Lecture 1

Financial markets and institution

In financial economics, a financial institution is an institution that provides financial
services for its clients or members. Probably the most important financial service
provided by financial institutions is acting as financial intermediaries. Most financial
institutions are highly regulated by government bodies. Broadly speaking, there are three
major types of financial institution[1]:

1. Deposit-taking institutions that accept and manage deposits and make loans (this
category includes banks, credit unions, trust companies, and mortgage loan
companies);
2. Insurance companies and pension funds; and
3. Brokers, underwriters and investment funds.

In economics, a financial market is a mechanism that allows people to easily buy and
sell (trade) financial securities (such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value at low transaction costs
and at prices that reflect the efficient-market hypothesis.

Financial markets have evolved significantly over several hundred years and are
undergoing constant innovation to improve liquidity.

Both general markets (where many commodities are traded) and specialized markets
(where only one commodity is traded) exist. Markets work by placing many interested
buyers and sellers in one "place", thus making it easier for them to find each other. An
economy which relies primarily on interactions between buyers and sellers to allocate
resources is known as a market economy in contrast either to a command economy or to a
non-market economy such as a gift economy.

In finance, financial markets facilitate –

 The raising of capital (in the capital markets);

 The transfer of risk (in the derivatives markets);
 International trade (in the currency markets)

– and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital.
These receipts are securities which may be freely bought or sold. In return for lending
money to the borrower, the lender will expect some compensation in the form of interest
or dividends.
In mathematical finance, the concept of a financial market is defined in terms of a
continuous-time Brownian motion stochastic process.

Definition

In economics, typically, the term market means the aggregate of possible buyers and
sellers of a thing and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations
that facilitate the trade in financial securities, e.g., a stock exchange or commodity
exchange. This may be a physical location (like the NYSE) or an electronic system (like
NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions
(merger, spinoff) are outside an exchange, while any two companies or people, for
whatever reason, may agree to sell stock from the one to the other without using an
exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade
on a stock exchange, and people are building electronic systems for these as well, similar
to stock exchanges.

Financial markets can be domestic or they can be international.

Types of financial markets

The financial markets can be divided into different subtypes:

 Capital markets which consist of:

o Stock markets, which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of financial
risk.
o Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign exchange.

Lecture 2

Capital market and money market

The capital markets consist of primary markets and secondary markets. Newly formed
(issued) securities are bought or sold in primary markets. Secondary markets allow
investors to sell securities that they hold or buy existing securities.

The capital market is the market for securities, where companies and governments can
raise longterm funds. It is a market in which money is lent for periods longer than a year.
[1]
The capital market includes the stock market and the bond market. Financial
regulators, such as the U.S. Securities and Exchange Commission (SEC), oversee the
capital markets in their designated countries to ensure that investors are protected against
fraud.

The capital markets consist of the primary market and the secondary market. The primary
markets are where new stock and bonds issues are sold (underwriting) to investors. The
secondary markets are where existing securities are sold and bought from one investor or
speculator to another, usually on an exchange (e.g. the New York Stock Exchange).

Money Market

In finance, the money market is the global financial market for short-term borrowing
and lending. It provides short-term liquid funding for the global financial system. The
money market is where short-term obligations such as Treasury bills, commercial paper
and bankers' acceptances are bought and sold.

The money market consists of financial institutions and dealers in money or credit who
wish to either borrow or lend. Participants borrow and lend for short periods of time,
typically up to thirteen months. Money market trades in short term financial instruments
commonly called "paper". This contrasts with the capital market for longer-term funding,
which is supplied by bonds and equity.

Common money market instruments

 Certificate of deposit - A time deposit at a bank with a specific maturity date;

large-denomination certificates of deposits can be sold before maturity.
 Repurchase agreements - Short-term loans—normally for less than two weeks and
frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
 Commercial paper - An unsecured promissory notes with a fixed maturity of one
to 270 days; usually sold at a discount from face value.
 Treasury bills - Short-term debt obligations of a national government that are
issued to mature in 3 to 12 months. For the U.S., see Treasury bills.
 Money market mutual funds - Pooled short maturity, high quality investments
which buy money market securities on behalf of retail or institutional investors.
 Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.
Lecture-3

Primary market
The primary market is that part of the capital markets that deals with the issuance of
new securities. Companies, governments or public sector institutions can obtain funding
through the sale of a new stock or bond issue. This is typically done through a syndicate
of securities dealers. The process of selling new issues to investors is called underwriting.
In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a
commission that is built into the price of the security offering, though it can be found in
the prospectus.

Features of primary markets are:

 This is the market for new long term equity capital. The primary market is the
market where the securities are sold for the first time. Therefore it is also called
the new issue market (NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the
investors.
 Primary issues are used by companies for the purpose of setting up new business
or for expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation
in the economy.
 The new issue market does not include certain other sources of new long term
external finance, such as loans from financial institutions. Borrowers in the new
issue market may be raising capital for converting private capital into public
capital; this is known as "going public."
 The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

 Initial public offering;

 Rights issue (for existing companies);
 Preferential issue.

Lecture-4

secondary market
The secondary market, also known as the aftermarket, is the financial market where
previously issued securities and financial instruments such as stock, bonds, options, and
futures are bought and sold.[1]. The term "secondary market" is also used to refer to the
market for any used goods or assets, or an alternative use for an existing product or asset
where the customer base is the second market (for example, corn has been traditionally
used primarily for food production and feedstock, but a second- or third- market has
developed for use in ethanol production).

With primary issuances of securities or financial instruments, or the primary market,

investors purchase these securities directly from issuers such as corporations issuing
shares in an IPO or private placement, or directly from the federal government in the case
of treasuries. After the initial issuance, investors can purchase from other investors in the
secondary market.

The secondary market for a variety of assets can vary from fragmented to centralized, and
from illiquid to very liquid. The major stock exchanges are the most visible example of
liquid secondary markets - in this case, for stocks of publicly traded companies.
Exchanges such as the New York Stock Exchange, Nasdaq and the American Stock
Exchange provide a centralized, liquid secondary market for the investors who own
stocks that trade on those exchanges. Most bonds and structured products trade “over the
counter,” or by phoning the bond desk of one’s broker-dealer.

Function

Secondary marketing is vital to an efficient and modern capital market. [citation needed] In the
secondary market, securities are sold by and transferred from one investor or speculator
to another. It is therefore important that the secondary market be highly liquid (originally,
the only way to create this liquidity was for investors and speculators to meet at a fixed
place regularly; this is how stock exchanges originated, see History of the Stock
Exchange). As a general rule, the greater the number of investors that participate in a
given marketplace, and the greater the centralization of that marketplace, the more liquid
the market.

Fundamentally, secondary markets mesh the investor's preference for liquidity (i.e., the
investor's desire not to tie up his or her money for a long period of time, in case the
investor needs it to deal with unforeseen circumstances) with the capital user's preference
to be able to use the capital for an extended period of time.

Accurate share price allocates scarce capital more efficiently when new projects are
financed through a new primary market offering, but accuracy may also matters in the
secondary market because: 1) price accuracy can reduce the agency costs of management,
and make hostile takeover a less risky proposition and thus move capital into the hands of
better managers, and 2) accurate share price aids the efficient allocation of debt finance
whether debt offerings or institutional borrowing.

Lecture 5

call money market

A market that consists of the borrowing of money by brokers and dealers for the purpose
of meeting their credit needs.

Generally this money is used to either cover their customersâ?? margin accounts or
finance their own inventory of securities. Along with day-to-day loans, call money loans
play a significant role in interbank money dealings and between banks and money market
dealers. The term â??call moneyâ?? alone usually refers to either secured or unsecured
callable loans made by banks to money market dealers. Generally these loans are made
on a short term basis.

callable loan

A loan used by brokerage firms to maintain margin accounts or finance underwriting that
is repayable on demand at any time.

Also known as a call loan, broker call loan, or demand loan. The interest rate on a
callable loan, known as the call loan rate, is calculated daily. It is quoted daily in
newspapers as a money market indicator, and is usually a percentage point or so higher
than short-term rates such as the federal funds rate or Treasury bill note. Securities are
used as collateral for callable loans.

Interbank Call Money Market

A short-term money market, which allows for large financial institutions,

such as banks, mutual funds and corporations to borrow and lend money
at interbank rates. The loans in the call money market are very short,
usually lasting no longer than a week and are often used to help banks
meet reserve requirements.

While known as an interbank market, many of the players are not banks.
Mutual funds, large corporations and insurance companies are able to
participate in this market. Many countries, such as India, are beginning
to push for a purification of the call money market, but adding
regulations that allow only banks to participate.
Lecture 6

Treasury bill
Treasury Bills are money market instruments to finance the short term requirements of
the Government of India. These are discounted securities and thus are issued at a discount
to face value. The return to the investor is the difference between the maturity value and
issue price.

Types Of Treasury Bills

Benefits Of Investment In Treasury Bills
Features
Primary Market
Secondary Market & Players
Treasury Bills - An Effective Cash Management Product

Types Of Treasury Bills There are different types of Treasury bills based on the
maturity period and utility of the issuance like, ad-hoc Treasury bills, 3 months,
12months Treasury bills etc. In India, at present, the Treasury Bills are the 91-days and
364-days Treasury bills.

Benefits Of Investment In Treasury Bills

No tax deducted at source

Zero default risk being sovereign paper
Highly liquid money market instrument
Better returns especially in the short term
Transparency
Simplified settlement
High degree of tradeability and active secondary market facilitates meeting
unplanned fund requirements.

Features

  Form

The treasury bills are issued in the form of promissory note in physical form or by credit
to Subsidiary General Ledger (SGL) account or Gilt account in dematerialised form.

Minimum Amount Of Bids Bids for treasury bills are to be made for a minimum
amount of Rs 25000/- only and in multiples thereof.
   Eligibility:

All entities registered in India like banks, financial institutions, Primary Dealers, firms,
companies, corporate bodies, partnership firms, institutions, mutual funds, Foreign
Institutional Investors, State Governments, Provident Funds, trusts, research
organisations, Nepal Rashtra bank and even individuals are eligible to bid and purchase
Treasury bills.

  Repayment

The treasury bills are repaid at par on the expiry of their tenor at the office of the Reserve
Bank of India, Mumbai.

  Availability

All the treasury Bills are highly liquid instruments available both in the primary and
secondary market.

  Day Count

For treasury bills the day count is taken as 365 days for a year.

  Yield Calculation

The yield of a Treasury Bill is calculated as per the following formula:

(100-P)*365*100
Y= ------------------
P*D

Wherein Y = discounted yield

P= Price
D= Days to maturity

  Example

A cooperative bank wishes to buy 91 Days Treasury Bill Maturing on Dec. 6, 2002 on
Oct. 12, 2002. The rate quoted by seller is Rs. 99.1489 per Rs. 100 face values. The YTM
can be calculated as following:

The days to maturity of Treasury bill are 55 (October – 20 days, November – 30 days and
December – 5 days)

YTM = (100-99.1489) x 365 x 100/(99.1489*55) = 5.70%

Similarly if the YTM is quoted by the seller price can be calculated by inputting the price
in above formula.

Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do
not pay interest prior to maturity; instead they are sold at a discount of the par value to
create a positive yield to maturity. Many regard Treasury bills as the least risky
investment available to U.S. investors.

Regular weekly T-Bills are commonly issued with maturity dates of 28 days (or 4 weeks,
about a month), 91 days (or 13 weeks, about 3 months), and 182 days (or 26 weeks, about
6 months). Treasury Bills are sold by single price auctions held weekly. Offering
amounts for 13-week and 26-week bills are announced each Thursday for auction at 1:00
pm on the following Monday and settlement, or issuance, on Thursday. Offering amounts
for 4-week bills are announced on Monday for auction the next day, Tuesday, at 1:00 pm
and issuance on Thursday. Purchase orders at TreasuryDirect must be entered before
11:30 on the Monday of the auction. The minimum purchase - effective April 7, 2008 - is
$100. (This amount formerly had been $1,000.) Mature T-bills are also redeemed on each
Thursday. Banks and financial institutions, especially primary dealers, are the largest
purchasers of T-Bills.

Like other securities, individual issues of T-bills are identified with a unique CUSIP
number. The 13-week bill issued three months after a 26-week bill is considered a re-
opening of the 26-week bill and is given the same CUSIP number. The 4-week bill issued
two months after that and maturing on the same day is also considered a re-opening of the
26-week bill and shares the same CUSIP number. For example, the 26-week bill issued
on March 22, 2007 and maturing on September 20, 2007 has the same CUSIP number
(912795A27) as the 13-week bill issued on June 21, 2007 and maturing on September 20,
2007, and as the 4-week bill issued on August 23, 2007 that matures on September 20,
2007.

During periods when Treasury cash balances are particularly low, the Treasury may sell
cash management bills (or CMBs). These are sold at a discount and by auction just like
weekly Treasury bills. They differ in that they are irregular in amount, term (often less
than 21 days), and day of the week for auction, issuance, and maturity. When CMBs
mature on the same day as a regular weekly bill, usually Thursday, they are said to be on-
cycle. The CMB is considered another reopening of the bill and has the same CUSIP.
When CMBs mature on any other day, they are off-cycle and have a different CUSIP
number.

Treasury bills are quoted for purchase and sale in the secondary market on an annualized
percentage yield to maturity, or basis.

With the advent of TreasuryDirect, individuals can now purchase T-Bills online and have
funds withdrawn from and deposited directly to their personal bank account and earn
higher interest rates on their savings.
General calculation for yield on Treasury bills is

Lecture-7

Bill of exchange

A bill of exchange or "draft" is a written order by the drawer to the drawee to pay money
to the payee. A common type of bill of exchange is the cheque (check in American
English), defined as a bill of exchange drawn on a banker and payable on demand. Bills
of exchange are used primarily in international trade, and are written orders by one
person to his bank to pay the bearer a specific sum on a specific date. Prior to the advent
of paper currency, bills of exchange were a common means of exchange. They are not
used as often today.

A bill of exchange is an unconditional order in writing addressed by one person to

another, signed by the person giving it, requiring the person to whom it is addressed to
pay on demand or at fixed or determinable future time a sum certain in money to order or
to bearer. (Sec.126)

It is essentially an order made by one person to another to pay money to a third person.

A bill of exchange requires in its inception three parties--the drawer, the drawee, and the
payee.

The person who draws the bill is called the drawer. He gives the order to pay money to
third party. The party upon whom the bill is drawn is called the drawee. He is the person
to whom the bill is addressed and who is ordered to pay. he becomes an acceptor when he
indicates his willingness to pay the bill. (Sec.62) The party in whose favor the bill is
drawn or is payable is called the payee.

The parties need not all be distinct persons. Thus, the drawer may draw on himself
payable to his own order. (see Sec. 8)

A bill of exchange may be endorsed by the payee in favour of a third party, who may in
turn endorse it to a fourth, and so on indefinitely. The "holder in due course" may claim
the amount of the bill against the drawee and all previous endorsers, regardless of any
counterclaims that may have disabled the previous payee or endorser from doing so. This
is what is meant by saying that a bill is negotiable.

In some cases a bill is marked "not negotiable". In that case it can still be transferred to a
third party, but the third party can have no better right than the transferor.

Why do commercial bill have higher yields than T-bills?

The reason that commercial bills have higher yields than T-bills is due to
the varying credit quality of each bill type. The credit rating of the entity issuing the
bill gives investors an idea of the likelihood that they will be paid back in full. The
federal government's debt (T-bills) is considered to have the highest credit rating in
the market because of its size and ability to raise funds through taxes. On the other
hand, a company that issues commercial bills does not have the same ability to
generate cash inflow because it does not have the same power over consumers that a
government has over its electorate. In other words, commercial bills and T-
bills differ in the credit quality of the bodies that issue them. A higher yield acts as
compensation for investors who choose the higher-risk commercial bills.

For example, imagine that you have a choice between two three-month bills, both of
which yield 5%. The first bill is offered by a small biotech company and the other is
a U.S. government T-bill. Which bill is the wisest choice? In this case, any rational
investor will probably choose the T-bill over that offered by the
biotech company because it is far more likely that the U.S. government will pay
back its debt when compared to a far less stable, much smaller entity like the
biotech firm. If, on the other hand, the biotech bills are yielding 15%, the decision
becomes more complex. In order to make a decision, an investor would need to
factor in the likelihood that the small company could pay its debt as well as
the amount of risk he or she is willing to take on.

