hirer,
agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of
principal as well as interest, with an option to purchase.
Under this transaction, the hire purchaser acquires the property (goods) immediately on
signing the hire purchase agreement but the ownership or title of the same is transferred only
when the last installment is paid.
The hire purchase system is regulated by the Hire Purchase Act 1972.
This Act defines a hire purchase as "an agreement under which goods are let on hire and
under which the hirer has an option to purchase them in accordance with the terms of the
agreement and includes an agreement under which:
1) The owner delivers possession of goods thereof to a person on condition that such person
pays the agreed amount in periodic installments
2) The property in the goods is to pass to such person on the payment of the last of such
installments, and
3) Such person has a right to terminate the agreement at any time before the property so
Features of hire purchase –
Hire-Purchase System is governed by Hire-Purchase Act 1972
It is an agreement of hiring
It is an agreement between Hirer and Hire Vendor
Terms and conditions between the parties are entered and recorded in a document called
Hire-Purchase Agreement.
Cash price of goods is paid in installment on agreed terms.
The title to goods passes on last payment
The Hire Vendor (Seller) can take possession of goods if Hirer fails to pay installment
The Hirer is not responsible for risk of loss of goods, till the ownership is transferred.
The Hirer cannot mortgage, hire or sell or pledge the goods

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The Hirer has got a right to terminate the agreement at any time before the property so passes.
A document must be drawn up that sets out the specific conditions of the contract, in
particular it must state:
the price to pay if the sum is paid in cash,
the total price to be paid for when using hire-purchase,
the total cost of credit (the cumulative amount of interest + the cash price),
the date of the first payment,
the amount of each installment,
the number, the amounts and the frequency of the payments
Q. Explain Difference between lease financing and hire purchase.
Differentiation lease financing and hire purchase
Hire purchase should be distinguished from installment sale wherein property passes to the
purchaser with the payment of the first installment. But in case of HP (ownership remains
with the seller until the last installment is paid) buyer gets ownership after paying the last
installment. HP also differs from leasing as can be seen from the table below.
Point of difference Leasing Hire purchase
Meaning A lease transaction is a Hire purchase is a type of
commercial arrangement, installment credit under
whereby an equipment owner which the hire purchaser
or manufacturer conveys to agrees to take the goods on
the equipment user the right hire at a stated rental, which
to use the equipment in is inclusive of the repayment
return for a rental. of principal as well as
interest, with an option to

Option to user No option is provided to the HP- Option is provided to the

lessee (user) to purchase the hirer (user).
Nature of expenditure Lease rentals paid by the Only interest element
lessee are entirely revenue included in the HP
expenditure of the lessee. installments is revenue
expenditure by nature

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Components Lease rentals comprise of 2 HP installments comprise of

elements (1) finance charge 3 elements (1) normal trading
and (2) capital recovery. profit (2) finance charge and
(3) recovery of cost of
Reporting The leased assets are shown The asset on hire purchase is
by way of foot note only. shown in the balance sheet of
the hirer.
Depreciation In leasing, depreciation and In hire purchase, it can be
investment allowance cannot claimed by the hirer.
be claimed by the lessee.
Tax benefits The entire lease rental is tax Only the interest component
deductible expense. of the hire purchase
installment is tax deductible.

Salvage value The lessee not being the The hirer, in purchase, being
owner of the asset does not the owner of the asset, enjoys
enjoy the salvage value of the it.
Extent of finance Lease financing is invariably In hire purchase, a margin
100 % financing. It requires equal to 20-25 per cent of the
no immediate down payment cost of the asset is to be paid
or margin money by lessee. by the hirer.

Q. Describe advantages and disadvantages of hire purchase.

Advantages of HP
Facility of buying
People with small income can buy expensive articles such as car, house, furniture, etc. They
can make payment in easy installments and thereby improve their standard of living. The
buyer can return the goods if he is not satisfied with their quality or is unable to pay further
Thrift and savings

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Hire purchase system encourages people to reduce expenses and save money to pay
installments at regular intervals.
Higher sales
Hire purchase system helps to widen market for costly goods. People who cannot buy such
goods otherwise are tempted to purchase them on installments. The seller can take back the
goods if buyer makes default in payment.
Boon to small producers
Small scale units and farmers can buy machinery and equipment and pay installments out of
earnings. For example, an unemployed graduate can buy a taxi through hire purchase, earn
money from the taxi and pay installments out of such income.
Disadvantages of HP
Hire purchase system induces middle class people to buy luxury goods which they cannot
otherwise afford. They are tempted to pledge their future income. They may not be able to
repay installments in time. They suffer heavy loss when the seller takes back the goods on
default of payment.
Higher prices:
The buyer has to pay much higher prices than that payable on cash purchase. The seller adds
a margin to cover interest and risk. The seller may pass on goods of doubtful quality by
offering easy credit terms. The buyer does not get ownership of goods until last installment
paid. He cannot sell the goods before final payment.
Risk of bad debts:
When the buyer fails to pay installments, the seller may suffer loss. He may have to spend
money and time to recover goods from the buyer. There is risk of loss of goods lying with the
Large investment:
The hire purchase seller has to invest considerable funds because payments are received from
buyers over a long period of time.
Unit 3 Notes
Q, Discuss evaluation of factoring in India.
Evaluation of Factor
The factor or factoring company is the specialized financial organization that you sign a
factoring contract with.

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This contract establishes the framework within which you can sell your invoices to this
As soon as the contract is signed, you can send the factor your invoices as they are issued,
under the conditions established on beforehand.
Your factor pays the agreed amount and guarantees the collection of the trade receivable from
your customer when it is due.
Which tasks are handled by the factor?
The factor takes care of monitoring, managing and collecting your trade receivables:
monitors payment at the due date
conducts possible reminders
manages requests for potential extension
manages potential unpaid trade receivables
handles litigation, if necessary
How are the risks shared between the factor and the company?
Depending on the contract you have signed, you can:
either support your customer's unpaid invoices in the event it is insolvent, after unsuccessful
reminders from your factor (in this case, we speak of a contract with recourse), or
Choose to have your factor bear this risk, up to 100% of the trade receivable according to
your contract's negotiated terms. This is known as credit insurance (in this case, we speak of a
contract without recourse).
Evaluation of Factoring in India
Costs and Benefits of Factoring: From the point of view of the client there are two types of
costs involved:
Factoring Commission or Service Fee. It is paid for credit evaluation and collection and other
services and to cover bad debt losses. The amount of commission will depend on the total
volume of receivables and quality of receivables. The commission is expected to be higher
for without recourse factoring than the with recourse factoring.
Interest on advance granted by the factor to the firm.
Following benefit may be obtained from factoring:
Reduction of cost in collecting department
Reduction the bad debt loss
Important Points to be kept in Mind:
Factoring Commission is to be calculated on the receivables covered under factoring unless
otherwise mentioned.

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Gross advance is amount of receivables covered under factoring minus reserve, if any.
Net advance is Gross Advance minus up front interest on advance, if any, minus up front
commission, if any.
Rate of interest is to be applied always on Gross Advance.
For interest calculation time period is the age of the receivables.
Today factoring's rationale still includes the financial task of advancing funds to smaller
rapidly growing firms who sell to larger more creditworthy organizations. While almost
never taking possession of the goods sold, factors offer various combinations of money and
supportive services when advancing funds.
Q. What is Factoring? What are its characteristics?
Factoring is a financial transaction whereby a business sells its accounts
receivables (i.e., invoices) to a third party (called a factor) at a discount. In "advance"
factoring, the factor provides financing to the seller of the accounts in the form of a cash
"advance," often 70-85% of the purchase price of the accounts, with the balance of the
purchase price being paid, net of the factor's discount fee (commission) and other charges,
upon collection.

Financial management states, ―Factoring is a service involving the purchase by a financial
organization, called a factor, of receivables owned to manufacturers and distributors by their
customers, with the factor assuming full credit and collection responsibilities.‖
Factoring is a method used by some firms to obtain cash. Certain companies factor accounts
when the available cash balance held by the firm is insufficient to meet current obligations
and accommodate its other cash needs, such as new orders or contracts; in other industries,
however, such as textiles or apparel, for example, financially sound companies factor their
accounts simply because this is the historic method of finance.

The use of factoring to obtain the cash needed to accommodate a firm‘s immediate cash
needs will allow the firm to maintain a smaller ongoing cash balance. By reducing the size of
its cash balances, more money is made available for investment in the firm‘s growth.
Factoring enables you to :
Instantly turn your receivables into cash.
Avail credit protection for your receivables.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Take well informed credit decisions.

Outsource your sales ledger administration.
Factoring thus not only helps you in expanding your business ,but also provides you with an
efficient collection mechanism and protection against bad debts.
The three parties directly involved are: the one who sells the receivable, the debtor, and the
factor. The receivable is essentially a financial asset associated with the debtor's Liability to
pay money owed to the seller (usually for work performed or goods sold). The seller then
sells one or more of its invoices (the receivables) at a discount to the third party, the
specialized financial organization (aka the factor), to obtain cash. The sale of the receivables
essentially transfers ownership of the receivables to the factor, indicating the factor obtains
all of the rights and risks associated with the receivables. Accordingly, the factor obtains the
right to receive the payments made by the debtor for the invoice amount and must bear the
loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified of
the sale of the receivable, and the factor bills the debtor and makes all collections.
Critical to the factoring transaction, the seller should never collect the payments made by the
account debtor, otherwise the seller could potentially risk further advances from the factor.
There are three principal parts to the factoring transaction;
a.) The advance, a percentage of the invoice face value that is paid to the seller upon
b.) The reserve, the remainder of the total invoice amount held until the payment by the
account debtor is made and
c.) The fee, the cost associated with the transaction which is deducted from the reserve prior
to it being paid back the seller. Sometimes the factor charges the seller a service charge, as
well as interest based on how long the factor must wait to receive payments from the debtor.
Usually the period for factoring is 90 to 150 days. Some factoring companies allow even
more than 150 days.
Factoring is considered to be a costly source of finance compared to other sources of short
term borrowings.
Factoring receivables is an ideal financial solution for new and emerging firms without strong
financials. This is because credit worthiness is evaluated based on the financial strength of
the customer (debtor). Hence these companies can leverage on the financial strength of their
Bad debts will not be considered for factoring.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Credit rating is not mandatory. But the factoring companies usually carry out credit risk
analysis before entering into the agreement.
Factoring is a method of off balance sheet financing.
Cost of factoring=finance cost + operating cost. Factoring cost vary according to the
transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5%
to 3% per month depending upon the financial strength of the client's customer.
Indian firms offer factoring for invoices as low as 1000Rs
For delayed payments beyond the approved credit period, penal charge of around 1-2% per
month over and above the normal cost is charged (it varies like 1% for the first month and 2%
Factoring is a financing technique available to any type of company, in all business sectors
irrespective of its size, provided its customers are companies.
However, as for any financing, the financing organisation' s prior consent is necessary.
Factoring is a tool of receivable management employed to release funds tied up in credit
extended to customers.
1. Factoring is a service of financial nature involving the conversion of credit bills into cash.
Accounts receivables, bills recoverable and other credit dues resulting from credit sales
appear in the books of account as book credits.
2. The risk associated with credit are taken over by the factor which purchases these credit
receivables without recourse and collects them when due.
3. A factor performs at least two of the following functions:
i. Provides finance for the supplier including loans and advance payments.
ii. Maintains accounts, ledgers relating to receivables.
iii. Collects receivables.
iv. Protects risk of default in payments by debtors.
4. A factor is a financial institution which offers services relating to management and
financing of debts arising out of credit sales. It acts as another financial intermediary between
the buyer and seller.
5. Unlike a bank, a factor specialises in handling and collecting receivables in an efficient
manner. Payments are received by the factor directly since the invoices are assigned in favor
of the factor.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

6. Factor is responsible for sales accounting, debt collection and credit control protection
from bad debts, and rendering of advisory services to their clients.
7. Factoring is a tool of receivables management employed to release funds tied up in credit
extended to customers and to solve the problems relating to collection, delays and defaults of
the receivables.
Q. Explain the objectives and functions of Factoring?
To know who are providing the factoring facility.
To know the condition of the firms using the factoring facility.
To know the factors responsible for the growth of factoring in India.
To know the effect of growth of factoring in India.
To know as to how the firms are getting benefit by using the factoring facility.
Purchase and collection of debts
Sales ledger management
Credit investigation and undertaking of credit risk
Provision of finance against debts
Rendering consultancy services

Factoring Scheme

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Q. What are the types of factoring? Explain them.

