Académique Documents
Professionnel Documents
Culture Documents
V. Ranga Prasad
CCD II, C.O.
INDEX
No. Topic Page no.
01. BPLR vs Base Rate 3
02. BASLE COMMITTEE 8
03. COMMODITIES TRADING 21
04. CORPORATE GOVERNANCE 25
05. CIBIL 26
06. HEDGE FUNDS 28
07. HEDGING 29
08. MONETARY AND CREDIT POLICY of RBI 31
09. Money Laundering 32
10. PARTICIPATORY NOTES 34
11. SARFAESI 36
12. UNIVERSAL BANKING 38
13. BONDS AND DEBENTURES 40
14. CBLO 43
15. CRR, SLR, BANK RATE, REPO, REVERSE REPO 45
16. INDIAN DEBT MARKET 47
17. DERIVATIVES 48
18. DIVIDEND STRIPPING 51
19. Exchange Traded Funds 52
20. INDEX FUTURES 53
21. MONEY MARKET 54
22. MUTUAL FUNDS 57
23. VALUATION OF SECURITIES 63
24. TREASURY – STOCK MARKET 64
25. SWEAT EQUITY 73
26. RAROC Pricing / Economic Profit 74
27. TREASURY OPERATIONS 77
28. VALUE AT RISK ( VaR ) 78
29. YIELD TO MATURITY ( YTM ) 83
30. COMMERCIAL PAPER 86
31. 2nd Narasimham Committee 91
32. ASSET RECONSTRUCTION COMPANY 95
33. CREDIT RATING 97
34. Securitization 99
35. ADR & GDR 102
36. INDIAN BUDGET 105
37. CAMELS 108
38. PROMPT CORRECTIVE ACTION 110
39. NEGOTIABLE INSTRUMENTS 114
40. Balance Sheet 116
41. FUND FLOW STATEMENT AND CASH FLOW STATEMENT 130
Banking Topics of Interest 2010.doc Page: 3
What is BPLR ? What does BPLR stands for in banking? What is the full form
of BPLR? What is Benchmark Prime Lending Rate?
In banking parlance, the BPLR means the Benchmark Prime Lending Rate. BPLR is the
interest rate that commercial banks normally charge (or we can say they are expected
to charge) their most credit-worthy customers. Although as per Reserve Bank of India
rules, Banks are free to fix Benchmark Prime Lending Rate (BPLR) for credit limits over
Rs.2 lakh with the approval of their respective Boards yet BPLR has to be declared and
made uniformly applicable at all the branches. The banks may authorize their Asset-
Liability Management Committee (ALCO) to fix interest rates on Deposits and Advances,
subject to their reporting to the Board immediately thereafter. The banks should also
declare the maximum spread over BPLR with the approval of the ALCO/Board for all
advances.
Why RBI wanted to replace the existing system of BPLR? What prompted
RBI to set up Working Group for review of BPLR?
While initiating the move to replace the existing system of BPLR, RBI felt that the
existing lending rate system had lost relevance and hindered effective transmission of
monetary policy signals. For example, RBI reduced its its benchmark lending rate by
425 basis points in the last one year, but banks reduced their BPLR by about 200 basis
point cut. This was mainly because bulk of their lending was below their BPLR.
Although, prime rates (read BPLR) of Indian banks ranged between 11 percent and
15.75 percent, yet three-fourths of their total loans are made below these levels
because of competitive pressures in the fragmented banking sector.
The panel said while market conditions may necessitate lending below the base rate, the
need may be only for a short term. Besides, to ensure that such lending does not
proliferate, it should not exceed 15 percent
BPLR lending and the reasons thereof; (iii) to examine the wide divergence in BPLRs of
major banks; (iv) to suggest an appropriate loan pricing system for banks based on
international best practices; (v) to review the administered lending rates for small loans
up to Rs 2 lakh and for exporters; (vi) to suggest suitable benchmarks for floating
rate loans in the retail segment; and (vii) consider any other issue relating to lending
rates of banks.
(b) credit card receivables (c) loans to banks’ own employees; and (d) loans
under DRI scheme.
• The Base Rate could also serve as the reference benchmark rate for floating rate
loan products, apart from the other external market benchmark rates.
• At present the interest rates on education loans are linked to ceilings with
reference to the BPLR. In view of the critical role played by education loans in
developing human resource skills, the interest rate on these loans may continue
be administered. However, in view of the fact that the Base Rate is expected to
be significantly lower than BPLR, the Group recommends that there is a need to
change the mark up. Accordingly, the Group recommends that the interest rates
on all education loans may not exceed the average Base Rate of five largest
banks plus 200 basis points. Even with this stipulation, the actual lending rates
for education loans would be lower than the current rates prevailing. The
information on the average Base Rate should be disseminated by IBA on a
quarterly basis to enable banks to price their education loan portfolio.
• In order to bring about greater transparency in loan pricing, the banks should
continue to provide the information on lending rates to the Reserve Bank and
disseminate information on the Base Rate. In addition, banks should also provide
information on the actual minimum and maximum interest rates charged to
borrowers.
• All banks should follow the Banking Codes and Standards Board of India (BCSBI)
Codes for fair treatment of customers of banks, viz., the Code of Bank’s
Commitment to Customers (Code) and the Code of Bank’s Commitment to Micro
and Small Enterprises (MSE Code) scrupulously. The Group also recommends
that the Reserve Bank may require banks to publish summary information
relating to the number of complaints and compliance with the codes in their
annual reports.
RBI has placed a draft on the website for suggestions by November, 2009. The final
guidelines are expected to be issued by RBI thereafter.
Banking Topics of Interest 2010.doc Page: 6
BASLE COMMITTEE
Basle Committee - Origin
The Basle Committee (some people also spell it as “Basel Committee”) has played a
leading role in standardizing bank regulations across jurisdictions. Its origins can be
traced to 1974.
In 1974, Bank Herstatt, a German bank was liquidated. On the day of liquidation,
some banks had released payment of DM to this Bank in Frankfurt, inexchange for US
Dollars. However, due to difference in time-zone, Bank Herstatt received payments but
it ceased its operations before the counterparty banks could receive their USD
payments. The cross-jurisdictional problems, led the G-10 countries (at present G-10
consists of eleven countries, namely Belgium, Canada, France, Germany, Italy, Japan,
the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) and
Luxembourg to form a Standing Committee under the auspices of the Bank for
International Settlements (BIS). This Committee is called the “Basle Committee on
Banking Supervision”, The Committee comprises of representatives from Central
Banks and Regulatory Authorities of different countries. During the last few decades,
the major focus of the committee has been to :
In 1988, the Basle Committee published a set of minimal capital requirements for banks.
These became law in G-10 countries in 1992, with Japanese banks permitted an
extended transition period. The requirements have come to be known as the 1988
Basle Accord
The 1988 Basle Accord mainly focused on the core banking in the sense of deposit
taking and lending and its focus remained on credit risk. Bank assets were assigned
"risk weights” e.g. government debts were assigned 0% risk weight and bank debts
were assigned 20% risk weight, and other debt were assigned 100% weights. Banks
were asked to hold capital at least equal to 8% of the risk weighted value of assets.
Additional rules applied to contingent obligations, such as letter of credits and
derivatives.
Slowly it was felt that Banks have become more aggressive and are taking higher risk.
Thus, the Basle Committee decided to update the 1988 accord to include bank capital
requirements for market risk.
BASEL II AT A GLANCE
Basel I was very simple in its approach. However, Basel II is complex. Therefore,
even the BCBS does not expect this New Accord i.e. Basel II Accord to be adopted
widely and quickly. There is belief that countries would adopt the options and
approaches that are most appropriate for the state of their banking systems, their
supervisory structures and their markets,. Under the Basel II Accord, supervisors can
adopt the framework on an evolutionary basis and use elements of national discretion to
adapt it to their needs.
Under Basel II, the capital requirements are more risk sensitive as these are directly
related to the credit rating of each counter-party instead of counter-party category (as
was applicable under Basel I). Further, the New Accord requires banks to hold capital
not only for Credit and Market Risk but also for Operational Risk (OR) and where
warranted for interest rate risks, credit concentration risks, liquidity risks etc. All these
makes Basel II much more comprehensive than the earlier Basel I. Where as earlier,
banks were required to hold a uniform level of 8 per cent as minimum capital under
Basel I, now under the new accord, supervisors have the discretion to ask banks to hold
higher levels of minimum capital under Basel II (For example, in India the minimum
capital requirement is at 9% level). . Basel II has other advantages such as providing a
range of options for counter-party capital requirements and in the process reducing the
gap between required capital and regulatory capital. Basel II recognizes a wider range
of collaterals and provides incentives for improved risk management practices.
An interesting point to note here is that Basel II recognises the element of diversification
of risk in the SME sector and has assigned a lower risk weight for retail SME exposure
under Standardised Approach. The non-retail SME exposure would also attract a lower
risk weight where they have better external ratings under the Standardised Approach.
Shifting to Basel II, therefore, could be advantageous for economies whose banks have
significant SME exposure.
Supervisory values
set by the Basel
Provided by
Commitee
the bank
Maturity i.e. the or
based on own
remaining At rational
Implicitly estimates
economic discretion, provided
recognition (with an
maturity of the by bank based on
allowance to
exposure own estimates (with
exclude certain
an allowance to
exposures)
exclude certain
exposures)
Same as IRB
Provision dates Foundtion,
Default events plus :
Rating data
exposure data Historical loss
Default events
customer data to
Data Historical data to
segmention estimate LGD
Requirements estimate PDs (5
Data collateral (7 years)
years)
segmentation Historical
Collateral data
Exteranl Ratings exposue data
Collateral data to estimate
EAD (7 years)
Defined by the All collaterals from All types of
Credit Risk supervisory Standardized collaterals if
Mitigation regulator; including approach; bank can
techniques financial collateral, receivables from prove a CRMT
(CRMT) guarantees, credit goods and services; by internal
derivatives, other physical estimation.
Banking Topics of Interest 2010.doc Page: 12
management
system
• Systematic
tracking of loss
data
Major Requirements of Basel Accord for sound practices for Management and
Supervision of operational Risk :
• Establish a structured risk management framework for the bank
• Redesign process and approach
• Strengthen existing controls, policies and procedures
• Invest in staff training
• Automate processes
• Acceptance of risk as cost of doing business
• Transfer risk through subcontracting
• Contingency plan - Insurance
• Create risk awareness culture
(c )Products :
• Focus on key products / those with best return on regulatory capital
• Impact of differing capital treatment and return transparency will impact product
design;
• Increased risk based product pricing for those on sophisticated credit risk
approaches
• Those with less sophisticated risk approaches may be priced out of the market
(D) Customers :
• Increased transparency of account profitability
• Risk differentiated customer management through :
- Winners : (a) Prime mortgage customers; (b) Well rated entities
- Losers : (a) Small and medium sized businesses; (b) Higher credit risk
individuals ;
In India, RBI is instrumental to ensure implementation of Basel II. The reform process
started in early nineties of the last century have proved a boon for migrating to Basel
II. With the commencement of the banking sector reforms in the early 1990s, the RBI
has been consistently upgrading the Indian banking sector by adopting international
best practices. The approach to reforms has been one of having clarity about the
destination as also deciding on the sequence and pace of reforms to suit Indian
conditions. All these have helped India in moving ahead with the reforms without any
major disruptions.
In view of the RBI’s goal to have consistency and harmony with international standards
and its approach to adopt the pace as may be appropriate in the context of our country
specific needs, Reserve Bank of India in April 2003 accepted in principle to adopt the
New Capital Accord Basel II. RBI in its Annual Policy statement in May 2004 asked
banks in India to examine in depth the options available under Basel II and draw a road-
map by end December 2004 for migration to Basel II and review the progress made
thereof at quarterly intervals. Hence, at a minimum all banks in India begin to adopt
Standardized Approach for credit risk and Basic Indicator Approach for operational risk.
After adequate skills are developed, both in banks and at supervisory levels, some banks
may be allowed to migrate to IRB Approach. With the successful implementation of
banking sector reforms over the past decade, the Indian banking system has shown
substantial improvement on various parameters. It has become robust and displayed
Banking Topics of Interest 2010.doc Page: 16
significant resilience to shocks. There is ample evidence of the capacity of the Indian
banking system to migrate smoothly to Basel II norms.
• Whether capital for operational risk should be maintained separately for the
Indian branches in India or whether it may be maintained abroad at head office?
• Whether these banks can be mandated to maintain capital as per SA / BIA
approaches in India irrespective of the approaches adopted by the head office?
• Basel II could actually imply that the minimum requirements could become pro-
cyclical. No doubt prudent risk management policies and Pillars II and III would
help in overall stability. We feel that it would be preferable to have consistent
prudential norms in good and bad times rather than calibrate prudential norms to
counter pro-cyclicality.
• The existence of large and complex financial conglomerates could potentially
pose a systemic risk and it would be necessary to put in place supervisory
policies to address this.
• In the event of some banks adopting IRB Approach, while other banks adopt
Standardised Approach, the following profiles may emerge:
• Banks adopting IRB Approach will be much more risk sensitive than the banks on
Standardised Approach, since even a small change in degree of risk might
translate into a large impact on additional capital requirement for the IRB banks.
Hence IRB banks could avoid assuming high risk exposures. Since banks
adopting Standardised Approach are not equally risk sensitive and since the
relative capital requirement would be less for the same exposure, the banks on
Standardised Approach could be inclined to assume exposures to high risk
clients, which were not financed by IRB banks. As a result, high risk assets could
flow towards banks on Standardised Approach which need to maintain lower
capital on these assets than the banks on IRB Approach.
• Similarly, low risk assets would tend to get concentrated with IRB banks which
need to maintain lower capital on these assets than the Standardised Approach
banks.
• Hence, system as a whole may maintain lower capital than warranted.
• Due to concentration of higher risks, Standardised Approach banks can become
vulnerable at times of economic downturns.
The policy approach to Basel II in India is such that external perception about India
conforming to best international standards is positive and is in our favour. Commercial
banks in India will start implementing Basel II with effect from March 31, 2007. They
will initially adopt the Standardised Approach for credit risk and the Basic Indicator
Approach for operational risk. After adequate skills are developed, both by the banks
and also by the supervisors, some banks may be allowed to migrate to the Internal
Rating Based (IRB)
Approach.
Implementation of Basel II will require more capital for banks in India due to the fact
that operational risk is not captured under Basel I, and the capital charge for market risk
was not prescribed until recently. Though the cushion available in the system, which at
present has a CRAR of over 12 per cent, is comforting, banks are exploring various
avenues for meeting the capital requirements under Basel II.
RBI has been expanding the area of disclosures so as to have greater transparency with
regard to the financial position and risk profile of banks. Illustratively, with a view to
enhancing further transparency, all cases of penalty imposed by the RBI on the banks as
also directions issued on specific matters, including those arising out of inspection, are
Banking Topics of Interest 2010.doc Page: 18
to be placed in the public domain. Such proactive disclosures by the Regulator are
expected to have a salutary effect on the functioning of the banking system. In addition
to the above, any penal action taken against any foreign bank branches in India are also
shared with the Home country regulator with a view to enhance the quality of
consolidated supervision. These initiatives will be an important supplement to the Pillar 3
disclosures prescribed under Basel II, which in our opinion will further the cause of a
stable banking system.
d. Data issues – Implementation of Basel II, both under Standardised Approach and
IRB Approaches, would involve utilisation of data for computing capital requirements.
While the dependence on data under the Standardised Approach would be largely
similar to Basel I, the data requirements are considerable under the Advanced
Approaches. Banks would require adequate and acceptable historical data to compute
capital requirement under these Approaches. At the minimum banks need to have
historical data for computing the probability of default, loss given default and
operational risk losses. While building up this data base banks also need to ensure purity
and integrity of such data.
Banking Topics of Interest 2010.doc Page: 19
e. Capacity Building – Above all, capacity building, both in banks and the regulatory
bodies is a serious challenge, especially with regard to adoption of the advanced
approaches. Banks would need to focus on equipping their staff suitably to handle the
advanced risk management systems and supervisors need to equip themselves with
equal skills to have effective supervision. Given the demand for skills in the sector, the
level of attrition is likely to be high. Hence, banks need to focus on motivating the skilled
staff and retaining them. We have initiated supervisory capacity-building measures in
India to identify the gaps and to assess as well as quantify the extent of additional
capital, which may be required to be maintained by such banks. The magnitude of this
task, which is scheduled to be completed by December 2006, appears daunting since we
have as many as 90 scheduled commercial banks in India.
(f) External ratings – In a situation where countries do not have domestic rating
agencies or where the extent of rating penetration is low the capacity of banks in these
countries to relate capital requirements to the actual underlying risk will be seriously
handicapped. It would be necessary to develop domestic rating agencies and look at
methods for increasing the rating penetration of the rating agencies.
(h) Validating the concept of economic capital – The Basel II Framework will
promote adoption of stronger risk management practices by banks which will address all
major risks comprehensively. Basel II, by being risk sensitive, will enable banks to
bridge the gap between economic capital and regulatory capital. Through the Pillar II
requirements under Basel II, banks are expected to have their own internal
methodologies for assessing the risks and computing the capital requirements to support
those risks even for banks adopting the standardised approach for credit risk. This would
aid the banks to move in the direction of building their own economic capital models,
which can direct their business strategies. It is possible that many of the banks in
emerging economies might not have developed their internal capital adequacy
assessment processes (ICAAP). Implementation of Basel II would now require these
banks to have in place an ICAAP which meets the Basel II specifications. The regulators
would perhaps be required to take the initiative in this regard to enhance the level of
understanding of ICAAP in banks, the benefits that may accrue to them by adoption of
ICAAP and the likely focus of supervisory assessments in this regard.
