SHORT-TERM LENDING MARKET

The Indian economy is showing robust growth due to the inflow of FII’s in the Indian markets
(approximately $ 21 billion). The Sensex has crossed the 20,000 mark. There is immense liquidity in the
market. To correct this scenario, the Reserve Bank of India (RBI) raised the repo and reverse repo rate to
curb the excess liquidity in the market.

The repo rate was increased to 6 percent from 5.75 percent which means the Central Banks charge higher
interest rates to commercial banks and the commercial banks also further charge higher borrowing rates to
its customers. Also, the reverse repo rate was increased to 5 percent from 4.5 percent, meaning it is more
lucrative to park funds with the RBI, thereby preventing excess liquidity in the market.

There are many sources of raising short term funds like term loans from banks, corporate deposits etc.
Inter corporate deposits (ICDs) and Loan against shares (LAS) are some of the methods of short term
lending discussed in depth below.

A. INTERCORPORATE DEPOSITS

When borrowing from banks, there are many formalities in terms of documentations to be adhered to. All
these formalities can be done away with when borrowing and lending short term funds with the aid of
inter corporate deposits.

Inter-corporate deposits are deposits made by one company with another company, and usually carry a
term of six months. These deposits are made by corporate having surplus funds to cash starved
companies.

Features of Inter corporate deposits

• Since it is an unsecured loan, the risk involved is higher. Also, since the cost of funds (interest rates)
are much higher for a corporate than a bank, the rates in this market are higher than those in the other
markets.

• The short term credit rating of the corporate would determine the rate at which the corporate would
be able to borrow funds. Further the credit spreads demanded even for the top rated corporates would
be higher than similar rated banks and the rates on ICDs would be higher than those in the Certificate
of Deposit (CD) market. The tenor of ICD may range from 1 day to 1 year, but the most common
tenor of borrowing is for 90 days.

• The ICD market is not well organized with very little information available publicly about transaction
details.
• Primary dealers cannot lend in the ICD market, they are only entitled to borrow. The borrowing under
ICD is restricted to 50% of the Net Owned Funds and the minimum tenor of borrowing is for 7 days.
• Cash rich companies, NBFC’s and financial institutions are eligible to act as market participants.
Even stock broking firms qualify as market participants for ICDs.
• Defaulted companies are not allowed to extend loans.
• The amount cannot exceed 60 % of paid up capital and 100% of free reserves.
Types of inter corporate deposits

The three types of inter-corporate deposits are: three month deposits, six month deposits, and call
deposits.

• Three month deposits are the most popular type of inter-corporate deposits. These deposits are
generally considered by the borrowers to solve problems of short-term capital inadequacy. This type
of short-term cash problem may develop due to various issues, including tax payment, excessive raw
material import, breakdown in production, payment of dividends, delay in collection, and excessive
expenditure of capital. The annual rate of interest given for three month deposits is 12%.

• Six month deposits are usually made with first class borrowers, and the term for such deposits is six
months. The annual interest rate assigned for this type of deposit is 15%.

• The concept of call deposit is different from the previous two deposits. On giving a one day notice,
this deposit can be withdrawn by the lender. The annual interest rate on call deposits is around 10%.

Other types of ICDs

• Fixed rate ICD’s with a call/put option

Fixed rate ICDs are normal Inter-Corporate Deposits (ICDs) having periodic put/call options
exercisable any time after a pre-specified lock-in period.

Put Option is the option on the ICD, which is the right but not the obligation with the Investor, to
ask the Issuer of the ICD to redeem the ICD along with the accrued interest on the entire face value of
the ICD, from the date of placement of the ICD till the date of settlement of the put option of the ICD.

Call Option is the option on the ICD, which is the right but not the obligation with the Issuer of the
ICD, to ask the Investor of the ICD to accept redemption of the ICD along with the accrued interest
on the entire face value of the ICD, from the date of placement of the ICD till the date of settlement
of the call option of the ICD.

• Floating rate ICDs with a call/put option, wherein the rates are linked to a benchmark called MIBOR.

Why ICDs with Put/Call make sense?

For the Investor:

If the short term interest rates go up, it makes sense for the Investor to exercise the put option, i.e. ask the
Issuer of the ICD to repay the principal along with the accrued interest till the number of days the ICD is
held. The Investor can then invest the amount received in higher yielding short term issues.

For the Corporate:

If the short term interest rates go down, it makes sense for the Issuer to exercise the call option, i.e. cancel
the ICD and repay the principal before the original maturity, along with the accrued interest till the
number of days the ICD is held. The corporate can then borrow the amount again at lower short term
interest rates
Risks involved

• Liquidity risk
ICDs with periodic put/call have a very short maturity and they also have periodic put/call options. On
account of a temporary liquidity shortage, the corporates may face a temporary back stop liquidity
facility. This could translate into a liquidity risk for the corporates.

• Interest Rate Risk

If the interest rates rise, and the ICDs are put by the investor, then the re-funding of the liability would
have to be done at a higher interest rate for the remaining tenor. However, the converse is also true
for the investor, i.e. if the interest rates fall and the corporate calls the ICD, then the investor would
then have to deploy the funds at a lower interest rate for the balance tenor. However, seen practically,
the investors are generally deploying surplus short term funds rather than actually trading on interest
rates, and hence, on rise of interest rates, only if there is another borrower at higher rates, will the
investor put the ICD and redeploy the funds elsewhere. On the contrary, if the interest rates fall down,
the corporate will always get funding from alternative sources at lower rates, and hence is in a better
interest rate position than the investor.