Types of factoring
Full service factoring
With recourse factoring
Maturity factoring
Bulk factoring
Invoice factoring
Agency factoring
International factoring

Full Service factoring

Under this type a factor provides all kinds of services discussed above. Thus a factor provides
finance, administers the sales ledger, collects the debts at his risk and renders consultancy
service. This type of factoring is a standard one. If the debtors fail to repay the debts, the
entire responsibility falls on the shoulder of the factor since he assumes the credit risk also.
He cannot pass on this responsibility to his client and its also called as recourse factoring.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Factoring in its full form, or traditional factoring, is a continuous relationship between a

factor and the client (the supplier of goods and services to trade customers), in which the
factor purchases substantially all the trade debts of his client, arising from such sales, in the
normal course of doing business. This comprises all the factoring services, so that in return
for the agreed fees and finance charges, the client receives:
debt administration
collection of debts due
risk coverage, in case of non-payment of debt
This type of factoring is best suited for small and medium size companies, which have a swift
development and they need not only financing, but also administrative support and risk
coverage. It is also suited for large companies who target their exports to new markets.
Maturity factoring
Under this type, factor does not provide immediate cash payment to the client at the time of
assignment of debts. He undertakes to pay cash as and when collections are made from the
debtors. The entire amount collected less factoring fees is paid to the client immediately.
Hence it is also called collection factoring. When financing is not required, an arrangement is
made which comprises full administration of the sales ledger, collection from debtors and
protection against bad debts. This service is called maturity factoring.
Here no financing is involved but all other services are available. This lack of financing
makes the guarantees different. The risk consists only in debtors' risk; there is no seller's risk.
For the same reason, there are no financing commissions, the factor being remunerated
trough commission taxes.
The factor pays the client for the debts sold in one of the following ways:
After a certain period from the date of invoicing (i.e. 60 days), this being known as the
maturity period. The benefit of this method is that the client knows exactly when he will get
paid and can adjust his cash flow accordingly.
When every debtor pays his invoice or when the debtor is insolvable, on the condition that
the non-payment risk is insured
To apply for this service, the client is supposed to have enough finance resources; he
demands the factor to improve his weak debt administration, to diminish his indirect costs
and to ensure coverage against non-payment risk.
Recourse factoring

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Here the factor does not assume the credit risk. In other words, if the debtors do not repay
their dues in time, and if their debts are outstanding beyond a fixed period, say 60 to 90 days
from the due date, such debts are automatically assigned back to the client. The client has to
take up the work of collection of overdue account by himself. If the client wants the factor to
go on with the collection work of overdue accounts, the client has to pay extra charges called
refactoring charges.
Recourse factoring normally describes the service by which the factor provides finance for
the client and carries out the functions of sales ledger administration and collections, but does
not protect the client against bad debt.
Invoice factoring
Here the factor simply provides finance against invoices without undertaking any other
functions. All works connected with sales administration, collection of dues, etc., have to be
done by the client himself. The debtors are not at all notified and hence they are not aware of
the financing arrangement. This type of factoring is very confidential in nature and hence
called undisclosed factoring.
For the clients who need finance for the trade credit requirements of their debtors, but no
administrative service or risk coverage, another service is extensively provided by the
factoring companies.
In recent years, the service of invoice discounting has been more usually provided on a whole
turnover basis, by including all the client's sales or all his sales to particular customers. The
client maintains the sales ledger and collects from the debtors on behalf of the factor to whom
the ownership of the debts has been transferred, and arrangements are made for the proceeds
of collections to be paid by the client directly to the factor's bank account.
International factoring
For many companies, selling in an international market place is the ultimate challenge.
Different customs, currency systems, laws and languages still create barriers to trade.
International factoring provides solutions regardless of whether the exporter is a small
organization or a major corporation, being used by exporters who sell on open account or
documents against acceptance terms
International factoring provides the following benefits to the exporters:
Increased sales in foreign markets by offering competitive terms of sale
Protection against credit losses on foreign customers
Accelerated cash flow through faster collection
Lower costs than the aggregate charges for L/C (letter of credit) transactions

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

International factoring provides also benefits for the importers:

Purchase on convenient 'open account' terms
No need to open L/C
Expanded purchasing power without blocking existing lines of credit
Orders can be placed swiftly without incurring delays, L/C opening charges etc.

Q. Discuss the legal aspects of factoring?

Legal aspects of factoring
(1) The client gives an undertaking to sell and the factor agrees to purchase receivables
subject to terms and conditions mentioned in the agreement.
(2) The client warrants that the receivables are valid enforceable, undisputed and recoverable.
He also undertakes to settle disputes, damages and deduction relating to the bills assigned to
the factor.
(3) The client agrees that the bills purchased by the factor on a non-recourse basis (i.e.
approved bills) will arise only from transactions specifically approved by the factor or those
falling within the credit limits authorized by the factor.
(4) The client agrees to serve notices of assignments in the prescribed form to all those
customers whose receivables have been factored.
Q. Describe the advantages and disadvantages of factoring?
Factoring Advantages
Time Savings: Factoring can save you time and effort that would otherwise be spent on
collecting from customers. That energy can be redirected to other business-building
endeavors, like sales, marketing and client development.
Good Use for Growth: You can use the instant cash to generate growth, maybe hiring another
salesperson who will bring in more business; or buy an advertisement that will reach new
customers; or buy a piece of equipment that will accelerate production.
Doesn‘t Require Collateral: Unlike traditional bank loans, factoring doesn‘t require you to
risk your home or other property as collateral.
Qualify for More Funding: Factoring firms will typically give a cash advance on up to 80%
of your receivables, says Napolitano. That may be more than you would be able to get from a
Factoring provides a large and quick boost to cash flow. This may be very valuable for
businesses that are short of working capital. A business that is owed £500,000 may be able to
get £400,000 or more in just a few days.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Other advantages:
There are many factoring companies, so prices are usually competitive.
It can be a cost-effective way of outsourcing your sales ledger while freeing up your time to
manage the business.
It assists smoother cash flow and financial planning.
Some customers may respect factors and pay more quickly.
You may be given useful information about the credit standing of your customers and they
can help you to negotiate better terms with your suppliers.
Factors can prove an excellent strategic as well as financial resource when planning business
You will be protected from bad debts if you choose non-recourse factoring cash is released as
soon as orders are invoiced and is available for capital investment and funding of your next
Factoring Disadvantages:
The Stigma: The most common thing small business owners don‘t know about factoring,
Napolitano says, is that their customers are notified when a factor takes the receivables over.
―The customers are no longer paying you, they‘re paying the factoring company,‖ he says.
That may alert them to your cash flow trouble.
Less Control: Once you accept cash for your receivables, you give up a measure of control.
For example, the factoring company could deny your ability to do business with a particular
customer because of its poor credit history or rating, says Napolitano.
The Cost: While it may be necessary to have immediate access to cash, it will come at higher
price than loans. Factoring companies usually keep between 1% and 4% of a receivable as
their fee. Additionally, Napolitano says, they charge interest on the cash advance, typically at
prime rate plus 2%. That all can add up to more than 30% in annual interest.
Other Disadvantages:
The cost will mean a reduction in your profit margin on each order or service fulfilment.
It may reduce the scope for borrowing - book debts will not be available as security.
Factors may want to vet your customers and influence the way that you do business.
It may be difficult to end an arrangement with a factor as you will have to pay off any money
they have advanced you on invoices if the customer has not paid them yet.
Some customers may prefer to deal directly with you.
How the factor deals with your customers will affect what your customers think of you. Make
sure you use a reputable company that will not damage your reputation.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

You have to pay extra to remove your liability for bad debtors.
Example of factoring Org.
India Factoring (India Factoring & Finance Solutions Pvt Ltd), a joint venture of the state-
owned Punjab National Bank (PNB), Malta-based FIM Bank Group, Italy-based Banca IFIS,
and Blend Financial Services, Mumbai, is expanding its factoring services in the state.
Q. Differentiate between factoring and credit Insurance?
Factoring vis-à-vis credit Insurance
Factoring is the process where one company buys its receivables from another company. The
party buying these receivables, which may come in the form of invoices, are known as the
‗factor‘, and purchase these at a discounted rate to their actual value.
In ‗advance factoring‘ cases, a proportion of the agreed selling price of the receivables is paid
to the selling party, with the rest following suit once the factor has collected the receivables
themselves in full from the original debtor. Where ‗maturity factoring‘ is used, there is no
such advance payment, and the agreed price is paid once the value of the receivables has been
collected by the factor.
This can benefit the selling party in situations when their customers or debtors may be
unreliable, or are in a position that could hinder their ability to pay what they owe them, such
as insolvency. In cases such as this, factoring can provide piece of mind to the selling party,
who subsequently avoids the risk of losing out on payments and the threat of bad debt.
However this comes at a price, due to the receivables being sold at a discount to the factor
there is some loss of receivables.
Credit Insurance
Credit insurance is different to factoring, in that there is no ‗factor‘ that buys the receivables
of another company. Instead credit insurers work with a company to analyze their customer
base, and identify which particular debtors may pose the highest risk of failing to pay their
trade credit debts.
Once these are identified, credit insurers establish ‗credit limits‘ for each customer, which
reflects the agreed amount they insure those particular customers against, should they fail to
pay their trade credit debts.
Credit insurance can greatly benefit a company, as the policy holder will be protected against
bad debt and cases of customer insolvency. The credit limits placed on customers can also be
negotiated, should the policy holder wish to increase these values. A company can choose to
insure against all their customers, or a select few, however should bear in mind that the

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

number of customers and value of the credit limits on each one will be reflected in the price
of taking out a policy.
Trade credit insurers insure against the risk of non-payment. Most insurers also offer
additional products, such as collections services, buyer/country rating, portfolio assessment
and securitization.

Q. Differentiate between Bill discounting and Factoring?

Bill Discounting

While discounting a bill, the Bank buys the bill (i.e. Bill of Exchange or Promissory Note)
before it is due and credits the value of the bill after a discount charge to the customer's
account. The transaction is practically an advance against the security of the bill and the
discount represents the interest on the advance from the date of purchase of the bill until it is
due for payment.
Difference between Bill discounting and Factoring
1. Bill discounting is always with recourse whereas factoring can be either with recourse or
without recourse.
2. In Bill discounting the drawer undertakes the responsibility of collecting the bills and
remitting the proceeds to the financing agency, while the factor usually undertakes to collect
the bills of the client.
3. Bills discounting facility implies provision of finance and only that, but a factor also
provides other services like sales ledger maintenance and advisory services.
4. Discounted bills may be rediscounted several times before they mature for payment. Debts
purchased for factoring cannot be rediscounted, they can only be refinanced.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

5. Factoring implies the provision of bulk finance against several unpaid trade generated
invoices in batches; bill financing is individual transaction oriented i.e. each bill is separately
assessed and discounted.
6. Bills discounting does to involve assignment of debt as is the case with factoring.
Q. State the scope of factoring in India?
Factoring in India
Many global institutions, such as the World Bank, International Monetary Fund, and Asian
Development Bank, have put India‘s growth forecast at between 7.5-8 per cent, calling it the
fastest expanding national economy.
Industrial growth is slowly picking up. The government has given a huge impetus to
infrastructure activities and taken several steps to foster economic development, of which
factoring can take advantage.
Factoring companies in India do offer various types of services depending upon client needs,
including recourse and non-recourse factoring, domestic and international factoring, and
disclosed and undisclosed factoring. Most deals done in India are with recourse to the
corporate, since the factoring company and bank are not able to cover the credit risk on the
buyer. This is mainly because credit insurance is not allowed, as per regulations in India, for
the purpose of factoring. Thus, there is a need to build a suitable institutional infrastructure
which will not only enable an efficient and cost effective factoring and reverse factoring
process to be put in place, but also ensure sufficient liquidity is created for all stakeholders
through an active secondary market for the same.