Conclusion
Basel II is expected to foster financial stability through its risk sensitive framework which
will encourage banks to adopt improved risk management practices; require supervisors
to review the efficiency of banks’ risk management practices and capital allocation
methodologies; and empower market participants to make informed judgements on the
efficiency of banks and accordingly punish or reward banks.
While it is true that implementation of Basel II is not the be all and end all on the
subject of financial stability it must be recognised that banks are "special". Their sound
and efficient functioning is critical not only to the growth of the real sector but also for
strengthening the social infrastructure. Internationally, therefore, banks have moved
centre-stage and their performance is the cynosure of all eyes.
Source : Basel documents and speeches of RBI officials and circulars issued by RBI.
Banking Topics of Interest 2010.doc Page: 21
COMMODITIES TRADING
What is Commodities Trading:
Goods such as grains, metals, oil, cotton, coffee, sugar and cocoa are dealt in bulk at
wholesale levels. World wide, these commodities can be sold either on the spot market
for immediate delivery or on the commodities exchanges for later delivery. Trade on
the exchanges can be in various forms, including in the form of futures
contracts. Commodities are typically bought and sold in the futures markets where
producers combine with manufacturers and speculators to create a liquid
market. Commodities are often viewed as a hedge against inflation because their price
rises with the consumer price index.
The primary differences between the NMCEs and other single Commodity Exchanges
are that the NMCEs are required to be necessarily demutualised (i.e. not owned or
managed by members brokers), have automated trading, Settlement Guarantee
Mechanism, trade in all permitted commodities and have trading system available
across the country.
The latest among the above NMCE, is the National Commodity & Derivatives Exchange
Limited (NCDEX), which is a public limited company incorporated on April 23, 2003
under the Companies Act, 1956.
NCDEX :
National Commodity & Derivatives Exchange Limited (NCDEX) is an online multi
commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life Insurance
Corporation of India (LIC), National Bank for Agriculture and Rural Development
Banking Topics of Interest 2010.doc Page: 23
(NABARD) and National Stock Exchange of India Limited (NSE). NCDEX is the only
commodity exchange in the country promoted by national level institutions. It is likely
to provide a world-class commodity exchange platform for market participants to trade
in a wide spectrum of commodity derivatives driven by best global practices,
professionalism and transparency. NCDEX is located in Mumbai and offers facilities to its
members in about 91 cities throughout India. The reach will gradually be expanded to
other cities.
NCDEX has started trading of ten commodities - Gold, Silver, Soy Bean, Refined Soy
Bean Oil, Rapeseed-Mustard Seed, Expeller Rapeseed-Mustard Seed Oil, RBD Palmolein,
Crude Palm Oil and Cotton - medium and long staple varieties. At subsequent phases
trading in more commodities would be facilitated.
An individual, partnership firm, Private limited company, public limited Company, co-
operative societies are eligible to become members of NCDEX subject to the conditions
for the membership.
CORPORATE GOVERNANCE
Corporate Governance is concerned with the systems and processes for ensuring proper
accountability, probity and openness in the conduct of an organization’s business. Thus,
it is the process under which the organizations try to hold the balance between
economic and social goals and between individual and communal goals. In a nutshell,
we can say that the corporate governance framework strives to the efficient use of
resources and equally to require accountability for the stewardship of those resources.
The basic aim of Corporate Governance is to align as nearly as possible the interests of
individuals, corporations and society.
Corporate Governance has three important features, and these are :-
(a) Transparency in operations and decision-making.
(b) Accountability for the decisions taken
(c ) Accountability for the stakeholders
For example, it the duty of the Board members to ensure that in the case of
shareholders, the investments and the return on investment is safeguarded. This
means that the managements of the company has to ensure that the decisions taken
by them actually create wealth and do not destroy wealth. In case the net earnings are
less than the cost of capital it is considered as net destruction of wealth and can not be
considered as good governance.
Commercial Bureau : The Commercial Bureau, which has credit information on non-
individual borrowers, has been launched on May 8, 2006, with a database of 6.73 Lakh
accounts contributed by 37 Members. Subsequently, our database has grown over 17.8
Lakh accounts contributed by 71 Members. As per the relevant RBI circulars, CIBIL is
already maintaining a database of Suit-Filed accounts of Rs. 1 Crore and above and Suit-
Filed accounts (willful defaulters) of Rs. 25 Lacs and above.
In its initiative to improve Credit flow to SMEs, CIBIL is being supported under SME
Financing and Development Project implemented by Project Management Division,
SIDBI, with an aim to ensure flow of credit to the under penetrated SME sector while
increasing banks’ profitability and market penetration (via sound credit decisions) and
reducing non-performing loans (via credit information tools).
Consumer Bureau : The Consumer Bureau was launched on April 5, 2004 with a
database of 4 million accounts contributed by 13 Members. Subsequently, our database
has grown over 114 million accounts contributed by 94 Members. The Consumer Bureau
Banking Topics of Interest 2010.doc Page: 27
reports are available to Members, who have submitted all their data to CIBIL in an
acceptable format (Principle of Reciprocity).
Who Can Access CIRs? Can a Borrower obtain copy of CIR from CIBIL ?
Reports can be accessed by Members on the principle of reciprocity i.e. only those
Members who have provided all their data to CIBIL are permitted to access CIRs.
Members can do so only to take valid credit decisions. Disclosure to any other person or
entity is prohibited. However, a borrower can not obtain a copy of CIR from the CIBIL,
but when a Member has drawn a report on that borrower, a copy of the same can be
obtained from the Member by the borrower.
Banking Topics of Interest 2010.doc Page: 28
HEDGE FUNDS
Hedge funds are those funds where the fund manager is authorised to
use derivatives and borrowing to provide a higher return, albeit at a higher risk. Hedge
funds term is commonly used to describe those funds that do not indulge in
conventional investment fund, i.e. it uses strategies other than investing long. For
example
· Short selling
· Using arbitrage
· Trading derivatives
· Leveraging or borrowing
· Investing in out-of-favour or unrecognized undervalued securities
The name hedge fund is a misnomer as the funds may not actually hedge against risk.
The returns can be high, but so can be losses. These investments require expertise in
particular investment strategies. The hedge funds tend to be specialized, operating
within a given niche, specialty or industry that requires the particular expertise.
These funds that are extremely flexible in their investment options because they
use financial instruments generally beyond the reach of mutual funds, which have SEC
regulations and disclosure requirements that largely prevent them from using short-
selling, leverage, concentrated investments and derivatives. This flexibility, which
includes use of hedging strategies to protect downside risk, gives hedge funds the ability
to best manage investment risks.
a) Mutual funds are regulated and are not allowed to use the strategies like short
selling and derivatives. Hedge funds usually remain unregulated and
unrestricted. The restrictions on Hedge Funds are placed only by investors who
wants the adopt only those strategies where fund manager has best expertise.
b) The performance of the Mutual funds is usually measured vis a vis returns by a
benchmark index. On the other hand, Hedge funds are expected to deliver
absolute returns - under all circumstances, even if the indices are down.
c) Mutual funds are not able to effectively protect portfolios against declining
markets other than by going into cash or by shorting a limited amount of stock
index futures. Hedge funds, on the other hand, are able to not only protect
against declining markets, but also produce positive results, by using a variety
of hedgingand trading strategies.
d) Mutual funds pay fee based on a percent of assets under management, but
Hedge funds pay Fund Managers depending on the performance of funds plus a
fixed fee.
Banking Topics of Interest 2010.doc Page: 29
HEDGING
What is Hedging :
Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are
widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to
reduce the volatility of a portfolio, by reducing the risk. It needs to be noted that
hedging does not mean maximization of return. It only means reduction in variation of
return. It is quite possible that the return is higher in the absence of the hedge, but so
also is the possibility of a much lower return.
Long and short positions indicate whether a person has a net over-bought position
(long) or over-sold position (short).
One of the popular strategies for hedging is : "If you are long in cash underlying - Short
Future; and If short in cash underlying - Long Future".
This can be illustrated by a simple example. If one has bought 100 shares of say
Reliance Industries and want to Hedge against market movements, he has to short an
appropriate amount of Index Futures. This will reduce his overall exposure to events
affecting the whole market (systematic risk).
Suppose a major terrorist attack takes place, the entire market can sharply fall. In such
a case, his in Reliance Industries would be offset by the gains in his short position in
Index Futures.
Some other examples of where hedging strategies that can be really useful can be as
follows ::-
The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so
as to provide the maximum offset of risk. This depends on the
Hedgers wish to eliminate or reduce the price risk to which they are already exposed.
Speculators are those class of investors who willingly take price risks to profit from price
changes in the underlying.
The market provides a mechanism by which diverse and scattered opinions are reflected
in one single price of the underlying. Markets help in efficient transfer of risk from
Hedgers to speculators. Hedging only makes an outcome more certain. It does not
necessarily lead to a better outcome.
Banking Topics of Interest 2010.doc Page: 31
RBI Governor every year makes two policy announcements and these are always
considered as important event in the Indian financial circles and have great bearing on
the Indian economy. Two policy announcements made every year - usually, one in April
(known as slack season policy) and the second in October (known as busy season
policy) are eagerly awaited by all bankers. Previously these were called
Credit Policies or Monetary and Credit Policy. However, now a days RBI, announces its
"Annual Policy Statement" for the entire year, sometime in April and then reviews the
same in October.
The slack season policy is called so, as it takes policy decision for the period when rains
set in the Indian economy and economic activity is at a low ebb. This policy is
popularly known as the "slack season policy". However the policy announced in October
addresses the requirements of a period when hectic business activity takes place.
The policy is usually keenly awaited as it sets the rules and regulations for the Indian
banking sector for the next half year or so. The Annual Monetary and Credit Policy
announced in April/May and the Mid-term Review in October/ November serve several
purposes e.g. (i) as a framework for or supplement to the monetary and other relevant
measures that are taken from time to time to capture events affecting macroeconomic
assessments, in particular relating to fiscal management as well as seasonal factors;
and (ii) to set out the logic, intentions and actions related to the structural and
prudential aspects of the financial sector in our country. Further, the biannual
Statements add to greater transparency, better communication and contribute to an
effective consultation process.
Through these Policy announcements, RBI usually covers the following areas :-
(a) Domestic Developments : These include the GDP, inflation / price, money supply,
food and non-food credit, data etc during the last year or so and the projections for the
same for the forthcoming period. The behavior of various markets and the likely
scenario on interest rates front etc.
(b) External Developments : The global economic scenario during the last year and
the likely impact of the major concerns at the global level. The movements of the
rupee vs major currencies of the world and the concerns for foreign exchange
reserves etc. Major achievements or deficiencies in export and import sectors.
(c) Measures to be initiated for economic growth etc. : The policy announcments
give brief details of various measures already initiated or likely to be initiated for
financial sectors. These include changes in SLR, CRR, Bank Rate etc. The major policy
steps for risk management, control of credit, customer services also form part of the
policy announcements.
Banking Topics of Interest 2010.doc Page: 32
Money Laundering
What is money laundering?
Money Laundering is the process by which large amounts of illegally obtained money
(from drug trafficking, terrorist activity or other serious crimes) is given the appearance
of having originated from a legitimate source.
Money laundering involves disguising financial assets so that they can be used without
detection of the illegal activity that produced them. Through money laundering, the
launderer transforms the monetary proceeds derived from criminal activity into funds
with an apparently legal source
Thus, we can say Money Laundering' is the introduction of illegally gained assets into
the legal financial system with the aim of covering up its true origin. Some estimate
annual amounts of laundered money exceed $500 billion in the world.
The major objectives of Money Laundering activities are:
(a) Concealing the true ownership of illegally-obtained money and
(b) Placement, layering and integration of such funds
The concept of Money Laundering can be traced back to the “Hawala” transactions well
known in India for long time now. Hawala mechanism facilitates the conversion of
money from black to white. "Hawala" is an Arabic word meaning the transfer of
money or information between two persons using a third person. The Hawala
mechanism usually does not leave any paper trail and thus is a nightmare for the
investigative agencies. The profits generated from Hawala transactions are covertly
invested in real estate, films etc. so as to launder them.
A few years back it was thought of only petty crime, but with the changed
circumstances, especially after terrorist activities after September 11, 2001 attack on
World Trade Centre, money laundering is considered as a very serious crime.
Worldwide special Acts have been passed to check such activities.
The criminals have developed number of methods for the purpose of "Structuring" and
"Laundering" currency in the process of converting it from "dirty" to "clean" funds. The
major risk to a bank is in the potential for complicity and violation of Acts if such funds
are channeled through that Bank.
Egmont Group
The Egmont Group serves as an international network fostering improved
communication and interaction among FIUs. Egmont Group is named after the venue in
Brussels where the first such meeting of FIUs was held in June of 1995. The goal of the
Egmont Group is to provide a forum for FIUs around the world to improve support to
their respective governments in the fight against money laundering, terrorist financing
and other financial crimes. This support includes:
expanding and systematizing international cooperation in the reciprocal exchange
of financial intelligence information,
increasing the effectiveness of FIUs by offering training and personnel exchanges
to improve the expertise and capabilities of personnel employed by FIUs,
fostering better and secure communication among FIUs through the application
of technology, presently via the Egmont Secure Web (ESW), and
promoting the establishment of FIUs in those jurisdictions without a national
anti-money laundering/terrorist financing program in place, or in areas with a
program in the beginning stages of development
PARTICIPATORY NOTES
What are PNs:
Participatory Notes (PNs) are instruments used by foreign funds, and foreign institutional
investors for trading in the domestic market, who are not registered with SEBI, but are
interested in taking exposures in Indian securities market.
PNs are bascially contract notes and are issued by foreign institutional investors,
registered in India, to their overseas clients who may not be eligible to invest in the
Indian stock markets. Such foreign institutional investors (FIIs) invest funds in Indian
stock market, on the behalf of such investors, who prefer to avoid making disclosures
required by various regulators. The associates of these FIIs generally issue these notes
overseas.
Thus, we can say PNs are issued where the underlying assets are securities listed on the
Indian stock exchanges. And this route is mainly used by FIIs not registered with the
SEBI.
Vide press Release No. PR 19/2004 Dated 23.01.2004 SEBI reiterated that there is no
change in its policy of FII investments in India except by way of strengthening the
"know your client" regime. It has been made clear that with effect from 3rd February,
2004, overseas derivative instruments such as Participatory Notes (PNs) against
underlying Indian securities can be issued only to regulated entities and further
transfers, if any, of these instruments can also be to other regulated entities only. In
addition, to facilitate the process of transition, derivative instruments already issued and
outstanding against un-regulated entities will not be required to be terminated
Banking Topics of Interest 2010.doc Page: 35
immediately. It has been decided that the said contracts will be permitted to expire or to
be wound - down on maturity, or within a period of 5 years, whichever is earlier.
SEBI has also recently clarified that the following entities would be deemed
to be regulated entities for investing in Indian equities through P-Notes:-
1. Any entity incorporated in a jurisdiction that requires filing of constitutional
and/or other documents with a registrar of companies or comparable regulatory
agency or body under the applicable companies legislation in that jurisdiction
2. Any entity that is regulated, authorised or supervised by a central bank or any
other similar body provided that the entity must not only be authorised but also
be regulated by the aforesaid regulatory bodies
3. Any entity that is regulated, authorised or supervised by a securities or futures
commission or other securities or futures authority or commission in any country,
state or territory
4. Any entity that is a member of securities or futures exchanges or other similar
self-regulatory securities or futures authority or commission within any country,
state or territory.
5. Any individual or entity (such as fund, trust, collective investment scheme,
investment company or limited partnership) whose investment advisory function
is managed by an entity satisfying the criteria (a), (b) ,(c) or (d) above.
Banking Topics of Interest 2010.doc Page: 36
Thus, till the enactment of this Act, Banks/Financial Institutions had to enforce their
security through court. This was a very slow and time-consuming process. There was
also no provision in any of the present law in respect of hypothecation, though
hypothecation is one of the major security interest taken by the Bank/Financial
Institution. In view of the hardships faced by the Banking industry, the Securitisation
and Reconstruction of Financial Assets and Enforcement of Security Interest Act was
enacted with effect from 21.6. 2002.
Security Interest means right, title and interest of any kind whatsoever upon property,
created in favour of any secured creditor and includes any charge, hypothecation,
assignment other than those specified below.
The following are excluded from 'security interest' :- Provision of the Act shall
not apply to the following :
1. A lien on any goods , money or security given by or under the
Indian Contract Act, 1872 or the Sale of Goods Act, or any other law for the time
being in force.
2. A pledge of movables within the meaning of section 172 of Indian Contract Act,
3. Creation of any security in any aircraft as defined u/s 2(1) of Aircraft Act,
4. Creation of any security interest in any vessel as defined in section 3 (35) of
Merchant Shipping Act.
5. Any conditional sale, hire -purchase or lease or any other contract in which no
security interest has been created.
6. Any right of unpaid seller u/s 47 of Sale of Goods Act.
7. Any properties not liable to attachment or sale under first provision to section
60(1) of Code of Civil Procedures.
8. Any security interest for securing repayment of any financial asset not exceeding
one lakh Rupees.
9. Any security interest creating in agricultural land.
10. Any case in which the amount due to less than 20% of the principal amount and
interest thereon (i.e. where borrower has repaid more than 80% of principal
amount and interest. )
UNIVERSAL BANKING
Universal Banks refers to those banks that offer a wide range of financial services,
beyond saving accounts and loans, and includes investment banking, insurance etc.
Thus, universal banking is a combination of commercial banking, investment banking
and various other activities including insurance. They may sell insurance, underwrite
securities, and carry out securities transactions on behalf of others. They may own
equity interest in firms, including non-financial firms.