• Operational Risk
The investor and the corporate needs to keep a track of all the call and put options, and from which
time onwards, if there is a minimum lock in period. This could become a operational issue and the
settlement on the exercise of either options, if exercised. For this, a detailed procedure with specific
responsibilities for exercise of call and put options has to be laid down by both the issuer and the
investor of the ICD, at the time of the transaction.

Why companies borrow and lend in this market?

• The biggest advantage of inter-corporate deposits is that the transaction is free from bureaucratic and
legal hassles. The business world otherwise is regulated by a number of rules and regulations. The
existence of the inter-corporate deposits market shows that the corporate world can be regulated
without rules.

• The market of inter-corporate deposits maintains secrecy. The brokers in this market never reveal
their lists of lenders and borrowers, because they believe that if proper secrecy is not maintained the
rate of interest can fall abruptly.

• The market of inter-corporate deposits depends crucially on personal contacts. The decisions of
lending in this market are largely governed by personal contacts

• Advantages to the investors are as follows:

a. It helps the investors take advantage of the increase in interest rates, by exercising the put option.
b. It increases the yield on the investment, as the ICDs are unsecured and unrated, hence the
investor can demand a higher interest rate. However, as the nature of the instrument is as short as
the investor and the corporate would like, based on the corporate credit quality, the safety of the
instrument is well covered, to the extent that the investor has done a basic due diligence on the
borrower.
 c. As compared to competing short term investment avenues like call money, CPs, short term
secured debentures, etc. these instruments offer a relatively better yield for the same corporate for
similar tenors, while imparting more liquidity to the investor.

• Advantages to the corporate borrowing:

a. The corporates could use this instrument to meet their requirement for short maturity funds at
competitive rates.
b. The corporates would retain the flexibility of retiring these liabilities as per their requirements
because of the periodic put/call options.
c. The corporate can take advantage of any decline in the interest rates, by exercising the call option.
d. The corporates can raise money at a very short notice through this instrument, as the instrument is
unrated and unsecured and the corporate does not have to undertake any necessary formalities
before borrowing the money. All the documentation that is exchanged is a confirmation letter and
post dated cheques, if required.

Difference between ICD’s and Term loans

• The number of formalities required in the ICD market is way lesser as compared to term loan market.
This is one of the main reason why the borrowing is so high in the Inter corporate deposit market. A
corporate requiring immediate funds to meet its short term requirements can easily go in for
intercorporate deposits as the level of bureaucracy involved is lower. ( Easy availability of funds)

• Term loans are secured loans i.e. they are collateralized. ICS’s are unsecured financial instruments.

• As the ICD’s are unsecured, the risks involved is higher. Thus the interest rates are way higher in
ICD’s as compared to term loans which are available at a cheaper interest rate.

• Both the sources are available depending on the creditworthiness of the company. i.e. its credit rating
in the market.
B. LOAN AGAINST SHARES (LAS)

If one arises at a situation where their money is locked in select equities, and during depressed stock
market conditions, one doesn’t want to resort to panic sales of shares as they think it has upside potential.
The best option available at this point of time is to pledge your shares with a bank and get a loan based on
the value of the equities. This is called as getting loan against ones shares.

Why does one take loan against shares?

• The main purpose of taking loans against shares is to preserve investment, apart from taking care of
personal needs.

• People also resort to such a loan to meet their contingencies and get liquidity without actually selling
the shares. It is advisable to take loan against equity (shares & debentures) only when you are
expecting a certain sum of money a few months down the line and you need some funds in the
interim. If you are reinvesting the loan amount, ensure that the benefits you derive are more than the
cost you have to incur (which includes interest and processing fee).

Availability of loan against shares (Procedure of procurement)

• Loan against shares is available in the form of an overdraft facility against the pledge of financial
securities like shares and bonds. After you submit the loan application with all the share certificates
and other relevant documents, a current account- with free ATM card and access to phone banking is
opened in your name. You can then withdraw up to the amount sanctioned and interest will be
charged only for the number of days you use the amount. The loan amount that can be sanctioned
depends on two factors: the extent of funding on a particular stock and the price (called the base
price) considered by the lender for calculating the value of the shares.

• The Reserve Bank of India (RBI) allows banks to lend up to 75 per cent of the value of demat shares
and 50 per cent of the value of physical shares. However, banks can, and do, fix their own limits with
respect to the extent of funding within that range. Generally, demat shares get you a larger loan
amount, in a much faster time, at lesser rate of interest and at smaller processing fee, than those in
physical form.

• Banks will also do a weekly valuation of the securities, and more frequently should the market be
characterised by volatility. Consider a customer who approaches a bank with securities valued at Rs
10 lakh against which a loan of Rs 6 lakh is sanctioned. If, during periodic assessment, the bank
determines that the market value of the stocks has fallen to Rs 8 lakh (against which the maximum
amount that can be given is Rs 4.8 lakh), the customer has to make up for the difference of Rs 1.2
lakh either by pledging additional securities, or by depositing the difference with the bank, assuming
that the entire amount originally disbursed by the bank has been used up by the customer. Customers
are normally given a fair amount of time to make up for the shortfall. Should they fail to do so, the
bank is at liberty to sell the securities in its possession to recover the difference.
 Conversely, should there be an appreciation in the value of the securities pledged, the customer would
automatically be eligible for an enhancement in drawing power.

Necessary conditions

• The shares should be on the approved list of the bank, which would be revised from time to time.
• The shares should be fully paid up
• Scrips in the name of corporate, minors, Firms, HUF, and NRIs are not eligible for finance under this
scheme.
• The directors or promoters of companies cannot pledge scrips of the same company.