In order to address this issue, the Reserve Bank of India (RBI) published a concept paper on
‗Micro, Small & Medium Enterprises (MSME) Factoring-Trade Receivables Exchange‘ in
2014. It involved the setting up of an institutional mechanism for financing trade receivable
known as a ‗Trade Receivables Discounting System‘ (TReDS). The transactions processed
under TReDS will be non-recourse to the sellers. TReDS will provide the platform to bring
sellers, buyers, and financiers together for facilitating uploading, accepting, discounting,
trading, and settlement of MSME invoices. Initially TReDS would facilitate the discounting
of these factoring units by the financiers resulting in flow of funds to the MSMEs with final
payment of the factoring bill being made by the corporate buyer to the financier on due date.
Later on, TReDS would enable further discounting /re-discounting of the discounted
factoring units by the financiers, thus resulting in assignment in favors of other financiers.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

The RBI is expected to release further information on the functioning of the exchange once
the TReDS exchange operator is identified.
It is felt by many that things can be done to improve the market opinion and share of
factoring in the country, such as: creation of greater awareness, especially among MSMEs, on
the benefits of both domestic and export factoring; addressing the liquidity constraints facing
factors; factors and regulators simplifying products and transactions; a review of why
factoring companies are not allowed to avail of credit insurance; clarification on whether the
exemption granted in the Factoring Regulation Act, 2011 overrides existing state stamp laws
on assignment; and standardizing seller balance sheet treatment with regard to non-recourse
Growth of the Factoring industry in India and Abroad
Slow growth reasons:
The overall worldwide growth in factoring is estimated at 12%. Europe has the largest market
representing 64% of the world volumes with a growth of 18% during the year. America's
growth was 10%, whereas Australia recorded impressive growth of 40%. Asia saw a fall in
The growth trends mentioned above support the fact that there is enormous scope for
expansion worldwide and India is no exception to this. The potential in India is estimated at
an annual turnover of Rs. 15000 to Rs. 20000 cr, but large portion is untapped because of the
following reasons
Factoring is a standalone Product: Factoring is similar to Bill Discounting- What people fail
to understand is that though it is similar only in one aspect, i.e., both provides short term
finance against receivables, factoring also provides a package of other services.
Non-Recourse factoring is almost missing: Recourse factoring only provides financing but
not credit covers, whereas in case of non-recourse factoring, in the event of default of a
customer, the factor will bear the risk of bad debt. However, the facility, which will attract
more clients, is almost missing, in India Customers are still not aware of factoring Services:
Factors have not been successful in creating awareness about the concept of factoring. The
difference between factoring and bills discounting is still not clearly understood. The
customers are still not aware of the extra benefits and services they can enjoy through
factoring; they are not demanding these services from factoring service providers.
Bankers do not permit their Customer to Shift their Business to Factors: Every businessman
invariably has dealings with a bank. Hence, his banker does not permit him to shift his
account receivables business to a factor, but promises to meet his requirements.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Network of branches is poor for factoring.

Q. Discuss the future plans of factoring in India.
Future Trends
There have been various measures undertaken recently in trying to address the challenges
faced by the factoring industry, and increase the scope for factoring across the country. The
Enactment of the Factoring Regulation Act, 2011, was done with the aim of regulating
assignment of receivables in favour of factors, and delineating the rights and obligations of
parties to assignment of receivables. Broad features of the act include: assignment of debts
under factoring being exempted from stamp duty; assignment of debts being provided with
legal recognition; and notice of assignment being made mandatory.
In addition to the launch of TReDS, the RBI has introduced factors as a new category of non-
banking financial company (NBFC). It has also simplified the eligibility criteria with regard
to principal business – the NBFC Factor needs to ensure that financial assets in the factoring
business constitute at least 50 per cent of its total assets, and that its income derived from
factoring business is not less than 50 per cent of its gross income, as against 75 per cent
previously. RBI rulings mean factors can now also access credit information from credit
In order to facilitate factoring transactions for MSMEs, the government has approved
establishment of a Credit Guarantee Fund For Factoring (CGFF), set at Rs. 500 crore. The
credit guarantee for factoring has the advantage of motivating the factors to increase their
lending to MSMEs against factored debts by partially sharing their risk, and leading to an
increase in actual availability of credit to MSMEs.
These steps, along with the improved economic sentiment, should help drive factoring
industry development and change the face of conventional working capital finance in the
country.Current developments
Historically, factoring has shown positive correlation to growth in the manufacturing sector.
As the manufacturing base of a country expands, the scope for factoring also increases.
At the micro level, factoring is tailor-made for a company on the path of high-octane growth;
just as at the macro level it is suited for a growing economy like India.
There is only one direction in which factoring can go in India: upwards.
As the awareness level about the benefits of factoring increases, factoring will spread its
wings across the length and breadth of the country.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

It is not perhaps a coincidence that the rise of factoring in India has coincided with the rise of
Global Trade Finance Ltd.
(GTF) to the forefront. In every industry, every once in a while, a player suddenly emerges
who changes the entire paradigm of the business. In India, ICICI Bank did this to retail
We believe that GTF is in a position to do that to factoring.
Q. What is forfeiting? Explain its features?
The term ‗forfeit‘ is a French word denoting ‗to give something. Under forfeiting the exporter
gives up his right to receive payments in future under an export bill for immediate cash
payments by the forfeiter.
Forfeiting has been defined as ―the non- recourse purchase by a bank or any other financial
institution of receivables arising from an export of goods and services‖
The right to receive payment on the due date passes on to the forfeiter.
In trade finance, forfeiting is a financial transaction involving the purchasing
of receivables from exporters by a forfeiter. The forfeiter takes on all the risks associated with
the receivables but earns a margin.
The forfeiting is a transaction involving the sale of one of the firm's transactions. Forfeiting
is a mechanism by which the right for export receivables of an exporter (Client) is purchased
by a Financial Intermediary (Forfeiter) without recourse to him.
Exporter under Forfeiting surrenders his right for claiming payment for services rendered or
goods supplied to Importer in favor of Forfeiter.
Bank (Forfeiter) assumes default risk possessed by the Importer. Credit Sale gets converted
as Cash Sale. Forfeiting is arrangement without recourse to the Exporter (seller). Operated on
fixed rate basis (discount). Financing is available for up to 100% of value (unlike in
Factoring). It was introduced in the country in 1992.
Q. Explain how forfeiting works or what‘s the process of forfeiting?
How to Apply
The following is how forfeiting would normally apply:
The forfeiter gives commitment to purchase the export deal.
Both exporter and buyer of sign a commercial contract.
The product is delivered.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Bank gives guarantee to the buyer/importer.

Buyer hands over documents to the exporter.

Exporter delivers documents (or notes, etc.) to forfeiter.
Forfeiter discounts documents and pays exporter.
Forfeiter presents documents to the buyer's bank for payment at maturity.
Importer/buyer re-pays bank at maturity.




Q. Differentiate between factoring and forfeiting?

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services



Extent of Finance Usually 75 – 80% of the value 100% of Invoice value

of the invoice

Credit Worthiness Factor does the credit rating in The Forfeiting Bank relies
case of non-recourse factoring on the creditability of the
transaction Availing Bank.

Services provided Day-to-day administration of No services are provided

sales and other allied services

Recourse With or without recourse Always without recourse

Sales By Turnover By Bills

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Q. What are the advantages and disadvantages of forfeiting?

100 % Risk Cover
Country Risk (Political & Transfer Risk), could be absorbed without recourse or residual
Currency Risk: Floating exchange rates can have the effect of changing the contract value by
a considerable amount when converted into the exporter‘s own currency, and can lead to a
loss for the eventual holder of the claim.
Commercial Risk: Inability or unwillingness of the obligor or guarantor to fulfill its
obligations on due date.
Interest Rate Risk: All forfeiting cost (discount, days of grace, commission) are binding and
remain unchanged during the whole financing period.
Instant Cash
You could generate instant cash which relieves your balance sheet and improves your
liquidity. Your credit sale is transformed into a cash sale.
Flexibility and Simplicity
Simple documentation is generally achieved even for tailor-made financing solutions.
Complete credit administration and collection including relevant costs will be handled by the
Exporters improve their liquidity as they are paid in cash, without changing their borrowing
capacity and without making use of their money or policies.
It eliminates future political and administrative risks, such as trading risks and those related
to the exchange rate of the currencies involved, which means it is possible to know how
much the operation will cost, at a fixed interest rate, beforehand.
It saves on administration and collection costs.
No initial payment is necessary.
It is possible to offer clients longer payment periods, which is a tremendous advantage from a
commercial point of view.


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The main disadvantage, as in the case of factoring and confirming, is the high interest rates
and the fact that the forfeiter assumes the risk.
The exchange and administrative controls in some countries.
Importers are often not very willing to offer collateral or a guarantee.

Unit 4 Notes

Q. What is securitization? Explain its scope.


Securitization of debt or asset refers to the process of liquidating the illiquid and long term
assets like loans and receivables of financial institutions like banks by issuing marketable
securities against them. In other words it is a technique by which a long term, nonnegotiable
and high valued financial asset like hire purchase is converted into securities of small values
which can be tradable in the market just like shares.

Generally, extension of credit by banks and other financial institutions in the form of bills
purchase or discounting or hire purchase financing appears as an asset on their balance
sheets. Some of these assets are long term in nature and it implies that funds are locked up
unnecessarily for an undue long period. So to carry on their lending operations without
interruptions, they have to rely upon various other sources of finance which are not only
costly but are also not available easily.
Now, securitization is a readymade solution for them .It helps them to recycle funds at a
reasonable cost and with less credit risk. So it helps to remove these assets from the balance
sheets of financial institution by providing liquidity through tradable financial instruments.
From the risk management point of view , the lending financial institution have to absorb the
entire credit risk by holding the credit outstanding in their own portfolio. Securitization offers
a good scope for risk diversification.
As per Section 2 (z), "securitization" means acquisition of financial assets by any
securitization company or reconstruction company from any originator, whether by raising of
funds by such securitization company or reconstruction company from qualified institutional

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buyers by issue of security receipts representing undivided interest in such financial assets or

―Securitization is nothing but liquefying assets comprising loans and receivables of an

institution through systematic issuance of financial instruments‖
"Securitization" refers to the process of turning assets into securities -- financial instruments
that can be readily bought and sold in financial markets, the way stocks, bonds and futures
contracts are traded. When used in relation to real estate, securitization means taking
mortgages issued by banks and other lenders and converting them into securities that can be
sold to investors.