Universal Bank is quit popular in European Countries as compared to North American,
there are generally more restrictions in North America as to what services financial
institutions can offer.
Till recent times, the financial institutions were doing business on`long term' basis, both
on the assets and liabilities sides of the balance sheet, while commercial banks catered
to `short term' businesses. This demarcation was quite visible though at times they
breached this thin line. However, with the advent of market economy, this gap is being
bridged through `universal banking'. The rising NPAs and dearth of avenues for
resources for the financial institutions since 1990s, in the wake of falling market
sentiments have put these institutions in red. Some of such financial institutions are
finding hard to survive in the changed environment.
Universal banking has certain advantages and some disadvantages. University Banking
mostly results in greater economic efficiency in the form of lower cost, higher output
and better products. However large banks will have greater impact if they even fail.
Moreover, it is also felt that such institutions, by virtue of their sheer size, could gain
monopoly power in the market, and can result in undesirable consequences for
economic efficiency. It is also feared that combining commercial and investment
banking can gives rise to conflict of interests.
in moving towards such a system by banks and DFIs. Major areas requiring attention are
the status of financial sector reforms, the state of preparedness of the concerned
institutions, the evolution of the regulatory regime and above all a viable transition path
for institutions which are desirous of moving in the direction of universal banking. It is
proposed to adopt the following broad approach for considering proposals in this area:
The issue of universal banking came to limelight in 2000, when ICICI gave a
presentation to RBI to discuss the time frame and possible options for transforming itself
into an universal bank.
Later on RBI asked financial institutions which are interested to convert them into a
universal bank, to submit their plans for transition to a universal bank for consideration
and further discussions. FIs need to formulate a road map for the transition path and
strategy for smooth conversion into an universal bank over a specified time frame. The
plan should specifically provide for full compliance with prudential norms as applicable to
banks over the proposed period.
DEBENTURES :
Debenture is a debt security issued by a corporation. The debentures are in the
nature of loans to a company made by investors, as opposed to loans raised
from a bank. On their investments, the investors receive a fixed rate of interest
known as coupon rate. In India the debentures are issued by corporate.
Debentures may be "secured" or "unsecured". Secured Debentures are secured
against the security of a particular asset. They are termed as "unsecured" if
these are raised as a general loan. Debentures may be "convertible" into shares
or "redeemable" for cash at a specified future date. A convertible debenture
can be converted into either another type of bond / debenture at the given
maturity date or the same may be converted into equity as per the terms and
conditions of the debentures. Sometimes certain companies even issue
convertible debentures in which the right to buy shares at a later date and at a
certain price is contained in a separate warrant. Such warrants are usually
allowed to be detached from the bonds and can be sold separately.
Banking Topics of Interest 2010.doc Page: 41
Three major factors that affect the price of bonds and debentures are the :-
(a) Coupon rates of such instruments ;
(b) Credit quality / rating of the issuer.
(c) maturity period of the bonds
The above factors are explained below :-
(b) Credit Quality/Rating : When the credit quality of the issuer deteriorates, the
chances of default in interest and principal increases and thus market expects higher
interest from the company for taking higher risk, and thus the price of the bond falls
and vice versa.
(c) Maturity Period of the Bonds : Another factor that determines the price of a
bond is the "Maturity Period". A bond with a longer maturity instrument will rise or fall
more than a shorter maturity instrument.
(i) Default Risk / Credit Risk : This risk refers to the risk of default in payment of
interest and / or principal on due dates. There can be various reasons for such default
e.g. poor performance of the company. To manage such risks, the investor has to be
careful while taking decisions for investments in such bonds / debentures. He should
use various techniques of analysis of the financial statements of the company.
However, this is not always easy for a general investor and he / she is normally swayed
by the current trends in the market. This risk can be minimised by an investor on the
street, if he / she merely opts to invest only in bonds / debentures which carry good
ratings by known rating agencies like CARE, CRISIL, ICRA and FITCH.
(ii) Interest Rate Change Risk : Most of the bonds / debentures carry fixed coupon.
This means the return on such bonds / debentures is fixed during the tenure of the
instrument. However, in the financial market the rate of interests keep on changing on
day to day basis. Once an investor has made investments in fixed income bonds /
debentures, he is sure to get the returns (barring the default by the issuer), but if the
interests rate go up during the tenure of the instrument, he will be loser as he has lost
the opportunity of investing at a higher rate of returns. If rate of interests have gone
up and he wants to off-load his investment, he will be getting a price below the face
value of the instrument and thus his investments also gets eroded.
(iii) Purchasing Power Risk : This is another risk associated with almost all kinds of
investments. The money received from the fixed income bonds / debentures when
redeemed on maturity may not have the same purchasing power as at the time of
investment. This happens due to inflation. Sometimes the rate of inflation may be
Banking Topics of Interest 2010.doc Page: 42
even more than the coupon rate on such bonds. In such a situation it is considered as a
negative actual returns on the bonds / debentures
(iv) Reinvestment risk: It means that if market interest rates change during the
tenure of the instrument then intermediate cash flows get reinvested at lower rates of
interest
(v) Call Option Risk : These days most companies are smart and include a call option
in long term deep discount bonds and even in fixed income securities. This option
write in small letters about such options. Thus when interest rates actually fall, they will
call back the bonds and raise fresh funds at lower rates. In recent years, millions of
investors felt cheated, when IDBI recalled their 25 year bonds and investors were left in
the lurch.
(a) Bonds are safe since the returns are assured : As explained above, bonds too
carry the default risk. Therefore, this statement needs to be qualified. Poorly rated
bonds / debentures or unrated bonds of small companies can be as risky as equities.
(b) Government bonds are entirely risk free : This is also not true. There is little
doubt that the bonds issued by the Central government are free from default risk, but
such bonds do carry the interest rate risk, re-investment risk and erosion of purchasing
power risk.
(c) A good credit rating is assurance of the health of the bond issuer : This is
not always so. One has to remember that credit rating agencies normally rate
instruments and not the company per se. Thus a good rating for one instrument not
necessarily means that it is good to invest in all instruments of such company.
Banking Topics of Interest 2010.doc Page: 43
The participants in this market are banks, financial institutions, insurance companies,
mutual funds, primary dealers, NBFCs, non-Government Provident Funds, Corporates
etc. The participants open a Constituent SGL (CSGL) Account with CCIL for depositing
securities which are offered as collateral / margin for borrowing and lending of funds.
Eligible securities are Central Government securities including Treasury Bills.
How / Why CBLO is Superior to Repo / Call Money vs. REPO vs. CBLO:
There are broadly three channels through which banks in India primarily borrow and
lend funds in the overnight market. These are the (a) inter-bank call money market, (b)
the market for collateralised borrowing and lending obligations (CBLO) and (c) the repo
market. Slowly, banks are now moving to more secured form of lending in the money
market i.e. CBLO and repo markets, which have seen volumes rising. However, the
risk proposition differs across markets. While funds in the call market are lent on an
unsecured basis, both in the CBLO and repo markets, players on the borrowing end
need to place securities in the form of collateral. Interest rates, in CBLO and REPO
markets, are lower than those in the call market, due to lower risk levels involved.
Moreover, banks normally fix internal limits for borrowers and thus they do not lend in
call money beyond such internal limits. Such. These limits are fixed by banks based on
number of parameters which include the past ratings issued to the borrowers and the
net worth of that bank.
Banking Topics of Interest 2010.doc Page: 44
Repo has many drawbacks, for example in case of Repos there is no flexibility. The
obligations can be squared up only on the due date. Thus, even in case the liquidity
position of borrower improves, he cannot `prepay'. Similarly, in case the lender's
surplus liquidity position dries up, and he intends to call back the money, he cannot call
back his lendings.
However, in case of a CBLO holder, he can sell, or, an investor can buy it, at anytime
during its tenure. Unlike Repo, where the amount of deals normally runs into several
crores, CBLO is in denominations of Rs 50 lakh, and enabling part unwinding also. On
the CCIL platform, the borrowers submit their `offers' and lenders their `bids',
specifying the discount rate and maturity period. The bids/offers will be through an
auction screen called `auction market'. These orders are matched on the basis of the
best quotations, allowing, of course, for negotiations."
CBLO Dealing System is an automated order driven, on-line matching system provided
by CCIL so as to enable Members to borrow and lend funds against under CBLO
scheme. It also disseminates information regarding deals concluded, volumes, rate etc.,
and such other notifications as relevant to CBLO market
Banking Topics of Interest 2010.doc Page: 45
WHAT IS SLR? What is CRR? What is BANK RATE?, What are REPO AND
REVERSE REPOs? What is difference between CRR and SLR?
What is Bank rate? Bank Rate is the rate at which central bank of the country (in
India it is RBI) allows finance to commercial banks. Bank Rate is a tool, which central
bank uses for short-term purposes. Any upward revision in Bank Rate by central bank is
an indication that banks should also increase deposit rates as well as Prime Lending
Rate. This any revision in the Bank rate indicates could mean more or less interest on
your deposits and also an increase or decrease in your EMI.
What is Bank Rate ? (For Non Bankers) : This is the rate at which central bank
(RBI) lends money to other banks or financial institutions. If the bank rate goes up,
long-term interest rates also tend to move up, and vice-versa. Thus, it can said that
in case bank rate is hiked, in all likelihood banks will hikes their own lending rates to
ensure and they continue to make a profit.
What is CRR? The Reserve Bank of India (Amendment) Bill, 2006 has been enacted
and has come into force with its gazette notification. Consequent upon amendment to
sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the
monetary stability in the country, can prescribe Cash Reserve Ratio (CRR) for scheduled
banks without any floor rate or ceiling rate. [Before the enactment of this amendment,
in terms of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for
scheduled banks between 3 per cent and 20 per cent of total of their demand and time
liabilities].
RBI uses CRR either to drain excess liquidity or to release funds needed for the economy
from time to time. Increase in CRR means that banks have less funds available and
money is sucked out of circulation. Thus we can say that this serves duel purposes i.e. it
not only ensures that a portion of bank deposits is totally risk-free, but also enables RBI
to control liquidity in the system, and thereby, inflation by tying the hands of the banks
in lending money.
What is CRR (For Non Bankers) : CRR means Cash Reserve Ratio. Banks in India
are required to hold a certain proportion of their deposits in the form of cash.
However, actually Banks don’t hold these as cash with themselves, but deposit such
case with Reserve Bank of India (RBI) / currency chests, which is considered as
equivlanet to holding cash with themselves.. This minimum ratio (that is the part of
the total deposits to be held as cash) is stipulated by the RBI and is known as the
CRR or Cash Reserve Ratio. Thus, When a bank’s deposits increase by Rs100, and if
the cash reserve ratio is 9%, the banks will have to hold additional Rs 9 with RBI and
Bank will be able to use only Rs 91 for investments and lending / credit purpose.
Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be
able to use for lending and investment. This power of RBI to reduce the lendable
amount by increasing the CRR, makes it an instrument in the hands of a central bank
through which it can control the amount that banks lend. Thus, it is a tool used by
RBI to control liquidity in the banking system.
What is SLR? Every bank is required to maintain at the close of business every day, a
minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form
of cash, gold and un-encumbered approved securities. The ratio of liquid assets to
demand and time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is
Banking Topics of Interest 2010.doc Page: 46
24%. (reduced w.e.f. 8/11/208, from earlier 25%) RBI is empowered to increase this
ratio up to 40%. An increase in SLR also restrict the bank’s leverage position to pump
more money into the economy.
What is SLR ? (For Non Bankers) : SLR stands for Statutory Liquidity Ratio. This
term is used by bankers and indicates the minimum percentage of deposits that the
bank has to maintain in form of gold, cash or other approved securities. Thus, we can
say that it is ratio of cash and some other approved to liabilities (deposits) It regulates
the credit growth in India.
Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the
banks. When the repo rate increases borrowing from RBI becomes more expensive.
Therefore, we can say that in case, RBI wants to make it more expensive for the banks
to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for
banks to borrow money, it reduces the repo rate
Reverse Repo rate is the rate at which banks park their short-term excess liquidity
with the RBI. The RBI uses this tool when it feels there is too much money floating in
the banking system. An increase in the reverse repo rate means that the RBI will
borrow money from the banks at a higher rate of interest. As a result, banks would
prefer to keep their money with the RBI
Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in
the banking system by RBI, whereas Reverse repo rate signifies the rate at which the
central bank absorbs liquidity from the banks.
Bank Rate 6.00% (w.e.f. 29/04/2003)
Indian debt market can be broadly classified into two categories, namely
debt instruments issued by Central or State Governments and debt
instruments issued by Public and Private Sector. Different instruments
issued have some prominent features in respect of period of maturity and the
investors for such instruments. A gist of the structure of Indian debt market
is given below :-
Maturity
Who Issues Type of Instruments Who Invests Remarks
Periods
GOVERNMENT:-
Banks, Insurance
Zero Coupon Bonds;
Central 1 year to and PF Trusts, RBI,
Coupon Bearing GOI
Government 30 years Mutual Funds,
securities
Individuals
Banks, Insurance
91 days
Central and PF Trusts, RBI,
Treasury Bills and 364
Government Mutual Funds,
days
Individuals
State Coupon Bearing 5 years to Banks, Insurance
Government State Govt securities 10 years and PF Trusts
DERIVATIVES
What are Derivatives?
Derivatives have their origin in mathematics, where it is referred to a variable that has
derived it value from another variable. In financial market, derivatives are those
financial instruments whose value is derived from the price of some underlying asset,
such as stocks, bonds, currencies or commodities. One very interesting example to
understand the concept of underlying asset is considering “curd” as a derivative. The
price of curd always depends on the price of milk. In other words, we can say the
underlying asset on which the value of curd depends is the milk.
Example : Let us assume that a farmer wish to contract to sell his rice harvest at a
future date so as to eliminate the risk of a change in prices by that time. Such a
contract can take place in the Rice Forward Market. The price of such a contract
would certainly depend upon the current spot price of the rice. In this transaction, the
"rice forward" is the derivative, whereas the rice on the spot market is "the underlying"
commodity or asset.
(B) Futures : Forward contracts, which have the following features, are termed as
Futures:
(a) Traded in an Exchange
(b) Standardized in terms of quality and quantity
Thus, futures are defined as those forward contracts that are traded on an exchange
and where the counter-party is the exchange itself.
(C )Options : Options are considered as one-way contract where one party has the
right but not the obligation to trade in a particular asset at a particular price on a pre-
determined date(s) or in a particular time interval.
Thus an option is a contract, which gives the buyer the right, but not the obligation to
buy or sell particular assets (for example shares) at a specific price on or before a
specific date. ‘Option’, as the word itself suggests, gives the investor a choice to
Banking Topics of Interest 2010.doc Page: 49
exercise the option or not to exercise the same. To acquire this right the buyer of the
option has to pay a premium to the writer of the option (option seller) of the contract.
Option contracts which can be exercised on or before the expiry date are called
"American Options". On the other hand European options can be square off only on
the date of expiry. In Indian stock market options on Nifty are actually European
Options - meaning that the buyer of these options can exercise his option only on the
expiry day.
There are two kinds of options: Call Options and Put Options.
(D) SWAPS :
Swap is defined in number of ways. Simple speaking Swap is a contract between two
parties to exchange cash flows in the future according to agreed terms Swaps are used
to change the currency or interest rate exposure associated with investments.
Thus, we can say swap involves combined or simultaneous buying and selling operation
in which two counterparties agree to exchange streams of payments occurring over time
according to predetermined terms.
To elaborate more, we can say Swap is the simultaneous purchase and sale of the same
amount of a given currency for two different dates, against the sale and purchase of
another. A swap can be a swap against a forward. In essence, swapping is somewhat
similar to borrowing one currency and lending another for the same period. However,
any rate of return or cost of funds is expressed in the price differential between the two
sides of the transaction.
(i) Interest Rate Swaps (IRS) : Interest Rate Swaps are those agreements where
one side pays the other a particular interest rate (fixed or floating) and the other side
pays the first party other different interest rates (fixed or floating).
Thus, we can say IRS allow the entities to move from a fixed interest rate to a floating
rate or vice versa in the same currency. IRS is a bilateral financial contract under which
the parties agree to pay or receive the difference between an interest rate, fixed in
Banking Topics of Interest 2010.doc Page: 50
advance for the swap tenor, and a floating rate that is based upon an agreed
benchmark on a notional principal and for a specified period. These can also be based
upon two floating rates based upon different benchmarks. The difference between the
rates is settled in cash on a series of payment dates that occur during the life of a
swap. Thus, it is a series of FRAs (i.e. Forward Rate Agreements).
In interest rate swaps, there are no exchange of principals between the parties. There
is only exchange of interest obligations. The principal is notional and is used only to
calculate the interest payments between the parties. To understand the whole concept
we can consider the following example :-
(ii) Currency Swap : These help the treasury managers to hedge the exchange
risk. The currency swaps allow corporate to change both the interest rate profile and
currency denominations of its loans. Unlike in interest rate swaps, where only interest
payments are exchanged, in a currency swap both interest and principal are
exchanged. It involves exchanging principal and interest payment on a loan in one
currency for principal and interest payments on an approximately equal loan in another
currency, usually at the prevailing spot exchange rate. On maturity of the swap, the
respective principals are re-exchanged at the same exchange rate.
(iii) Coupon Swap : This derivative product is like a currency swap with a difference
that only the interest components of a loan is exchanged. In this case, the corporate
buy the instrument if it is expected that interest rates on the other currency is likely to
be lower. Interest rate caps and collar are used. A cap is an option which gives the
corporate the right but not the obligation, to exercise it. This derivative product
involves a strike price and an upfront premium.