In general, when there are two bills with the same maturity, the bill that has the
lower credit quality or rating will offer a higher yield to investors because there is a
greater chance that the creditor will be unable to meet its debt obligation.

Lecture-8

Commercial Paper
Commercial paper is a money-market security issued by large banks and corporations.
It is generally not used to finance long-term investments but rather to purchase inventory
or to manage working capital. It is commonly bought by money funds (the issuing
amounts are often too high for individual investors), and is generally regarded as a very
safe investment. As a relatively low-risk investment, commercial paper returns are not
large. There are four basic kinds of commercial paper: promissory notes, drafts, checks,
and certificates of deposit.

Because commercial paper maturities do not exceed 270 days and proceeds typically are
used only for current transactions, the notes are exempt from registration as securities
with the United States Securities and Exchange Commission.

Commercial paper is defined in Canada as having a maturity of not more than one year
and is exempt from dealer registration and prospectus requirements.
Commercial paper essentially can be compared as an alternative to lines of credit with a
bank. Once a business becomes large enough, and maintains a high enough credit rating,
then using commercial paper is always cheaper than using a bank line of credit.
Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to
the commercial paper. In this situation, banks often charge fees for the amount of the line
of the credit that does not have a balance. While these fees may seem like pure profit for
banks, if the company ever actually needs to use the line of credit it would likely be in
serious trouble and have difficulty repaying its liabilities.

Currently, more than 1,700 companies in the United States issue commercial paper.
Financial companies comprise the largest group of commercial paper issuers, accounting
for nearly 75 percent of the commercial paper outstanding at mid-year 1990. Financial-
company paper is issued by firms in commercial, savings and mortgage banking; sales,
personal and mortgage financing; factoring; finance leasing and other business lending;
insurance underwriting; and other investment activities. The remaining commercial paper
outstanding at mid-year 1990 -- over 25 percent -- was issued by nonfinancial firms such
as manufacturers, public utilities, industrial concerns and service industries.

Commercial paper was invented by Percy "Max" Hall, Vice President of Manufacturers
Hanover Trust Bank, in the 1920's.

Issuing commercial paper

There are two methods of issuing paper. The issuer can market the securities directly to a
buy and hold investor such as most money funds. Alternatively, it can sell the paper to a
dealer, who then sells the paper in the market. The dealer market for commercial paper
involves large securities firms and subsidiaries of bank holding companies. Most of these
firms also are dealers in US Treasury securities. Direct issuers of commercial paper
usually are financial companies that have frequent and sizable borrowing needs and find
it more economical to sell paper without the use of an intermediary. In the United States,
direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized,
which translates to $50,000 on every $100 million outstanding. This saving compensates
for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend
to be lower outside the United States.

Lecture 9

CD
A certificate of deposit or CD is a time deposit, a financial product commonly offered to
consumers by banks, thrift institutions, and credit unions.

CDs are similar to savings accounts in that they are insured and thus virtually risk-free;
they are "money in the bank" (CDs are insured by the FDIC for banks or by the NCUA
for credit unions). They are different from savings accounts in that the CD has a specific,
fixed term (often three months, six months, or one to five years), and, usually, a fixed
interest rate. It is intended that the CD be held until maturity, at which time the money
may be withdrawn together with the accrued interest.

In exchange for keeping the money on deposit for the agreed-on term, institutions usually
grant higher interest rates than they do on accounts from which money may be withdrawn
on demand, although this may not be the case in an inverted yield curve situation. Fixed
rates are common, but some institutions offer CDs with various forms of variable rates.
For example, in mid-2004, with interest rates expected to rise, many banks and credit
unions began to offer CDs with a "bump-up" feature. These allow for a single
readjustment of the interest rate, at a time of the consumer's choosing, during the term of
the CD. Sometimes, CDs that are indexed to the stock market, the bond market, or other
indices are introduced.

A few general guidelines for interest rates are:

 A larger principal should receive a higher interest rate, but may not.
 A longer term may or may not receive a higher interest rate, depending on the
current yield curve.
 Smaller institutions tend to offer higher interest rates than larger ones.
 Personal CD accounts generally receive higher interest rates than business CD
accounts.
 Banks and credit unions that are not insured by the FDIC or NCUA generally
offer higher interest rates.

Lecture 10

SEBI
SEBI is the Regulator for the Securities Market in India. Originally set up by the
Government of India in 1988, it acquired statutory form in 1992 with SEBI Act 1992
being passed by the Indian Parliament.Chaired by C B Bhave, SEBI is headquartered in
the popular business district of Bandra-Kurla complex in Mumbai, and has Northern,
Eastern, Southern and Western regional offices in New Delhi, Kolkata, Chennai and
Ahmedabad.

Organization Structure

Chandrasekhar Bhaskar Bhave is the sixth chairman of the Securities Market Regulator.
Prior to taking charge as Chairman SEBI, he had been the chairman of NSDL (National
Securities Depository Limited) ushering in paperless securities. Prior to his stint at
NSDL, he had served SEBI as a Senior Executive Director. He is a former Indian
Administrative Service officer of the 1975 batch.
The Board comprises[2]

Name Designation As per

CHAIRMAN (S.4(1)(a) of the SEBI

Mr CB Bhave Chairman SEBI
Act, 1992)

Mr KP Joint Secretary, Ministry of Member (S.4(1)(b) of the SEBI Act,

Krishnan Finance 1992)

Mr Anurag Secretary, Ministry of Corporate Member (S.4(1)(b) of the SEBI Act,

Goel Affairs 1992)

Dr G Mohan Director, National Judicial Member (S.4(1)(d) of the SEBI Act,

Gopal Academy, Bhopal 1992)

Member (S.4(1)(d) of the SEBI Act,

Mr MS Sahoo Whole Time Member, SEBI
1992)

Dr KM Member (S.4(1)(d) of the SEBI Act,

Whole Time Member, SEBI
Abraham 1992)

Mr Mohandas Member (S.4(1)(d) of the SEBI Act,

Director, Infosys
Pai 1992)

Functions and Responsibilities

SEBI has to be responsive to the needs of three groups, which constitute the market:

 the issuers of securities

 the investors
 the market intermediaries.

SEBI has three functions rolled into one body quasi-legislative, quasi-judicial and quasi-
executive. It drafts regulations in its legislative capacity, it conducts investigation and
enforcement action in its executive function and it passes rulings and orders in its judicial
capacity. Though this makes it very powerful, there is an appeals process to create
accountability. There is a Securities Appellate Tribunal which is a three member tribunal
and is presently headed by a former Chief Justice of a High court - Mr. Justice NK Sodhi.
A second appeal lies directly to the Supreme Court.

SEBI has enjoyed success as a regulator by pushing systemic reforms aggressively and
successively (e.g. the quick movement towards making the markets electronic and
paperless rolling settlement on T+2 basis). SEBI has been active in setting up the
regulations as required under law

Lecture 11

Venture Capital
Venture capital (also known as VC or Venture) is a type of private equity capital
typically provided to immature, high-potential, growth companies in the interest of
generating a return through an eventual realization event such as an IPO or trade sale of
the company. Venture capital investments are generally made as cash in exchange for
shares in the invested company.

Venture capital typically comes from institutional investors and high net worth
individuals and is pooled together by dedicated investment firms.

A venture capitalist (also known as a VC) is a person or investment firm that makes
venture investments, and these venture capitalists are expected to bring managerial and
technical expertise as well as capital to their investments. A venture capital fund refers
to a pooled investment vehicle (often an LP or LLC) that primarily invests the financial
capital of third-party investors in enterprises that are too risky for the standard capital
markets or bank loans.

Venture capital is most attractive for new companies with limited operating history that
are too small to raise capital in the public markets and are too immature to secure a bank
loan or complete a debt offering. In exchange for the high risk that venture capitalists
assume by investing in smaller and less mature companies, venture capitalists usually get
significant control over company decisions, in addition to a significant portion of the
company's ownership (and consequently value).

History

With few exceptions, private equity in the first half of the 20th century was the domain of
wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs
were notable investors in private companies in the first half of the century. In 1938,
Laurance S. Rockefeller helped finance the creation of both Eastern Air Lines and
Douglas Aircraft and the Rockefeller family had vast holdings in a variety of companies.
Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become
Warburg Pincus, with investments in both leveraged buyouts and venture capital.
Origins of modern private equity

Before World War II, venture capital investments (originally known as "development
capital") were primarily the domain of wealthy individuals and families. It was not until
after World War II that what is considered today to be true private equity investments
began to emerge marked by the founding of the first two venture capital firms in 1946:
American Research and Development Corporation. (ARDC) and J.H. Whitney &
Company.[1]

A VAX-11/780 system created by Digital Equipment Corporation, the first major venture
capital success story

ARDC was founded by Georges Doriot, the "father of venture capitalism" [2] (former dean
of Harvard Business School), with Ralph Flanders and Karl Compton (former president
of MIT), to encourage private sector investments in businesses run by soldiers who were
returning from World War II. ARDC's significance was primarily that it was the first
institutional private equity investment firm that raised capital from sources other than
wealthy families although it had several notable investment successes as well. [3] ARDC is
credited with the first major venture capital success story when its 1957 investment of
$70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million
after the company's initial public offering in 1968 (representing a return of over 500
times on its investment and an annualized rate of return of 101%).[4] Former employees of
ARDC went on to found several prominent venture capital firms including Greylock
Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland
Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). [5]
ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot
merged ARDC with Textron after having invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno
Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933
and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius
Vanderbilt Whitney. By far Whitney's most famous investment was in Florida Foods
Corporation. The company developed an innovative method for delivering nutrition to
American soldiers, which later came to be known as Minute Maid orange juice and was
sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make
investments in leveraged buyout transactions and raised $750 million for its sixth
institutional private equity fund in 2005.

Early venture capital and the growth of Silicon Valley

Sand Hill Road in Menlo Park, California, where many Bay Area venture capital firms
are based

One of the first steps toward a professionally-managed venture capital industry was the
passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed
the U.S. Small Business Administration (SBA) to license private "Small Business
Investment Companies" (SBICs) to help the financing and management of the small
entrepreneurial businesses in the United States.[6]

During the 1960s and 1970s, venture capital firms focused their investment activity
primarily on starting and expanding companies. More often than not, these companies
were exploiting breakthroughs in electronic, medical or data-processing technology. As a
result, venture capital came to be almost synonymous with technology finance.

It is commonly noted that the first venture-backed startup is Fairchild Semiconductor

(which produced the first commercially practicable integrated circuit), funded in 1959 by
what would later become Venrock Associates.[7] Venrock was founded in 1969 by
Laurance S. Rockefeller, the fourth of John D. Rockefeller's six children as a way to
allow other Rockefeller children to develop exposure to venture capital investments.

It was also in the 1960s that the common form of private equity fund, still in use today,
emerged. Private equity firms organized limited partnerships to hold investments in
which the investment professionals served as general partner and the investors, who were
passive limited partners, put up the capital. The compensation structure, still in use today,
also emerged with limited partners paying an annual management fee of 1-2% and a
carried interest typically representing up to 20% of the profits of the partnership.

The growth of the venture capital industry was fueled by the emergence of the
independent investment firms on Sand Hill Road, beginning with Kleiner, Perkins,
Caufield & Byers and Sequoia Capital in 1972. Located, in Menlo Park, CA, Kleiner
Perkins, Sequoia and later venture capital firms would have access to the burgeoning
technology industries in the area. By the early 1970s, there were many semiconductor
companies based in the Santa Clara Valley as well as early computer firms using their
devices and programming and service companies.[8] Throughout the 1970s, a group of
private equity firms, focused primarily on venture capital investments, would be founded
that would become the model for later leveraged buyout and venture capital investment
firms. In 1973, with the number of new venture capital firms increasing, leading venture
capitalists formed the National Venture Capital Association (NVCA). The NVCA was to
serve as the industry trade group for the venture capital industry.[9] Venture capital firms
suffered a temporary downturn in 1974, when the stock market crashed and investors
were naturally wary of this new kind of investment fund.

It was not until 1978 that venture capital experienced its first major fundraising year, as
the industry raised approximately $750 million. With the passage of the Employee
Retirement Income Security Act (ERISA) in 1974, corporate pension funds were
prohibited from holding certain risky investments including many investments in
privately held companies. In 1978, the US Labor Department relaxed certain of the
ERISA restrictions, under the "prudent man rule,"[10] thus allowing corporate pension
funds to invest in the asset class and providing a major source of capital available to
venture capitalists.

Venture capital in the 1980s

The public successes of the venture capital industry in the 1970s and early 1980s (e.g.,
Digital Equipment Corporation, Apple, Genentech) gave rise to a major proliferation of
venture capital investment firms. From just a few dozen firms at the start of the decade,
there were over 650 firms by the end of the 1980s, each searching for the next major
"home run". While the number of firms multiplied, the capital managed by these firms
increased only 11% from $28 billion to $31 billion over the course of the decade.[11]

The growth the industry was hampered by sharply declining returns and certain venture
firms began posting losses for the first time. In addition to the increased competition
among firms, several other factors impacted returns. The market for initial public
offerings cooled in the mid-1980s before collapsing after the stock market crash in 1987
and foreign corporations, particularly from Japan and Korea, flooded early stage
companies with capital.[11]

In response to the changing conditions, corporations that had sponsored in-house venture
investment arms, including General Electric and Paine Webber either sold off or closed
these venture capital units. Additionally, venture capital units within Chemical Bank and
Continental Illinois National Bank, among others, began shifting their focus from funding
early stage companies toward investments in more mature companies. Even industry
founders J.H. Whitney & Company and Warburg Pincus began to transition toward
leveraged buyouts and growth capital investments.[11][12][13]

The venture capital boom and the Internet Bubble (1995 to 2000)

By the end of the 1980s, venture capital returns were relatively low, particularly in
comparison with their emerging leveraged buyout cousins, due in part to the competition
for hot startups, excess supply of IPOs and the inexperience of many venture capital fund
managers. Growth in the venture capital industry remained limited through the 1980s and
the first half of the 1990s increasing from $3 billion in 1983 to just over $4 billion more
than a decade later in 1994.

After a shakeout of venture capital mangers, the more successful firms retrenched,
focusing increasingly on improving operations at their portfolio companies rather than
continuously making new investments. Results would begin to turn very attractive,
successful and would ultimately generate the venture capital boom of the 1990s. Former
Wharton Professor Andrew Metrick refers to these first 15 years of the modern venture
capital industry beginning in 1980 as the "pre-boom period" in anticipation of the boom
that would begin in 1995 and last through the bursting of the Internet bubble in 2000.[14]

The late 1990s were a boom time for the venture capital, as firms on Sand Hill Road in
Menlo Park and Silicon Valley benefited from a huge surge of interest in the nascent
Internet and other computer technologies. Initial public offerings of stock for technology
and other growth companies were in abundance and venture firms were reaping large
windfalls.

The bursting of the Internet Bubble and the private equity crash (2000 to 2003)
The Nasdaq crash and technology slump that started in March 2000 shook virtually the
entire venture capital industry as valuations for startup technology companies collapsed.
Over the next two years, many venture firms had been forced to write-off their large
proportions of their investments and many funds were significantly "under water" (the
values of the fund's investments were below the amount of capital invested). Venture
capital investors sought to reduce size of commitments they had made to venture capital
funds and in numerous instances, investors sought to unload existing commitments for
cents on the dollar in the secondary market. By mid-2003, the venture capital industry
had shriveled to about half its 2001 capacity. Nevertheless, PricewaterhouseCoopers'
MoneyTree Survey shows that total venture capital investments held steady at 2003
levels through the second quarter of 2005.

Although the post-boom years represent just a small fraction of the peak levels of venture
investment reached in 2000, they still represent an increase over the levels of investment
from 1980 through 1995. As a percentage of GDP, venture investment was 0.058%
percent in 1994, peaked at 1.087% (nearly 19x the 1994 level) in 2000 and ranged from
0.164% to 0.182 % in 2003 and 2004. The revival of an Internet-driven environment in
2004 through 2007 helped to revive the venture capital environment. However, as a
percentage of the overall private equity market, venture capital has still not reached its
mid-1990s level, let alone its peak in 2000.