Scope of securitization
Additional source of fund: the originator is much benefited because securitization provides an
additional source of funds by converting an otherwise illiquid asset into ready liquidity. As a
result there is an immediate improvement in the cash flow of the originator. Thus, it acts as a
source of liquidity.
Greater profitability: securitization helps financial institution to get liquid cash from medium
term and long term assets immediately rather than over a longer period. It leads to greater
recycling of funds which, in turn, leads to higher business turnover and profitability. Again
the cash flows could be recycled for investment in higher yielding assets. This means greater
profitability. Moreover, economics of scale can be achieved since securitization offers scope
for the fuller utilization of the existing capabilities by providing liquid cash immediately. It
results in additional business turnover.
Enhancement of capital adequacy ratio: securitization enables FIs to enhance their capital
adequacy ratio by reducing their assets volume. The process of securitization necessitates the
selection of a pool of assets by the FIs to be sold or transferred to another institution called
SPV. Once the assets are transferred, they are removed from the balance sheet of the
Spreading of credit risk: securitization facilitates the spreading of credit risk to different
parties involved in the process of securitization. In the absence of securitization the entire
credit risk associated with a particular financial transaction has to be borne by the originator
himself. Now the originator is able to diversify the risk factors among the various parties
involved in securitization. Thus, securitization helps to achieve diversification of credit risks

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which are greater in the case of medium term and long term loans. Thus, it is used as tool for
risk management.
Lower cost of funding: In view of enhancement of cash flows and diversification of risk
factors, securitization enables the originator to have an easy access to the securities market at
debt ratings higher than its overall corporate rating can issue asset backed securities at lower
interest due to high credit rating on such securities
Provision of multiple instruments: form the investors point of view, securitization provides
multiple new investment instruments so as to meet the varying requirements of the investing
public. It also offers varieties of instruments for other financial intermediaries like mutual
funds, insurance, pension funds, etc.
Higher rate of return: when compared to traditional debt securities like bonds and debentures,
securitized securities offer better rate of return along with better liquidity. These instruments
are rated by good credit rating agencies and hence more attractive.
Prevention of idle capital: in the absence of securitization, capital would remain idle in the
form of ill- liquid assets like mortgagees, term loans, etc. in many of the lending institutions.

Q. Write a short note on Residential Real Estate.

Securitization of Residential Real Estate
Securitization of residential mortgages is the mother of all securitizations. Residential
mortgage-backed securities (RMBS) are generally passed through securities or bonds based
on cash flows from residential home loans, as opposed to commercial real estate loans.

Evidently enough, the residential mortgage market was one of the most appropriate
applications of securitization. That is why, for good reasons, some or the other way of
refinancing mortgages has been found in most parts of the world. If in USA, it was
securitization, in Europe, a traditional mortgage funding instrument, brief has been in vogue
for almost 200 years.

There are two very strong reasons for RMBS being tuned to securitization: one, the long
maturities of residential mortgages, and two, the fact that mortgage lending is backed by
charge over real estate, which is a strong asset-backing enabling the investors to take an
independent exposure on the receivables. The govt. support to development of secondary
markets in mortgages has also been a strong reason, and the governments easily took this as
one of their major welfare activities.

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Q. Write a short note on Securitization as a Funding Mechanism.

Securitization as a Funding Mechanism

Securitization deals with the conversion of assets, which are not marketable, into marketable
ones. Simply put, securitization means the conversion of existing or future cash in-flows of
any person into tradable security, which then may be sold in the market. The cash inflow
from financial assets such as mortgage loans, automobile loans, trade receivables, credit card
receivables, fare collections become the security against which borrowings are raised. In fact,
even individuals can take the help of securitization instruments for better economic
For the purpose of distinction, the conversion of existing assets into marketable securities is
known as asset-backed securitization and the conversion of future cash flows into marketable
securities is known as future-flows securitization.
A versatile financing tool, securitization enables customization to meet client needs across a
wide range of industries in a variety of financing situations with existing or future receivable
cash flows. It offers many unprecedented benefits - the most significant being that the
transaction can enjoy a credit rating much higher than that of the originator.
This is because the lender is assured of regular cash inflows, there is an enhanced element of
creditworthiness and therefore, the lender may be open to offering the loan at a lower rate of
To cite an example, an individual having regular inflows by way of rent from property can
raise a loan by offering his rent receivables as security i.e. the rent receipts will first be used
to pay the loan and then for other purposes.
An established financing tool in developed economies, securitization is fast becoming an
increasingly important source of financing in emerging markets. Across the world,
securitization is being perceived as a means of providing access to diversified sources of
The following parties are involved in securitization
the originator
a special; purpose vehicle or a trust
A merchant or investment banker
A credit rating agency
A servicing agent

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The original borrower

The prospective investors
The process and participants in funding
Section 5 of the Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002, mandates that only banks and financial institutions can securitise
their financial assets.
In the traditional lending process, a bank makes a loan, maintaining it as an asset on its
balance sheet, collecting principal and interest, and monitoring whether there is any
deterioration in borrower's creditworthiness.
This requires a bank to hold assets (loans given) till maturity. The funds of the bank are
blocked in these loans and to meet its growing fund requirement a bank has to raise additional
funds from the market. Securitization is a way of unlocking these blocked funds.

Explanation with Example

Consider a bank, ABC Bank. The loans given out by this bank are its assets. Thus, the bank
has a pool of these assets on its balance sheet and so the funds of the bank are locked up in
these loans. The bank gives loans to its customers. The customers who have taken a loan
from the ABC bank are known as obligors.
To free these blocked funds the assets are transferred by the originator (the person who holds
the assets, ABC Bank in this case) to a special purpose vehicle (SPV).
The SPV is a separate entity formed exclusively for the facilitation of the securitization
process and providing funds to the originator. The assets being transferred to the SPV need to
be homogenous in terms of the underlying asset, maturity and risk profile.

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What this means is that only one type of asset (eg: auto loans) of similar maturity (eg: 20 to
24 months) will be bundled together for creating the securitized instrument. The SPV will act
as an intermediary which divides the assets of the originator into marketable securities.
These securities issued by the SPV to the investors and are known as pass-through-
certificates (PTCs).The cash flows (which will include principal repayment, interest and
prepayments received ) received from the obligors are passed onto the investors (investors
who have invested in the PTCs) on a pro rata basis once the service fees has been deducted.
The difference between rate of interest payable by the obligor and return promised to the
investor investing in PTCs is the servicing fee for the SPV.
The way the PTCs are structured the cash flows are unpredictable as there will always be a
certain percentage of obligors who won't pay up and this cannot be known in advance.
Though various steps are taken to take care of this, some amount of risk still remains.
The investors can be banks, mutual funds, other financial institutions, government etc. In
India only qualified institutional buyers (QIBs) who possess the expertise and the financial
muscle to invest in securities market are allowed to invest in PTCs.
Mutual funds, financial institutions (FIs), scheduled commercial banks, insurance companies,
provident funds, pension funds, state industrial development corporations, et cetera fall under
the definition of being a QIB. The reason for the same being that since PTCs are new to the
Indian market only informed big players are capable of taking on the risk that comes with this
type of investment.
In order to facilitate a wide distribution of securitized instruments, evaluation of their quality
is of utmost importance. This is carried on by rating the securitized instrument which will
acquaint the investor with the degree of risk involved.
The rating agency rates the securitized instruments on the basis of asset quality, and not on
the basis of rating of the originator. So particular transaction of securitization can enjoy a
credit rating which is much better than that of the originator.
High rated securitized instruments can offer low risk and higher yields to investors. The low
risk of securitized instruments is attributable to their backing by financial assets and some
credit enhancement measures like insurance/underwriting, guarantee, etc used by the
The administrator or the servicer is appointed to collect the payments from the obligors. The
servicer follows up with the defaulters and uses legal remedies against them. In the case of
ABC bank, the SPV can have a servicer to collect the loan repayment installments from the
people who have taken loan from the bank. Normally the originator carries out this activity.

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Once assets are securitized, these assets are removed from the bank's books and the money
generated through securitization can be used for other profitable uses, like for giving new
For an originator (ABC bank in the example), securitization is an alternative to corporate debt
or equity for meeting its funding requirements. As the securitized instruments can have a
better credit rating than the company, the originator can get funds from new investors and
additional funds from existing investors at a lower cost than debt.
Q. What are asset backed security.

Asset-backed security
An asset-backed security is a security whose value and income payments are derived from
and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is
typically a group of small and illiquid assets that are unable to be sold individually. Pooling
the assets into financial instruments allows them to be sold to general investors, a process
called securitization, and allows the risk of investing in the underlying assets to be diversified
because each security will represent a fraction of the total value of the diverse pool of
underlying assets. The pools of underlying assets can include common payments from credit
cards, auto loans, and mortgage loans, to secret cash flows from aircraft leases, royalty
payments and movie revenues.
Asset securitization needs :-
Robust financial infrastructure
The Legal Environment
The Accounting Environment
The Regulatory Environment
The Taxation Environment
Back-office Systems

Benefits to Originator
•Off balance sheet financing
•Regulatory capital relief
•Multiple alternative sources of funding
•Conversion of illiquid assets into liquid securities
•Systemically solves ALM problems in the sector - mismatch due to difference in tenor and
characteristics of assets (mostly fixed rate and up to 30 years) and liabilities

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Benefits to Investor
•Enjoys low cost operations and servicing due to economies of scale of the originator
•Credit risk is minimized
–Exposure on rated, low-risk housing loans
–Expertise of originators helps maintain quality of underlying assets
–Credit enhancement possible

Benefits to Financial System

•Cleaner books due to expertise of originators
•Systemically solves the ALM problems in the sector
•Encourages an efficient market
•Results in substantial benefits to the end customer of home loans

Q. What are Asset and mortgage backed security?

Asset and mortgage backed security

Asset-backed securities (ABS) and mortgage-backed securities (MBS) are two important
types of asset classes. MBS are securities created from the pooling of mortgages, and then
sold to interested investors, whereas ABS have evolved out of MBS and are created from the
pooling of non-mortgage assets. These are usually backed by credit card receivables, home
equity loans, student loans and auto loans. The ABS market was developed in the 1980s and
has become increasingly important to the U.S. debt market.
There are three parties involved in the structure of ABS and MBS: the seller, the issuer and
the investor. Sellers are the companies that generate loans and sell them to issuers. They also
take the responsibility of acting as the servicer, collecting principal and interest payments
from borrowers. Issuers buy loans from sellers and pool them together to issue ABS or MBS
to investors. They can be a third-party company or special-purpose vehicle (SPV). ABS and
MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to
acquire additional funding. Investors of ABS and MBS are usually institutional investors and
they use ABS and MBS to obtain higher yields than government bonds, as well as to provide
a way to diversify their portfolios.

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Most bonds backed by mortgages are classified as an MBS. This can be confusing, because a
security derived from an MBS is also called an MBS.
Mortgage-Backed Securities (MBS) are bank originated securities that are backed by a pool
of either residential or commercial mortgage loans. These securities therefore represent
payment claims against an SPV that are backed by a pool of secured loans, i.e. mortgages that
comprise cash flows from real estate loans. In short these securities represent derivative real
estate cash flows.

Building on the definition of a bond, a mortgage-backed security (MBS) is an asset-backed

security that represents a claim on the cash flows from mortgage loans through a process
known as securitization.

A bond is an obligation on behalf of the bond issuer to make interest payments to the bond
holder until the bond matures (or comes due). At that time, the bond issuer pays the face
value of the bond to the bond holder and the bond is termed matured or redeemed. The 'face'
value of the bond usually remains the same throughout the life of the bond. In the case of
MBSs, the bond issuer is a collection of mortgages. The interest payments to the bond holder
are the interest payments being made on those mortgages. The process of securitization
determines which mortgages are brought together.
There is one concept, central to MBSs that needs to be understood. In the case of bonds, the
principal is usually paid back as a single payment to the bond holder at maturity. Since in the
case of mortgages, each periodic payment consists of principal and interest, this principal is
paid back to the MBS holder along with the interest payment. Thus the total face value of the
MBS is constantly reducing. We have a new term to help determine the principal outstanding
factor. The factor tells us what percentage of the original 'face' of the MBS remains to be
Thus, the MBS's structure is also known as a pass-through. Both interest payments and
principal payments are passed through to the MBS holder.
Many home loans do not remain in the lender's possession for very long. Instead, shortly after
issuing the loan, the lender will sell the mortgage to an investor on the secondary mortgage
market. The investor will often pool a number of mortgages together and sell them to other
investors as a financial security. This process of transforming home loans into securities is
known as "mortgage securitization," and carries with it a number of economic advantages.
Mortgage-backed security sub-types include:

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Pass-through securities are issued by a trust and allocate the cash flows from the underlying
pool to the securities holders on a pro rata basis. A trust that issues pass-through certificates
are taxed under the grantor trust rules of the Internal Revenue Code. Under these rules, the
holders of a pass-through certificate are taxed as a direct owner of the portion of the trust a
locatable to the certificate. In order for the issuer to be recognized as a trust for tax purposes,
there can be no significant power under the trust agreement to change the composition of the
asset pool or otherwise to reinvest payments received, and the trust must have, with limited
exceptions, only a single class of ownership interests.
A residential mortgage-backed security (RMBS) is a pass-through MBS backed by mortgages
on residential property.
A commercial mortgage-backed security (CMBS) is a pass-through MBS backed by
mortgages on commercial property.
A collateralized mortgage obligation or "Pay-through bond" are debt obligations of a legal
entity that is collateralized by the assets it owns. Pay-through bonds are typically divided into
classes that have different maturities and different priorities for the receipt of principal and in
some case of interest. They often contain a sequential pay security structure with at least two
classes of mortgage-backed securities issued, with one class receiving scheduled principal
payments and prepayments before any other class. For tax purposes, it is important for pay-
through securities to be classified as debt for income tax purposes.