Banking Topics of Interest 2010.doc Page: 51
DIVIDEND STRIPPING
Exchange Traded Fund, popularly known as ETFs, are the financial instruments, tradable
on a stock exchange, that invests in the stocks of an index in approximately the same
proportion as held in the index. ETFs, are a hybrid of open-ended mutual funds and
listed individual stocks. In simple terms, ETFs are funds that are listed on stock
exchanges and trade like individual stocks. However, unlike mutual funds, ETFs do not
sell their shares directly to investors for cash. A securities firm creates ETFs by
depositing a basket of stocks. This large block of stocks is called a creation unit. In
return for these stocks deposited, the ETF receives shares, which are then offered to
investors over the stock exchange.
Therefore, ETFs bring the trading and real time pricing advantages of individual stocks
to mutual funds. To sum up some of the features of these Funds are :-
(a) These are a hybrid of open and close-ended funds;
(b) They are listed on the stock exchange (Similar to the close-ended funds);
(c) They create and redeem units in keeping with rise and fall in demand (Like open-
ended funds).
(d) They are passively managed (similar to index funds).
INDEX FUTURES
What are Index Futures:
Index Futures are Future contracts (A futures contract is a forward contract, which is
traded on an Exchange) where the underlying asset is the Index. The index futures
contracts are based on the popular market benchmark Nifty and S & P index. Both
the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) launched
index futures in June 2000. This is of great help when one wants to take a position on
market movements. Suppose you feel that the markets are bullish and the Sensex would
cross 12000 points. Instead of buying shares that constitute the Index you can buy the
market by taking a position on the Index Future.
Index futures can be used for hedging, speculating, arbitrage, cash flow management
and asset allocation. BSE / NSE defines the characteristics of the futures contract such
as the underlying index, market lot, and the maturity date of the contract. The futures
contracts are available for trading from introduction to the expiry date.
Long and short positions indicate whether you have a net over-bought position (long) or
over-sold position (short).
Banking Topics of Interest 2010.doc Page: 54
MONEY MARKET
The money market is a market for short term instruments. They are considered as the
most liquid of all the investments and are frequently referred as “Near Money
Instruments”. The instruments of less than one year maturity is referred to as money
market instruments. This market acts as an equilibrating mechanism and helps to
deploy or borrow funds for short durations. Although money market is frequently
considered as a separate market, but in reality it is only a sub-section of the fixed
income bond market. The only difference between the money market and the bond
market is that the money market specializes in a short term debt securities and they
these are sometimes referred as “cash investments” also.
(1) CALL / NOTICE MONEY : Historically this market has few players and restricted
to commercial, cooperative and foreign banks and primary dealers. The Calls are placed
for overnight, whereas Notice Money is placed for 2 to 14 days. RBI issues certain
guidelines for the call money market so as to avoid volatility in the market and to restrict
excessive dependence on this market to meet the long term needs of the institutions.
Some Non-banking entities like Financial Institutions, Insurance Cos., Mutual Funds are
allowed only as lenders in the Call Money market.
Repo is short for “Repurchase Agreement”. It is also termed as 'Buy Back', 'RP', or
'Ready Forward' (RF). It is a sale of securities with an agreement to repurchase the
same on a future date and at a specific price. Institutions like Banks who deal in
government securities use this instrument as a form of overnight borrowing. Under this
method, a dealer or other holder of government securities sells the securities to a lender
and agrees to repurchase them at an agreed future date at an agreed price. They are
usually very short-term, from overnight to 30 days or more. This short-term maturity
and government backing means repos provide lenders with extremely low risk. Thus, in
short, we can say Repo is the sale of a security with a commitment to repurchase the
same security at a specified price on a specified date for a pre-determined period.
The term 'REVERSE REPURCHASE AGREEMENT' (Reverse Repo) refers to a repos deal
viewed from the perspective of the supplier of funds. In this case, the assets are bought
with an agreement to resell them at a fixed price on a future date. Thus transaction
is called Repo for the institution who is a borrowing the money and it is
“Reverse Repo” for the institution who is lending the money.
Term Repo – It is exactly the same as “Repo” except that the period of borrowing /
lending is greater than 30 days.
COMMERCIAL PAPERS :
These are popularly called “CPs” and are a short term money market instruments
comprising of unsecured negotiable short term usance promissory note with fixed
maturity issued at discount to the face value. Another important feature of these
instruments is that these are freely transferable by endorsement and delivery. Now
these can be issued only in demat form. Some other features of these are :-
CERTIFICATE OF DEPOSITS
These are popularly called “CDs” and are short term money market instruments
comprising of unsecured negotiable short term usance promissory note with fixed
maturity issued at discount to the face value. Thus, CD is a negotiable interest-bearing
debt instrument of specific maturity issued by banks.
They too are freely transferable by endorsement and delivery and are available in
physical form. These are issued by banks and FIs to mobilize bulk resources and can
be issued / traded in multiples of Rs.5 lacs each. Thus CD represents the title to a
TIME DEPOSIT with a bank. However, it is a liquid instrument since it can be traded in
the Secondary Market. It is issued with a maturity of less than one year and is issued at
a discount from the face value. Interest is the difference between the issue price and
the face value, which the holder receives at maturity.
Banking Topics of Interest 2010.doc Page: 56
BILLS REDISCOUNTING :
INTER-CORPORATE DEPOSITS :
These are issued by RBI for different maturities, but not exceeding 364 days. At
present RBI issues only 91 days and 364 days Treasury Bills. These TBills, as they
are popularly known in the market, are issued at discount to face value by RBI for
funding the short term requirement of Central Government. The payment of
discount and repayment of Principle is guaranteed by central government
These are new instruments for the Indian money market. The institutions and
individuals with large surpluses can use this mode. They are unsecured money market
instruments and funds are generally invested for few weeks, but exit from the Fund is
usually available at a 24 hour notice. Net Asset Value is declared by the Mutual Fund on
daily basis. Returns fluctuate with rise and fall of the financial markets.
Banking Topics of Interest 2010.doc Page: 57
NAV=
Market value of the fund’s investments + Receivables +Accrued Income– Liabilities-
Accrued Expenses
_______________________________________________________________________
Number of Outstanding units
3. The investor is spared of the time and effort required for daily f tracking the
price movements.
4. Investors can invest even small amounts
5. In case of open-ended funds, the investment is very liquid as it can be redeemed
at any time with the fund unlike direct investment in stocks/bonds.
These Funds invest their funds mainly in equity shares. Their main Objective is the
growth through capital appreciation over a period ranging from medium to long-term.
The returns in such funds carry maximum risk as their performance is usually directly
linked to the returns on the stock markets. These are usually considered as best for
investors who are young and have capacity to bear risk Based on the objectives of the
investments these funds are named as :
• Sector funds: These funds invest mainly in equity shares of companies of a
particular sector or industry. These funds give the best returns if that particular
sector shows growth. They are also highest risk as downward trend in the
sectors will result in negative returns.
• Balanced Funds : As the name suggests, these funds invest both in equity
shares and fixed-income-bearing instruments (debt) in some proportion. These
Funds are usually able to provide a steady return as the investment in fixed
income bonds reduces the volatility of the funds They are best suited for
investors who are willing to take moderate risks in a span of medium- to long-
term
• Diversified funds : These funds invest in shares of companies in different
sectors
• Index funds: These funds invest mainly on a similar pattern as that of Nifty or
BSE 30. The returns on these fund normally in line with the returns of the index
to which these are benchmarked.
• Tax Saving Funds : Such Funds offer tax benefits to investors under the
Income Tax Act. U/s 80C or Capital Gains U/s 54EA and 54EB. They are best
suited for investors who wants to invest in equities and save tax too.
• Debt / Income Funds : These Funds invest predominantly in high-rated fixed-
income-bearing instruments like bonds, debentures, government securities,
Banking Topics of Interest 2010.doc Page: 59
Open-ended Funds These funds do not have a fixed date of redemption. Generally
they are open for subscription and redemption throughout the year. Their prices are
linked to the daily net asset value (NAV). From the investors' perspective, they are much
more liquid than closed-ended funds. Investors are permitted to join or withdraw from
the fund after an initial lock-in period.
Close-ended Funds : These funds are open initially for entry during the Initial Public
Offering (IPO) and thereafter closed for entry as well as exit. These funds have a fixed
date of redemption. One of the characteristics of the close-ended schemes is that they
are generally traded at a discount to NAV; but the discount narrows as maturity nears.
These funds are open for subscription only once and can be redeemed only on the fixed
date of redemption. The units of these funds are listed (with certain exceptions), are
tradable and the subscribers to the fund would be able to exit from the fund at any time
through the secondary market.
Interval funds : These funds combine the features of both open–ended and close-
ended funds wherein the fund is close-ended for the first couple of years and open-
ended thereafter. Some funds allow fresh subscriptions and redemption at fixed times
every year (say every six months) in order to reduce the administrative aspects of daily
entry or exit, yet providing reasonable liquidity.
Domestic funds : These funds mobilise the savings of nationals within the country.
Offshore Funds : These funds facilitate cross border fund flow. They invest in
securities of foreign companies. They attract foreign capital for investment.
Banking Topics of Interest 2010.doc Page: 60
(a) Growth Plan and Dividend Plan : Growth Plan is a plan under which, the returns
from investments are reinvested and income is usually not distributed The investor
thus only realizes capital appreciation on the investment by sale of units. On the other
hand, under the Dividend Plan, income is distributed from time to time.
(c) Systematic Investment Plan (SIP) :Also called Automatic Investment Plan (AIP)
- The investor under this Plan have the option for investing at specified periodicity in a
specified scheme of the Mutual Fund for a constant sum of investment. This helps the
investors to capture the high and lows of the market and become less risky.
(d) Systematic Withdrawal Plan (SWP) : Also called as Automatic Withdrawal Plan
(AWP) allows the investors to withdraw a pre-determined amount from his fund at a
pre-determined interval.
Open ended schemes usually do not have any lock in period. Some close ended
schemes have a minimum lock in period. However, Tax Saving Schemes have a
minimum lock-in period in terms of the tax laws The lock-in period for different tax
saving schemes are as follows:
Name the Factors Who Affect / Influence the Performance of the Mutual
Funds?
The performances of Mutual funds depends on number of factors, viz stock market
performance; overall growth in the economy; interest rates in the economy and credit
quality. Fund Manager's experience and expertise also plays a major role in the
performance of the MFs, especially in balanced and diversified funds.
d) The trustees shall be bound to make such disclosures to the unit holders as are
essential in order to keep them informed about any information which may have an
adverse bearing on their investments.
e) 75% of the unit holders with the prior approval of SEBI can terminate the AMC of
the fund.
f) 75% of the unit holders can pass a resolution to wind-up the scheme.
g) An investor can send complaints to SEBI, who will take up the matter with the
concerned Mutual Funds and follow up with them till they are resolved.
Banking Topics of Interest 2010.doc Page: 63
VALUATION OF SECURITIES
Classification
(i) The entire investment portfolio of the banks (including SLR securities and non-
SLR securities) should be classified under three categories viz. 'Held to Maturity',
'Available for Sale' and 'Held for Trading'. However, in the Balance Sheet,
the investments will continue to be disclosed as per the existing six classifications
viz. a) Government securities, b) Other approved securities, c) Shares,
d) Debentures & Bonds, e) Subsidiaries/joint ventures and f) Others (CP,
Mutual Fund Units, etc.).
(ii) Banks should decide the category of the investment at the time of acquisition
and the decision should be recorded on the investment proposals.
Held to Maturity
(a) Investments classified under Held to Maturity category need not be marked
to market and will be carried at acquisition cost unless it is more than the face
value, in which case the premium should be amortised over the period
remaining to maturity.
(b) Banks should recognise any diminution, other than temporary, in the value of
their investments in subsidiaries/ joint ventures which are included under Held
to Maturity category and provide therefor. Such diminution should be
determined and provided for each investment individually.
The individual scrips in the Available for Sale category will be marked to market
at the quarterly or at more frequent intervals. While the net depreciation under each
classification referred to at 3.2(i) above should be recognised and fully provided for,
the net appreciation under each classification should be ignored. The book value of
the individual securities would not undergo any change after the revaluation.
The individual scrips in the Held for Trading category will be marked to market at
monthly or at more frequent intervals as in the case of those in the Available for
Sale category. The book value of the individual securities in this category would not
undergo any change after marking to market.
Banking Topics of Interest 2010.doc Page: 64
Equity Shares constitute the ownership capital of a company. The equity holder has the
right of voting and is entitled to dividend whenever the profits of the company are
distributed.
Preference Shares are a hybrid of equity shares and a fixed income instruments. The
preference share holders also enjoy the ownership rights like equity holders, but they do
not have voting rights except in respect of certain resolutions affecting their rights or
when their dividends are due are in arrears for the last two financial years. However,
they are entitled to get fixed dividend before any dividend is declared to the equity
share holders. As these shares have preferred rights for payment of dividend over the
equity holders, they are called Preference Shares. Moreover, they also enjoy
preferential right over equity holders in respect of payment of capital in the unlikely
event of winding up of the company. However, this right is subject to the claims of the
creditors. There are different types of Preference shares, e.g. :
(a) Redeemable and Non-Redeemable preference shares;
(b) Cumulative and Non-cumulative preference shares;
(c) Participating and Non-participating preference shares;
(d) Convertible and Non-Convertible preference shares
(d) There is equal risk that the price of the share bought through IPO or public
issue may get listed at below the offer price or may fall below the offer price
within a few days or weeks of the listing.
The Exchange was set up to aid enterprising promoters in raising finance for new
projects in a cost effective manner and to provide investors with a transparent &
efficient mode of trading. OTCEI introduced many novel concepts to the Indian capital
markets such as screen-based nationwide trading, sponsorship of companies, market
making and scripless trading. The exchange has assisted in providing capital for
enterprises that have gone on to build successful brands for themselves like VIP
Advanta, Sonora Tiles & Brilliant mineral water, etc. OTCEI was promoted jointly by the
ICICI, UTI, IFCI, IDBI, SBI Capital Markets Ltd., Canbank Financial Services Ltd., the
General Insurance Corp. and LIC. One of the objectives of this Exchange to provide a
less expensive method of getting the shares listed for trading and for raising capital
from the market.
OCTEI is the only exchange which allows listing of companies with paid-up below Rs.3
crores. Thus small companies can make best use of this Exchange. One of the
advantages of trading on OTCEI is that it offers greater liquidity through hybrid trading
(market making and order book system) It was expected to a watershed in the stock
trading in India. However, after aggressive marketing of NSE, this Exchange has lost
most of its shine and the experiment appears to be not of much success.
A Governing Board having 20 directors is the apex body at BSE. It decides the policies
and regulates the affairs of the Exchange. The Governing Board consists of 9 elected
directors, who are from the broking community (one third of them retire ever year by
rotation), three SEBI nominees, six public representatives and an Executive Director &
Chief Executive Officer and a Chief Operating Officer.
BSE has objective to provide an efficient and transparent market for trading in
securities, debt and derivatives. It also strives to upholds the interests of the investors
and educate and enlighten them by conducting investor education programmes and
making available to them necessary informative inputs. BSE has also now become
screen based trading Exchange.
The scrips traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z'
groups. The 'A' group shares represent those, which are in the carry forward system
(Badla). The 'F' group represents the debt market (fixed income securities) segment.
The 'Z' group scrips are the blacklisted companies. The 'C' group covers the odd lot
securities in 'A', 'B1' & 'B2' groups and Rights renunciations.
trading terminals across the country has won the confidence of the investors in short
duration. The use the latest technology for fully screen based trading system has
helped the NSE to eliminate the physical trading floor. The screen based trading
system ensures transparency and helps the investors to get the best price. The
settlement system has been made much more efficient and quick. The latest
technology and communications have made the NSE the leading Exchange of India
BSE vs NSE : In addition to BSE and NSE, there are 22 Regional Stock Exchanges.
However, the Bombay Stock Exchange (BSE) and the National Stock Exchange of India
Ltd (NSE) are the two primary exchanges in India at present. These two Exchanges
have established themselves as the two leading exchanges and account for over 80 per
cent of the equity volume traded in India. The competition between NSE and BSE has
become real hot and both are trying to have an edge over the other. BSE has more
number of listed companies, whereas the NSE has less number of listed companies.
BSE has also broken the barrier of being Mumbai based Exchange as its terminals are
spread all over India.
Both the exchanges have switched over from the open outcry trading system to a fully
automated computerized mode of trading. The systems on two exchanges are known
by different names, i.e. (i) BOLT (BSE On Line Trading) and (ii) NEAT (National
Exchange Automated Trading) System. It facilitates more efficient processing, automatic
order matching, faster execution of trades and transparency.
Both the Exchanges are closed on Saturdays and Sundays. In case of both the
exchanges, the key regulator governing the exchanges is SEBI. .
NYSE AND NASDAQ : These two exchanges are well known stock exchanges in the
financial world. They are in North America and these account for a major portion of the
world’s stock market tradings. Some of the major features of these Exchanges makes
them different from each other. Some of these dis-similarities between two exchanges
are :-
(a) NYSE is located in New York and all trades that take place in this
Exchange actually occur on the trading floor of the NYSE. Thus, NYSE has
physical location and the brokers trade on the floor of the Exchange. On the
other hand, the Nasdaq does not have trading floor in physical mode, but it
is a Exchange on a telecommunications network. Here brokers are not
present on the trading floor, but trading takes place directly between
investors and their buyers or sellers, who are the market makers through a
electronic network.
(b) NYSE is an auction market, where individuals buy and sell the shares
between one another. The transactions are auction based where the
highest bidding price is matched with the lowest asking price. On the other
hand, the Nasdaq is a dealer’s market where market participants do not buy
or sell to one another, but they buy or sell to and from a dealer. Such
dealers are known as market makers.