However, venture capital funds, which were responsible for much of the fundraising
volume in 2000 (the height of the dot-com bubble), raised only $25.1 billion in 2006, a
2% percent decline from 2005 and a significant decline from its peak.[15]

Venture capital firms and funds

Lecture- 12

Structure of venture capital firms

Venture capital firms are typically structured as partnerships, the general partners of
which serve as the managers of the firm and will serve as investment advisors to the
venture capital funds raised. Venture capital firms may also be structured as limited
liability companies, in which case the firm's managers are known as managing members.
Investors in venture capital funds are known as limited partners. This constituency
comprises both high net worth individuals and institutions with large amounts of
available capital, such as state and private pension funds, university financial
endowments, foundations, insurance companies, and pooled investment vehicles, called
fund of funds or mutual funds.

Roles within venture capital firms

Within the venture capital industry, the general partners and other investment
professionals of the venture capital firm are often referred to as "venture capitalists" or
"VCs". Typical career backgrounds vary, but broadly speaking venture capitalists come
from either an operational or a finance background. Venture capitalists with an
operational background tend to be former founders or executives of companies similar to
those which the partnership finances or will have served as management consultants.
Venture capitalists with finance backgrounds tend to have investment banking or other
corporate finance experience.

Although the titles are not entirely uniform from firm to firm, other positions at venture
capital firms include:

 Venture partners - Venture partners are expected to source potential investment

opportunities ("bring in deals") and typically are compensated only for those deals
with which they are involved.

 Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and

perform due diligence on potential deals. EIRs are engaged by venture capital
firms temporarily (six to 18 months) and are expected to develop and pitch startup
ideas to their host firm (although neither party is bound to work with each other).
Some EIR's move on to executive positions within a portfolio company.

 Principal - This is a mid-level investment professional position, and often

considered a "partner-track" position. Principals will have been promoted from a
senior associate position or who have commensurate experience in another field
such as investment banking or management consulting.

 Associate - This is typically the most junior apprentice position within a venture
capital firm. After a few successful years, an associate may move up to the
"senior associate" position and potentially principal and beyond. Associates will
often have worked for 1-2 years in another field such as investment banking or
management consulting.

Structure of the funds

Most venture capital funds have a fixed life of 10 years, with the possibility of a few
years of extensions to allow for private companies still seeking liquidity. The investing
cycle for most funds is generally three to five years, after which the focus is managing
and making follow-on investments in an existing portfolio. This model was pioneered by
successful funds in Silicon Valley through the 1980s to invest in technological trends
broadly but only during their period of ascendance, and to cut exposure to management
and marketing risks of any individual firm or its product.

In such a fund, the investors have a fixed commitment to the fund that is initially
unfunded and subsequently "called down" by the venture capital fund over time as the
fund makes its investments. There are substantial penalties for a Limited Partner (or
investor) that fails to participate in a capital call.

Compensation
Venture capitalists are compensated through a combination of management fees and
carried interest (often referred to as a "two and 20" arrangement:

 Management fees – an annual payment made by the investors in the fund to the
fund's manager to pay for the private equity firm's investment operations. [16] In a
typical venture capital fund, the general partners receive an annual management
fee equal to up to 2% of the committed capital.

 Carried interest - a share of the profits of the fund (typically 20%), paid to the
private equity fund’s management company as a performance incentive. The
remaining 80% of the profits are paid to the fund's investors [16] Strong Limited
Partner interest in top-tier venture firms has led to a general trend toward terms
more favorable to the venture partnership, and certain groups are able to
command carried interest of 25-30% on their funds.

Because a fund may run out of capital prior to the end of its life, larger venture capital
firms usually have several overlapping funds at the same time; this lets the larger firm
keep specialists in all stages of the development of firms almost constantly engaged.
Smaller firms tend to thrive or fail with their initial industry contacts; by the time the
fund cashes out, an entirely-new generation of technologies and people is ascending,
whom the general partners may not know well, and so it is prudent to reassess and shift
industries or personnel rather than attempt to simply invest more in the industry or people
the partners already know.

Venture capital funding

Venture capital is not generally suitable for all entrepreneurs. Venture capitalists are
typically very selective in deciding what to invest in; as a rule of thumb, a fund may
invest in as few as one in four hundred opportunities presented to it. Funds are most
interested in ventures with exceptionally high growth potential, as only such
opportunities are likely capable of providing the financial returns and successful exit
event within the required timeframe (typically 3-7 years) that venture capitalists expect.

Because investments are illiquid and require 3-7 years to harvest, venture capitalists are
expected to carry out detailed due diligence prior to investment. Venture capitalists also
are expected to nurture the companies in which they invest, in order to increase the
likelihood of reaching a IPO stage when valuations are favourable. Venture capitalists
typically assist at four stages in the company's development:[17]

 Idea generation;
 Start-up;
 Ramp up; and
 Exit

This need for high returns makes venture funding an expensive capital source for
companies, and most suitable for businesses having large up-front capital requirements
which cannot be financed by cheaper alternatives such as debt. That is most commonly
the case for intangible assets such as software, and other intellectual property, whose
value is unproven. In turn this explains why venture capital is most prevalent in the fast-
growing technology and life sciences or biotechnology fields.

If a company does have the qualities venture capitalists seek including a solid business
plan, a good management team, investment and passion from the founders, a good
potential to exit the investment before the end of their funding cycle, and target minimum
returns in excess of 40% per year, it will find it easier to raise venture capital.

Lecture- 13

main alternatives to venture capital

Because of the strict requirements venture capitalists have for potential investments,
many entrepreneurs seek initial funding from angel investors, who may be more willing
to invest in highly speculative opportunities, or may have a prior relationship with the
entrepreneur.

Furthermore, many venture capital firms will only seriously evaluate an investment in a
start-up otherwise unknown to them if the company can prove at least some of its claims
about the technology and/or market potential for its product or services. To achieve this,
or even just to avoid the dilutive effects of receiving funding before such claims are
proven, many start-ups seek to self-finance until they reach a point where they can
credibly approach outside capital providers such as venture capitalists or angel investors.
This practice is called "bootstrapping".

There has been some debate since the dot com boom that a "funding gap" has developed
between the friends and family investments typically in the $0 to $250,000 range and the
amounts that most Venture Capital Funds prefer to invest between $1 to $2MM. This
funding gap may be accentuated by the fact that some successful Venture Capital funds
have been drawn to raise ever-larger funds, requiring them to search for correspondingly
larger investment opportunities. This 'gap' is often filled by angel investors as well as
equity investment companies who specialize in investments in startups from the range of
$250,000 to $1MM. The National Venture Capital association estimates that the latter
now invest more than $30 billion a year in the USA in contrast to the $20 billion a year
invested by organized Venture Capital funds.[citation needed]

In industries where assets can be securitized effectively because they reliably generate
future revenue streams or have a good potential for resale in case of foreclosure,
businesses may more cheaply be able to raise debt to finance their growth. Good
examples would include asset-intensive extractive industries such as mining, or
manufacturing industries. Offshore funding is provided via specialist venture capital
trusts which seek to utilise securitization in structuring hybrid multi market transactions
via an SPV (special purpose vehicle): a corporate entity that is designed solely for the
purpose of the financing.
In addition to traditional venture capital and angel networks, groups have emerged which
allow groups of small investors or entrepreneurs themselves to compete in a privatized
business plan competition where the group itself serves as the investor through a
democratic process.

Geographical differences

Venture capital, as an industry, originated in the United States and Amercan firms have
traditionally been the largest participants in venture deals and the bulk of venture capital
has been deployed in American companies. However, increasingly, non-US venture
investment is growing and the number and size of non-US venture capitalists have been
expanding.

Venture capital has been used as a tool for economic development in a variety of
developing regions. In many of these regions, with less developed financial sectors,
venture capital plays a role in facilitating access to finance for small and medium
enterprises (SMEs), which in most cases would not qualify for receiving bank loans.

United States

Venture capitalists invested some $6.6 billion in 797 deals in U.S. during the third quarter
of 2006, according to the MoneyTree Report by PricewaterhouseCoopers and the
National Venture Capital Association based on data by Thomson Financial.

A recent National Venture Capital Association survey found that majority (69%) of
venture capitalists predict that venture investments in U.S. will level between $20-29
billion in 2007.

Canada

Canadian technology companies have attracted interest from the global venture capital
community in part as a result of a generous program of tax credits for scientific research
and development (SR&ED). These tax credits are only available to Canadian controlled
private companies (CCPCs). A CCPC must be incorporated in Canada. This creates a
tension with many U.S.-based investors, since Canadian tax laws contain irritants that
have historically made exits from Canadian companies difficult for U.S.-based venture
capital investors.

Canada also has a fairly unique form of venture capital generation in its Labour
Sponsored Venture Capital Corporations (LSVCC). These funds, also known as Retail
Venture Capital or Labour Sponsored Investment Funds (LSIF), are generally sponsored
by labor unions and offer tax breaks from government to encourage retail investors to
purchase the funds. Generally, these Retail Venture Capital funds only invest in
companies where the majority of employees are in Canada. However, innovative
structures have been developed to permit LSVCCs to direct in Canadian subsidiaries of
corporations incorporated in jurisdictions outside of Canada.
Europe

Europe has a large and growing number of active venture firms. Capital raised in the
region in 2005, including buy-out funds, exceeded €60mn, of which €12.6mn was
specifically for venture investment. The European Venture Capital Association includes a
list of active firms and other statistics. In 2006 the top three countries receiving the most
venture capital investments were the United Kingdom (515 minority stakes sold for
€1.78bn), France (195 deals worth €875m), and Germany (207 deals worth €428m)
according to data gathered by Library House.[18]

European venture capital investment in the second quarter of 2007 rose 5% to 1.14 billion
euros from the first quarter. However, due to bigger sized deals in early stage
investments, the number of deals was down 20% to 213. The second quarter venture
capital investment results were significant in terms of early-round investment, where as
much as 600 million euros (about 42.8% of the total capital) were invested in 126 early
round deals (which comprised more than half of the total number of deals).[19]

India

The investment of capitalists in Indian industries in the first half of 2006 is $3 billion and
is expected to reach $6.5 billion at the end of the year.

Venture Capital Fund

The Reserve Bank of India, in regard to foreign exchange management act, frames the
policy. The regulations of RBI for venture capital funds are that a SEBI registered
venture capital fund investor can invest with the general permission of the RBI into
Venture Capital Fund or Indian venture capital undertakings, according to the rules and
regulations as specified by RBI notifications from time to time. In income-tax act 1962
venture capital fund consider as a pass through entity & not taxed , but income from this
is taxed in investers hand

China

In China, venture funding more than doubled from $420,000 in 2002 to almost $1 million
in 2003. For the first half of 2004, venture capital investment rose 32% from 2003. By
2005, led by a wave of successful IPOs on the NASDAQ and revised government
regulations, China-dedicated funds raised US$4 million in committed capital.

Vietnam

In Vietnam, venture funding has been increasing rapidly as Vietnamese overseas

returnees and Vietnamese ex-managers of multinational companies increasingly establish
new companies with ambitious growth plans. Firms such as Mekong Ventures, IDG
Vietnam Ventures and DFJ-VinaCapital have pioneered investments in seed-stage and
start-up stage companies in Vietnam. The $20 Million Challenge is Vietnam's first
business plan contest for local entrepreneurs.
Lecture 14

Merchant bank
In banking, a merchant bank is a financial institution primarily engaged in offering
financial services and advice to corporations and to wealthy individuals. The term can
also be used to describe the private equity activities of banking.[1] The chief distinction
between an investment bank and a merchant bank is that a merchant bank invests its own
capital in a client company whereas an investment bank purely distributes (and trades)
the securities of that company in its capital raising role. Both merchant banks and
investment banks provide fee based corporate advisory services including in relation to
mergers and acquisitions.

History

Merchant banks, now so called, are in fact the original "banks". These were invented in
the Middle Ages by Italian grain merchants. As the Lombardy merchants and bankers
grew in stature based on the strength of the Lombard plains cereal crops, many displaced
Jews fleeing Spanish persecution were attracted to the trade. They brought with them
ancient practices from the middle and far east silk routes. Originally intended for the
finance of long trading journeys, these methods were now utilized to finance the
production of grain.

The Jews could not hold land in Italy, so they entered the great trading piazzas and halls
of Lombardy, alongside the local traders, and set up their benches to trade in crops. They
had one great advantage over the locals. Christians were strictly forbidden the sin of
usury. The Jewish newcomers, on the other hand, could lend to farmers against crops in
the field, a high-risk loan at what would have been considered usurious rates by the
Church, but did not bind the Jews. In this way they could secure the grain sale rights
against the eventual harvest. They then began to advance against the delivery of grain
shipped to distant ports. In both cases they made their profit from the present discount
against the future price. This two-handed trade was time consuming and soon there arose
a class of merchants, who were trading grain debt instead of grain.

The Jewish trader performed both finance (credit) and an underwriting (insurance)
functions. He would derive an income from lending the farmer money to develop and
manufacture (through seeding, growing, weeding and harvesting) his annual crop (the
crop loan at the beginning of the growing season). He would underwrite (insure) the
delivery of the crop (through crop or commodity insurance) to the merchant wholesaler
who was the ultimate purchaser of the farmer’s harvest. And he would make
arrangements to supply this buyer through alternative sources (the merchant function) of
supply (such as grain stores or alternate producer markets), should any particular farming
district suffer a seasonal crop failure. He could also keep the farmer (or other commodity
producer) in business during a drought or other crop failure, through the issuance of a
crop (or commodity) insurance against the hazard of failure of his crop.
Thus in his underlying financial function the merchant banker (trader) would ensure the
continuous smooth flowing of the commodity (crop, wool, salt; salt-cod, etc.) markets by
providing both credit and insurance.

It was a short step from financing trade on their own behalf to settling trades for others,
and then to holding deposits for settlement of "billete" or notes written by the people who
were still brokering the actual grain. And so the merchant's "benches" (bank is a
corruption of the Italian for bench, banca, as in a counter) in the great grain markets
became centers for holding money against a bill (billette, a note, a letter of formal
exchange, later a bill of exchange, later still, a cheque).

These deposited funds were intended to be held for the settlement of grain trades, but
often were used for the bench's own trades in the meantime. The term bankrupt is a
corruption of the Italian banca rotta, or broken bench, which is what happened when
someone lost his traders' deposits. Being "broke" has the same connotation.

A sensible manner of discounting interest to the depositors against what could be earned
by employing their money in the trade of the bench soon developed; in short, selling an
"interest" to them in a specific trade, thus overcoming the usury objection. Once again
this merely developed what was an ancient method of financing long distance transport of
goods.

Islam makes similar condemnations of usury as Christianity.

The medieval Italian markets were disrupted by wars and in any case were limited by the
fractured nature of the Italian states. And so the next generation of bankers arose from
migrant Jewish merchants in the great wheat growing areas of Germany and Poland.
Many of these merchants were from the same families who had been part of the
development of the banking process in Italy. They also had links with family members
who had, centuries before, fled Spain for both Italy and England.

This course of events set the stage for the rise of banking names which still resonate
today: Schroders, Warburgs, Rothschilds, even the ill-fated Barings, were all the product
of the continental grain trade, and indirectly, the early Iberian persecution of Jews. These
and other great merchant banking families dealt in everything from underwriting bonds to
originating foreign loans. Bullion trading and bond issuing were some of the specialties
of the Rothschild family.

Lecture 15

Role of Banks and financial institutions

Banking in India originated in the first decade of 18th century. The first banks were The
General Bank of India, which started in 1786, and Bank of Hindustan, both of which are
now defunct. The oldest bank in existence in India is the State Bank of India, which
originated in the "The Bank of Bengal" in Calcutta in June 1806. This was one of the
three presidency banks, the other two being the Bank of Bombay and the Bank of
Madras. The presidency banks were established under charters from the British East India
Company. They merged in 1925 to form the Imperial Bank of India, which, upon India's
independence, became the State Bank of India. For many years the Presidency banks
acted as quasi-central banks, as did their successors. The Reserve Bank of India formally
took on the responsibility of regulating the Indian banking sector from 1935. After India's
independence in 1947, the Reserve Bank was nationalized and given broader powers.

A couple of decades later, foreign banks such as Credit Lyonnais started their Calcutta
operations in the 1850s. At that point of time, Calcutta was the most active trading port,
mainly due to the trade of the British Empire, and due to which banking activity took
roots there and prospered.