Q. Describe benefits of MBS.

Benefits of MBS
Spreading Risk
From the perspective of investors, one of the chief advantages of mortgage securitization is
that it spreads the risk of a decline in loan value among a far larger number of parties. Instead
of a single lender taking on the risk of its mortgages, the risk is transferred to a wider pool of
investors. Investors can choose between safer securities, which usually generate lower rates
of interest, and riskier mortgages, which generally command higher rates.
More Market Participation
The securitization of mortgages has turned home loans into an asset with considerable
diversification, attracting a far greater number of investors than would the sale of individual
mortgages. This allows a larger number of participants into the mortgage market, helping to
increase the liquidity of the assets and establish a fairer market price. Unlike individual
mortgages, mortgage securities are sufficiently liquid--enough that they are routinely rated by

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major credit-rating agencies. These ratings provide valuable information to investors about
the soundness of the underlying mortgages.
Makes Capital Available
Before the advent of mortgage securitization, most lenders who issued loans would have to
keep them on their books and wait for money collected from mortgage payments to trickle in
before they had the capital necessary to make new loans. However, with mortgage
securitization, lenders can package the loans shortly after they are issued and sell them to
investors in exchange for the cash necessary to issue new loans. This allows more loans to be
issued, a benefit for both lenders and borrowers.
Lower Mortgage Rates
One of the advantages of securitization for mortgage holders is that a more liquid mortgage
market and a spreading out of risk eventually lead to lower interest rates on home loans.
While individual rates are still largely tied to a person's credit rating, mortgage rates as a
whole are made lower because securitization allows lenders to reduce costs. A paper
presented to the Federal Reserve Board finds a positive correlation between securitization and
lower rates of interest for home loans, suggesting that the savings enjoyed by lenders are
passed on to borrowers.
Q. Explain Real Estate or Property Securitization.

Real Estate or Property Securitization is defined by the Securitization of real estate assets, i.e.
real property or real estate receivables. In short Real Estate Securitization describes the
financing of property through the securitization of real estate cash flows and property values
without the bank as a lending intermediary. However, the bank will take part in the
transaction, not as the lending institution, but as the arranger of the financing. Therefore the
bank is not going to commit valuable equity. It will only earn the structuring fees. In this
constellation the lending spread can be distributed between the originator, the arranger and
the investors.

By a residential mortgage-backed security (RMBS), we mean a security that is created when

residential mortgages are packaged together to form a pool of mortgage loans and then one or
more debt obligations are issued backed by the cash flow generated from the pool of
mortgage loans. ―Backed‖ means that the principal and interest due to the investors in an
RMBS come from the principal and interest payments made by the borrowers whose loans

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are part of the pool of mortgages. A mortgage loan that is included in an RMBS is said to be
securitized, and the process of creating an RMBS is referred to as securitization.

Q. Explain the process of mortgage.

The Mortgage Process
The home mortgage process can often appear to be a daunting one, especially to first time
home buyers. While there is nothing simple about getting a mortgage, it does not have to be
difficult. It‘s up to your mortgage provider to communicate clearly with you through the
The Mortgage process has five primary steps –
1) Pre-Qualification
2) Loan Application
3) Interest Rate Lock
4) Loan Approval Process
5) Closing
Any one of these processes can appear to be lengthy and confusing. Virtually all of the
paperwork involved is required by state and federal law. Work with your mortgage provider
to ensure you understand each step of the process.
1) Pre-Qualification
Before a borrower begins their search for a new home, they should always be Pre-Approved.
This process helps to determine what they can afford. You can submit your Pre-Qualification
certificate with the purchase contract to the seller which enhances the offer and will make
you more attractive to the seller.
2) Loan Application
Once all parties have agreed to the purchase price and terms have been signed, there is an
executed contract, which becomes the foundation of the new mortgage. There are now 3 steps
that need to be accomplished by the borrower in order to proceed with the loan.
• Decide on a loan program.
• Sign all necessary loan documents
• Borrower must gather all their personal documentation to submit
3) Locking an Interest Rate
• The borrower may choose to lock their rate at the time of application or may choose to
float their loan to be locked at a later time.

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• Generally speaking, the best pricing is available at 30 and 45 day locks. Knowing the
closing date on the Purchase Contract helps us to determine the best time to lock the rate.
• Rates fluctuate every day. It is always a good idea to secure your rate as soon as you can
to avoid a surprise increase if the market rises.
4) The Approval Process
There are three major steps that are being accomplished between the client‘s application
signing and their closing.
• Appraisal - An appraisal is necessary to close your loan.
• Title and escrow - The real estate attorneys will generally order these services and then
forward the findings to so that we may include them in final package.
• Underwriting - Each loan will be sent to an approved underwriter who reviews the
application, supporting documentation, financial information, sales contract, appraisal and
title to be sure all necessary criteria and regulations are met.
5) Closing
• The day before closing, the title company will generate a final statement of charges that
incorporate the lender‘s, attorney‘s, realtor‘s and title fees as well as taxes and insurance
• On the closing day, you‘ll sign all final closing documents at a title company.
• Typically, your first mortgage payment will not start until the second of the month after
the closing date.

Q. What is Graduated-payment Mortgage?

Graduated-payment Mortgage: Type of fixed-rate mortgage in which the payment increases
gradually from an initial low base level to a desired final level. Typically, the payments will
grow 7-12% annually from their initial base payment amount until the full payment is
In a graduated payment mortgage, only the low initial rate is used to qualify the buyer, which
allows many people who might not otherwise qualify for a mortgage to own a home. This
type of mortgage payment system may be optimal for young homeowners as their income
levels gradually rise to meet higher mortgage payments.
GPM stands for "graduated payment mortgage", meaning a mortgage on which the payment
starts low and rises over time. Since the initial payment is used to qualify the borrower, the
GPM may allow a borrower to qualify who would not qualify with a standard fixed-rate
mortgage (FRM).

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The graduated payment mortgage seems to be an attractive option for first-time home buyers
or those who currently do not have the resources to afford high monthly home mortgage
payments. Even though the amounts of payments are drawn out and scheduled, it requires
borrowers to predict their future earnings potential and how much they are able to pay in the
future, which may be tricky. Borrowers could overestimate their future earning potential and
not be able to keep up with the increased monthly payments.
Eventually, even if the graduated payment mortgage lets borrowers save at the present time
by paying low monthly amounts; the overall expense of a graduated payment mortgage loan
is higher than that of conventional mortgages, especially when negative amortization is
GPMs are available in 30 year and 15 year amortization, and for both conforming and jumbo
mortgage. Over a period of time, typically 5 to 15 years, the monthly payments increase
every year according to a predetermined percentage. For instance, a borrower may have a 30-
year graduated payment mortgage with monthly payments that increase by 7% every year for
five years. At the end of five years, the increases stop. The borrower would then pay this new
increased amount monthly for the rest of the 25-year loan term.

Unit 5 Notes
Q. What are Depositories? Explain its evolution.
Meaning of depository
A depository is an organisation which holds securities (like shares, debentures, bonds,
government securities, mutual fund units etc.) of investors in electronic form at the request of
the investors through a registered Depository Participant. It also provides services related to
transactions in securities.
Evolution of Depository
A significant development of the 20th century particularly in its later part is expansion of
financial market world over which mostly was driven by globalization, technology,
innovations and increasing trade volume. India has not been an exception with probably
largest number of listed companies with a very large investor population and ever increasing
volumes of trades.

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However, this continuous growth in activities increased problems associated with stock
trading. Most of these problems arose due to the intrinsic nature of paper based trading and
settlement, like theft or loss of share certificates. This system required handling of huge
volumes of paper leading to increased costs and inefficiencies.
The process beginning from buying shares through the stock exchanges till getting the
certificates duly endorsed in the buyer‘s name was indeed quite complex and time-consuming
and was riddled with a variety of problems.
Growing number of investors participating in the capital market has increased the possibility
of being hit by a bad delivery, The cost and time spent by the brokers for rectification of
these bad deliveries tends to be higher with the geographical spread of the clients.
The increase in trade volumes lead to exponential rise in the back office operations thus
limiting the growth potential of the broking members. The inconvenience faced by investors
(in areas that are far flung and away from the main metros) in settlement of trade also limits
the opportunity for such investors, especially in participating in auction trading. The physical
form of holding and trading in securities also acted as a bottleneck for broking community in
capital market operations.
Risk exposure of the investor also increased due to this trading in paper. Some of these
associated risks were: delay in transfer of shares, possibility of forgery on various documents
leading to bad deliveries, legal disputes etc., and possibility of theft of share certificates,
prevalence of fake certificates in the market, mutilation or loss of share certificates in transit.
Thus, the system of security transactions was not as investor-friendly as it ought to be. In this
scenario dematerialized trading under depository system is certainly a welcome move. This
popular financial service emerged in Germany first time.
India has adopted the Depository System for securities trading in which book entry is done
electronically and no paper is involved. The physical form of securities is extinguished and
shares or securities are held in an electronic form. Before the introduction of the depository
system through the Depository Act, 1996, the process of sale, purchase and transfer of
securities was a huge problem, and there was no safety at all.
Q. What is depositories Act 1996?
Depositories Act, 1996
The Depositories Act, 1996 provides for the establishment of depositories in securities with
the objective of ensuring free transferability of securities with speed, accuracy and security
(a) making securities freely transferable subject to certain exceptions;

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(b) dematerialization of the securities in the depository mode; and

(c) providing for maintenance of ownership records in a book entry form. In order to
streamline the settlement process, the Act envisages transfer of ownership of securities
electronically by book entry. The Act has made the securities of all companies freely
transferable in the depository mode, restricting the company‘s right to use discretion in
effecting the transfer of securities. The other procedural and the transfer deed requirements
stated in the Companies Act have also been dispensed with.
Q. What do you mean by Dematerialization? What are the benefits of Demat?
Dematerialization Meaning
Dematerialization or ―Demat‖ is a process whereby your securities like shares, debentures
etc, are converted into electronic data and stored in computers by a Depository. Securities
registered in your name are surrendered to depository participant (DP) and these are sent to
the respective companies who will cancel them after ―Dematerialization‖ and credit your
depository account with the DP. The securities on Dematerialization appear as balances in
your depository account. These balances are transferable like physical shares. If at a later
date, you wish to have these ―demat‖ securities converted back into paper certificates, the
Depository helps you to do this.
Depository Participant
A Depository Participant (DP) is described as an agent of the depository. They are the
intermediaries between the depository and the investors. The relationship between the DPs
and the depository is governed by an agreement made between the two under the
Depositories Act, 1996. In a strictly legal sense, a DP is an entity who is registered as such
with SEBI under the provisions of the SEBI Act. As per the provisions of this Act, a DP can
offer depository related services only after obtaining a certificate of registration from SEBI.
Benefits of Demat
Transacting the depository way has several advantages over the traditional system of
transacting using share certificates. Some of the benefits are:
Trading in demat segment completely eliminates the risk of bad deliveries, which in turn
eliminates all cost and wastage of time associated with follow up for rectification. This
reduction in risk associated with bad delivery has lead to reduction in brokerage to the extent
of 0.5% by quite a few brokerage firms.
In case of transfer of electronic shares, you save 0.5% in stamp duty.
You also avoid the cost of courier/ notarization/ the need for further follow-up with your
broker for shares returned for company objection