(c) It is generally believed that the companies listed on NYSE are established
and stable companies. A number of stocks listed on NYSE are from blue chip
companies. On the other hand, the companies listed on the Nasdaq
exchange are considered to belong to high-tech market dealing in new age
of internet or electronics. These stocks are considered to be more growth
oriented but highly volatile.
Banking Topics of Interest 2010.doc Page: 68
One buys shares to make profits – some have short term goals others have
long term goals. But this is one of the most difficult questions as to what to
buy and when to buy the same. In this world no one can consistently predict
as to buying of which shares will certainly result in profits. It is a very wide
topic and it is not the scope of this article to discuss these in detail but certain
fundamentals are discussed.
The price of a share depends on two things - how the company’s business is faring and
what is the outlook for the economic growth of the economy as a whole. Analysing
stocks, or assessing their future prices is broadly down through two methods of analysis
- the fundamental and the technical. A fundamental analysis looks at all things that
could possibly affect the business of a company. Some of the major items that are
looked by the fundamental analysts are: the company’s sales and earnings, the
operating margins, the management of the company, the company’s prospects in future
and the prospects of the industry and the competition it faces etc.
However, merely impressive sales and profit figures don't impress many investors. They
look beyond these figures and look into the the company’s growth rate i.e., rate of
growth in sales as well as profits. A fast growing company has good capital
appreciation.
Banking Topics of Interest 2010.doc Page: 69
(C )Dematerialisation or DEMAT :
Dematerialization (or Demat) is the process by which an investor can get the physical
certificates (also called paper certificates) converted into electronic form. The shares in
electronic forms are kept in an account with the Depository Participant. The investor
can dematerialise only those certificates that are registered in his name and these
certificates belong to the list of securities admitted for dematerialisation at NSDL.
In the physical mode, the certificates were subject to many problems like forged
certificates, lost certificates, mutilated certificates etc. With the increasing volume on
the stock markets, it was becoming impossible to handle the same in physical form on
regular basis. In view of these problems associated with physical mode of certificates,
now it has been made compulsory for all shares to be converted into demat mode. The
stock exchanges now a days do not allow delivery through physical mode.
We can sum up the major advantages of trading through demat shares:-
(a) The problems relating to transfer of shares like bad deliveries, difference in
signatures, theft, fire, and mutation of shares do not occur in demat shares.
(b) The investors do not have to pay stamp duty for buying the shares in demat
form.
(c) The brokerage fee has reduced as the paperwork at the broker end has
considerably reduced.
(D) Depository : The depositories are organizations who are responsible to maintain
investor's securities in the electronic form. A depository can therefore be considered like
a "Bank" for securities. In India there are two depositories, namely NSDL and CDSL.
The depository concept is almost similar to the Bank, with the exception that banks
handle funds whereas a depository handles securities of the investors. An investor
wishing to utilize the services of a depository, needs to open an account with the
depository through a Depository Participant.
(E) Depository Participant (DP) : DPs are the market intermediary through whom
the depository services are availed by the investors. SEBI regulations require that DP
should be an organization involved in the business of providing financial services like
banks, brokers, custodians and financial institutions. This system of using the existing
distribution channel (mainly constituting DPs) helps the depository to reach a wide cross
section of investors spread across a large geographical area at a minimum cost.
As per SEBI guidelines the Book needs to be kept open for a minimum period of 5
days. The issuer is entitled to fix the floor price (it means the minimum price) at which
bids can be made by the investors.
The major differences in offer of securities through book building and through
normal public issue are :
(a) The allotment price is not known to the investor at the time of investment (though
price band is known to him). In case of public issues the exact price at which securities
will be allotted is known at the time of application itself.
(b) In case of book building, the demand for the securities is made known on daily
basis, but in case of normal public issue the total demand is known only after the
closure of the issue.
How does the Book Building System Works : First of all the issuer appoints a
merchant banker as the Lead Manager and Book Runner. A prospectus is filed with
SEBI for approval. The book runner then collects orders from various investors through
underwriters and other participating members. Thus, the orders from the clients for
the quantity of security required by them at various prices at which they are comfortable
are collected. Based on these informations, a book a prepared where the information
relating to the orders received is recorded. On receipt of sufficient number of orders,
the Book is closed. Based on the orders, the cut off price is decided and securities are
allotted.
In equity market, recently the Book Building mode has been used some companies
wherein the investors are asked to apply like normal public issue but with the price of
their choice (of course, within the price band declared by the issuer).
BSE and the NSE both certain pre-defined methods of circuit breakers. The circuit is
thus the band between the lower and upper limits. Circuits are built to check the
volatility in the market, to arrest panic and to keep the market under some control.
Market Wide Circuit Breakers : The “Market Wide Circuit Breakers” have been
introduced at a national level in the Indian markets for the first time. This is on the
lines of the system prevailing in the US markets.
In order to contain large market movements, SEBI has mandated that the Market Wide
Circuit Breakers (MWCB) which at 10-15-20% of the movements in either BSE Sensex
or NSE Nifty, whichever is breached earlier, would be applicable. This provides cooling
period to the market participants and enable them to re-act to the market movements.
The trading halt on all stock exchanges would take place as under:-
Banking Topics of Interest 2010.doc Page: 72
(a) In case of a 10% movement of either index, there would be a 1-hour market halt if
the movement takes place before 1:00 p.m. In case the movement takes place at or
after 1 p.m. but before 2:30 p.m., there will be a trading halt for 1/2 hour. In case the
movement takes place at or after 2:30 p.m., there will be no trading halt at the 10%
level and the market will continue trading.
(b) In case of a 15% movement of either index, there will be a 2-hour market halt if the
movement takes place before 1:00 p.m. If the 15% trigger is reached on or after 1:00
p.m. but before 2 p.m., there will be 1-hour halt. If the 15% trigger is reached on or
after 2:00 p.m., the trading will halt for the remainder of the day.
(c) In case of a 20% movement of the either index, the trading will halt for the
remainder of the day.
The above percentages are required to be translated by the Exchanges into absolute
points of the Index variation on a quarterly basis, i.e., based on the closing index on the
last trading day of the quarter and advised to the market participants in advance. Based
on these absolute points, market wide circuit breakers are applied for the next quarter.
Circuit Filters
The Exchanges as per the directions from SEBI, are required to apply Circuit Filters on
all scrips traded in Rolling Settlements at 20% of the closing price of the scrips on the
previous day. However, in the Rolling Settlement Scenario, since the trading horizon is
only one day, the application of these Circuit Filters may pose high settlement default
risk, when a market participant is not able to square off his speculative trading position,
as the scrip may have hit the Circuit Filter. Therefore, in all 54 scrips, which form part
of the Sensex and Nifty or in which derivative products like stock options and Futures
are available, no circuit filters are applicable w.e.f. July 2, 2001. In other words, the
prices of these scrips can have free fall or increase within a day. However, in view of
the market developments that took place in September, 2001, SEBI has directed the
Exchanges to impose daily circuit filter of 10% on these 54 scrips. Accordingly, these 54
scrips have daily circuit filter of 10% and the remaining scrips in CRS have a daily circuit
filter of 20%.
(H) Inside Trading : Securities and Exchange Board of India (Prohibition of Insider
Trading) Regulations, 1992, has banned the inside trading in India. Inside trading
refers to the dealing of securities by an insider with the motive of making
profits or avoiding losses. The said Act defines aninsider as “any person who, is
or was connected with the company or is deemed to have been connected with the
company, and who is reasonably expected to have access to unpublished price sensitive
information in respect of securities of a company, or who has received or has had access
to such unpublished price sensitive information”. The "dealing in securities" means
an act of subscribing, buying, selling or agreeing to subscribe, buy, sell or deal in any
securities by any person either as principal or agent”.
(I) Going Short : When a person does not have shares and still sells the them in the
market, it is known as going short on a stock. This method is adopted by trader to get
short term gains, when they expect the price to decline. However, in the present day
when a rolling settlement cycle has been introduced, the trader has to cover the stock
by purchasing the same from market before the end of the day on which he had gone
short.
Banking Topics of Interest 2010.doc Page: 73
SWEAT EQUITY
Sweat Equity is the equity issued by the company to employees or director’s at
a discount for consideration other than cash, for providing the know-how or making
available rights in the nature of intellectual property rights or value addition.
In acquiring assets, banks should use the pricing mechanism in conjunction with
product/ geography/ industry/ tenor limits. For example, if a bank believes that
construction loans for commercial complexes are unattractive from a portfolio
perspective, it can raise the price of these loans to a level that will act as a disincentive
to borrowers. This is an instance of marginal cost pricing - the notion that the price
of an asset should compensate the institution for its marginal cost as measured on a
risk-adjusted basis. Marginal cost pricing may not always work. A bank may have idle
capacity and capital that has not been deployed. While such an institution clearly would
not want to make a loan at a negative spread, it would probably view even a small
positive spread as worthwhile as long as the added risk was acceptable.
Institutions tend to book unattractively priced loans when they are unable to allocate
their cost base with clarity or to make fine differentiations of their risks. If a bank cannot
allocate its costs, then it will make no distinction between the cost of lending to
borrowers that require little analysis and the cost of lending to borrowers that require a
considerable amount of review and follow up. Similarly, if the spread is tied to a too
coarsely graded risk rating system (one, for example, with just four grades) then it is
more difficult to differentiate among risks when pricing than if the risk rating is
graduated over a larger scale with, say, 15 grades.
A cost-plus-profit pricing strategy will work in the short run, but in the long run
borrowers will balk and start looking for alternatives. Cost-plus-profit pricing will also
work when a bank has some flexibility to compete on an array of services rather than
exclusively on price. The difficulties with pricing are greater in markets where the lender
is a price taker rather than a price leader.
The pricing is based on the borrower's risk rating, tenor, collateral, guarantees, historic
loan loss rates, and covenants. A capital charge is applied based on a hurdlerate and a
capital ratioª. Using these assumptions, the rate to be charged for a loan to a customer
with a given rating could be calculated.
This relatively simple approach to credit pricing works well as long as the assumptions
are correct - especially those about the borrower’s credit quality. This method is used in
many banks today. The main drawbacks of this method are:
· Only ‘expected losses’ are linked to the borrower’s credit quality. The
capital charge based on the volatility of losses in the credit risk category may
also be too small. If the loan were to default, the loss would have to be
made up from income from non-defaulting loans.
Banks have long struggled to find the best ways of allocating capital in a manner
consistent with the risks taken. They have found it difficult to come up with a consistent
and credible way of allocating capital for such varying sources of revenue as loan
commitments, revolving lines of credit (which have no maturity), and secured versus
unsecured lending. The different approaches for allocating capital are as under:
Banking Topics of Interest 2010.doc Page: 75
relationship or a transaction. Although not all assets have market price distribution,
RAROC is a first step toward examining an institution’s entire balance sheet on a mark-
to-market basis - if only to understand the risk-return trade-offs that have been made.
TREASURY OPERATIONS
Now a days most of Banks in India like to classify their business into two primary
business segments, namely Treasury operations (i.e. Investments) and Banking
operations (other than Treasury).
The role of Treasury has gained prominence in recent past as a sizable portion of the
income of the banks in India has come from investments. Moreover, the poor growth
of credit portfolio of Banks has left the banks with no alternative but to increase the size
of their investment portfolio.
(a) Rupees Treasury :- The Rupee Treasury carries out the bank’s rupee-based
treasury functions in the domestic market. Broadly, these include asset
liabilitymanagement, investments and trading. The Rupee Treasury also manages the
bank’s position regarding statutory requirements like the cash reserve ratio (CRR) and
the statutory liquidity ratio (SLR), as per the norms of the Reserve Bank of India. The
products included in rupee treasury are :-
(c ) Derivatives Desk
In last few years the Bank are moving towards the Integrated
Treasury operations where all the above separate desks are integrated and there is one
integrated Treasury.
Banking Topics of Interest 2010.doc Page: 78
Thus we can say VaR is a measure of potential loss from an unlikely, adverse event in a
normal, everyday market environment. VaR is denominated in units of a currency, e.g.,
Rupees or US dollars, say X million rupees, where the chance of losing more than X
dollars is, say, 1 in 100 over some future time interval, say 1 day.
Therefore, we can say that VaR is a statistical measure of risk exposure. The calculation
of VaR requires the application of statistical theory. To calculate VAR, one needs to
choose a common measurement unit, a time horizon, and a probability. The common
unit can be Indian Rupees USD, EURO , or whatever currency the organization primarily
uses to do business. The chosen probability of loss usually ranges between 1 and 5
percent. The time horizon can be of any length, but it is assumed that the portfolio
composition does not change during the holding period. The most common holding
periods used are one day, one week, or two weeks. The choice of the holding period
depends on the liquidity of the assets in the portfolio and how frequently they are
traded. Relatively less liquid assets call for a longer holding period.
Originally VaR was used as an information tool. i.e. it was used to communicate to
management a feeling for the exposure to changes in market prices. Later on market
risk was incorporated into the actual risk control structure. i.e., trading limits were based
on VaR calculations. Now a days VaR is also used in the incentive structure as
well.i.e., VaR is a component determining risk-adjusted performance and compensation.
The Bank for International Settlements (BIS) has accepted VaR as a measurement of
market risks and provision of capital adequacy for market risks, subject to approval by
Banking Topics of Interest 2010.doc Page: 79
banks' supervisory authorities. Thus, VAR models have been accepted by both
practitioners and bank regulators as the state of the art in quantitative risk
measurement. In its recent risk-based capital proposal, the Basle Committee on
Banking Supervision endorsed the use of banks' VAR models to allocate capital for
market risk. The Basle standard covers internationally active banks and applies only to
their trading account. The proposal offers two alternatives: "standardized" and "internal
models." In India Standardized Approach has been accepted for the time being, but
slowly Banks will move to Internal models which will be based on VaR models.
Quantitative standards relate to specific features of the VAR model. They call for the use
of a 1 percent probability level and a two-week holding period. In addition, the VAR thus
found is to be multiplied by a factor of three. The multiplication factor is designed to
allow for potential weaknesses in the modeling process and other non quantifiable
factors, such as incorrect assumptions about distributions, unstable volatilities, and
extreme market movements.
Many practitioners, however, consider these standards too restrictive. They note that a
holding period of two weeks is too long for many instruments, as traders get in and out
of positions many times during a typical day. Moreover, a two-week holding period
combined with a 1 percent probability safeguards against events that can be expected
to occur only once in four years. This makes it difficult to validate the model within a
reasonable period of time.
It should be noted that a few features of the proposal have been modified as a result of
industry criticism. In particular, an earlier version of the proposal allowed the models to
account for correlations of asset returns within, but not among, asset classes, such as
equities, currencies, and bonds. Now, all correlations are allowed.
VaR is also used as a MIS tool in the trading portfolio in the trading portfolio to “slice
and dice” risk by levels/ products/geographic/level of organisation etc. It is also used to
set risk limits. In its strategic perspective, VaR is used to decisions as to what business
to do and what not to do. However VaR as a useful MIS tool has to be “back tested” by
comparing each day’s VaR with actuals and necessary reexamination of assumptions
needs to be made so as to be close to reality. VaR, therefore, cannot substitute sound
management judgement, internal control and other complementary methods. It is used
to measure and manage market risks in trading portfolio and investment portfolio.
further and assume that the historical data themselves follow a specific distribution
(e.g., a "normal distribution" in RiskMetrics(TM)).
There are three main approaches to calculating value-at-risk: the correlation method,
also known as the variance/covariance matrix method; historical
simulationand Monte Carlo simulation. All three methods require a statement of
three basic parameters: holding period, confidence interval and the historical time
horizon over which the asset prices are observed.
The Monte Carlo simulation method calculates the change in the value of a portfolio
using a sample of randomly generated price scenarios. Here the user has to make
certain assumptions about market structures, correlations between risk factors and the
volatility of these factors. He is essentially imposing his views and experience as
opposed to the naive approach of the historical simulation method.
The historical simulation approach calculates the change in the value of a position
using the actual historical movements of the underlying asset(s), but starting from the
current value of the asset. It does not need a variance/covariance matrix. The length of
the historical period chosen does impact the results because if the period istoo short, it
may not capture the full variety of events and relationships between the various assets
and within each asset class, and if it is too long, may be too stale to predict the future.
The advantage of this method is that it does not require the user to make any explicit
Banking Topics of Interest 2010.doc Page: 81
assumptions about correlations and the dynamics of the risk factors because the
simulation follows every historical move.
Estimating Volatility
VaR uses past data to compute volatility. Different methods are employed to estimate
volatility. One is arithmetic moving average from historical time series data. The other is
the exponential moving average method. In the exponential moving average method,
the volatility estimates rises faster to shocks and declines gradually. Further, different
banks take different number of days of past data to estimate volatility. Volatility also
does not capture unexpected events like EMU crisis of September 1992 (called “event
risk”). All these complicate the estimation of volatility. VaR should be used in
combination with "stress testing" to take care of event risks. Stress test takes into
account the worst case scenario.
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For the sake of uniformity in valuation, RBI has asked Banks to use the prices
/ YTMs released by FIMMDA every month for valuation of their securities.
While banks have to make a provision when the value of their bonds
depreciate, they cannot book profits. However, they are allowed to write
back the depreciation provided in the previous year.
The reason that YTM applies exactly to a zero coupon bond is that there is no
interest to be reinvested. The entire return comes from the difference
between the purchase price and the face value of the bond. In ordinary
bonds, this difference is treated as a capital gain/loss and taxed when sold.
However in a zero coupon bond, that gain is treated as interest income and
taxed annually according to the gain in accreted value. Since there are no
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COMMERCIAL PAPER
Introduction
Commercial Paper (CP) is an unsecured money market instrument issued in the
form of a promissory note. CP, as a privately placed instrument, was introduced in India
in 1990 with a view to enabling highly rated corporate borrowers to diversify their
sources of short-term borrowings and to provide an additional instrument to investors.