Early history

The first fully Indian owned bank was the Allahabad Bank, established in 1865.
However, at the end of late-18th century, there were hardly any banks in India in the
modern sense of the term. At the time of the American Civil War, a void was created as
the supply of cotton to Lancashire stopped from the Americas. Some banks were opened
at that time to finance industry, including speculative trading in cotton. With large
exposure to speculative ventures, most of the banks opened in India during that period
failed. The depositors lost money and lost interest in keeping deposits with banks.
Subsequently, banking in India remained the exclusive domain of Europeans for next
several decades until the beginning of the 20th century.

The Bank of Bengal, which later became the State Bank of India.

At this time, the Indian economy was passing through a relative period of stability.
Around five decades have elapsed since the India's First war of Independence, and the
social, industrial and other infrastructure have developed. At that time there were very
small banks operated by Indians, and most of them were owned and operated by
particular communities.

The presidency banks dominated banking in India. There were also some exchange banks
and a number of Indian joint stock banks. All these banks operated in different segments
of the economy. The exchange banks, mostly owned by Europeans, concentrated on
financing foreign trade. Indian joint stock banks were generally under capitalized and
lacked the experience and maturity to compete with the presidency and exchange banks.
This segmentation let Lord Curzon to observe, "In respect of banking it seems we are
behind the times. We are like some old fashioned sailing ship, divided by solid wooden
bulkheads into separate and cumbersome compartments."

By the 1900s, the market expanded with the establishment of banks such as Punjab
National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of which
were founded under private ownership. The Swadeshi movement in particular inspired
local businessmen and political figures to found banks of and for the Indian community.
A number of banks established then have survived to the present such as Bank of India,
Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and Central Bank of
India.

From World War I to Independence

The period during the First World War (1914-1918) through the end of the Second World
War (1939-1945), and two years thereafter until the independence of India were
challenging for Indian banking. The years of the First World War were turbulent, and it
took its toll with banks simply collapsing despite the Indian economy gaining indirect
boost due to war-related economic activities. At least 94 banks in India failed between
1913 and 1918 as indicated in the following table:

Number of
Authorised capital Paid-up Capital
Years banks
(Rs. Lakhs) (Rs. Lakhs)
that failed

1913 12 274 35

1914 42 710 109

1915 11 56 5

1916 13 231 4

1917 9 76 25

1918 7 209 1
Post-independence

The partition of India in 1947 adversely impacted the economies of Punjab and West
Bengal, paralyzing banking activities for months. India's independence marked the end of
a regime of the Laissez-faire for the Indian banking. The Government of India initiated
measures to play an active role in the economic life of the nation, and the Industrial
Policy Resolution adopted by the government in 1948 envisaged a mixed economy. This
resulted into greater involvement of the state in different segments of the economy
including banking and finance. The major steps to regulate banking included:

 In 1948, the Reserve Bank of India, India's central banking authority, was
nationalized, and it became an institution owned by the Government of India.
 In 1949, the Banking Regulation Act was enacted which empowered the Reserve
Bank of India (RBI) "to regulate, control, and inspect the banks in India."
 The Banking Regulation Act also provided that no new bank or branch of an
existing bank may be opened without a license from the RBI, and no two banks
could have common directors.

However, despite these provisions, control and regulations, banks in India except the
State Bank of India, continued to be owned and operated by private persons. This
changed with the nationalization of major banks in India on 19th July, 1969.

Nationalisation

By the 1960s, the Indian banking industry has become an important tool to facilitate the
development of the Indian economy. At the same time, it has emerged as a large
employer, and a debate has ensued about the possibility to nationalize the banking
industry. Indira Gandhi, the-then Prime Minister of India expressed the intention of the
GOI in the annual conference of the All India Congress Meeting in a paper entitled
"Stray thoughts on Bank Nationalisation." The paper was received with positive
enthusiasm. Thereafter, her move was swift and sudden, and the GOI issued an ordinance
and nationalised the 14 largest commercial banks with effect from the midnight of July
19, 1969. Jayaprakash Narayan, a national leader of India, described the step as a
"masterstroke of political sagacity." Within two weeks of the issue of the ordinance, the
Parliament passed the Banking Companies (Acquition and Transfer of Undertaking) Bill,
and it received the presidential approval on 9th August, 1969.

A second dose of nationalisation of 6 more commercial banks followed in 1980. The

stated reason for the nationalisation was to give the government more control of credit
delivery. With the second dose of nationalisation, the GOI controlled around 91% of the
banking business of India.

After this, until the 1990s, the nationalised banks grew at a pace of around 4%, closer to
the average growth rate of the Indian economy.

Liberalisation
In the early 1990s the then Narsimha Rao government embarked on a policy of
liberalisation and gave licences to a small number of private banks, which came to be
known as New Generation tech-savvy banks, which included banks such as Global Trust
Bank (the first of such new generation banks to be set up)which later amalgamated with
Oriental Bank of Commerce,UTI Bank(now re-named as Axis Bank), ICICI Bank and
HDFC Bank. This move, along with the rapid growth in the economy of India,
kickstarted the banking sector in India, which has seen rapid growth with strong
contribution from all the three sectors of banks, namely, government banks, private banks
and foreign banks.

The next stage for the Indian banking has been setup with the proposed relaxation in the
norms for Foreign Direct Investment, where all Foreign Investors in banks may be given
voting rights which could exceed the present cap of 10%,at present it has gone up to 49%
with some restrictions.

The new policy shook the Banking sector in India completely. Bankers, till this time,
were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of functioning.
The new wave ushered in a modern outlook and tech-savvy methods of working for
traditional banks.All this led to the retail boom in India. People not just demanded more
from their banks but also received more.

Current situation

Currently (2007), banking in India is generally fairly mature in terms of supply, product
range and reach-even though reach in rural India still remains a challenge for the private
sector and foreign banks. In terms of quality of assets and capital adequacy, Indian banks
are considered to have clean, strong and transparent balance sheets relative to other banks
in comparable economies in its region. The Reserve Bank of India is an autonomous
body, with minimal pressure from the government. The stated policy of the Bank on the
Indian Rupee is to manage volatility but without any fixed exchange rate-and this has
mostly been true.

With the growth in the Indian economy expected to be strong for quite some time-
especially in its services sector-the demand for banking services, especially retail
banking, mortgages and investment services are expected to be strong. One may also
expect M&As, takeovers, and asset sales.

In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake
in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an investor
has been allowed to hold more than 5% in a private sector bank since the RBI announced
norms in 2005 that any stake exceeding 5% in the private sector banks would need to be
vetted by them.

Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks
(that is with the Government of India holding a stake), 29 private banks (these do not
have government stake; they may be publicly listed and traded on stock exchanges) and
31 foreign banks. They have a combined network of over 53,000 branches and 17,000
ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks
hold over 75 percent of total assets of the banking industry, with the private and foreign
banks holding 18.2% and 6.5% respectively.

Lecture-16

Functions of Commercial Banks in India

 Accepting deposits

 Loans and Advances

 Agency Functions

 Dealing in Foreign Exchange

 Credit Creation

 Popularizing Cheque system

 Transfer of funds

Sources of Funds

 Paid-up capital

 Reserve and surpluses

 Deposits

Application of Funds

 Liquidity

 Profitability

 Safety

 Convertibility

 Social considerations

Lecture 17
Privatisation
Privatization is the incidence or process of transferring ownership of a business,
enterprise, agency or public service from the public sector (government) to the private
sector (business). In a broader sense, privatization refers to transfer of any government
function to the private sector including governmental functions like revenue collection
and law enforcement.[1]

The term "Privatization" also has been used to describe two unrelated transactions. The
first is a buyout, by the majority owner, of all shares of a public corporation or holding
company's stock, privatizing a publicly traded stock. The second is a demutualization of a
mutual organization or cooperative to form a joint stock company.[2]

Origin of the term

It has been claimed that the term was first used in the 1930s by The Economist in
covering Nazi German economic policy.[3][4]

History

There is a long history of privatization dating from Ancient Greece when the government
contracted out almost everything to the private sector[5]. In the Roman Republic private
individuals and companies performed the majority of services including tax collection,
army supplies, religious sacrifices and construction. However, the Roman Empire also
created state-owned enterprises — for example, much of the grain was eventually
produced on estates owned by the Emperor. Some scholars suggest that the cost of
bureaucracy was one of the reasons for the fall of the Roman Empire [5].

In more recent times Winston Churchill's government privatized the British steel industry
in the 1950s, and West Germany's government embarked on large-scale privatisation,
including selling its majority stake in Volkswagen to small investors in a public share
offering in 1961 [5]. However, it was in the 1980's under the leaderships of Margaret
Thatcher in the UK and Ronald Reagan in the USA, that privatization gained its real
momentum in the modern era.

Types of privatisation

There are three main methods of privatisation:

 Share issue privatisation (SIP) - selling shares on the stock market

 Asset sale privatisation - selling the entire firms or part of it to a strategic investor,
usually by auction or using Treuhand model
 Voucher privatisation - shares of ownership are distributed to all citizens, usually
for free or at a very low price.

Share issue privatisation is the most common type of privatisation.

Share issue can broaden and deepen domestic capital markets, boosting liquidity and
potentially economic growth, but if the capital markets are insufficiently developed it
may be difficult to find enough buyers, and transaction costs (e.g. underpricing required)
may be higher. For this reason, many governments elect for listings in the more
developed and liquid markets. Euronext, and the London, New York and Hong Kong
Stock Exchanges are popular because they are highly developed and sophisticated.

As a result of higher political and currency risk deterring foreign investors, asset sales are
more common in developing countries.

Voucher privatisation has mainly been used in the transition economies of Central and
Eastern Europe, such as Russia, Poland, the Czech Republic, and Slovakia.

A very substantial benefit to share or asset sale privatisations is that bidders compete to
offer the state the highest price, creating revenues for the state to redistribute in addition
to new tax revenue. Voucher privatisations, on the other hand, would be a genuine return
of the assets into the hands of the general population, and create a real sense of
participation and inclusion. Vouchers, like all other private property, could then be sold
on if preferred by what companies are offering.

Arguments for and against privatisation

Pro-privatisation

Proponents of privatisation believe that private market factors can more efficiently
deliver many goods or service than government due to free market competition. In
general, it is argued that over time this will lead to lower prices, improved quality, more
choices, less corruption, less red tape, and quicker delivery. Many proponents do not
argue that everything should be privatised. According to them, market failures and
natural monopolies could be problematic. However, some Austrian school economists
and anarcho-capitalists would prefer that everything be privatised, including the state
itself.

The basic economic argument given for privatisation is that governments have few
incentives to ensure that the enterprises they own are well run. One problem is the lack of
comparison in state monopolies. It is difficult to know if an enterprise is efficient or not
without competitors to compare against. Another is that the central government
administration, and the voters who elect them, have difficulty evaluating the efficiency of
numerous and very different enterprises. A private owner, often specializing and gaining
great knowledge about a certain industrial sector, can evaluate and then reward or punish
the management in much fewer enterprises much more efficiently. Also, governments
can raise money by taxation or simply printing money should revenues be insufficient,
unlike a private owner.

If there are both private and state owned enterprises competing against each other, then
the state owned may borrow money more cheaply from the debt markets than private
enterprises, since the state owned enterprises are ultimately backed by the taxation and
printing press power of the state, gaining an unfair advantage.

Privatising a non-profitable company which was state-owned may force the company to
raise prices in order to become profitable. However, this would remove the need for the
state to provide tax money in order to cover the losses.

 Performance. State-run industries tend to be bureaucratic. A political

government may only be motivated to improve a function when its poor
performance becomes politically sensitive, and such an improvement can be
reversed easily by another regime.
 Increased efficiency. Private companies and firms have a greater incentive to
produce more goods and services for the sake of reaching a customer base and
hence increasing profits. A state-owned firm would not be as productive due to
the lack of financing allocated by the entire government's budget that must
consider other areas of the economy.
 Specialisation A private business has the ability to focus all relevant human and
financial resources onto specific functions. A state-owned firm does not have the
necessary resources to specialise its goods and services as a result of the general
products provided to the greatest number of people in the population.
 Improvements. Conversely, the government may put off improvements due to
political sensitivity and special interests — even in cases of companies that are
run well and better serve their customers' needs.
 Corruption. A monopolized function is prone to corruption; decisions are made
primarily for political reasons, personal gain of the decision-maker (i.e. "graft"),
rather than economic ones. Corruption (or principal-agent issues) during the
privatisation process - however - can result in significant underpricing of the
asset. This allows for more immediate and efficient corrupt transfer of value - not
just from ongoing cash flow, but from the entire lifetime of the asset stream.
Often such transfers are difficult to reverse.

 Accountability. Managers of privately owned companies are accountable to their

owners/shareholders and to the consumer, and can only exist and thrive where
needs are met. Managers of publicly owned companies are required to be more
accountable to the broader community and to political "stakeholders". This can
reduce their ability to directly and specifically serve the needs of their customers,
and can bias investment decisions away from otherwise profitable areas.
 Civil-liberty concerns. A company controlled by the state may have access to
information or assets which may be used against dissidents or any individuals
who disagree with their policies.
 Goals. A political government tends to run an industry or company for political
goals rather than economic ones.
 Capital. Privately held companies can sometimes more easily raise investment
capital in the financial markets when such local markets exist and are suitably
liquid. While interest rates for private companies are often higher than for
government debt, this can serve as a useful constraint to promote efficient
 investments by private companies, instead of cross-subsidizing them with the
overall credit-risk of the country. Investment decisions are then governed by
market interest rates. State-owned industries have to compete with demands from
other government departments and special interests. In either case, for smaller
markets, political risk may add substantially to the cost of capital.

 Security. Governments have had the tendency to "bail out" poorly run businesses,
often due to the sensitivity of job losses, when economically, it may be better to
let the business fold.
 Lack of market discipline. Poorly managed state companies are insulated from
the same discipline as private companies, which could go bankrupt, have their
management removed, or be taken over by competitors. Private companies are
also able to take greater risks and then seek bankruptcy protection against
creditors if those risks turn sour.
 Natural monopolies. The existence of natural monopolies does not mean that
these sectors must be state owned. Governments can enact or are armed with anti-
trust legislation and bodies to deal with anti-competitive behavior of all
companies public or private.
 Concentration of wealth. Ownership of and profits from successful enterprises
tend to be dispersed and diversified -particularly in voucher privatisation. The
availability of more investment vehicles stimulates capital markets and promotes
liquidity and job creation.
 Political influence. Nationalized industries are prone to interference from
politicians for political or populist reasons. Examples include making an industry
buy supplies from local producers (when that may be more expensive than buying
from abroad), forcing an industry to freeze its prices/fares to satisfy the electorate
or control inflation, increasing its staffing to reduce unemployment, or moving its
operations to marginal constituencies.
 Profits. Corporations exist to generate profits for their shareholders. Private
companies make a profit by enticing consumers to buy their products in
preference to their competitors' (or by increasing primary demand for their
products, or by reducing costs). Private corporations typically profit more if they
serve the needs of their clients well. Corporations of different sizes may target
different market niches in order to focus on marginal groups and satisfy their
demand. A company with good corporate governance will therefore be
incentivized to meet the needs of its customers efficiently.

Anti-privatization

Opponents of privatisation dispute the claims concerning the alleged lack of incentive for
governments to ensure that the enterprises they own are well run, on the basis of the idea
that governments are proxy owners answerable to the people. It is argued that a
government which runs nationalized enterprises poorly will lose public support and votes,
while a government which runs those enterprises well will gain public support and votes.
Thus, democratic governments do have an incentive to maximize efficiency in
nationalized companies, due to the pressure of future elections.
Opponents of certain privatisations believe certain parts of the social terrain should
remain closed to market forces in order to protect them from the unpredictability and
ruthlessness of the market (such as private prisons, basic health care, and basic
education). Another view is that some of the utilities which government provides benefit
society at large and are indirect and difficult to measure or unable to produce a profit,
such as defense. Still another is that natural monopolies are by definition not subject to
competition and better administrated by the state.

The controlling ethical issue in the anti-privatisation perspective is the need for
responsible stewardship of social support missions. Market interactions are all guided by
self-interest, and successful actors in a healthy market must be committed to charging the
maximum price that the market will bear. Privatisation opponents believe that this model
is not compatible with government missions for social support, whose primary aim is
delivering affordability and quality of service to society.

Many privatisation opponents also warn against the practice's inherent tendency toward
corruption. As many areas which the government could provide are essentially profitless,
the only way private companies could, to any degree, operate them would be through
contracts or block payments. In these cases, the private firm's performance in a particular
project would be removed from their performance, and embezzlement and dangerous cost
cutting measures might be taken to maximize profits.