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In case the certificates are lost in transit or when the share certificates become mutilated or
misplaced, to obtain duplicate certificates, you may have to spend at least Rs500 for
indemnity bond, newspaper advertisement etc, which can be completely eliminated in the
demat form.
You can also receive your bonuses and rights into your depository account as a direct credit,
thus eliminating risk of loss in transit.
You can also expect a lower interest charge for loans taken against demat shares as compared
to the interest for loan against physical shares. This could result in a saving of about 0.25% to
1.5%. Some banks have already announced this.
RBI has increased the limit of loans against dematerialized securities as collateral to Rs2mn
per borrower as against Rs1mn per borrower in case of loans against physical securities.
RBI has also reduced the minimum margin to 25% for loans against dematerialized securities
as against 50% for loans against physical securities.
Q. Explain some Key Features of the Depository System in India.
Key Features of the Depository System in India
1. Multi-Depository System: The depository model adopted in India provides for a
competitive multi-depository system. There can be various entities providing depository
services. A depository should be a company formed under the Company Act, 1956 and
should have been granted a certificate of registration under the Securities and Exchange
Board of India Act, 1992. Presently, there are two depositories registered with SEBI, namely:
National Securities Depository Limited (NSDL), and
Central Depository Service Limited (CDSL)
2. Depository services through depository participants: The depositories can provide their
services to investors through their agents called depository participants. These agents are
appointed subject to the conditions prescribed under Securities and Exchange Board of India
(Depositories and Participants) Regulations, 1996 and other applicable conditions.
3. Dematerialization: The model adopted in India provides for dematerialization of securities.
This is a significant step in the direction of achieving a completely paper-free securities
market. Dematerialization is a process by which physical certificates of an investor are
converted into electronic form and credited to the account of the depository participant.
4. Fungibility: The securities held in dematerialized form do not bear any notable feature like
distinctive number, folio number or certificate number. Once shares get dematerialized, they
lose their identity in terms of share certificate distinctive numbers and folio numbers. Thus all

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securities in the same class are identical and interchangeable. For example, all equity shares
in the class of fully paid up shares are interchangeable.
5. Registered Owner/ Beneficial Owner: In the depository system, the ownership of securities
dematerialized is bifurcated between Registered Owner and Beneficial Owner. According to
the Depositories Act, ‗Registered Owner‘ means a depository whose name is entered as such
in the register of the issuer. A ‗Beneficial Owner‘ means a person whose name is recorded as
such with the depository. Though the securities are registered in the name of the depository
actually holding them, the rights, benefits and liabilities in respect of the securities held by
the depository remain with the beneficial owner. For the securities dematerialized,
NSDL/CDSL is the Registered Owner in the books of the issuer; but ownership rights and
liabilities rest with Beneficial Owner. All the rights, duties and liabilities underlying the
security are on the beneficial owner of the security.
6. Free Transferability of shares: Transfer of shares held in dematerialized form takes place
freely through electronic book-entry system.
Q. Describe the advantages and disadvantages of Depository System?
Advantages of the Depository System
The advantages of dematerialization of securities are as follows:
Share certificates, on dematerialization, are cancelled and the same will not be sent back to
the investor. The shares, represented by dematerialized share certificates are fungible and,
therefore, certificate numbers and distinctive numbers are cancelled and become non-
It enables processing of share trading and transfers electronically without involving share
certificates and transfer deeds, thus eliminating the paper work involved in scrip-based
trading and share transfer system.
Transfer of dematerialized securities is immediate and unlike in the case of physical transfer
where the change of ownership has to be informed to the company in order to be registered as
such, in case of transfer in dematerialized form, beneficial ownership will be transferred as
soon as the shares are transferred from one account to another.
The investor is also relieved of problems like bad delivery, fake certificates, shares under
litigation, signature difference of transferor and the like.
There is no need to fill a transfer form for transfer of shares and affix share transfer stamps.
There is saving in time and cost on account of elimination of posting of certificates.
The threat of loss of certificates or fraudulent interception of certificates in transit that causes
anxiety to the investors, are eliminated.

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Disadvantages/Problems of the Depository System

Some disadvantages were about the depository system were known beforehand. But since the
advantages outweighed the shortcomings of dematerialization, the depository system was
given the go-ahead.
Lack of control: Trading in securities may become uncontrolled in case of dematerialized
Need for greater supervision: It is incumbent upon the capital market regulator to keep a
close watch on the trading in dematerialized securities and see to it that trading does not act
as a detriment to investors. The role of key market players in case of dematerialized
securities, such as stock brokers, needs to be supervised as they have the capability of
manipulating the market.
Complexity of the system: Multiple regulatory frameworks have to be confirmed to,
including the Depositories Act, Regulations and the various Bye Laws of various
depositories. Additionally, agreements are entered at various levels in the process of
dematerialization. These may cause anxiety to the investor desirous of simplicity in terms of
transactions in dematerialized securities.
Besides the above mentioned disadvantages, some other problems with the system have been
discovered subsequently. With new regulations people are finding more and more loopholes
in the system. Some examples of the malpractices and fraudulent activities that take place
Current regulations prohibit multiple bids or applications by a single person. But investors
open multiple demat accounts and make multiple applications to subscribe to IPOs in the
hope of getting allotment of shares.
Some listed companies had obtained duplicate shares after the originals were pledged with
banks and then sold the duplicates in the secondary market to make a profit.
Promoters of some companies dematerialized shares in excess of the company‘s issued
Certain investors pledged shares with banks and got the same shares reissued as duplicates.
There is an undue delay in the settlement of complaints by investors against depository
participants. This is because there is no single body that is in charge of ensuring full
compliance by these companies.
Q. Explain the process of dematerialization?

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To dematerialize your share certificates you have to:

Fill up a dematerialization request form, which is available with your DP;
Submit your share certificates along with the form; (write ―surrendered for demat‖ on the
face of the certificate before submitting it for demat)
Receive credit for the dematerialized shares into your account in 15 days.
Dematerialized shares do not have any distinctive or certificate numbers. These shares are
fungible – which means that 100 shares of a security are the same as any other 100 shares of
that security.
The investor can dematerialize only those certificates that are already registered in his name
and belong to the list of securities admitted for Dematerialization at NSDL. Shares held in
street name (market deliveries) cannot be dematerialized. If the share certificates that investor

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wants to dematerialize do not belong to the list of securities eligible for Dematerialization
specified by NSDL, he can approach the company and request them to sign up with NSDL to
make their securities available for Dematerialization. Odd lot share certificates can also be
No transfer deed is required for dematerializing certificates, the certificates have to be
accompanied by a demat request form (DRF) which can be obtained from DPs. It is
compulsory to mention the ISIN number of the company while filling up the Demat Request
form. This, to a certain extent, ensures that the security mentioned in the Demat Request
Form is the same as the one the investor intends to dematerialize. However, the investor need
not remember cryptic numbers and can take the help of his DP in filling these forms.
Dematerialization is not compulsory. According to the Depositories Act, 1996, an investor
has the option to hold shares either in physical or in dematerialized form. An investor can
hold part of his holdings in demat form and part of his holdings in the form of share
certificates for the same security.
Securities bearing the same distinctive numbers as demat securities can still float in the
market. It is a case of forged certificates and normal procedures that are being followed in the
physical market will be used to weed them out. The concerned stock exchanges where the
securities are listed are informed of the details of securities dematerialized and
An investor can dematerialize shares that are pledged with a bank, which is a DP as well.
Q. Explain in detail the Depository System.
The Depository System (NSDL and CDSL)
NSDL, the first and largest depository in India, established in August 1996 and promoted by
institutions of national stature responsible for economic development of the country has since
established a national infrastructure of international standards that handles most of the
securities held and settled in dematerialised form in the Indian capital market.

Although India had a vibrant capital market which is more than a century old, the paper-
based settlement of trades caused substantial problems like bad delivery and delayed transfer
of title till recently. The enactment of Depositories Act in August 1996 paved the way for
establishment of NSDL, the first depository in India. This depository promoted by institutions
of national stature responsible for economic developm1ent of the country has since
established a national infrastructure of international standard that handles most of the trading
and settlement in dematerialised form in Indian capital market.

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Using innovative and flexible technology systems, NSDL works to support the investors and
brokers in the capital market of the country. NSDL aims at ensuring the safety and soundness
of Indian marketplaces by developing settlement solutions that increase efficiency, minimise
risk and reduce costs. At NSDL, we play a quiet but central role in developing products and
services that will continue to nurture the growing needs of the financial services industry.

In the depository system, securities are held in depository accounts, which is more or less
similar to holding funds in bank accounts. Transfer of ownership of securities is done through
simple account transfers. This method does away with all the risks and hassles normally
associated with paperwork. Consequently, the cost of transacting in a depository environment
is considerably lower as compared to transacting in certificates.

The Depositories Act, 1996, defines a depository to mean "a company formed and registered
under the Companies Act, 1956 and which has been granted a certificate of registration under
sub-section (IA) of section 12 of the Securities and Exchange Board of India Act, 1992.

The principal function of a depository is to dematerialize securities and enable their

transactions in book-entry form. The securities are transferred by debiting the transferor's
depository account and crediting the transferee's depository account. A depository is very
much like a bank in many of its operations. We can draw an analogy between the two in
order to get a better understanding of the depository system.

Q. What are the Eligibility Criteria for a Depository?

Eligibility Criteria for a Depository – Any of the following may promote a depository:
1. A public financial Institution as defined in section 4A of the Companies Act, 1956;
2. A bank included in the Second Schedule to the Reserve Bank of India Act, 1934;
3. A foreign bank operating in India with the approval of the Reserve Bank of India;
4. A recognized stock exchange;
5. An institution engaged in providing financial services where not less than 75% of the
equity is held jointly or severally by these institutions;
6. A custodian of securities approved by Government of India, and
7. A foreign financial services institution approved by Government of India.

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The promoters of a depository are also known as its sponsors. A depository company must
have a minimum net worth of Rs. 100 crore. The sponsor(s) of the depository have to hold at
least 51% of the equity capital of the depository company. Participants of that depository, if
any, can hold the balance of the equity capital. However, no single participant can hold, at
any point of time, more than 5% of the equity capital. No foreign entity, individually or
collectively either as a sponsor or as a DP, or as a sponsor and DP together, can hold more
than 20% of the equity capital of the depository.

Registration – As per the provisions of the SEBI Act, a depository can deal in securities only
after obtaining a certificate of registration from SEBI. The sponsors of the proposed
depository should apply to SEBI for a certificate of registration in the prescribed form. On
being satisfied with the eligibility parameters of a company to act as a depository, SEBI may
grant a certificate of registration subject to certain conditions.

Commencement of Business – A depository that has obtained registration as stated above,

can function only if it obtains a certificate of commencement of business from SEBI. A
depository must apply for and obtain a certificate of commencement of business from SEBI
within one year from the date of receiving the certificate of registration from SEBI.