Subsequently, primary dealers, satellite dealers* and all-India financial institutions were
also permitted to issue CP to enable them to meet their short-term funding requirements
for their operations. Guidelines for issue of CP are presently governed by various
directives issued by the Reserve Bank of India, as amended from time to time. The
guidelines for issue of CP incorporating all the amendments issued till date is given
below for ready reference.
2. Corporates and primary dealers (PDs), and the all-India financial institutions
(FIs) that have been permitted to raise short-term resources under the umbrella limit
fixed by Reserve Bank of India are eligible to issue CP.
*: The system of satellite dealers has since been discontinued with effect from June 1,
2002.
3. A corporate would be eligible to issue CP provided: (a) the tangible net worth of
the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b)
company has been sanctioned working capital limit by bank/s or all-India financial
institution/s; and (c) the borrowal account of the company is classified as a Standard
Asset by the financing bank/s/ institution/s.
Rating Requirement
4. All eligible participants shall obtain the credit rating for issuance of Commercial
Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or the
Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other
credit rating agencies as may be specified by the Reserve Bank of India from time to
time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such
equivalent rating by other agencies. The issuers shall ensure at the time of issuance of
CP that the rating so obtained is current and has not fallen due for review.
Maturity
Denominations.
8. An FI can issue CP within the overall umbrella limit fixed by the RBI, i.e., issue
of CP together with other instruments, viz., term money borrowings, term deposits,
certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its
net owned funds, as per the latest audited balance sheet.
10. Every issue of CP, including renewal, should be treated as a fresh issue.
Investment in CP
12. CP may be issued to and held by individuals, banking companies, other
corporate bodies registered or incorporated in India and unincorporated bodies, Non-
Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment
by FIIs would be within the limits set for their investments by Securities and Exchange
Board of India (SEBI).
Mode of Issuance
Payment of CP
17. The initial investor in CP shall pay the discounted value of the CP by means of a
crossed account payee cheque to the account of the issuer through IPA. On maturity of
CP, when CP is held in physical form, the holder of CP shall present the instrument for
payment to the issuer through the IPA. However, when CP is held in demat form, the
holder of CP will have to get it redeemed through the depository and receive payment
from the IPA.
Stand-by Facility
18. In view of CP being a 'stand alone' product, it would not be obligatory in any
manner on the part of the banks and FIs to provide stand-by facility to the issuers of
CP. Banks and FIs have, however, the flexibility to provide for a CP issue, credit
enhancement by way of stand-by assistance/credit, back-stop facility etc. based on their
commercial judgement, subject to prudential norms as applicable and with specific
approval of their Boards.
19. Non-bank entities including corporates may also provide unconditional and
irrevocable guarantee for credit enhancement for CP issue provided:
(i) the issuer fulfils the eligibility criteria prescribed for issuance of CP;
(ii) the guarantor has a credit rating at least one notch higher than the issuer
given by an approved credit rating agency; and
(iii) the offer document for CP properly discloses the net worth of the guarantor
company, the names of the companies to which the guarantor has issued similar
guarantees, the extent of the guarantees offered by the guarantor company, and
the conditions under which the guarantee will be invoked.
20. Every issuer must appoint an IPA for issuance of CP. The issuer should disclose
to the potential investors its financial position as per the standard market practice. After
the exchange of deal confirmation between the investor and the issuer, issuing company
shall issue physical certificates to the investor or arrange for crediting the CP to the
investor's account with a depository. Investors shall be given a copy of IPA certificate to
the effect that the issuer has a valid agreement with the IPA and documents are in
order (Schedule III).
21. The role and responsibilities of issuer, issuing and paying agent (IPA) and credit
rating agency (CRA) are set out below:
(a) Issuer
With the simplification in the procedures for CP issuance, issuers would now
have more flexibility. Issuers would, however, have to ensure that the guidelines and
procedures laid down for CP issuance are strictly adhered to.
Banking Topics of Interest 2010.doc Page: 89
(i) IPA would ensure that issuer has the minimum credit rating as stipulated by RBI
and amount mobilised through issuance of CP is within the quantum indicated by
CRA for the specified rating or as approved by its Board of Directors, whichever
is lower.
(ii) IPA has to verify all the documents submitted by the issuer, viz., copy of board
resolution, signatures of authorised executants (when CP in physical form) and
issue a certificate that documents are in order. It should also certify that it has a
valid agreement with the issuer (Schedule III).
(iii) Certified copies of original documents verified by the IPA should be held in the
custody of IPA.
(v) IPAs, which are NDS member, should report the details of CP issue on NDS
platform within two days from the date of completion of the issue.
(vi) Further, all scheduled banks, acting as an IPA, will continue to report CP
issuance details as hitherto within three days from the date of completion of the
issue, incorporating details as per Schedule II till NDS reporting stabilizes to the
satisfaction of RBI. The discontinuation of reporting of CP details to MPD would
be communicated separately at a later stage.
(i) Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of
capital market instruments shall be applicable to them (CRAs) for rating CP.
(ii) Further, the credit rating agency would henceforth have the discretion to
determine the validity period of the rating depending upon its perception about
the strength of the issuer. Accordingly, CRA shall at the time of rating, clearly
indicate the date when the rating is due for review.
(iii) While the CRAs can decide the validity period of credit rating, they would have
to closely monitor the rating assigned to issuers vis-a-vis their track record at
regular intervals and would be required to make their revision in the ratings
public through their publications and website.
Documentation Procedure :
22. Fixed Income Money Market and Derivatives Association of India (FIMMDA) may
prescribe, in consultation with the RBI, for operational flexibility and smooth functioning
of CP market, any standardised procedure and documentation that are to be followed by
the participants, in consonance with the international best practices. Issuer/IPAs may
refer to the detailed guidelines issued by FIMMDA in this regard on July 5, 2001.
Banking Topics of Interest 2010.doc Page: 90
23. Violation of these guidelines will attract penalties and may also include debarring
of the entity from the CP market.
Default in CP Market :
24. In order to monitor defaults in redemption of CP, scheduled banks which act as
IPAs, are advised to immediately report, on occurrence, full particulars of defaults in
repayment of CPs to the Monetary Policy Department, Reserve Bank of India, Central
Office, Fort, Mumbai,
In early 1997, Mr.Narasimham was again asked to chair another committee to review
the progress based on the 1st Committee report and to suggest a new vision for Indian
banking industry. In April, 1998, Narasimham Committee submitted its report and
recommended some major changes in the financial sector. Many of these
recommendations have been accepted and are under process of implementation.
These recommendations can be broadly classified into following categories :-
Minimum capital to risk assets ratio (CRAR) be RBI has partially implemented
increased from the existing 8 per cent to 10 per cent; the same by fixing CRAR at
an intermediate minimum target of 9 per cent be 9%. However, the ratio has
achieved by 2000 and the ratio of 10 per cent by not yet been increased to 10%.
2002; RBI to be empowered to raise this further for
individual banks if the risk profile warrants such an
increase. Individual banks' shortfalls in the CRAR be
treated on the same line as adopted for reserve
Banking Topics of Interest 2010.doc Page: 92
In India, income stops accruing when interest or Implemented w.e.f. year ending
installment of principal is not paid within 180 days, 31/03/2004.
which should be reduced to 90 days in a phased
manner by 2002.
Introduction of a general provision of 1 per cent on RBI has introduced provision @
standard assets in a phased manner be considered by 0.25%. It is likely to be
RBI. increased in years to come.
As an incentive to make specific provisions, they may
be made tax deductible
There should be an independent loan review The major banks have already
mechanism especially for large borrowal accounts implemented these exposure
and systems to identify potential NPAs. Banks may limits. Slowly other banks are
evolve a filtering mechanism by stipulating in-house also progressing in this field.
prudential limits beyond which exposures on
single/group borrowers are taken keeping in view
their risk profile as revealed through credit rating
and other relevant factors
Banks and FIs should have a system of recruiting Some banks are already
killed manpower from the open market recruiting specialist officers from
the open market.
Public sector banks should be given flexibility to This is yet to be implemented
determined managerial remuneration levels taking
into account market trends
There may be need to redefine the scope of external
vigilance and investigation agencies with regard to
banking business.
There is need to develop information and control Risk Management, Asset
system in several areas like better tracking of Liability Management and
spreads, costs and NPSs for higher profitability, improvement in treasury have
accurate and timely information for strategic already been introduced in most
decision to identify and promote profitable products banks.
and customers, risk and asset-liability management;
and efficient treasury management.
With the conversion of activities between The process has already started. ICICI
banks and DFIs, the DFIs should, over a Ltd. Has converted itself into a bank by
period of time convert themselves to bank. A merger withICICI Bank Ltd. IDBI,
DFI which converts to bank be given time to SIDBI are likely to follow.
face in reserve equipment in respect of its
liability to bring it on par with requirement
relating to commercial bank.
Mergers of Public Sector Banks should Indian Banks have yet to take cue from
emanate from the management of the banks this recommendation and are
Banking Topics of Interest 2010.doc Page: 94
Why ARC :
In last 15 years or so the a number of economies around the world have witnessed the
problem of non performing assets. A high level of NPAs in the banking system can
severely affect the economy in many ways. The high level of NPAs leads to diversion of
banking resources towards resolution of this problems. This causes an opportunity loss
for more productive use of resources. The banks tend to become risk averse in making
new loans, particularly to small and medium sized companies. Thus, large scale NPAs
when left unattended, cause continued economic and financial degradation of the
country. The realization of these problems has lead to greater attention to resolve the
NPAs. ARCs have been used world-wide, particularly in Asia, to resolve bad-loan
problems. However, these had a varying degree of success in different countries.
ARCs focus on NPAs and allows the banking system to act as "clean bank".
ARC in India :
In India the problem of recovery from NPAs was recognized in 1997 by Government of
India. The Narasimhan Committee Report mentioned that an important aspect of the
continuing reform process was to reduce the high level of NPAs as a means of banking
sector reform. It was expected that with a combination of policy and institutional
development, new NPAs in future could be lower. However, the huge backlog of
existing NPAs continued to hound the banking sector. It impinged severely on banks
performance and their profitability. The Report envisaged creation of an "Asset
Recovery Fund" to take the NPAs off the lender's books at a discount.
Accordingly, Asset Reconstruction Company (Securitization Company / Reconstruction
Company) is a company registered under Section 3 of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (SRFAESI) Act,
2002. It is regulated by Reserve Bank of India as an Non Banking Financial Company (
u/s 45I ( f ) (iii) of RBI Act, 1934).
RBI has exempted ARCs from the compliances under section 45-IA, 45-IB and 45-IC of
the Reserve Bank Act, 1934. ARC functions like an AMC within the guidelines issued by
RBI.
ARC has been set up to provide a focused approach to Non-Performing Loans resolution
issue by:-
(a) isolating Non Performing Loans (NPLs) from the Financial System (FS),
(b) freeing the financial system to focus on their core activities and
(c) Facilitating development of market for distressed assets.
Functions of ARC :
As per RBI Notification No. DNBS.2/CGM(CSM)-2003, dated April 23, 2003, ARC
performs the following functions :-
(i) Acquisition of financial assets (as defined u/s 2(L) of SRFAESI Act, 2002)
(ii) Change or take over of Management / Sale or Lease of Business of the Borrower
(iii) Rescheduling of Debts
Banking Topics of Interest 2010.doc Page: 96
(iv) Enforcement of Security Interest (as per section 13(4) of SRFAESI Act, 2002)
(v) Settlement of dues payable by the borrower
What is ARCIL?
ARCIL is the first asset reconstruction company (ARC) in the country to commence the
business of resolution of non-performing loans (NPLs) acquired from Indian banks and
financial institutions. It commenced business consequent to the enactment of the
Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, 2002 (Securitisation Act, 2002). As the first ARC, Arcil played a pioneering
role in setting standards for the industry in India. It has been spearheading the drive to
recreate value out of NPLs and in doing so, it continues to play a proactive role in
reenergizing the Indian industry through critical times.
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CREDIT RATING
What is Credit Rating?
Credit Rating is a grade assigned to a business concern to denote the current
assessment of the credit worthiness of the concern, with respect to its future ability to
meet its obligations in re-payment of principal and interest. These grades (ratings) are
based on various factors such as a borrower's networth, payment history, industry's
future prospects, etc. However, there is no exact science to rating a borrower's credit,
and different lenders may assign different grades to the same borrower.
Ratings by the Credit rating agencies is based on a quantitative study of the financials of
the company and qualitative factors such as management quality and integrity, the
strength of its brands, parent support etc. The main focus while rating a company is to
measure the relative ability and willingness of the issuer of the instrumentto meet its
obligations on the due dates. Industry risk is another factor which determines the cap
for the ratings. For example, non-banking financial companies rarely get high ratings
because of the high risk tag attached to this sector.
Rating Agencies :
CRISIL, CARE, ICRA, FITCH are the rating agencies in India. CRISIL is the oldest
rating agency in India and was originally promoted by ICICI. ICRA was promoted by
IFCI. CARE was promoted by IDBI.
RATING SCALES : Although different rating agencies sometime use different symbols to
indicate the rating, yet the following rating system used by CRISIL for debentures /
bonds (long term debt instruments) indicates the most popular rating assignment
system in India :-
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Investment Grades :-
Speculative Grades :-
C `C' rating indicate the presence of factors that make them "vulnerable
Substantial to defaul"t; timely payment of interest and principal is possible only if
Risk favourable circumstances continue.
Securitization
What is Securitization :
RBI in its circular on Securitization of Standard Assets, describes Securitization “as a
process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV)
in return for an immediate cash payment”. In such cases the cash flow from the
underlying pool of assets is used to service the securities issued by the SPV.
Let us try to understand it from a layman’s view. In the normal course assets like loans
and securities held by banks/financial institutions are expected to yield a quantifiable
stream of future income (e.g. EMIs etc.) . However, since this income is yet to be
realised, it cannot be brought onto their books immediately. Through the process of
Securitization Banks try to encash these future flow of as-yet-unrealised income.
We can also sum up that securitisation means the conversion of existing or future cash
in-flows into tradable security which then is 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.
Securitization thus follows a two-stage process. In the first stage there is sale of single
asset or pooling and sale of pool of assets to a 'bankruptcy remote' special purpose
vehicle (SPV) in return for an immediate cash payment and in the second stage
repackaging and selling the security interests representing claims on incoming cash
flows from the asset or pool of assets to third party investors by issuance of tradable
debt securities.
Process of Securitization :
We have seen above that Securitisation is a process by which the future cash inflows of
an entity ( originator ) are converted and sold as debt instruments. These debt
instruments are popularly known as “Pay Through or Pass Through Certificates”, with a
fixed rate of return to the holders of beneficial interest.
Under this process, the originator of a typical securitisation actually transfers a portfolio
of financial assets to a “Special Purpose Vehicle” ( SPV ). (An SPV is an entity specially
created for doing the securitisation deal. It invites investment from investors, uses the
invested funds to acquire to receivables of the originator An SPV may be a trust,
corporation, or any other legal entity.)
As a consideration for the transfer of such a portfolio, the originator gets cash up-front
on the basis of a mutually agreed valuation of the receivables.
The transfer value of the receivables is arrived in such a way so as to give the lenders a
reasonable rate of return. In ‘pass-through’ and ‘pay-through’ securitisations, receivables
are transferred to the SPV at the inception of the securitisation, and no further transfers
are made. All cash collections are paid to the holders of beneficial interests in the SPV (
basically the lenders).
Thus, we can say that a securitisation deal usually passes through the following stages
: has the following stages :-
· First of all the originator determines which assets they wants to securitise.
· At second stage originator has to find out a SPV or new SPV is formed.
· The SPV collects the funds from investors and in return issues securities to
them.
· The SPV acquires the receivables under an agreement at their discounted
value.
· The Servicer for the transaction is appointed, who is usually the originator.
· The debtors are /are not notified depending on the legal requirements.
· The Servicer collects the receivables, usually in an escrow mechanism, and
pays off the collection to the SPV.
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· The SPV either passes the collection to the investors, or reinvests the same to
pay off to investors at stated intervals.
· In case of default, the servicer takes action against the debtors as the SPV’s
agent.
· When only a small amount of outstanding receivables are left to be collected,
the originator may clean up the transaction by buying back the outstanding
receivables.
· At the end of the transaction, the originator’s profit, if retained and subject to
any losses to the extent agreed by the originator, in the transaction is paid off.
· Securitization helps in raise funds for the standard assets, though the
rating of the originator may not be high;
· Securitised assets ( receivables ) go off the balance sheet of the originator
which at times can be of great help to the originator. For example, a bank may
need to reduce its exposure to credit so as to meet the capital adequacy norms.
· Securitization also helps in generating liquidity which may ;be critical at times
for the bank / company.
· Small investors are able to profit from such deals as under this scheme even
they can invest small amounts through SPV and acquire beneficial interest in the
securitized assets. .
Securitisation in India started around 1991. However, the first few transactions that
took place during the period from 1991-2000 period were in the nature ofsecured
lending. However, it was from 2002 that this segment saw some renewed activity with
auto loans on the forefront. Indian market was still afraid to take chances and the
issues were predominantly of ‘AAA’ rated notes.
There are only few players in the Indian market , which is dominated by few private
sector banks and some aggressive Mutufal Funds only. Public sector banks remain
mostly out of picture due to various reasons including the legal issues. These
impediments have failed to develop the secondary market.
In spite of number of constraints, the securitization market in India grew significantly
during the period from 2002 to 2004. In April 2005 RBI issued the draft guidelines.
This resulted in slow down in the market as banks were readjusting their strategies in
the light of draft guidelines.