Furthermore, large corporations can pay public relations professionals to convince

decision-makers that privitazation is a sensible idea, whether or not this is actually the
case. Corporations typically have far more resources for expert testimony,
advertisements, conferences and other propaganda efforts than anti-privatisation
advocates. Of course, this fact has no bearing on the merits of privatisation itself.

Some would also point out that privatising certain functions of government might hamper
coordination, and charge firms with specialized and limited capabilities to perform
functions which they are not suited for. In rebuilding a war torn nation's infrastructure,
for example, a private firm would, in order to provide security, either have to hire
security, which would be both necessarily limited and complicate their functions, or
coordinate with government, which, due to a lack of command structure shared between
firm and government, might be difficult. A government agency, on the other hand, would
have the entire military of a nation to draw upon for security, whose chain of command is
clearly defined. Opponents would say that this is a false assertion: numerous books refer
to poor organization between government departments (for example the Hurricane
Katrina incident).

Furthermore, opponents of privatisation argue that it is undesirable to transfer state-

owned assets into private hands for the following reasons:

 Performance. A democratically elected government is accountable to the people

through a legislature, Congress or Parliament, and is motivated to safeguarding
 the assets of the nation. The profit motive may be subordinated to social
objectives.
 Improvements. the government is motivated to performance improvements as
well run businesses contribute to the State's revenues.
 Corruption. Government ministers and civil servants are bound to uphold the
highest ethical standards, and standards of probity are guaranteed through codes
of conduct and declarations of interest. However, the selling process could lack
transparency, allowing the purchaser and civil servants controlling the sale to gain
personally.
 Accountability. The public does not have any control or oversight of private
companies.
 Civil-liberty concerns. A democratically elected government is accountable to
the people through a parliament, and can intervene when civil liberties are
threatened.
 Goals. The government may seek to use state companies as instruments to further
social goals for the benefit of the nation as a whole.
 Capital. Governments can raise money in the financial markets most cheaply to
re-lend to state-owned enterprises.
 Lack of market discipline. Governments have chosen to keep certain
companies/industries under public ownership because of their strategic
importance or sensitive nature.
 Cuts in essential services. If a government-owned company providing an
essential service (such as the water supply) to all citizens is privatised, its new
owner(s) could lead to the abandoning of the social obligation to those who are
less able to pay, or to regions where this service is unprofitable.
 Natural monopolies. Privatisation will not result in true competition if a natural
monopoly exists.
 Concentration of wealth. Profits from successful enterprises end up in private,
often foreign, hands instead of being available for the common good.
 Political influence. Governments may more easily exert pressure on state-owned
firms to help implementing government policy.
 Downsizing. Private companies often face a conflict between profitability and
service levels, and could over-react to short-term events. A state-owned company
might have a longer-term view, and thus be less likely to cut back on maintenance
or staff costs, training etc, to stem short term losses. Many private companies
have downsized while making record profits.
 Profit. Private companies do not have any goal other than to maximize profits. A
private company will serve the needs of those who are most willing (and able) to
pay, as opposed to the needs of the majority, and are thus anti-democratic. The
more necessary a good is, the lower the price elasticity of demand, as people will
attempt to buy it no matter the price. In the case of price elasticity of demand is
zero (perfectly unelastic good), demand part of supply and demand theories does
not work.
 Privatisation and Poverty. It is acknowledged by many studies that there are
winners and losers with privatisation. The number of losers —which may add up
to the size and severity of poverty—can be unexpectedly large if the method and
 process of privatisation and how it is implemented are seriously flawed (e.g. lack
of transparency leading to state-owned assets being appropriated at minuscule
amounts by those with political connections, absence of regulatory institutions
leading to transfer of monopoly rents from public to private sector, improper
design and inadequate control of the privatisation process leading to asset
stripping.[6]
 Job Loss. Due to the additional financial burden placed on privatized companies
to succeed without any government help, unlike the public companies, jobs could
be lost to keep more money in the company.

Lecture 18

Globalization
Globalization (or globalisation) describes an ongoing process by which regional
economies, societies and cultures have become integrated through globe-spanning
networks of exchange. The term is sometimes used to refer specifically to economic
globalization: the integration of national economies into the international economy
through trade, foreign direct investment, capital flows, migration, and the spread of
technology.[3]. However, globalization is usually recognized as being driven by a
combination of economic, technological, sociocultural, political and biological factors.[4]
The term can also refer to the transnational dissemination of ideas, languages, or popular
culture.

Definitions

An early description of globalization was penned by the American entrepreneur-turned-

minister Charles Taze Russell who coined the term 'corporate giants' in 1897. [5]
However, it was not until the 1960s that the term began to be widely used by economists
and other social scientists. It had achieved widespread use in the mainstream press by the
later half of the 1980s. Since its inception, the concept of globalization has inspired
numerous competing definitions and interpretations. [6]

The United Nations ESCWA has written that globalization "is a widely-used term that
can be defined in a number of different ways. When used in an economic context, it
refers to the reduction and removal of barriers between national borders in order to
facilitate the flow of goods, capital, services and labour...although considerable barriers
remain to the flow of labour...Globalization is not a new phenomenon. It began in the late
nineteenth century, but its spread slowed during the period from the start of the First
World War until the third quarter of the twentieth century. This slowdown can be
attributed to the inwardlooking policies pursued by a number of countries in order to
protect their respective industries.. however, the pace of globalization picked up rapidly
during the fourth quarter of the twentieth century..."[7]

Saskia Sassen writes that "a good part of globalization consists of an enormous variety of
micro-processes that begin to denationalize what had been constructed as national -
whether policies, capital, political subjectivities, urban spaces, temporal frames, or any
other of a variety of dynamics and domains."[8]

Tom G. Palmer of the Cato Institute defines globalization as "the diminution or

elimination of state-enforced restrictions on exchanges across borders and the
increasingly integrated and complex global system of production and exchange that has
emerged as a result."[9]

Thomas L. Friedman has examined the impact of the "flattening" of the world, and argues
that globalized trade, outsourcing, supply-chaining, and political forces have changed the
world permanently, for both better and worse. He also argues that the pace of
globalization is quickening and will continue to have a growing impact on business
organization and practice.[10]

Noam Chomsky argues that the word globalization is also used, in a doctrinal sense, to
describe the neoliberal form of economic globalization.[11]

Herman E. Daly argues that sometimes the terms internationalization and globalization
are used interchangeably but there is a significant formal difference. The term
"internationalization" (or internationalisation) refers to the importance of international
trade, relations, treaties etc. owing to the (hypothetical) immobility of labor and capital
between or among nations.

History

The historical origins of globalization are the subject of on-going debate. Though some
scholars situate the origins of globalization in the modern era, others regard it as a
phenomenon with a long history.

Perhaps the most extreme proponent of a deep historical origin for globalization was
Andre Gunder Frank, an economist associated with dependency theory. Frank argued that
a form of globalization has been in existence since the rise of trade links between Sumer
and the Indus Valley Civilization in the third millenium B.C.[12] Critics of this idea point
out that it rests upon an overly-broad definition of globalization.

Others have perceived an early form of globalization in the trade links between the
Roman Empire, the Parthian empire, and the Han Dynasty. The increasing articulation of
commercial links between these powers inspired the development of the Silk Road,
which started in western China, reached the boundaries of the Parthian empire, and
continued onwards towards Rome.

The Islamic Golden Age was also an important early stage of globalization, when Muslim
traders and explorers established a sustained economy across the Old World resulting in a
globalization of crops, trade, knowledge and technology. Globally significant crops such
as [[sugar] and cotton became widely cultivated across the Muslim world in this period,
while the necessity of learning Arabic and completing the Hajj created a cosmopolitan
culture.

The advent of the Mongol Empire, though destabalizing to the commercial centers of the
Middle East and China, greatly facilitated travel along the Silk Road. This permitted
travelers and missionaries such as Marco Polo to journey successfully (and profitably)
from one end of Eurasia to the other. The so-called Pax Mongolica of the twelfth century
had several other notable globalizing effects. It witnessed the creation of the first
international postal service, as well as the rapid transmission of epidemic diseases such as
bubonic plague across the newly-unified regions of Central Asia. [13] These pre-modern
phases of global or hemispheric exchange are sometimes known as archaic globalization.

Up to the time of the voyages of discovery, however, even the largest systems of
international exchange were limited to the Old World. The sixteenth century represented
a qualitative change in the patterns of globalization because it was the first period in
which the New World began to engage in substantial cultural, material and biologic
exchange with Africa and Eurasia. This phase is sometimes known as proto-
globalization. It was characterized by the rise of maritime European empires, particularly
the Portuguese Empire, the Spanish Empire, and later the British Empire and Dutch
Empire. It can be said to have begun shortly before the turn of the 16th century, when the
two Kingdoms of the Iberian Peninsula - the Kingdom of Portugal and the Kingdom of
Castile, began to send exploratory voyages to the Americas and around the Horn of
Africa. These new sea routes permitted sustained contact and trade between all of the
world's inhabited regions for the first time.

Global integration continued through the expansion of European trade in the 16th and
17th centuries, when the Portuguese and Spanish Empires colonized the Americas,
followed eventually by France and England. Globalization has had a tremendous impact
on cultures, particularly indigenous cultures, around the world. In the 15th century,
Portugal's Company of Guinea was one of the first chartered commercial companies
established by Europeans in other continent during the Age of Discovery, whose task was
to deal with the spices and to fix the prices of the goods.

In the 17th century, globalization became a business phenomenon when the British East
India Company (founded in 1600), which is often described as the first multinational
corporation, was established, as well as the Dutch East India Company (founded in 1602)
and the Portuguese East India Company (founded in 1628). Because of the large
investment and financing needs and the high risks involved with international trade, the
British East India Company became the first company in the world to share risk and
enable joint ownership of companies through the issuance of shares of stock: an
important driver for globalization.

The 19th century witnessed the advent of globalization in something approaching its
modern form. Industrialization permitted the cheap production of household items using
economies of scale, while rapid population growth created sustained demand for
commodities and manufactures. Globalization in this period was decisively shaped by
nineteenth-century imperialism. After the Opium Wars and the completion of the British
conquest of India, the vast populations of these regions became ready consumers of
European exports. Meanwhile, the conquest of new parts of the globe, notably sub-
Saharan Africa, by the European powers yielded valuable natural resources such as
rubber, diamonds and coal and helped fuel trade and investment between the European
imperial powers, their colonies, and the United States.

It was in this period that areas of sub-saharan Africa and the Island Pacific were
incorporated into the world system. The first phase of "modern globalization" began to
break down at the beginning of the 20th century with the first World War. Said John
Maynard Keynes[14],

The novelist VM Yeates criticised the financial forces of globalisation as a factor in

creating WWI.[15]

The final death knell for this phase of globalization came during the gold standard crisis
and Great Depression in the late 1920s and early 1930s.

Globalization in the middle decades of the twentieth century was largely driven by the
global expansion of multinational corporations based in the United States and the
worldwide export of American culture through the new media of film, television and
recorded music.

In early 2000s much of the industrialized world entered into a deep recession.[16] Some
analysts say the world is going through a period of deglobalization after years of
increasing economic integration.[17][18] Up to 45% of global wealth had been destroyed by
the global financial crisis in little less than a year and a half.[19]

Modern globalization

Night view of Shanghai, China

Globalization, since World War II, is largely the result of planning by politicians to break
down borders hampering trade to increase prosperity and interdependence thereby
decreasing the chance of future war. Their work led to the Bretton Woods conference, an
agreement by the world's leading politicians to lay down the framework for international
commerce and finance, and the founding of several international institutions intended to
oversee the processes of globalization.

These institutions include the International Bank for Reconstruction and Development
(the World Bank), and the International Monetary Fund. Globalization has been
facilitated by advances in technology which have reduced the costs of trade, and trade
negotiation rounds, originally under the auspices of the General Agreement on Tariffs
and Trade (GATT), which led to a series of agreements to remove restrictions on free
trade.
Since World War II, barriers to international trade have been considerably lowered
through international agreements - GATT. Particular initiatives carried out as a result of
GATT and the World Trade Organization (WTO), for which GATT is the foundation,
have included:

 Promotion of free trade:

o elimination of tariffs; creation of free trade zones with small or no tariffs
o Reduced transportation costs, especially resulting from development of
containerization for ocean shipping.
o Reduction or elimination of capital controls
o Reduction, elimination, or harmonization of subsidies for local businesses
o Creation of subsidies for global corporations
o Harmonization of intellectual property laws across the majority of states,
with more restrictions
o Supranational recognition of intellectual property restrictions (e.g. patents
granted by China would be recognized in the United States)

Cultural globalization, driven by communication technology and the worldwide

marketing of Western cultural industries, was understood at first as a process of
homogenization, as the global domination of American culture at the expense of
traditional diversity. However, a contrasting trend soon became evident in the emergence
of movements protesting against globalization and giving new momentum to the defense
of local uniqueness, individuality, and identity, but largely without success. [20]

The Uruguay Round (1986 to 1994)[21] led to a treaty to create the WTO to mediate trade
disputes and set up a uniform platform of trading. Other bilateral and multilateral trade
agreements, including sections of Europe's Maastricht Treaty and the North American
Free Trade Agreement (NAFTA) have also been signed in pursuit of the goal of reducing
tariffs and barriers to trade.

World exports rose from 8.5% in 1970, to 16.1% of total gross world product in 2001

Effects of globalization

The construction of continental hotels is a major consequence of globalization process in

affiliation with tourism and travel industry, Dariush Grand Hotel, Kish, Iran

Globalization has various aspects which affect the world in several different ways such
as:

 Industrial - emergence of worldwide production markets and broader access to a

range of foreign products for consumers and companies. Particularly movement
of material and goods between and within national boundaries.[citation needed]
 Financial - emergence of worldwide financial markets and better access to
external financing for borrowers. As these worldwide structures grew more
quickly than any transnational regulatory regime, the instability of the global
 financial infrastructure dramatically increased, as evidenced by the financial
crises of late 2008.[citation needed]
 Economic - realization of a global common market, based on the freedom of
exchange of goods and capital. The interconnectedness of these markets, however
meant that an economic collapse in any one given country could not be contained.
[citation needed]

 Political - some use "globalization" to mean the creation of a world government

which regulates the relationships among governments and guarantees the rights
arising from social and economic globalization. [25] Politically, the United States
has enjoyed a position of power among the world powers; in part because of its
strong and wealthy economy. With the influence of globalization and with the
help of The United States’ own economy, the People's Republic of China has
experienced some tremendous growth within the past decade. If China continues
to grow at the rate projected by the trends, then it is very likely that in the next
twenty years, there will be a major reallocation of power among the world
leaders. China will have enough wealth, industry, and technology to rival the
United States for the position of leading world power.[26]
 Informational - increase in information flows between geographically remote
locations. Arguably this is a technological change with the advent of fibre optic
communications, satellites, and increased availability of telephone and Internet.
 Language - the most popular language is English.[27]
o About 35% of the world's mail, telexes, and cables are in English.
o Approximately 40% of the world's radio programs are in English.
o About 50% of all Internet traffic uses English.[28]
 Competition - Survival in the new global business market calls for improved
productivity and increased competition. Due to the market becoming worldwide,
companies in various industries have to upgrade their products and use
technology skillfully in order to face increased competition.[29]
 Ecological - the advent of global environmental challenges that might be solved
with international cooperation, such as climate change, cross-boundary water and
air pollution, over-fishing of the ocean, and the spread of invasive species. Since
many factories are built in developing countries with less environmental
regulation, globalism and free trade may increase pollution. On the other hand,
economic development historically required a "dirty" industrial stage, and it is
argued that developing countries should not, via regulation, be prohibited from
increasing their standard of living.
 Cultural - growth of cross-cultural contacts; advent of new categories of
consciousness and identities which embodies cultural diffusion, the desire to
increase one's standard of living and enjoy foreign products and ideas, adopt new
technology and practices, and participate in a "world culture". Some bemoan the
resulting consumerism and loss of languages. Also see Transformation of culture.
o Spreading of multiculturalism, and better individual access to cultural
diversity (e.g. through the export of Hollywood and Bollywood movies).
Some consider such "imported" culture a danger, since it may supplant the
local culture, causing reduction in diversity or even assimilation. Others
 consider multiculturalism to promote peace and understanding between
peoples.
o Greater international travel and tourism. WHO estimates that up to
500,000 people are on planes at any time.[30]
o Greater immigration, including illegal immigration
o Spread of local consumer products (e.g. food) to other countries (often
adapted to their culture).
o Worldwide fads and pop culture such as Pokémon, Sudoku, Numa Numa,
Origami, Idol series, YouTube, Orkut, Facebook, and MySpace.
Accessible to those who have Internet or Television, leaving out a
substantial segment of the Earth's population.
o Worldwide sporting events such as FIFA World Cup and the Olympic
Games.
o Incorporation of multinational corporations in to new media. As the
sponsors of the All-Blacks rugby team, Adidas had created a parallel
website with a downloadable interactive rugby game for its fans to play
and compete.[31]
 Social - development of the system of non-governmental organisations as main
agents of global public policy, including humanitarian aid and developmental
efforts.[32]
 Technical
o Development of a global telecommunications infrastructure and greater
transborder data flow, using such technologies as the Internet,
communication satellites, submarine fiber optic cable, and wireless
telephones
o Increase in the number of standards applied globally; e.g. copyright laws,
patents and world trade agreements.
 Legal/Ethical
o The creation of the international criminal court and international justice
movements.
o Crime importation and raising awareness of global crime-fighting efforts
and cooperation.
o The emergence of Global administrative law.