SEBI grants a certificate of commencement of business if it is satisfied that the depository

has adequate systems and safeguards to prevent manipulation of records and transactions.
SEBI take into account all matters relevant to the efficient and orderly functioning of the
depository. It particularly examines whether:

1. The depository has a net worth of not less than Rs. 100 crore;
2. The Bye-Laws of the depository have been approved by SEBI;
3. The automatic data processing systems of the depository have been protected against
unauthorized access, alteration, destruction, disclosure or dissemination of records and data;
4. The network, through which continuous electronic means of communication are
established between the depository, participants, issuers and issuers' agents, is secure against
unauthorized entry or access;

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Records to be maintained by Depository – Every depository is required to maintain the

following records and documents. These have to be preserved for a minimum period of five
1. Records of securities dematerialized and rematerialized.
2. The names of the transferor, transferee, and the dates of transfer of securities.
3. A register and an index of beneficial owners.
4. Details of the holdings of the securities of beneficial owners as at the end of each day.
5. Records of instructions received from, and sent to, participants, issuers, issuers' agents and
beneficial owners.
6. Records of approval, notice, entry and cancellation of pledge or hypothecation.
7. Details of participants.
8. Details of securities declared to be eligible for dematerialization in the depository.
9. Such other records as may be specified by SEBI for carrying on the activities as a

Q. Write a short note on NSDL and CDSL?

Brief description on NSDL and CDSL
At present there are two depositories in India, National Securities Depository Limited
(NSDL) and Central Depository Services (CDS). NSDL is the first Indian depository, it was
inaugurated in November 1996. NSDL was set up with an initial capital of US$28mn,
promoted by Industrial Development Bank of India (IDBI), Unit Trust of India (UTI) and
National Stock Exchange of India Ltd. (NSEIL). Later, State Bank of India (SBI) also
became a shareholder.
The other depository is Central Depository Services (CDS). It is still in the process of linking
with the stock exchanges. It has registered around 20 DPs and has signed up with 40
companies. It had received a certificate of commencement of business from Sebi on February
8, 1999.
These depositories have appointed different Depository Participants (DP) for them. An
investor can open an account with any of the depositories‘ DP. But transfers arising out of
trades on the stock exchanges can take place only amongst account-holders with NSDL‘s
DPs. This is because only NSDL is linked to the stock exchanges (nine of them including the
main ones-National Stock Exchange and Bombay Stock Exchange).

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In order to facilitate transfers between investors having accounts in the two existing
depositories in the country the Securities and Exchange Board of India has asked all stock
exchanges to link up with the depositories. Sebi has also directed the companies‘ registrar
and transfer agents to effect change of registered ownership in its books within two hours of
receiving a transfer request from the depositories. Once connected to both the depositories the
stock exchanges have also to ensure that inter-depository transfers take place smoothly. It
also involves the two depositories connecting with each other. The NSDL and CDS have
signed an agreement for inter-depository connectivity.
National Securities Depository Limited
National Securities Depository Limited is the first depository to be set-up in India. It was
incorporated on December 12, 1995. The Industrial Development Bank of India (IDBI) - the
largest development bank in India, Unit Trust of India (UTI) - the largest Indian mutual fund
and the National Stock Exchange (NSE) - the largest stock exchange in India, sponsored the
setting up of NSDL and subscribed to the initial capital. NSDL commenced operations on
November 8, 1996.

NSDL is a public limited company incorporated under the Companies Act, 1956. NSDL had
a paid up equity capital of Rs. 105 crore. The paid up capital has been reduced to Rs. 80 crore
since NSDL has bought back its shares of the face value of Rs. 25 crore in the year 2000.
However, its net worth is above the Rs. 100 crore, as required by SEBI regulations.

Basic Services
Under the provisions of the Depositories Act, NSDL provides various services to investors
and other participants in the capital market like, clearing members, stock exchanges, banks
and issuers of securities. These include basic facilities like account maintenance,
dematerialization, rematerialization, settlement of trades through market transfers, off market
transfers & inter-depository transfers, distribution of non-cash corporate actions and
nomination/ transmission.

The depository system, which links the issuers, depository participants (DPs), NSDL and
Clearing Corporation/ Clearing house of stock exchanges, facilitates holding of securities in
dematerialized form and effects transfers by means of account transfers. This system which

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facilitates scrip less trading offers various direct and indirect services to the market

Management of NSDL
NSDL is a public limited company managed by a professional Board of Directors. The day-
today operations are conducted by the Managing Director and CEO. To assist the MD and
CEO in his functions, the Board appoints an Executive Committee (EC) of not more than 15
The eligibility criteria and period of nomination, etc. are governed by the Bye-Laws of NSDL
in this regard.

NSDL performs the following functions through depository participants :
Enables the surrender and withdrawal of securities to and from the depository
(Dematerialization and rematerialization).
Maintains investor holdings in the electronic form.
Effects settlement of securities traded on the exchanges.
Carries out settlement of trades not done on the stock exchange (off-market trades).
Transfer of securities.
Pledging/hypothecation of dematerialized securities.
Electronic credit in public offerings of companies or corporate actions.
Receipt of non-cash corporate benefits like bonus rights, etc. in electronic form.
The model for Dematerialization of NSDL
(a) Investor surrenders certificates for dematerialization to depositary participant.
(b) Depositary participant intimates NSDL of the request through the system.
(c) Depositary participant‘s submits the certificate to the registers.
(d) Registrar confirms the dematerialization request from NSDL
(e) NSDL updates its account of informs the depositary participant.
(f) Depositary participant updates its accounts and inform the investor.
An Investor makes a dematerialization request, along with the investor physical certificates of
securities, to the issuer or its registrar through a depositary participant. After prescribed
verification and confirmation, their registrar substitutes in its records NSDL as registered
owner in respect of the securities and inform NSDL accordingly. NSDL then enters the name

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of the investor as the beneficial owner of the securities, credits the investor‘s account, and
informs the investor‘s depositary participant accordingly.
The entire process of dematerialization may take about 15 days.
Introduction CSDL
Central Depository Services Limited (CDSL) is the second Indian central securities
depository. It is based in Mumbai. Its main function is the holding securities either in
certificated or un-certificated i.e. dematerialized form; it helps to enable the book entry
transfer of securities. It began operating in February in the year 1999. Its main promoters are

A Depository facilitates holding of securities in the electronic form and enables securities
transactions to be processed by book entry. The Depository Participant (DP), who as an agent
of the depository, offers depository services to investors. According to SEBI guidelines,
financial institutions, banks, custodians, stockbrokers, etc. are eligible to act as DPs. The
investor who is known as beneficial owner (BO) has to open a demat account through any DP
for dematerialization of his holdings and transferring securities.

The balances in the investors account recorded and maintained with CDSL can be obtained
through the DP. The DP is required to provide the investor, at regular intervals, a statement of
account which gives the details of the securities holdings and transactions. The depository
system has effectively eliminated paper-based certificates which were prone to be fake,
forged, counterfeit resulting in bad deliveries. CDSL offers an efficient and instantaneous
transfer of securities.

CDSL was promoted by BSE Ltd. jointly with leading banks such as State Bank of India,
Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank and Union Bank of
India. CDSL was set up with the objective of providing convenient, dependable and secure
depository services at affordable cost to all market participants. Some of the important
milestones of CDSL system are:

CDSL received the certificate of commencement of business from SEBI in February, 1999.
Honourable Union Finance Minister, Shri Yashwant Sinha flagged off the operations of
CDSL on July 15, 1999.Settlement of trades in the demat mode through BOI Shareholding
Limited, the clearing house of BSE Ltd., started in July 1999.All leading stock exchanges like

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the BSE Ltd. (formerly known as Bombay Stock Exchange Ltd.), National Stock Exchange
and MCX Stock Exchange Limited have established connectivity with CDSL.

The main role and the different functions of a depository are as follows:
Maintenance of individual investors‘ beneficial holdings in an electronic form
Dematerialization and re-materialization of securities
Account transfer for settlement of trades in electronic shares
Allotments in the electronic form in case of initial public offerings
Distribution of non-cash corporate actions
Facility for freezing/locking of investor accounts
Facility for pledge and hypothecation of securities

Q. Differentiate between NSDL and CDSL.

Comparison between NSDL and CDSL:

Particulars NSDL CDSL

Full form ‗National Securities ‗Central Depository

Depository Limited‘. Securities Limited‘.

Founded November 1996 February 1999

Headquarters Mumbai, India. Mumbai, India.

Promoters IDBI, UTI, etc. HDFC, SBI, BOI and BOB.

Market National Stock Exchange Bombay Stock Exchange


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Unit VI
Security Brokerage

Q. Define brokers. What are their functions?


Broker is an individual or party (brokerage firm) that arranges transactions between a buyer
and a seller, and gets a commission when the deal is executed. A broker who also acts as a
seller or as a buyer becomes a principal party to the deal. Distinguish agent: one who acts on
behalf of a principal.

In general a broker is an independent agent used extensively in some industries. The prime
responsibility of a broker is to bring sellers and buyers together. Therefore, a broker is the
third -person facilitator between a buyer and a seller. An example would be a real estate
broker who facilitates the sale of a property.

Brokers also can furnish considerable market information regarding prices, products and
market conditions. Brokers may represent either the seller (90 percent of the time) or the
buyer (10 percent) but not both at the same time. An example would be a stockbroker, who
makes the sale or purchase of securities on behalf of his client. Brokers play a huge role in
the sale of stocks, bonds and other financial services.

Definition of 'Broker'

1. An individual or firm that charges a fee or commission for executing buy and sell orders
submitted by an investor.

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2. The role of a firm when it acts as an agent for a customer and charges the customer a
commission for its services.
3. A licensed real estate professional who typically represents the seller of a property. A
broker's duties may include: determining market values, advertising properties for sale,
showing properties to prospective buyers, and advising clients with regard to offers and
related matters.

Functions and role of broker:

The broker‘s primary role is to serve as the vehicle through which you either buy or sell
stock. Brokers can also be individuals who work for such firms.

Although you can buy some stocks directly from the company that issues them, to purchase
most stocks, you still need a broker.

Although the primary task of brokers is the buying and selling of securities (keep in mind that
the word securities refers to the world of financial or paper investments, and that stocks are
only a small part of that world), such as stocks, they can perform other tasks for you,
including the following:

- Providing advisory services - Investors pay brokers a fee for investment advice. Customers
also get access to the firm‘s research.
- Offering limited banking services - Brokers can offer features such as interest-bearing
accounts, check writing, direct deposit, and credit cards.
- Brokering other securities - Brokers can also buy bonds, mutual funds, options, Exchange
Traded Funds (ETFs), and other investments on your behalf.

Personal stockbrokers make their money from individual investors like you and me through
various fees, including the following:
- Brokerage commissions - This fee is for buying and/or selling stocks and other securities.
- Margin interest charges - This interest is charged to investors for borrowing against their
brokerage account for investment purposes.

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- Service charges - These charges are for performing administrative tasks and other functions.
Brokers charge fees to investors for Individual Retirement Accounts (IRAs) and for mailing
stocks in certificate form.

Q. What is brokerage?

Meaning of Brokerage

The maximum brokerage chargeable by the Trading Member in respect of trades affected in
the securities admitted to dealing on the segment of the Exchange is fixed at 2.5% of the
contract price, exclusive of statutory taxes. This maximum brokerage is inclusive of sub-
brokerage. The brokerage should be indicated separately from the price, in the contract note.
The TM may not share brokerage with a person who is a TM or in employment of another


If a client has sold 10,000 shares of a scrip @ Rs. 50, what is the maximum brokerage that
the client can be charged?

Maximum brokerage = brokerage rate*value of the transaction

= 2.5 %*( 10000 shares*Rs. 50)

= Rs. 12,500

There are advantages to using a broker.

1. First, they know their market and have already established relations with prospective
2. Brokers have the tools and resources to reach the largest possible base of buyers.
3. They then screen these potential buyers for revenue that would support the potential

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4. An individual producer, on the other hand, especially one new in the market, probably
will not have the same access to customers as a broker.
5. Another benefit of using a broker is cost — they might be cheaper in smaller markets,
with smaller accounts, or with a limited line of products.