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In February 2006, the Reserve Bank of India (RBI) has issued final guidelines for the
Securitisation of Standard Assets. These guidelines have consolidated a number of
prevailing market practices with some stringent requirements on capital and profit
recognition. These guidelines are likely to further slow down the issuance of these
assets as market will take its own time to re-adjust to the revised guidelines which are
considered as stringent. However, in the long run the market is likely to grow as now
legal framework is available and RBI has given its node for this segment of activitiy.
Indian securitisation market is still young and banks have only limited exposure in this
segment. However, slowly it is maturing rapidly through innovation, increasing
sophistication and new issuances.
Under “ Pay Through Certificates”, the SPV instead of transferring undivided interest on
the receivables, actually issues debt securities (for example bonds, repayable on fixed
dates). These debt securities in turn are backed by the mortgages transferred by the
originator to the SPV.
Here the SPV can make temporary reinvestment of cash flows to the extent required for
bridging the gap between the date of payments on the mortgages along with the
income out of reinvestment to retire the bonds. Such bonds were called mortgage –
backed bonds.
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Thus, the DRs are physical certificates, which allow investors to hold shares in equity
of other countries. . This type of instruments first started in USA in late 1920s and are
commonly known as American depository receipt (ADR). Later on these have become
popular in other parts of the world also in the form of Global Depository Receipts
(GDRs). Some other common type of DRs are European DRs and International DRs.
In nut shell we can say ADRs are typically traded on a US national stock exchange,
such as the New York Stock Exchange (NYSE) or the American Stock Exchange, while
GDRs are commonly listed on European stock exchanges such as the London Stock
Exchange. Both ADRs and GDRs are usually denominated in US dollars, but these can
also be denominated in Euros.
ADRs were introduced with a view to simplify the physical handling and legal
technicalities governing foreign securities as a result of the complexities involved in
buying shares in foreign countries. Trading in foreign securities is prone to number of
difficulties like different prices and in different currency values, which keep in changing
almost on daily basis. In view of such problems, U.S. banks found a simple
methodology wherein they purchase a bulk lot of shares from foreign company and
then bundle these shares into groups, and reissue them and get these quoted on
American stock markets.
For the American public ADRs simplify investing. So when Americans purchase Infy (the
Infosys Technologies ADR) stocks listed on Nasdaq, they do so directly in dollars,
without converting them from rupees. Such companies are required to declqare
Banking Topics of Interest 2010.doc Page: 103
The above indicates that ADRs are issued to offer investment routes that avoid the
expensive and cumbersome laws that apply sometimes to non-citizens buying shares on
local exchanges. ADRs are listed on the NYSE, AMEX, or NASDAQ.
Global Depository Receipt (GDR): These are similar to the ADR but are usually
listed on exchanges outside the U.S., such as Luxembourg or London. Dividends are
usually paid in U.S. dollars. The first GDR was issued in 1990.
ADVANTAGES OF ADRs:
There are many advantages of ADRs. For individuals, ADRs are an easy and cost
effective way to buy shares of a foreign company. The individuals are able to save
considerable money and energy by trading in ADRs, as it reduces administrative costs
and avoids foreign taxes on each transaction. Foreign entities prefer ADRs, because
they get more U.S. exposure and it allows them to tap the American equity markets.
.
The shares represented by ADRs are without voting rights. However, any foreigner
can purchase these securities whereas shares in India can be purchased on Indian Stock
Exchanges only by NRIs or PIOs or FIIs. The purchaser has a theoretical right to
exchange the receipt without voting rights for the shares with voting rights (RBI
permission required) but in practice, no one appears to be interested in exercising this
right.
The shares will not be listed in India , but have to be listed in the home country.
The IDRs will allow the Indian investors to tap the opportunities in stocks of foreign
companies and that too without the risk of investing directly which may not be too
friendly. Thus, now Indian investors will have easy access to international capital
market.
Normally, the DR are allowed to be exchanged for the underlying shares held by the
custodian and sold in the home country and vice-versa. However, in the case of IDRs,
automatic fungibility is not permitted.
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SEBI has issued guidelines for issuance of IDRs in April, 2006, Some of the major
norms for issuance of IDRs are as follows. SEBI has set Rs 50 crore as the lower limit
for the IDRs to be issued by the Indian companies. Moreover, the minimum
investment required in the IDR issue by the investors has been fixed at Rs two lakh.
Non-Resident Indians and Foreign Institutional Investors (FIIs) have not been allowed to
purchase or possess IDRs without special permission from the Reserve Bank of India
(RBI). Also, the IDR issuing company should have good track record with respect to
securities market regulations and companies not meeting the criteria will not be allowed
to raise funds from the domestic market If the IDR issuer fails to receive minimum 90
per cent subscription on the date of closure of the issue, or the subscription level later
falls below 90 per cent due to cheques not being honoured or withdrawal of
applications, the company has to refund the entire subscription amount received, SEBI
said. Also, in case of delay beyond eight days after the company becomes liable to pay
the amount, the company shall pay interest at the rate of 15 per cent per annum for the
period of delay.
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INDIAN BUDGET
What is Budget :
Budget is a financial statement of planned revenue and expenditure of the Government
Of India in respect of a financial year. Indian Constitution authorises the government
to present before the Parliament, the annual financial statement for the fiscal year
running from 1 April to 31 March. The budget at a glance gives a list of the
government's receipts and expenditure in a brief manner along with the break up of plan
and non plan receipts and expenditure, resources transferred to state and UT
Governments, highlights of central plan. The explanatory notes given complete the
picture to make the reader understand various terms.
This Annual Financial Statement shows the receipts and payments of government under
the three parts in which government accounts are kept:
(a) Consolidated Fund;
(b) Contingency Fund; and
(c) Public Account .
The Union Budget actually comprises of the (i) Revenue Budget and the
(ii) Capital Budget. This is because, under the Constitution, the Budget has to distinguish
expenditure on revenue account from other expenditure.
Revenue Receipts : Revenue receipts consist of tax collected by the government and
other receipts consisting of interest and dividend on investments made by government,
fees and other receipts for services rendered by government
Every year at the time of Budget, government also issues a key to Budget. This gives
in detail about the various concepts of Budget and must be read by everybody who
wants to known what exactly is the Budget in Indian context. Click BELOW to view the
Key to Budget for 2003-04
Budget deficit : It is the excess of total expenditure over total receipts, with
borrowing not included among receipts. This deficit is funded by borrowing. In other
words, it is the amount by which planned expenditure is greater than the expected
income for a particular period/ project.
Consolidated Fund : All revenues received by Government, the loans raised by it, and
receipts from recoveries of loans granted by it, form the Consolidated Fund. All
expenditure of Government is incurred from the Consolidated Fund and no amount can
be withdrawn from the Fund without authorization from Parliament.
Contingency Fund : This is the fund into which the Government uses in emergencies -
to meet urgent, unforeseen expenditures which can't wait for authorization by
Parliament. The Contingency Fund is an more like an imprest placed at the disposal of
the President for such financial exigencies. The Government subsequently obtains
Parliamentary approval for such expenditure and for the withdrawal of an equivalent
amount from the Consolidated Fund. The amount spent from the Contingency Fund is
recouped to the Fund.
CENVAT : This expands to Central Value Added Tax, an excise duty levied on
manufacturers. It was introduced in the budget of 2000-01, with a single rate of 16%
across the board with special excise duty (SED) on various goods. It was designed to
reduce the cascading effect of indirect taxes on final products. As a scheme, CENVAT is
more liberal and extensive than the erstwhile MODVAT, with most goods being brought
within its ambit and no declarations or statutory records needed.
Gross National Product : It is the total market value of the finished goods and
services manufactured within the country in a given financial year, plus income earned
by the local residents from investments made abroad, minus the income earned by
foreigners in the domestic market.
Fiscal Deficit : This is the gap between the government's total spending and the sum
of its revenue receipts and non-debt capital receipts. It represents the total amount of
borrowed funds required by the government to fully meet its expenditure
Revenue Deficit : The difference between revenue expenditure and revenue receipt is
known as revenue deficit. It shows the shortfall of government’s current receipts over
current expenditure. If the capital expenditure and capital receipts are taken into
account too, there will be a gap between the receipts and expenditure of a year. This
gap constitutes the overall budgetary deficit, and it is covered by the issue of 91-day
Treasury Bills, mostly held by the RBI.
Plan Outlay : Plan Outlay is the amount for expenditure on projects, schemes and
programmes announced in the Plan. The money for the Plan Outlay is raised through
budgetary support and internal and extra-budgetary resources. The budgetary support is
also shown as plan expenditure in government accounts
Plan Expenditure : The government's expenditure can be broken up into Plan and
Non-plan Expenditure. Money given from the government's account for the central Plan
is called Plan Expenditure. This is developmental in nature and is spent on schemes
detailed in the Plan.
Banking Topics of Interest 2010.doc Page: 108
CAMELS
In 1994, the RBI established the Board of Financial Supervision (BFS), which operates as
a unit of the RBI. The entire supervisory mechanism was realigned to suit the changing
needs of a strong and stable financial system. The supervisory jurisdiction of the BFS
was slowly extended to the entire financial system barring the capital market institutions
and the insurance sector. Its mandate is to strengthen supervision of the financial
system by integrating oversight of the activities of financial services firms. The BFS has
also established a sub-committee to routinely examine auditing practices, quality, and
coverage.
In addition to the normal on-site inspections, Reserve Bank of India also conducts off-
site surveillance which particularly focuses on the risk profile of the supervised entity.
The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995 as an
additional tool for supervision of commercial banks. It was introduced with the aim to
supplement the on-site inspections. Under off-site system, 12 returns (called DSB
returns) are called from the financial institutions, wich focus on supervisory concerns
such as capital adequacy, asset quality, large credits and concentrations, connected
lending, earnings and risk exposures (viz. currency, liquidity and interest rate risks).
In 1995, RBI had set up a working group under the chairmanship of Shri S.
Padmanabhan to review the banking supervision system. The Committee certain
recommendations and based on such suggetions a rating system for domestic and
foreign banks based on the international CAMELS model combining financial
management and systems and control elements was introduced for the inspection cycle
commencing from July 1998. It recommended that the banks should be rated on a five
point scale (A to E) based on th elines of international CAMELS rating model. CAMELS
evaluates banks on the following six parameters :-
(a) Capital Adequacy :Capital adequacy is measured by the ratio of capital to risk-
weighted assets (CRAR). A sound capital base strengthens confidence of depositors
(b) Asset Quality : One of the indicators for asset quality is the ratio of non-performing
loans to total loans (GNPA). The gross non-performing loans to gross advances ratio is
more indicative of the quality of credit decisions made by bankers. Higher GNPA is
indicative of poor credit decision-making.
(c) Management : The ratio of non-interest expenditures to total assets (MGNT) can be
one of the measures to assess the working of the management. . This variable, which
includes a variety of expenses, such as payroll, workers compensation and training
investment, reflects the management policy stance.
(e) Liquidity : Cash maintained by the banks and balances with central bank, to total
asset ratio (LQD) is an indicator of bank's liquidity. In general, banks with a larger
volume of liquid assets are perceived safe, since these assets would allow banks to meet
unexpected withdrawals.
Rating
Rating symbol indicates
Symbol
A Bank is sound in every respect
B Bank is fundamentally sound but with moderate weaknesses
financial, operational or compliance weaknesses that give cause for
C
supervisory concern.
serious or immoderate finance, operational and managerial weaknesses
D
that could impair future viability
critical financial weaknesses and there is high possibililty of failure in
E
the near future.
Banking Topics of Interest 2010.doc Page: 110
These objectives are sought to be achieved by establishing various trigger points and
graded mandatory responses by the supervisors. This represents partial replacement
of regulatory discretion by rules, as the prescribed actions are generally likely to be a
mix of mandatory and discretionary actions. The case for automatic rules is that it will
contain regulatory forbearance (i.e. hoping that problems will solve themselves) - which
has been a very common complaint against the supervisors - and will lead to prompter
action. Prompt actions are important as the cost of restructuring / liquidation of a bank
is likely to rise, the longer that action is delayed."
The scheme was origianlly implemented initially for a period of one year.
Scheme :
As per the scheme, the Reserve Bank of India will initiate certain Structured Actions in
respect of the banks which have hit the Trigger Points in terms of CRAR, Net NPA and
ROA. The Reserve Bank, at its discretion, can also resort to additional actions
(Discretionary Actions) as indicated under each of the Trigger Points.
Banking Topics of Interest 2010.doc Page: 111
Trigger
Structured Action Discretionary Actions
Points
CRR :
(i) RBI will order recapitalisation
(a)Submission and implementation (ii)Bank will not increase its stake in
of capital restoration plan by the subsidiaries
bank (iii) Bank will reduce its exposure to
(i) CRAR less (b)Bank will restrict expansion of its sensitive sectors like capital market,
than 9%, but risk-weighted assets real estate or investment in non-SLR
equal or (c) Bank will not enter into new lines securities
more than of business (iv) RBI will impose restrictions on
6% (d) Bank will not access / renew the bank on borrowings from inter
costly deposits and CDs bank market
(e) Bank will reduce / skip dividend
payments (v) Bank will revise its credit
/ investment strategyand controls
(i) Bank / Govt. to take steps to
bring in new Management / Board
(a) All Structured actions as in (ii) Bank will appoint consultants for
earlier zone business/ organisational
(b) Discussion by RBI with the restructuring
(ii) CRAR less
bank’s Board on corrective plan of (iii) Bank / Govt. to take steps to
than 6%, but
action change promoters / to change
equal or
(c) RBI will order recapitalisation ownership
more than
(d) Bank will not increase its stake (iv) RBI / Govt. will take steps to
3%
in subsidiaries merge the bank if it fails to submit /
(e) Bank will revise its credit / implement recapitalisation plan or
investment strategy and controls fails to recapitalise pursuant to an
order, within such period as RBI
may stipulate
(a) Bank / Govt. to take steps to
bring in new Management / Board
(b) Bank will appoint consultants for
business / organisational
restructuring
(c) Bank / Govt. to take steps to
(iii) CRAR change promoters / to change
less than 3% ownership
(d) RBI / Govt. will take steps to
merge the bank if it fails to submit /
implement recapitalisation plan or
fails to recapitalise pursuant to an
order, within such period as RBI
may stipulate
NPAs :
(i) Net NPAs (a) Bank to undertake special drive (i) Bank will not enter into new lines
over 10% to reduce the stock of NPAs and of business
but less than contain generation of fresh NPAs
Banking Topics of Interest 2010.doc Page: 112
15% (b) Bank will review its loan policy (ii) Bank will reduce / skip dividend
(c) Bank will take steps to upgrade payments
credit appraisal skills and systems
(d) Bank will strengthen follow-up of (iii)Bank will not increase its stake in
advances including loan review subsidiaries
mechanism for large loans
(e)Bank will follow-up suit filed /
decreed debts effectively
(f) Bank will put in place proper
credit-risk management polices /
process / procedures / prudential
limits
(g) Bank will reduce loan
concentration - individual, group,
sector, industry, etc.
(a) All Structured actions as in
earlier zone
(b) Discussion by RBI with the
bank’s Board on corrective plan of
(ii) Net NPAs action
15% and (c) Bank will not enter into new lines
above of business
(d) Bank will reduce / skip dividend
payments
(e) Bank will not increase its stake
in subsidiaries
Return on
Assets :
(a) Bank will not access / renew
costly deposits and CDs
(b) Bank will take steps to Increase
fee-based income
(c) Bank will take steps to contain (a) Bank will not incur any capital
administrative expenses expenditure other than for
(d)Bank will launch special drive to technological upgradation and for
Return on
reduce the stock of NPAs and such emergent replacements within
Assets below
contain generation of fresh NPAs Board approved limits
0.25%
(e) Bank will not enter into new
lines of business (b) Bank will not expand its staff /
(f) Bank will reduce / skip dividend fill up vacancies
payments
(g) RBI will impose restrictions on
the bank on borrowings from inter
bank market
Any other action:
In addition to the above actions, Reserve Bank has the right to direct a bank to take any
other action or implement any other direction, in the interest of the concerned bank or
in the interest of its depositors.
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Under the PCA framework, the larger the deterioration based on the trigger points, the
tighter the stipulations for the bank so that the liability does not increase further.
NEGOTIABLE INSTRUMENTS
Any body connected with business comes across quite frequently with words like
"Negotiable Instruments". These have great significance in the modern business world,
but very few people really know what are Negotiable Instruments and what is the
significance if an instrument falls in the category of Negotiable Instruments.
(iv) Every transfer of a negotiable instrument was made before the date of maturity
(in case of instrument payable otherwise than on demand).
(v) The endorsements appearing upon an instrument were made in the order in
which they appear on the instrument.
(vi) The lost negotiable instrument was duly stamped.
(vii) A holder of a negotiable instrument is a holder in due course. However, under
certain conditions like fraud or unlawful consideration, the burden of proving that the
holder is a holder in due course may lie upon him.
Banking Topics of Interest 2010.doc Page: 116
Balance Sheet
What is Balance Sheet :
The balance sheet is an accounting statement that summarises the various assets,
liabilities and equities held by a company on a specific date. The equities are usually
considered as part of the liabilities. The balance sheet is always drawn up at the close
of business day, but is most relevant on the last day of the company's accounting
period (the balance sheet date).
Balance sheet is an important documents not only for bank managers who sanction loan
but is equally important to others who give credits and invest in equity etc. All creditors
and investors all need to familiarize themselves with the assets, liabilities, and equity of
a company. The balance sheet is the best place to find all information at one place. The
reason as to why balance sheet is so called is that it is statement where Assets =
Liabilities + Equity
(i) Authorised Capital : This is the maximum amount of capital that can be raised by the
company. However, it is not compulsory for the company to raise the full authorised
capital.