Cultural effects

Culture is defined as patterns of human activity and the symbols that give these activities
significance. Culture is what people eat, how they dress, beliefs they hold, and activities
they practice. Globalization has joined different cultures and made it into something
different. As Erla Zwingle, from the National Geographic article titled “Globalization”
states, “When cultures receive outside influences, they ignore some and adopt others, and
then almost immediately start to transform them.”[33]

One classic culture aspect is food. Someone in America can be eating Japanese noodles
for lunch while someone in Sydney, Australia is eating classic Italian meatballs. India is
known for their curry and exotic spices. France is known for its cheeses. America is
known for its burgers and fries. McDonalds is an American company which is now a
global enterprise with 31,000 locations worldwide. Those locations include Kuwait,
Egypt, and Malta. This company is just one example of food going big on the global
scale.

Meditation has been a sacred practice for centuries in Indian culture. It calms the body
and helps one connect to their inner being while shying away from their conditioned self.
Before globalization, Americans did not meditate or practice yoga. After globalization,
this is more common. Some people are even traveling to India to get the full experience
themselves.

Another common practice brought about by globalization is Chinese symbol tattoos.

These tattoos are popular with today’s younger generation despite the fact that, in China,
tattoos are not thought of as cool[34]. Also, the Westerners who get these tattoos often
don't know what they mean, [35] making this an example of cultural appropriation.

The internet breaks down cultural boundaries across the world by enabling easy, near-
instantaneous communication between people anywhere in a variety of digital forms and
media. The Internet is associated with the process of cultural globalization because it
allows interaction and communication between people with very different lifestyles and
from very different cultures. Photo sharing websites allow interaction even where
language would otherwise be a barrier.

Negative effects

Globalization has been one of the most hotly-debated topics in international

economics over the past few years. Rapid growth and poverty reduction in China,
India, and other countries that were poor 20 years ago, has been a positive aspect of
globalization. But globalization has also generated significant international
opposition over concerns that it has increased inequality and environmental
degradation.[36] In the Midwestern United States, globalization has eaten away at its
competitive edge in industry and agriculture, lowering the quality of life in locations
that have not adapted to the change

Lecture 19

Yield curve
The US dollar yield curve as of 9 February 2005. The curve has a typical upward sloping
shape.

In finance, the yield curve is the relation between the interest rate (or cost of borrowing)
and the time to maturity of the debt for a given borrower in a given currency. For
example, the current U.S. dollar interest rates paid on U.S. Treasury securities for various
maturities are closely watched by many traders, and are commonly plotted on a graph
such as the one on the right which is informally called "the yield curve." More formal
mathematical descriptions of this relation are often called the term structure of interest
rates.

The yield of a debt instrument is the annualized percentage increase in the value of the
investment. For instance, a bank account that pays an interest rate of 4% per year has a
4% yield. In general the percentage per year that can be earned is dependent on the length
of time that the money is invested. For example, a bank may offer a "savings rate" higher
than the normal checking account rate if the customer is prepared to leave money
untouched for five years. Investing for a period of time t gives a yield Y(t).

This function Y is called the yield curve, and it is often, but not always, an increasing
function of t. Yield curves are used by fixed income analysts, who analyze bonds and
related securities, to understand conditions in financial markets and to seek trading
opportunities. Economists use the curves to understand economic conditions.

The yield curve function Y is actually only known with certainty for a few specific
maturity dates, the other maturities are calculated by interpolation (see Construction of
the full yield curve from market data below).

The typical shape of the yield curve

The British pound yield curve as of 9 February 2005. This curve is unusual in that long-
term rates are lower than short-term ones.

Yield curves are usually upward sloping asymptotically; the longer the maturity, the
higher the yield, with diminishing marginal growth. There are two common explanations
for this phenomenon. First, it may be that the market is anticipating a rise in the risk-free
rate. If investors hold off investing now, they may receive a better rate in the future.
Therefore, under the arbitrage pricing theory, investors who are willing to lock their
money in now need to be compensated for the anticipated rise in rates — thus the higher
interest rate on long-term investments.

However, interest rates can fall just as they can rise. Another explanation is that longer
maturities entail greater risks for the investor (i.e. the lender). Risk premium should be
paid, since with longer maturities, more catastrophic events might occur that impact the
investment. This explanation depends on the notion that the economy faces more
uncertainties in the distant future than in the near term, and the risk of future adverse
events (such as default and higher short-term interest rates) is higher than the chance of
future positive events (such as lower short-term interest rates). This effect is referred to as
the liquidity spread. If the market expects more volatility in the future, even if interest
rates are anticipated to decline, the increase in the risk premium can influence the spread
and cause an increasing yield.

The opposite situation — short-term interest rates higher than long-term — also can
occur. For instance, in November 2004, the yield curve for UK Government bonds was
partially inverted. The yield for the 10 year bond stood at 4.68%, but only 4.45% on the
thirty year bond. The market's anticipation of falling interest rates causes such incidents.
Negative liquidity premiums can exist if long-term investors dominate the market, but the
prevailing view is that a positive liquidity premium dominates, so only the anticipation of
falling interest rates will cause an inverted yield curve. Strongly inverted yield curves
have historically preceded economic depressions.

The yield curve may also be flat or hump-shaped, due to anticipated interest rates being
steady, or short-term volatility outweighing long-term volatility.

Yield curves move on a daily basis, reflecting the market's reaction to news. A further
"stylized fact" is that yield curves tend to move in parallel (i.e., the yield curve shifts up
and down as interest rate levels rise and fall).
Types of yield curve

There is no single yield curve describing the cost of money for everybody. The most
important factor in determining a yield curve is the currency in which it is denominated.
The economic situation of the countries and companies using each currency is a primary
factor in determining the yield curve. For example the sluggish economic growth of
Japan throughout the late 1990s and early 2000s has meant the yen yield curve is very
low (rising from virtually zero at the three month point to only 2% at the 30 year point).
By contrast the British pound curve ranges from 4-5% along its curve.

Different institutions borrow money at different rates, depending on their

creditworthiness. The yield curves corresponding to the bonds issued by governments in
their own currency are called the government bond yield curve (government curve).
Banks with high credit ratings (Aa/AA or above) borrow money from each other at the
LIBOR rates. These yield curves are typically a little higher than government curves.
They are the most important and widely used in the financial markets, and are known
variously as the LIBOR curve or the swap curve. The construction of the swap curve is
described below.

Besides the government curve and the LIBOR curve, there are corporate (company)
curves. These are constructed from the yields of bonds issued by corporations. Since
corporations have less creditworthiness than governments and most large banks, these
yields are typically higher. Corporate yield curves are often quoted in terms of a "credit
spread" over the relevant swap curve. For instance the five-year yield curve point for
Vodafone might be quoted as LIBOR +0.25%, where 0.25% (often written as 25 basis
points or 25bps) is the credit spread.

Normal yield curve

From the post-Great Depression era to the present, the yield curve has usually been
"normal" meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve
is positive). This positive slope reflects investor expectations for the economy to grow in
the future and, importantly, for this growth to be associated with a greater expectation
that inflation will rise in the future rather than fall. This expectation of higher inflation
leads to expectations that the central bank will tighten monetary policy by raising short
term interest rates in the future to slow economic growth and dampen inflationary
pressure. It also creates a need for a risk premium associated with the uncertainty about
the future rate of inflation and the risk this poses to the future value of cash flows.
Investors price these risks into the yield curve by demanding higher yields for maturities
further into the future.

However, a positively sloped yield curve has not always been the norm. Through much of
the 19th century and early 20th century the US economy experienced trend growth with
persistent deflation, not inflation. During this period the yield curve was typically
inverted, reflecting the fact that deflation made current cash flows less valuable than
future cash flows. During this period of persistent deflation, a 'normal' yield curve was
negatively sloped.

Steep yield curve

Historically, the 20-year Treasury bond yield has averaged approximately two percentage
points above that of three-month Treasury bills. In situations when this gap increases (e.g.
20-year Treasury yield rises relatively higher than the three-month Treasury yield), the
economy is expected to improve quickly in the future. This type of curve can be seen at
the beginning of an economic expansion (or after the end of a recession). Here, economic
stagnation will have depressed short-term interest rates; however, rates begin to rise once
the demand for capital is re-established by growing economic activity.

Flat or humped yield curve

A flat yield curve is observed when all maturities have similar yields, whereas a humped
curve results when short-term and long-term yields are equal and medium-term yields are
higher than those of the short-term and long-term. A flat curve sends signals of
uncertainty in the economy. This mixed signal can revert back to a normal curve or could
later result into an inverted curve. It cannot be explained by the Segmented Market theory
discussed below.

Inverted yield curve

An inverted yield curve occurs when long-term yields fall below short-term yields.
Under unusual circumstances, long-term investors will settle for lower yields now if
they think the economy will slow or even decline in the future. An inverted curve
has indicated a worsening economic situation in the future 5 out of 6 times since
1970. The New York Federal Reserve regards it as a valuable forecasting tool in
predicting recessions two to six quarters ahead. In addition to potentially signaling
an economic decline, inverted yield curves also imply that the market believes
inflation will remain low. This is because, even if there is a recession, a low bond
yield will still be offset by low inflation. However, technical factors, such as a flight
to quality or global economic or currency situations, may cause an increase in
demand for bonds on the long end of the yield curve, causing long-term rates to fall.
This was seen in 1998 during the Long Term Capital Management failure when
there was a slight inversion on part of the curve.

Lecture 20

Credit rating
A credit rating assesses the credit worthiness of an individual, corporation, or even a
country. Credit ratings are calculated from financial history and current assets and
liabilities. Typically, a credit rating tells a lender or investor the probability of the subject
being able to pay back a loan. However, in recent years, credit ratings have also been
used to adjust insurance premiums, determine employment eligibility, and establish the
amount of a utility or leasing deposit.

A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high
interest rates, or the refusal of a loan by the creditor.

Personal credit ratings

In the United States, an individual's credit history is compiled and maintained by

companies called credit bureaus. Credit worthiness is usually determined through a
statistical analysis of the available credit data. A common form of this analysis is a 3-
digit credit score provided by independent financial service companies such as the FICO
credit score. (The term, a registered trademark, comes from Fair Isaac Corporation, which
pioneered the credit rating concept in the late 1950s.)

An individual's credit score, along with his or her credit report, affects his or her ability to
borrow money through financial institutions such as banks.

In Canada, the most common ratings are the North American Standard Account Ratings,
also known as the "R" ratings, which have a range between R0 and R9. R0 refers to a
new account; R1 refers to on-time payments; R9 refers to bad debt.

The factors which may influence a person's credit rating are:[1]

 ability to pay a loan

 interest
 amount of credit used
 saving patterns[not in citation given]
 spending patterns
 debt

Corporate credit ratings

The credit rating of a corporation is a financial indicator to potential investors of debt

securities such as bonds. These are assigned by credit rating agencies such as Standard &
Poor's, Moody's or Fitch Ratings and have letter designations such as AAA, B, CC. The
Standard & Poor's rating scale is as follows: AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
Anything lower than a BBB rating is considered a speculative or junk bond. The Moody's
rating system is similar in concept but the verbage is a little different. It is as follows:
AAA, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1,
Caa2, Caa3, Ca, C

Sovereign credit ratings

A sovereign credit rating is the credit rating of a sovereign entity, i.e. a country. The
sovereign credit rating indicates the risk level of the investing environment of a country
and is used by investors looking to invest abroad. It takes political risk into account.

Source: Euromoney Country risk March 2008[2]

Country risk rankings The
Least risky countries, Score out of
Previous Country Overall score table
100
Rank
1 1 Luxembourg 99.88
2 2 Norway 97.47
3 3 Switzerland 96.21
4 4 Denmark 93.39
5 5 Sweden 92.96
6 6 Ireland 92.36
7 10 Austria 92.25
8 9 Finland 91.95
9 8 Netherlands 91.95
United
10 7 91.27
States

shows the ten least-risky countries for investment as of March 2008. Ratings are further
broken down into components including political risk, economic risk. Euromoney's bi-
annual country risk index "Country risk survey"monitors the political and economic
stability of 185 sovereign countries. Results focus foremost on economics, specifically
sovereign default risk and/or payment default risk for exporters (a.k.a. "trade credit" risk).

Short term rating

A short term rating is a probability factor of an individual going into default within a
year. This is in contrast to long-term rating which is evaluated over a long timeframe.

Credit rating agencies

Credit scores for individuals are assigned by credit bureaus (US; UK: credit reference
agencies). Credit ratings for corporations and sovereign debt are assigned by credit rating
agencies.

In the United States, the main credit bureaus are Experian, Equifax, and TransUnion. A
relatively new credit bureau in the US is Innovis.[3]
In the United Kingdom, the main credit reference agencies for individuals are Experian,
Equifax, and Callcredit. There is no universal credit rating as such, rather each individual
lender credit scores based on its own wish-list of a perfect customer.[4]

In Canada, the main credit bureaus for individuals are Equifax, TransUnion and Northern
Credit Bureaus/ Experian.[5]

In India, the main credit bureaus are CRISIL, ICRA and Credit Registration Office
(CRO).

The largest credit rating agencies (which tend to operate worldwide) are Moody's,
Standard and Poor's and Fitch Ratings.
CRISIL is India's leading rating agency, and is the fourth largest in the world.

With over a 70% share of the Indian Ratings market, CRISIL Ratings is the agency of
choice for issuers and investors.

CRISIL Ratings is a full service rating agency that offers a comprehensive range of
rating services. CRISIL Ratings provides the most reliable opinions on risk by
combining its understanding of risk and the science of building risk frameworks, with a
contextual understanding of business.

CRISIL is the only rating agency to operate on the basis of a sectoral specialisation,
which underpins the sharpness of analysis, responsiveness of the process and large-
scale dissemination of opinion pieces.

CRISIL has rated over 6,797 debt instruments worth Rs.13.53 trillion (over USD343
billion)* issued by over 4,600 debt issuers, including manufacturing companies, banks,
financial institutions (FIs), state governments and municipal corporations.
CRISIL Ratings also offers technical know-how overseas. For instance, it has provided
assistance and training for setting up ratings agencies in Malaysia (RAM) and Israel
and in the Caribbean . In March 2004, CRISIL took up an equity stake of about 9% in
the share capital of the Caribbean Information & Credit Rating Services Limited
(CariCRIS), with an investment of US $ 300,000. The Caribbean rating agency is a
unique initiative -- it is the world's first regional credit rating agency. It will offer rating
and other services in 19 countries. CRISIL will also provide technical assistance to the
agency to establish and stabilise its operations.
* 1 USD = INR 39.435 as on Dec 31, 2007

Lecture 21

Loan Pricing:
It’s safe to say that we all want our money to earn the highest possible interest rate in the
P2P marketplace. How do we know when an interest rate is not right for us or when it is
too good for our own good? Is there a framework that can help us answer this question?