Q. Explain types of brokers?

Types of Brokers

1. Jobbers

2. Tarawaniwalas

3. Commission Brokers

4. Sub-Brokers/ Remisers

5. Authorized Clerks

1. Jobbers:

A slang term for a market maker on the London Stock Exchange prior to October 1986 is
jobber. Jobbers, also called "stockjobbers," acted as market makers. They held shares on their
own books and created market liquidity by buying and selling securities, and matching
investors' buy and sell orders through their brokers, who were not allowed to make markets.
The term "jobber" is also used to describe a small-scale wholesaler or middleman in the retail
goods trade.

Little is known about jobbers' activities because they kept few records, but in the early 19th
century, London had hundreds of jobbing firms. Jobbers' numbers declined dramatically over
the course of the 20th century until they ceased to exist in October 1986. This month was
when the "Big Bang," a major shift in the London Stock Exchange's operations, occurred.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

London's financial sector was suddenly deregulated, fixed commissions were replaced by
negotiated commissions and electronic trading was implemented.

A jobber is a market dealer, buying and selling in quick succession for a profit of few ticks
(few paise). These are also called as "scalpers" at few places.

If a jobber observes that a particular scrip is going up then he / she will purchase a quantity
and keep it for selling immediately e.g. buy @100 sell @ 100.40 to 100.80 and if the price
doesn't go up within 10 to 20 seconds, they will sell the entire lot @ whatever be the price.
They will do such trading for the entire day and earn nice amount at the end of the day.

2. Tarawaniwalas:

These are active member in the Bombay stock exchange. He is very similar to a jobber in the
London stock exchange particularly with regard to the method of transacting business. But
these can act both as a broker as well as a jobber. Basically he is a jobber. At the same time,
he is not prohibited from acting as a broker. The drawback of this system is that they can act
against the interest of the investors by purchasing securities from them in his own name at
lower prices and selling the same securities to them at higher prices. Hence, many
committees have pointed out the questionable practice is being adopted by them.

3. Commission brokers:

They are nothing but a broker. He buys and sells securities on behalf of the clients for a
commission. He is permitted to deal with non-members directly. He does not purchase or sell
in his own name. Generally, a broker acts for a large number of his clients and deals in large
variety of securities. He gets the order from the clients and executes them through Jobbers.

4. Sub-brokers:

According to the BSE website – ―Sub-broker‖ means any person not being a member of a
Stock Exchange who acts on behalf of a member-broker as an agent or otherwise for assisting
the investors in buying, selling or dealing in securities through such member-brokers.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

All Sub-brokers are required to obtain a Certificate of Registration from SEBI without which
they are not permitted to deal in securities. SEBI has directed that no broker shall deal with a
person who is acting as a sub-broker unless he is registered with SEBI and it shall be the
responsibility of the member-broker to ensure that his clients are not acting in the capacity of
a sub-broker unless they are registered with SEBI as a sub-broker.

It is mandatory for member-brokers to enter into an agreement with all the sub-brokers. The
agreement lays down the rights and responsibilities of member-brokers as well as sub-

The Trading Members of the Exchange may appoint sub-brokers to act as agents of the
concerned Trading Member for assisting investors in buying, selling or dealing in securities.
A sub-broker is an important intermediary between the Trading Member and the client.

A sub-broker may be an individual, a partnership firm or a corporate. The applicant (in case
of individual), directors (in case of corporate) or partners (in case of partnership firm) need to
comply with the following requirements:

(a) They should not be less than 21 years of age;

(b) They should not have been convicted of any offence involving fraud or dishonesty;
(c) They should have at least passed 12th standard equivalent examination from an institution
recognized by the Government;
(d) They should not have been debarred by SEBI

Sub-brokers are affiliated to the Trading Members, and are required to be registered with
SEBI. A sub-broker is allowed to be associated with only one Trading Member of the
Exchange. The sub-broker is required to adhere to NSE‘s ‗Know your Clients‘ (KYC)
requirements. The Trading Member has to ensure the settlement of all its deals, even if the
deals may have originated from its sub-broker.

In case the Trading Member or a sub-broker intends to cancel the registration as a sub-broker,
the sub-broker is required to submit the original SEBI Registration certificate through their
affiliated Trading Member. While applying for cancellation of registration, the affiliated
Trading Member needs to give a public notification to this effect.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

5. Authorized clerks:

He is one who is appointed by a stock broker to assist him in the business of securities. They
are the assistant or agents. They buy or sell on the behalf of employers. They cannot transact
business on their own account. Each broker can have a specified number of them. A broker
cannot be present always on the trading floor of a stock exchange and therefore he requires
the assistance of others to carry on the trading activities on his behalf. These are given power
of attorney to act on behalf of brokers and hence they can sign on behalf of brokers.

For example: BSE broker can have maximum 5 clerks, In Calcutta stock exchange it is 8 and
it is 3 in Madras Stock Exchange.

Q. Write a short note on contract note?

Contract Note

Contract note is a confirmation of trade(s) done on a particular day for and on behalf of a
client. A stock-broker should issue a contract note to his clients for trades (purchase/ sale of
securities). The contract note should contain name and address (registered office address as
well as dealing office address) of the Trading Member, the SEBI registration number of the
Trading Member, details of trade viz. order number, trade number, order time, trade time,
security name, quantity, trade price, brokerage, settlement number and details of other levies.

The Trading Member is required to preserve the duplicate copy of the contract notes issued
for a minimum of five years. The TM should ensure that:

(a) Contract note is issued to a client within 24 hours and should be signed by the trading
member or by an authorized signatory trading member;
(b) Contract notes are in the prescribed format;
(c) Stamp duty is paid;
(d) All statutory levies are shown separately in the contract note.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

Q. Explain the Difference between broker and Jobber.


Definition Judges the worth of Acts professionally in an
securities. organized market.

Nature He is a professionally He is a commission agent.

independent broker.

Object He works for profit. He works for commission.

Dealing He can deal either with a He deals with his clients.

broker or another jobber.
Purchase and/or sale of He deals in securities on his He deals in securities on
securities own behalf. i.e., on his own behalf of the clients who are
name. non members of stock

Remuneration Difference between buy and They cannot charge more

sell price of the scrip. than 2.5 %.

A broker, on the other hand, has a couple of definitions. Normally, or typically, what
distinguishes a broker is that he doesn't take title, or ownership. You may look upon him as a

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

This is an individual that knows both buyers and sellers of something, and he brings them
together and facilitates the sale. Typically he will represent the sellers, and is paid by the
seller for bringing the buyer to the seller, and facilitating the sale.

One difference between a jobber and broker are their definitions. Jobbers are primarily part of
a wholesale chain of distribution whereas a broker has a broader definition. The example I
gave you previously is what a broker would be in a wholesale situation, but there are other
different types of brokers.

Think of "facilitator" in the broader sense. This is someone who represents a service or a
product, but doesn't take title to that product. This could be on the wholesale level, but it
could also be on the retail level, also.

Example: If you want to buy a house, you want to talk to a person that has access to a lot of
houses for sale. You would talk to a real estate broker. This is a person that doesn't take title
(owns) the houses, but rather, brings the buyer and seller together. Now in this example, the
real estate broker could represent the seller, or represent the buyer. But his main job is to
facilitate the sale by bringing buyers and sellers together.

And with this, there are also business brokers, investment brokers, boat brokers, and any
other kinds of brokers. It is their job to bring buyers and sellers together.

Jobbers and brokers both play a role in stock sales and purchases, but they're involved in
different stages of the process. Brokers carry out transactions for the investors who hire them.
Jobbers, on the other hand, exist to make sure that when brokers need to buy or sell shares for
a client they have someone to buy from or sell to.

Q. Explain objectives of SEBI for brokers.

SEBI Objectives

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

1. Registering and regulating the working of stock brokers, sub-brokers, share transfer agents,
underwriter who may be associated securities market in any manner.

2. Registering and regulating the working of collective investment scheme including mutual

3. Prohibiting insider trading in securities.

4. Regulating substantial acquisition of shares and takeovers of companies

5. Calling for information from, undertaking inspection, conducting inquiries and audits of
stock exchanges and intermediaries and self regulatory organizations in the securities market.

6. Performing such function and exercising such powers under the provisions of the capital
issues (control) act 1947 and SCRA 1956, as may be delegated to it by the central

7. Performing such other functions as may be prescribed.

Q. Explain SEBI Regulations relating to brokerage business in India.

Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India (SEBI)
with statutory powers for
(a) protecting the interests of investors in securities
(b) promoting the development of the securities market and
(c) regulating the securities market. Its regulatory jurisdiction extends over corporate in the
issuance of capital and transfer of securities, in addition to all intermediaries and persons
associated with securities market.

SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit.
In particular, it has powers for:

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

• regulating the business in stock exchanges and any other securities markets.
• registering and regulating the working of stock brokers, sub–brokers etc.
• promoting and regulating self-regulatory organizations
• prohibiting fraudulent and unfair trade practices relating to securities markets.
• calling for information from, undertaking inspection, conducting inquiries and audits of the
stock exchanges, mutual funds and other persons associated with the securities market and
other intermediaries and self–regulatory organizations in the securities market.
• performing such functions and exercising according to Securities Contracts (Regulation)
Act, 1956, as may be delegated to it by the Central Government.

Q. What are SEBI (Intermediaries) Regulations, 2008.

One of the main functions of SEBI is to register and regulate the functioning of various types
of intermediaries and persons associated with securities market in a manner as to ensure
smooth functioning of the markets and protection of interests of the investors.

These intermediaries, as detailed in the SEBI Act are: stock-brokers, sub-broker, share
transfer agents, bankers to an issue, trustees of trust deed, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisers, depositories, participants,
custodians of securities, foreign institutional investors, credit rating agencies, asset
management companies, clearing members of a clearing corporation, trading member of a
derivative segment of a stock exchange, collective investment schemes, venture capital funds,
mutual funds, and any other intermediary associated with the securities market.

SEBI had issued regulations governing the registration and regulatory framework for each of
these intermediaries. However, given the fact that many requirements and obligations of most
intermediaries are common, SEBI has consolidated these requirements and issued the SEBI
(Intermediaries) Regulations, 2008. These regulations were notified on May 26, 2009. These
regulations apply to all the intermediaries mentioned above, except foreign institutional
investors, foreign venture capital investors, mutual funds, collective investment schemes and
venture capital funds.

The salient features of the Regulations are as under:

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services

a) The SEBI Regulations put in place a comprehensive regulation which is applicable to all
intermediaries. The common requirements such as grant of registration, general obligations,
common code of conduct, common procedure for action in case of default and miscellaneous
provisions are applicable for all intermediaries.

b) The registration process has been simplified. An applicant can file application in the
prescribed format along with additional information as required under the relevant
regulations along with the requisite fees. The existing intermediaries may, within the
prescribed time, file the disclosure in the specified form. The disclosures are required to be
made public by uploading the information on the website specified by SEBI. The information
of commercial confidence and private information furnished to SEBI shall be treated
confidential. In the event intermediary wishes to operate in a capacity as an intermediary in a
new category, such person may only file the additional shortened forms disclosing the
specific requirements of the new category as per the relevant regulations.

c) The Fit and Proper criteria have been modified to make it principle based. The common
code of conduct has been specified at one place.

d) The registration granted to intermediaries has been made permanent unless surrendered by
the intermediary or suspended or cancelled in accordance with these regulations.

e) Procedure for action in case of default and manner of suspension or cancellation of

certificate has been simplified to shorten the time usually faced by the parties without
compromising with the right of reasonable opportunity to be heard. Surrender of certificate
has been enabled without going through lengthy procedures.

f) While common requirements will be governed by the new regulations, the intermediary
specific requirements continue to be as per the relevant regulations applicable to individual
intermediaries. The relevant regulations are amended from time to time to provide for the
specific requirements.

Acropolis Institute of Management Studies and Research, Indore
BBA VI Sem. (Finance) : Merchant Banking and Financial Services