(ii) Issued Capital : This is the amount of capital which company intends to raise at a
given point of time. This amount is usually mentioned in the Memorandum of
Association of a company.
(iii) Subscribed Capital : This is the capital which has actually been subscribed.
(iv) Paid Up capital : This is the amount of capital that has been called and received
against the subscribed capital.
For the purpose of Balance Sheet, paid up capital is of utmost importance
(b) Reserves : - There are various types of reserves, some of important types of
reserves are :-
(i) Share Premium Reserve : Whenever a company issues shares on premium, the
amount collected by the company above the face value of the share is called "premium".
The amount collected as "premium" is known as share premium reserve. On such share
premium reserve no dividend is payable.
Banking Topics of Interest 2010.doc Page: 117
(ii) Revaluation Reserves : Sometimes a company re-values (i.e. revises) its assets. This
re-valuation is done to make the asset show the true market value of the asset. Thus
asset is shown at a higher value than the previous book value and the corresponding
increase is created on liability side by increasing reserves under "revaluation reserves".
(iii) Depreciation Reserve : Usually when a depreciation is made in asset, the value of
the asset is credited with the depreciation amount and equal amount is debited to profit
and loss account. However, sometimes companies companies debit the depreciation
amount to profit and loss account, but instead of crediting the same to asset account,
they credit the amount to Depreciation Reserve Account. Such an entry is called
deprecaition reserve. Therefore, while calculating the networth of a company, it should
be excluded from the owned funds by setting it off against the value of the fixed assets.
(iv) General Reserves : This kind of reserves consists of the profits which have not been
actually distributed among the shareholders. This acts as a cushion for the company for
any future loss.
Intangible assets: These are 'non-monetary' but 'identifiable' assets that have no
physical substance. Current accounting guidelines mean they almost always relate to
goodwill, though may include patents, licenses, trademarks and so on.
Tangible assets: These are 'long-lived' physical items held for the purpose of earning
revenue. Typically these assets include land, property, plant, machinery, fixtures,
fittings and motor vehicles.
Current assets: Cash in the bank and 'temporary' assets that the company expects to
turn into cash. Stocks (at the lower of either cost or net realisable value), any goods
held for resale, raw materials to be used in manufacture and work in progress.are
examples of such assets.
(a) FIFO = FIRST - IN FIRST OUT: In this method, it is assumed that inventory first
purchased is first consumed/sold out and hence the valuation is done as per purchase
price of those items purchased earlier.
(b) LIFO = LAST IN FIRST OUT: In this method, the valuation of item sold first is
done as per purchase price of the last one, assuming that the items purchased in the
last are consumed / sold.
Investments: A firm may invest its surplus fund in Government Securities or debt
instruments or equities of the corporate sector.
Current liabilities: The liabilities which are to be met out of the current assets within
one year or within one operating cycle (whichever is longer). It includes acceptances,
sundry creditors, advance payments, unclaimed dividends, expenses accrued.
Thus, in nutshell, we can say liabilities the company expects to meet within twelve
months of the balance sheet date are called current liabilities.
Long Term or Term Liabilities : These are the liabilities which-are usually for more
than one year and include all the liabilities other than current liabilities and provisions
(see below).
Unsecured Loans: These are loans and advances (including short term) from Banks/
Subsidiaries/others obtained without creating any charge on the assets of the Firm. It
includes fixed deposits received from public.
Acceptances: These are bills of exchange accepted by the firms and generally known
as," Bills Payable". In case of promissory notes it is referred to as "Notes Payable".
Accounts Payable: These represents the debts of the creditors for purchase which is
not evidenced by any formal acceptance as defined above. These are. also referred to
as "Sundry Creditors".
Accrued Liabilities: These represent the obligations accrued but not paid and shall be
paid in the next accounting period.
Provisions: When a liability cannot be precisely determined, it is estimated and
provided for. Examples are provisions for dividends/taxation/PF/contingencies/Debts etc.
Banking Topics of Interest 2010.doc Page: 119
Net Sales: Whenever goods are supplied to the customers, these are recorded as sales
in the company's account books. The sum total of such sales during a period is referred
as 'gross sales'. However, some of goods thus supplied may be subsequently returned
by the customers due to various reasons, e.g. the goods may not be strictly as per
specification demanded by the customer, or these got damaged during transit etc. Such
returns and allowances are separately accounted for and at the time of preparation of
P&L Statement, the value of such goods are set off against gross sales. This is known as
'net sales' or "Sales".
Cash Discount / Sales Discount / Trade Discounts: Some companies, with a view
to" boost early" realisation of receivables, allow some discount, e.g. an entity may
specify that if their bills are paid within 15 days, 5% discount will be allowed. This is
called "Cash Discount" or "Sales Discount". Some companies agree to sell the goods at a
price lower than the normal price provided the customer agrees to buy the goods in
bulk. Such a discount is known as trade "discount" and is generally not shown in the
P&L A/C separately, rather taken into account in the value of Sales.
Other Income: Income obtained from the Business operations of an entity is called
Operating Income and Income arising out of an activity which is not the business
activity of the firm, are referred as 'non-operating income' or 'other Income'. For
example, on sale of fixed assets an entity may be able to realise more than the book
value of such an asset. This is called other income.
Manufacturing Expenses: The expenses which are directly incurred on the production
/ manufacturing process (such as freight, factory rent, electric charges at the factory
site, wages of labour in the factory etc.) are called manufacturing expenses. These are
direct input costs incurred towards the product manufacturing.
Cost of goods sold: It refers to the direct input costs of goods sold, and comprises of
cost of the raw material and manufacturing expenses. It can be calculated as follows:
Opening Stock + Purchases + Manufacturing Expenses - Closing Stock
Gross Profit: It is the difference between sales and cost of goods sold. This represents
the margin of profit at the point of production of goods.
Operating Expenses: All the expenses which are not directly incurred on production,
but are necessary to run the business, are grouped as "operating expenses". It covers
all expenses relating to selling & distribution as well as general administration expenses
(including personnel expenses) and indirect costs, such as depreciation.
Depreciation: In case of fixed assets, usually a part of its life is 'being utilised in a
particular accounting year, and thus a certain portion of its cost (depending upon the
total expected economic life of the asset), is appropriated in the shape of "depreciation"
in each accounting year The value of fixed assets at original cost is called "Gross Fixed
Assets" and the value of the asset arrived after deducting depreciation is called "Net
Fixed Assets". The two methods mostly used for calculating this expense are known as
(a) Straight Line Method and (b) Written down value method or diminishing value
method.
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In the straight line method, the depreciation is arrived at by dividing the original cost of
a fixed asset by its expected economic life. On the other hand, in case of the "written
down value" method, the expiration is calculated every year at a pre-determined rate on
the amount of the depreciated value (i.e. original cost - earlier depreciation charged) at
the end of the previous year.
Current Assets
Current Liabilities
• Cash in Hand
• Cash at Bank
• Creditors
• Marketable securities
• Bills Payable
• Bills Receivable
• Bank Overdraft
• Stock and Trade
• Outstanding expenses
• Accrued Income
• Income Tax payable
• Prepaid Expenses
• Advances from customers
• Advances to Others
Non-Current Assets
• Building
Non-Current Liabilities
• Land
• Equity Share Capital
• Plant and Machinery
• Preference Share Capital
• Furniture and Fixtures
• Debentures
• Patent Rights
• Long Term Loans
• Trademarks
• Profit & Loss (Cr.)
• Profit and loss Account
• Share Premium Account
(DR)
• Share Forfeited Account
• Discount on Issue of Shares
• Capital Reserve
and
• Provisions Like Provision for Tax, Dep.
Debentures
• Proposed Dividend
• Preliminary Expenses
• Appropriation of Profit E.g. transfer to General
• Other Deferred Expenditure
Reserve, Workman Compensation Fund, Debentures
• Long-Term Investments
Sinking Fund, Capital Redemption Reserve etc.
• Goodwill
Banking Topics of Interest 2010.doc Page: 121
Solution :
Schedule of changes in Working Capital
Particulars 2003 2004 Inc. Dec.
Current Assets A 240000 375000 135000
30000
Current liabilities B 120000 150000
The Companies Act provides for two formats of Balance Sheet. One is the conventional
'T" format, wherein assets and liabilities are grouped in descending order of their
liquidity. The other is the vertical format, which was introduced in 1979 on the basis of
International Accounting Standards. So far as non-corporate entities are concerned, IBA,
in collaboration with Institute of Chartered Accountants of India, evolved formats for
Financial Statements which were later on approved by RBI.
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Financial Statements : There are four basic financial statements that provide
information needed by financial analysts to evaluate a company. These are :-:
The Balance Sheet
The Income Statement / Profit and Loss Account
The Funds Flow statement
The Cash Flows Statement
Moreover, , a company's annual report is almost always accompanied by "Notes to the
financial statement".
(b) To know the solvency of the entity : Analysis of the financial statements
discloses whether the business is in a position to pay its short-term and long term
liabilities in time.
(c) To know the financial strength : It also discloses the total position of the
business regarding its goodwill, internal finance system etc.
(d) Comparative study with other firms : The comparative study of the profitability
of various firms engaged in the same industry can be done to study the position of the
firm in respect of sales, profitability etc
(e) Capability to pay interest and dividend : The analysis also helps to assess
whether the entity will have sufficient profits to pay the interest in time and whether it
has the capacity to pay the dividend in future at a higher ratio.
(2) Affected by window dressing : Most of the firm resort to window dressing and
try to cover their weak points so that they do not face problems with their bankers and
shareholders etc. It is common practice by firms to overvalue their closing stock and
Banking Topics of Interest 2010.doc Page: 124
Time Series Analysis : This reflects the movement of various financial characteristics
over a period. Under this technqiue, the financial characteristics of a firm are compared
over a number of years so as to know the directions in which the firm is moving.
RATIO ANALYSIS
A ratio can be defined the relationship between two or more variables. In finance these
variables are taken from the balance sheet or profit or loss account. Ratio Analysis is
one of the most widely used tool for the analysis of financial statements of a business
entity. Ratios are usually expressed in various mathematical terms such as percentage,
no. of times, or in numbers & compared with some standards.
Ratio analysis does not merely mean the calculations of ratios. It actually refers to the
comparing of different numbers from the balance sheet, income statement and cash
flow statements so as to arrrive at certain conclusions. The comparison of such ratios
can be of similar ratios of two or more different companies or against the same ratios of
the same entity. Ratios of a company may also be compared with same ratios of the
industry or economy. Such comparison gives us a meaningful idea as to how the entity
has performed in the past and what are its potential in the future. Thus, we can say that
ratio analysis helps in meaningful summerisation of large number of financial data to
provide a qualitative judgement about the financial performance of a business entity.
(a) Liquidity Ratios - These ratios indicate the ability of the entity to maintain the
short term liquidty for discharing the current liabiites. A company is expected to have
sufficient short term liquidity so that it can meet its current obligations. In case it fails to
meet its current obligations, it loses creditors' confidence and is always threatened by
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short term insolvency. Such a situation can even lead to closure of the unit itself. Some
of the frequently used ratios which fall under this category are (i) Current Ratio (ii)
Quick Ratio and (iii) Working Capital Turnover Ratio.
(b) Activity Ratios - These ratios indicate operational efficiency of the entity in utilising
the available resources. In other words, we can say that these ratios measure the
efficiency of the entity in using the available funds, especially the funds raised on short
term basis. These ratios help banker to ascertain the working capital need of the entity.
Some of the important activity ratios are (i) Inventory turnover; (ii) Debtor turnover; (iii)
Fixed assets turnover; (iv) current assets / working capital turnover. Activity ratios
indicate the efficiency of a business organisation in utilisation of funds, particularly funds
of short term nature.
(d) Profitability Ratios - These ratios indicates the capacity and efficiency of the firm
to generate profit and surplus out of the main business. Some of the important
profitability ratios are (i) Return on Equity; (ii) Return on investment or capital employed
etc.
LIQUDITY RATIOS :
Type of
How to Calculate Remarks
Ratio
Current ratio is calculated by
dividing current assets by current
liabilities. Therefore,
Current Ratio= Current Assets
As per RBI stipulation, the minimum
/ Current liabilities
current ratio of a firm should not be
less than 1.33:1
Here current assets refers to cash
and those assets which can be
However, banks consider current ratio
Current converted to cash within a period
of 2:1 as satisfactory. Usually, higher
Ratio of one year, whereas current
current ratio is desirable but
liabilities are liabilities that are to
unreasonable high current ratio is
be discharged within one year.
undesirable as it brings down the profit
Current assets should be
of the unit due to inefficient use of
reasonably higher than current
current assets.
liabilities to take care of the firm's
short term liquidity. Current ratio
represents margin of safety for
creditors.
The quick ratio is the ratio Although current assets are considered
Quick between quick current assets and to be liquid in nature, but certain
Ratio / current liabiliites. The quick assets assets like inventory, prepaid
Acid Test include cash / bank balances + expenses, unquoted shares etc. may
Ratio receivables upto 6 months + not be that liquid. Thus, such assets
quickly realisable securities such may not be available for paying off
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ACTIVITY RATIOS :
Type of
How to Calculate Remarks
Ratio
It is calculated by dividing This ratio shows as to how many times the
cost of goods sold by inventory turnovers / rotates in a year.
Average This ratio is important especially for bankers
inventory. as it helps them to assessing the working
Inventory Turnover = Cost capital need.
Inventory
of goods sold / Average A high ratio suggests lower level of
Turnover
inventory. inventory, indicating lesser probability of
Cost of goods can be stock becoming obsolete or unsaleable. It
calculated by deducting the also indicates better inventory control and
gross profit from the Net financial management of the unit
sales; A low ratio on the other hand indicates
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created out of profit not those created for not accept the debt
meeting specific liabilities or revaluation equity ratio more than
reserve.. 2:1.
The debt service
coverage ratio indicates
the ability of the firm to
generate cash accruals
for repayment of
Debt Service DSCR = (PAT+Depreciation+Interest on Long
instalment and interest.
Coverage term Debt)/(Yearly repayment of long term
DSCR provide a basis
Ratio (DSCR) debt+interest on long term)
for fixation of
repayment schedule.
DSCR of 2:1 and above
is usually considered
satisfactory by bankers.
This ratio is considered
as an extension of
Debt-Equity Ratio as iit
includes the effects
Total Total indebtedness Ratio = (Total Term of shortterm debt of
Indebtedness Liability+Total Current Liability) / (Tangible Net firm also.
Ratio Worth) A lower ratio indicates
the lesser dependence
of firm on outside
liability, both long term
as well as short term.
PROFITABILITY RATIOS
Type of Ratio How to Calculate Remarks
This ratio shows the gross profit margin
available to unit or efficiency of the firm
in producing each unit of product.The
Gross Profit Ratio = ratio indicates the average spread
Gross Profit Ratio (Gross Profit / Net available between cost of sales and sales
Sales) X 100 revenue.
A higher trend may be due to :
a) higher sales price b) lower cost of
sales .
This Ratio indicates the margin of profit
on sales/operations, indicating the
Operating Profit operational efficiency of a unit.
Ratio= (Operating Sometimes, profit of a unit includes profit
Operating Profit Ratio
Profits / Net Sales) X from secondary activities and are actually
100 not sustainable in long term. This this
ratio indirectly shows the viability of main
operation in long run.
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Cash flow shows the steady flow of money in and out of an organization, or the amount
of cash that a business enterprise earns and holds during the financial period. However,
Cash Flow doesn’t report the profit & loss of the company and is merely an indicator on
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Two major fields of Cash Flow are ‘Cash Inflow’ and ‘Cash Outflow', which refers to the
following: -
a) Cash Inflow refers to the money that flows in to the organization in the shape of
sales, investments, borrowings and advances.
b) Cash outflow refers to all the money that is paid out in the shape of of procurement
costs, operation costs, staff salaries and other miscellaneous expenses
Cash generated from Business operations and Cash generated from investments are
shown separately and these two terms refers to the following :-
Cash from Business Operations: Revenue that is generated from the sale of company’s
products or usage of its service on a day-to-day basis makes up for cash from Business
operations in the Cash flow statement. Basically it’s the cash that end consumer gives to
the company in return of its product or service.
Cash from Investments: Organizations also invest in equity shares and various other
investment instruments. Cash generated from these activities and also from acquisition
of other companies refer to cash from Investments. Some of these activities are also
posted as negative cash outflow as to make investments, money flows out of the
organization.
Cash Flow Statement is considered as a tool to plan the short term liquidity position. The
cash flow statement actually helps the management of the business to ascertain as to
how much cash is needed to meet its due obligations and when it will be available. This
also helps the entity in investing the surplus cash in profitable business.
Sources of cash:
The sources are generally grouped into categories, namely
(a) internal source of cash e.g , net profit, depreciation, writing of the assets, gain or
loss from sale of fixed asset and transfer to reserves;
(b) external source of cash : e.g., increase in capital, increase in term liabilities,
reduction in fixed assets or othe( non current assets, decrease in inter corporate
investments and advances, increase in short term bank borrowings, increase in other
current liabilities, decrease in inventory and receivables and decrease in other current
assets.
Uses of cash:
- Net loss.
- Decrease in term liabilities.
- Increase in fixed assets or other non - current assets.
- Incre&se in inter - corporate investment or advances.
- Dividend payments or drawings or tax payments.
- Decrease in short term bank borrowings.
- Decrease in other current liabilities.
- Increase in inventory and receivables.
- Increase in other current assets.
How does a "Funds Flow Statement" differs from "Cash Flow Statement" ?
The major difference between Funds Flow Statement and Cash Flow Statement can be
listed as follows :-:
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2. Usefulness (b) Funds flow is useful for long term financial planning.