Since P2P lending is Web 2.0 retail bank lending minus the bank, let’s look to traditional
banking for some ideas. Each bank has its own in-house loan pricing model. However,
banks use the following models to determine what interest rate to charge their borrowers:

• Cost-plus Pricing. In this pricing model, the interest rate charged on a loan has
four components:
cost of funds (interest cost on deposits or money market borrowings used to fund
the loan);
cost of servicing the loan (application and payment processing, wages, salaries
and occupancy expense); risk premium (default risk inherent in the loan); and
profit margin (adequate return on bank capital).
The latter three items can be bundled into what bankers call a “spread,” expressed
as a per annum rate, to simplify its use in the pricing formula. Thus, you can look
at a quoted bank lending rate (say, 10% p.a.) as consisting of a cost (say, 6%) plus
a certain spread (say, 4%).
• Relationship-based Pricing. Under this approach, a “prime” or base rate is
established by the bank for its most creditworthy customers on short-term
working capital loans. The prime rate, once established, becomes a benchmark for
many other types of loan products of the bank.
To maintain an adequate business return using this approach, a bank adds a spread
(as discussed above) when lending to non-prime borrowers, in a way that would
keep its funding and operating costs and risk premium as competitive as possible.
• Risk-based Pricing. This pricing scheme is decidedly more complex than the
previous two because of the variety of risk-adjustment methods that are currently
in use. Most of these are too technical to explain and are not relevant for our
purposes here at Lending Club.
Lending Club uses a leading-edge risk-adjustment-based method with a credit-scoring
system to set an appropriate default premium when determining a potential borrower’s
interest rate.

With risk-based pricing, a borrower with better credit will always get a lower rate, due to
the expected lower losses to be incurred from his account. With this pricing method, less
risky borrowers do not subsidize the cost of credit for more risky borrowers.

Knowing about the various loan pricing methods, you can better understand how
professional bankers price their loans. You can now also approach P2P lending more
scientifically than before.

One conclusion you should draw is that on Lending Club, borrowers can receive lower
more competitive rates than they would get from banks. Lending Club does not have the
large cost structure that banks face.

Another conclusion we can make is that there is no right or wrong method. To take it to
the extreme, if you lend money elsewhere you can opt to be totally arbitrary and devoid
of any method when deciding on your loan rate.

If you set your loan rate with a willful disregard for credit risk in order to attract or retain
borrowers, you will be engaging in an unsafe and unsound lending practice. Instead, lend
on Lending Club where you will benefit from the most advanced methods to set a
reasonable rate that will allow you to earn money at relatively low risk.

Lecture 22

Non-Performing Asset
In liberalizing economy banking and financial sector get high priority. Indian banking
sector of having a serious problem due non performing. The financial reforms have
helped largely to clean NPA was around Rs. 52,000 crores in the year 2004. The earning
capacity and profitability of the bank are highly affected due to this

NPA is defined as an advance for which interest or repayment of principal or both remain
out standing for a period of more than two quarters. The level of NPA act as an indicator
showing the bankers credit risks and efficiency of allocation of resource.

Reasons:

Various studies have been conducted to analysis the reasons for NPA. What ever may be
complete elimination of NPA is impossible. The reasons may be widely classified in two:

(1) Over hang component

(2) Incremental component
 Over hang component is due to the environment reasons, business cycle etc.

Incremental component may be due to internal bank management, credit policy, terms of
credit etc.

Asset Classification :

The RBI has issued guidelines to banks for classification of assets into four categories.

1. Standard assets:
These are loans which do not have any problem are less risk.

2. Substandard assets:
These are assets which come under the category of NPA for a period of less then 12
months.

3. Doubtful assets:
These are NPA exceeding 12 months

4. Loss assets:
These NPA which are identified as unreliable by internal inspector of bank or auditors or
by RBI.

The classification of assets of scheduled commercial bank.

Table 1                                                                                                                    
(Amount Rs. crores)

Assets 2001 2002 2003 2004

494716 609972 709260 837130
Standard assets
(88.6) (89.6) (91.2) (92.8)
Sub standard 18206 21382 20078 21026
assets (3.3) (3.1) (2.6) (2.3)
37756 41201 39731 36247
Doubtful assets
(6.8) (6.1) (5.1) (4.36)
8001 8370 8971 7625
Loss assets
(1.4) (1.2) (1.2) (0.8)
63963 70953 68780 902027
Total  NPA
(11.4) (10.4) (8.8) (100)

Income recognition and provisioning

Income from NPA is not recognized on accrued basic but is booked as income only
when, it is actually received. RBI has also tightened red the provisions norms against
asset classification. It ranges from 0.25% to 100% from standard asset to loss asset
 respectively.

Gross and net NPA of different sector of bank

Table 2                                                                                     (end of March 31) (in %)

category Gross NPA/ Gross Advance

2001 2002 2003 2004
Public sector bank 12.37 11.09 9.36 7.79
Private sector 8.37 9.64 8.07 5.84
Foreign bank 6.84 5.38 5.25 4.62

Table 3                                                                                         (end of March 31) (in %)

category Net NPA / Net Advance

2001 2002 2003 2004
Public sector bank 6.74 5.82 4.53 2.98
Private sector 2.27 2.49 2.32 1.32
Foreign bank 1.82 1.89 1.76 1.49

The table II and III shows that the percentage of gross NPA/ gross advance and net NPA/
net advance are in a decreasing trend. This shows the sign of efficiency in public and
private sector bamks.but still if compared to foreign banks Indian private sector and
public sector banks have a higher NPA.

Management of NPA

The table II&III shows that during initial sage the percentage of NPA was higher. This
was due to show ineffective recovery of bank credit, lacuna in credit recovery system,
inadequate legal provision etc. Various steps have been taken by the government to
recover and reduce NPAs. Some of them are.

1. One time settlement / compromise scheme

2. Lok adalats
3. Debt Recovery Tribunals
4. Securitization and reconstruction of financial assets and enforcement of Security
Interest Act 2002.
5. Corporate Reconstruction Companies
6.  credit information on defaulters and role of credit information bureaus

CONCLUSION

The Indian banking sector is facing a serious problem of NPA. The extent of NPA is
comparatively higher in public sectors banks. (Table II&III). To improve the efficiency
and profitability, the NPA has to be scheduled. Various steps have been taken by
government to reduce the NPA. It is highly impossible to have zero percentage NPA. But
at least Indian banks can try competing with foreign banks to maintain international
standard.

 
WHAT IS A NPA (NON PERFORMING ASSET)
Action for enforcement of security interest can be initiated only if the secured asset is
classified as Non Performing Asset.
Non Performing Asset means an asset or account of borrower, which has been classified
by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance
with the directions or guidelines relating to asset classification issued by RBI.
An amount due under any credit facility is treated as "past due" when it has not been paid
within 30 days from the due date. Due to the improvement in the payment and settlement
systems, recovery climate, upgradation of technology in the banking system, etc., it was
decided to dispense with 'past due' concept, with effect from March 31, 2001.
Accordingly, as from that date, a Non performing asset (NPA) shell be an advance where
i. interest and /or installment of principal remain overdue for a period of more than
180 days in respect of a Term Loan,
ii. the account remains 'out of order' for a period of more than 180 days, in respect
of an overdraft/ cash Credit(OD/CC),
iii. the bill remains overdue for a period of more than 180 days in the case of bills
purchased and discounted,
iv. interest and/ or installment of principal remains overdue for two harvest seasons
but for a period not exceeding two half years in the case of an advance granted for
agricultural purpose, and
v. any amount to be received remains overdue for a period of more than 180 days in
respect of other accounts.
With a view to moving towards international best practices and to ensure greater
transparency, it has been decided to adopt the '90 days overdue' norm for identification of
NPAs, form the year ending March 31, 2004. Accordingly, with effect form March 31,
2004, a non-performing asset (NPA) shell be a loan or an advance where;
i. interest and /or installment of principal remain overdue for a period of more than
90 days in respect of a Term Loan,
ii. the account remains 'out of order' for a period of more than 90 days, inrespect of
an overdraft/ cash Credit(OD/CC),
iii. the bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted,
 iv. interest and/ or installment of principal remains overdue for two harvest seasons
but for a period not exceeding two half years in the case of an advance granted for
agricultural purpose, and
v. any amount to be received remains overdue for a period of more than 90 days in
respect of other accounts.
'Out of order'
An account should be treated as 'out of order' if the outstanding balance remains
continuously in excess of the sanctioned limit/ drawing power. In case where the
outstanding balance in the principal operating account is less than the sanctioned limit/
drawing power, but there are no credits continuously for six months as on the date of
balance sheet or credits are not enough to cover the interest debited during the same
period, these account should be treated as 'out of order'.
Overdue
Any amount due to the bank under any credit facility is 'overdue' if it is not paid on the
due date fixed by the bank.

Lecture 23
Capital Adequacy Mechanism in Banks
Bankers for International Settlement (BIS)
met at Basel, a place in Switzerland, to discuss about the common issues
concerning banks all over the world. The BIS 1988 Capital Accord, which was
implemented in India during the economic liberalisation and globalisation in 1991, was
the first attempt to prescribe rule-based Capital Adequacy norms for all the international
banks so as to ensure a level playing field for them. The Reserve Bank
of India (RBI) had released the draft guidelines on Basel II in Feb 2005, on the basis of
the recommendations of the Basel Committee on Banking Supervision (BCBS) but the
final guidelines are still awaited even though it had earlier been indicated that the
implementation programme would commence in March 2007.
In view of the postponement of implementation of Basel II norms to March 2008
or 2009 as against the initially indicated date of 31st March 07, it seems that RBI will
take some more time before it releases final guidelines on Basel II norms.
In the pre-liberalisation era when ownership of banks primarily rested with the
government, quantum of Capital Fund in banks was not given due importance. However,
the combined forces of Liberalisation, Privatisation and Globalisation
(LPG) later compelled the public sector banks, hitherto shielded from the vagaries of
market forces, to come to terms with the market realities. Internationally, certain
minimum capital in relation to risk-weighted assets has to be maintained besides adopting
stiff norms in respect of income recognition, asset classification and provisioning.
As advocated in the Basel II norms, multi pronged approach would be required to
meet the challenges of maintaining capital at the regulator-mandated level in the face of
recognising risk factors in the banking sector. Banks are exposed to severe competition
compelling them to encounter financial and non-financial risks. Business grows mainly
by taking risks – and hence the entity must strike a trade off between the two as risk and
uncertainty form an integral part of banking operation.
Why Capital Adequacy?
Risk is the possibility that both expected and unexpected events may have an adverse
impact on the bank’s capital and earnings. While the expected losses are taken care of
through suitable pricing mechanism, the unexpected losses are to be borne by the bank
itself with the help of requisite capital, which is reflected
in Capital Adequacy Ratio. Ownership of commercial PSU banks being predominantly
with the government there are budgetary constraints necessitating resources of long-term
nature, viz. equity being tapped from the market. The capital structure and the quantum
of capital held by the bank indicate the ability to function as credit creator having
multiplier effect in the economy, as this is the primary function of banks, particularly the
PSU ones in India. While the shareholders view capital as a tool to maximise wealth,
regulator views it as a cushion to absorb unexpected loss. As the proportion of deposit to
the equity is very
Risk means the possibility that both expected and unexpected events can have an
adverse impact on a bank’s capital and earnings. While the expected losses are
taken
care of through suitable pricing mechanism, the unexpected losses are to be borne
by the bank itself with the help of requisite capital, which is reflected in Capital
Adequacy
Ratio. This article provides an overview of the concept.
Banking & F inance
high, shareholder in a bank cannot disregard
and ignore the collective risk appetite of large
depositors as bank is a highly leveraged entity.
Substitution of equity by debt viz. deposits,
visualise low margin of error when it comes to
lending and investments activities, which are
the primary avenues to deploy bank funds.
Thus, from the point of view of shareholder,
capitalisation is a debt equity balancing exercise
and the regulator views it as a risk minimisation
effort. Requirement of capital is not just to meet
the regulatory stipulations but also to increase
the financial robustness.
Low capital acts as a limiting factor for
enlarging business. The need for ideal capital
may increase in the years to come owing to pick
up in credit resulting in re-alignment in riskweighted
assets.
The Basel II Capital Accord
Though it became a universal benchmark for
assessing the adequacy of regulatory capital,
the first Capital Accord had certain inherent
shortcomings such as non-differentiation of
credit quality, pre-dominant factor of credit risk
in the capital adequacy calculation, no impact
on maturity structure, non-recognition of credit
risk mitigation techniques, devoid of operational
risk element, absence of supervisory mechanism
and market discipline.
The Basel Committee recognised that the
objectives of safety and soundness cannot
be achieved solely through capital adequacy
requirements and hence the Capital Accord
II comprise sophisticated multi-dimensional
approaches consisting mainly of three pillars,
viz. Minimum Capital Requirement, Supervisory
Review Mechanism and Market Discipline. Basel
II accord can be considered as fully implemented
only if all the three pillars are put in place, as a
whole package.
While getting support from a large body of
shareholders is a difficult proposition when
the bank’s performance is adverse, a smaller
shareholder base limits the ability of bank
to garner funds. Capital has no maturity or
repayment requirement and is expected to
remain as a permanent component of the core
capital, not to bother about return of money,
although return on money may be a matter of
constant concern.
While Basel standards require banks to have
a capital adequacy ratio of 8% with Tier I not
less than 4% (50% of 8), the RBI has mandated
the banks incorporated in India to maintain the
Capital Adequacy Ratio (CAR) at 9% on an ongoing
basis. Maintenance of CAR is like aiming
at a moving target as the composition of riskweighted
assets gets changed every minute
on account of fluctuation in the risk profile of a
bank as the business mix across the branches is
a dynamic scenario.
The objective of Basel II is to introduce a more
risk-sensitive capital framework with incentives
for good risk management practices. It goes
without saying that under Basel II approach
capital requirements will increase for those
banks that hold high risk assets (low quality
assets) and come down to those with low risk
assets (high quality assets). A balanced portfolio
as well as effective risk management control
systems may need less capital requirements.
The Capital Adequacy Ratio is the percentage
of bank’s Capital Funds in relation to the Risk
Weighted Assets of the bank. In the New Capital
Accord, viz. Basle II, while the definition of
Capital Fund remained the same as that in 1988,
the method of calculation of Risk Weighted
Assets has been modified to factor operational
risk in addition to the credit Risk that alone was
reckoned in 1988 Capital Accord. Capital charge
for market risk was added to 1988 Accord few
years ago.
Banks may adopt any of the approaches
suitable to them for arriving at the total risk
weighted assets. There are several approaches
to arrive at the capital requirement of a bank
factoring the credit, market and operational
risks. There are several approaches to measure
credit risk, market & operational risks as against
1936 The Chartered Accountant June 2007
Banking & F inance
the 1988 accord where there was only one
approach to measure credit risk.
Reverse Of Capital Adequacy
In banks, asset creation is an activity that is
subsequent to the capital formation and deposit
mobilisation. Therefore, the proposition should
be that how much asset could be created for
a given capital without exposing to high risk?
Hence, in ideal situation and taking a radical
view, stipulation of Asset Creation Multiple
(ACM) in place of Capital Adequacy Ratio (CAR)
would be more appropriate and rational. That
is to say, instead of Minimum Capital Adequacy
Ratio of 8%, implying holding of Rs. 8 by way of
capital for every Rs. 100 risk weighted assets,
stipulation of Maximum Asset Creation Multiple
of 12.5 (100/8) times, implying that asset can be
created to the maximum extent of 12.5 times of
capital, would be meaningful.
Stipulating Capital Adequacy Ratio involves
adjusting the capital according to the asset,
rather than the other way around. Is it not like
cutting the body (capital) according to the cloth
(asset)?
However, as assets had been already created
when the norms of capital adequacy ratio were
introduced, Capital Adequacy Ratio, instead
of Asset Creation Multiples, is adopted. It may,
however, be noted that at least in respect of
the new banks starting from Zero the Asset
Creation Multiple (ACM) could have been
seriously considered. Nevertheless, as the
banks graduate from financial intermediary into
risk intermediary, liability management also
assumes equal importance, if not more than
asset management.
With the decision of the government not to
bring down the government stake in PSU banks
to below 51% coupled with low capability to
increase the Capital Funds, it may be right time to
examine whether the principle and terminology
of Asset Creation Multiple can be introduced.
Component of Capital Funds
Capital, in relation to the financial institution
like banks, denotes Capital Funds, which are the
total Owned Funds available to the institution
for a reasonably long time without involvement
of repayment.
The Capital Funds consist of Tier I, Tier II and
Tier III Capital, the components of which are
explained below.
Tier I:
a) Owned Funds: The paid up capital brought
in by the owners, for it is not envisaged to
be repaid during the normal course of the
business.
b) Perpetual Non-cumulative Preference
shares eligible for inclusion as Tier I capital.
c) Statutory Reserves and other disclosed
free reserves created by appropriation of
Retained Earnings.
d) Other surplus like share premium, etc.
e) Capital Reserves representing surplus arisen
out of sale proceeds of fixed assets.
f ) Innovative Perpetual Debt Instruments
(IPDI) eligible for inclusion as Tier I capital.
Tier II:
a) Revaluation Reserves - 45 % of the increase
in valuation (discount 55%).
b) Undisclosed reserves - Reserves not
encumbered to known liabilities.
c) General Provision and - Maximum of 1.25 %
of RWA, after reckoning reserves all known
losses & foreseeable potential loss (including
floating provisions).
d) Hybrid instruments - capital instruments
having the debt & equity characters,
inclusive of redeemable preferential shares.
e) Subordinated debts - Depending on the
maturity period, certain percentage of
The Chartered Accountant 1937 June 2007
Banking & F inance
debts not exceeding 50 % of Tier I capital.
Instruments with initial period of less than 5
Year & residual period of 1 year are not to be
considered. Graded discount @ 20% per year
for debts aged 5 years or below.
Tier II capital is restricted to the extent of 100
% of Tier I capital
Tier III
This is arranged to meet part of market risk,
viz. changes in interest rate, exchange rate,
equity prices, commodity prices, etc. Issuance of
short term subordinated debt subject to lock-in
period clause of 2 years and also limited to the
extent of 250 % of Tier I Capital would form part
of Tier III capital. In India, Tier III capital has not
yet been introduced by the regulator.
It may be noted that Investments made in
subsidiaries, intangible assets, adverse balance
in the Profit & Loss account, etc. are deducted
while the VRS related deferred revenue
expenditure, if any, is specially permitted not to
be reduced while arriving at the Capital Funds.
Certain norms are applicable for the cross
holding of bonds, investment in equity shares of
other banks. Banks are advised against entering
into swap transactions involving conversion of
Innovative Tier I / Tier II bonds into floating rate
foreign currency liabilities.
Let us now discuss the three components of
risk, viz. Credit Risk, Market Risk and Operational
Risk as well as its measurement in the calculation
of capital adequacy ratio, in detail.
Credit Risk
Credit Risk is the default of the borrower
in meeting the financial obligations and also
deterioration in the quality of asset thereby
impacting its realisation. Basel II provides for
three approaches, viz. Standardised Approach,
Foundation Internal Rating Based (FIRB)
Approach and Advanced Internal Rating Based
(AIRB) Approach to measure Credit Risk.
In the Standardised Approach, the bank
allocates risk weight to fund and non-fund based
assets, depending on the quality of assets as
reflected in the risk rating (unsolicited by bank)
secured by the borrower from External Credit
Rating Institutions, recognised by the regulator.
Risk weight of 100% may entail a capital charge
of 9%, a risk weight of 20% may entail a capital
charge of 1.8%, etc.
In Foundation Internal Rating Based approach,
borrower is rated and the results are translated
into estimates of a potential future loss amount
that forms the basis for calculation of Probability
of Default and the remaining risk components
such as Loss Given Default and Earnings at
Default are provided by the regulator. As far as
Advanced Internal Rating Based approach is
concerned, all the risk components such as PD,
LGD & EAD are calculated by banks internally.
The risk weights for sovereigns depend on
its credit rating and all banks in a given country
will be assigned a risk weight one category
less favourable than that assigned to claims on
sovereign of incorporation with a cap of 100%.
In case of banks incorporated in countries rated
below B, the risk weight will be capped at 150%.
The risk weights for exposure to corporate would
vary from 20% to 150%, depending on rating.
The unrated corporate is given a 100% weight
for the reason that there may be certain good
corporates which are not rated, thus providing
option to the corporates to remain unrated.
Basel II provides a mechanism for recognition
of Credit Risk Mitigation (CRM) measures
such as collaterals, guarantees, etc. through
what is known as ‘Hair Cut’ approach. In this,
the exposure is inflated and security value is
discounted so as to factor the market fluctuation
aspects in a conservative manner by narrowing
the gap between the two.
Market Risk
Market Risk, which is dynamic in nature,
is measured through standardised maturity
method/duration method or internal models
approach. Banks are required to adopt
Standardised duration method and maintain
capital charge for market risk on securities
1938 The Chartered Accountant June 2007
Banking & F inance
included in the Held for Trading (HFT) and
Available for Sale (AFS) categories, open position
of Gold – Forex – derivatives.
Capital charge is for interest rate risk and
equities in the trading book. With a view to
protect against an adverse movement in the
price of an individual security owing to factors
related to individual issuer, specific charge for
each security, similar to conventional capital
charge on credit risk, is envisaged. General
market risks charge towards interest rate risk
in the portfolio, capture the risk of loss arising
from changes in market interest rates.
Operational Risk
Operational risk is crucial, for it relates
to the loss arising out of the failure in the
systems, procedures, people, etc having wider
ramification than that of transaction specific
credit risk and market risk. This is a new element
introduced in the Basel II. The three approaches
are Basic Indicator Approach, Standardised
Approach and Advanced Measurement
Approach, as explained below:
The Basic Indicator Approach is the simplest
one, where one indicator such as interest
income or risk weighted assets,
etc. is reckoned as a reference
point and is multiplied by a factor
called Alpha and as per the Basel
Committee, it is fixed at 15%.
Standardised approach is
an improved version on the Basic Indicator
Approach and it entails different Beta factors for
various Business Lines, as detailed below:
Depending on the mix of the Business Lines,
the capital charge may nearly be equal to or
slightly vary from the one arrived through the
Basic Indicator approach.
Advanced Measurement Approach is based
on the internal loss data estimation for each
combination of business lines. A bank is required
to calculate the expected loss value to ascertain
the required capital to be allocated/assigned.
It is a general feeling that on account of
capital charge for operational risk, banks in
India may have to earmark significant capital of
around Rs. 10,000 cr or so, which is definitely a
heavy burden to the banking sector.

Lecture 24 - 25

Interest rate, risk and inflation

An interest rate is the price a borrower pays for the use of money they do not own, for
instance a small company might borrow from a bank to kick start their business, and the
return a lender receives for deferring the use of funds, by lending it to the borrower.
Interest rates are normally expressed as a percentage rate over the period of one year.

Interest rates targets are also a vital tool of monetary policy and are used to control
variables like investment, inflation, and unemployment.

Historical interest rates

Germany experienced deposit interest rates from 14% in 1969 down to almost 2% in
2003

Interest rates throughout history have been variously set either by national governments
or central banks. For example, the Federal Reserve federal funds rate in the United States
has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England
base rate varied between 0.5% and 15% from 1989 to 2009,[1] [2]and Germany
experienced rates close to 90% in the 1920s down to about 2% in the 2000s. [3][4] During
an attempt to tackle spiralling hyperinflation in 2007, the Central Bank of Zimbabwe
increased interest rates for borrowing to 800%.[5]

Causes of interest rates

 Deferred consumption. When money is loaned the lender delays spending the
money on consumption goods. Since according to time preference theory people
prefer goods now to goods later, in a free market there will be a positive interest
rate.
  Inflationary expectations. Most economies generally exhibit inflation, meaning
a given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this.

 Alternative investments. The lender has a choice between using his money in
different investments. If he chooses one, he forgoes the returns from all the others.
Different investments effectively compete for funds.

 Risks of investment. There is always a risk that the borrower will go bankrupt,
abscond, or otherwise default on the loan. This means that a lender generally
charges a risk premium to ensure that, across his investments, he is compensated
for those that fail.

 Liquidity preference. People prefer to have their resources available in a form

that can immediately be exchanged, rather than a form that takes time or money to
realise.

 Taxes. Because some of the gains from interest may be subject to taxes, the
lender may insist on a higher rate to make up for this loss.

Real vs nominal interest rates

The nominal interest rate is the amount, in money terms, of interest payable.

For example, suppose a household deposits $100 with a bank for 1 year and they receive
interest of $10. At the end of the year their balance is $110. In this case, the nominal
interest rate is 10% per annum.

The real interest rate, which measures the purchasing power of interest receipts, is
calculated by adjusting the nominal rate charged to take inflation into account. (See real
vs. nominal in economics.)

If inflation in the economy has been 10% in the year, then the $110 in the account at the
end of the year buys the same amount as the $100 did a year ago. The real interest rate, in
this case, is zero.

After the fact, the 'realized' real interest rate, which has actually occurred, is:

where p = the actual inflation rate over the year.

The expected real returns on an investment, before it is made, are:

where:

= nominal interest rate

= real interest rate
 = expected or projected inflation over the year

Market interest rates

There is a market for investments which ultimately includes the money market, bond
market, stock market and currency market as well as retail financial institutions like
banks.

Exactly how these markets function is a complex question. However, economists

generally agree that the interest rates yielded by any investment take into account:

 The risk-free cost of capital

 Inflationary expectations
 The level of risk in the investment
 The costs of the transaction

Risk-free cost of capital

The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever
entirely risk-free, bills issued by major nations like the United States are generally
regarded as risk-free benchmarks.

This rate incorporates the deferred consumption and alternative investments elements of
interest.

Inflationary expectations

According to the theory of rational expectations, people form an expectation of what will
happen to inflation in the future. They then ensure that they offer or ask a nominal
interest rate that means they have the appropriate real interest rate on their investment.

This is given by the formula:

where:

= offered nominal interest rate

= desired real interest rate
= inflationary expectations

Risk

The level of risk in investments is taken into consideration. This is why very volatile
investments like shares and junk bonds have higher returns than safer ones like
government bonds.
The extra interest charged on a risky investment is the risk premium. The required risk
premium is dependent on the risk preferences of the lender.

If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their

returns to double. So for an investment normally returning $100 they would require $200
back. A risk-averse lender would require more than $200 back and a risk-loving lender
less than $200. Evidence suggests that most lenders are in fact risk-averse.

Generally speaking a longer-term investment carries a maturity risk premium, because

long-term loans are exposed to more risk of default during their duration.

Liquidity preference

Most investors prefer their money to be in cash than in less fungible investments. Cash is
on hand to be spent immediately if the need arises, but some investments require time or
effort to transfer into spendable form. This is known as liquidity preference. A 1-year
loan, for instance, is very liquid compared to a 10-year loan. A 10-year US Treasury
bond, however, is liquid because it can easily be sold on the market.

A market interest-rate model

A basic interest rate pricing model for an asset

Assuming perfect information, pe is the same for all participants in the market, and this is
identical to:

where

in is the nominal interest rate on a given investment

ir is the risk-free return to capital
i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.
Treasury Bills).
rp = a risk premium reflecting the length of the investment and the likelihood the
borrower will default
lp = liquidity premium (reflecting the perceived difficulty of converting the asset
into money and thus into goods).

Interest rate notations

What is commonly referred to as the interest rate in the media is generally the rate
offered on overnight deposits by the Central Bank or other authority, annualised.

The total interest on an investment depends on the timescale the interest is calculated on,
because interest paid may be compounded.
In finance, the effective interest rate is often derived from the yield, a composite measure
which takes into account all payments of interest and capital from the investment.

In retail finance, the annual percentage rate and effective annual rate concepts have been
introduced to help consumers easily compare different products with different payment
structures.

Money market mutual funds quote their rate of interest as the 7 Day SEC Yield.

Interest rates in macroeconomics

Output and unemployment

Interest rates are the main determinant of investment on a macroeconomic scale. Broadly
speaking, if interest rates increase across the board, then investment decreases, causing a
fall in national income.

A government institution, usually a central bank, can lend money to financial institutions
to influence their interest rates as the main tool of monetary policy. Usually central bank
interest rates are lower than commercial interest rates since banks borrow money from
the central bank then lend the money at a higher rate to generate most of their profit.

By altering interest rates, the government institution is able to affect the interest rates
faced by everyone who wants to borrow money for economic investment. Investment can
change rapidly in response to changes in interest rates, affecting national income.

Open Market Operations in the United States

The effective federal funds rate in the US charted over fifty years

The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely
by targeting the federal funds rate. This is the rate that banks charge each other for
overnight loans of federal funds, which are the reserves held by banks at the Fed. Open
market operations are one tool within monetary policy implemented by the Federal
Reserve to steer short-term interest rates. Using the power to buy and sell treasury
securities, the Open Market Desk at the Federal Reserve Bank of New York can supply
the market with dollars by purchasing Treasury-notes, hence increasing the nation's
money supply. By increasing the money supply or Aggregate Supply of Funding (ASF),
interest rates will fall due to the excess of dollars banks will end up with in their reserves.
Excess reserves may be lent in the Fed funds market to other banks, thus driving down
rates.

Money and inflation

Loans, bonds, and shares have some of the characteristics of money and are included in
the broad money supply.
By setting i*n, the government institution can affect the markets to alter the total of loans,
bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad
money supply.

Through the quantity theory of money, increases in the money supply lead to inflation.

Lecture-26-29

Concept of Mutual Funds

A Mutual Fund is a trust that pools the savings of a number of investors who share a
common financial goal. The money thus collected is then invested in capital market
instruments such as shares, debentures and other securities. The income earned through
these investments and the capital appreciation realised are shared by its unit holders in
proportion to the number of units owned by them. Thus a Mutual Fund is the most
suitable investment for the common man as it offers an opportunity to invest in a
diversified, professionally managed basket of securities at a relatively low cost. The flow
chart below describes broadly the working of a mutual fund:

Mutual Fund Operation Flow Chart

Mutual Funds Industry in India

The origin of mutual fund industry in India is with the introduction of the concept of
mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated
from the year 1987 when non-UTI players entered the industry.

In the past decade, Indian mutual fund industry had seen a dramatic imporvements, both
qualitywise as well as quantitywise. Before, the monopoly of the market had seen an
ending phase, the Assets Under Management (AUM) was Rs. 67bn. The private sector
entry to the fund family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it
reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is
less than the deposits of SBI alone, constitute less than 11% of the total deposits held by
the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry in India is new in the
country. Large sections of Indian investors are yet to be intellectuated with the concept.
Hence, it is the prime responsibility of all mutual fund companies, to market the product
correctly abreast of selling.

The mutual fund industry can be broadly put into four phases according to the
development of the sector. Each phase is briefly described as under.

First Phase - 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up
by the Reserve Bank of India and functioned under the Regulatory and administrative
control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the
Industrial Development Bank of India (IDBI) took over the regulatory and administrative
control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the
end of 1988 UTI had Rs.6,700 crores of assets under management.

Second Phase - 1987-1993 (Entry of Public Sector Funds)

Entry of non-UTI mutual funds. SBI Mutual Fund was the first followed by Canbank
Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank
Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92).
LIC in 1989 and GIC in 1990. The end of 1993 marked Rs.47,004 as assets under
management.

Third Phase - 1993-2003 (Entry of Private Sector Funds)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the
year in which the first Mutual Fund Regulations came into being, under which all mutual
funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer
(now merged with Franklin Templeton) was the first private sector mutual fund registered
in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive
and revised Mutual Fund Regulations in 1996. The industry now functions under the
SEBI (Mutual Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds
setting up funds in India and also the industry has witnessed several mergers and
acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets
of Rs. 1,21,805 crores. The Unit Trust of India with Rs.44,541 crores of assets under
management was way ahead of other mutual funds.

Fourth Phase - since February 2003

This phase had bitter experience for UTI. It was bifurcated into two separate entities. One
is the Specified Undertaking of the Unit Trust of India with AUM of Rs.29,835 crores (as
on January 2003). The Specified Undertaking of Unit Trust of India, functioning under an
administrator and under the rules framed by Government of India and does not come
under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is
registered with SEBI and functions under the Mutual Fund Regulations. With the
bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of
AUM and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual
Fund Regulations, and with recent mergers taking place among different private sector
funds, the mutual fund industry has entered its current phase of consolidation and growth.
As at the end of September, 2004, there were 29 funds, which manage assets of
Rs.153108 crores under 421 schemes.

The major players in the Indian Mutual Fund Industry are:

GROWTH IN ASSETS UNDER MANAGEMENT

Note:
Erstwhile UTI was bifurcated into UTI Mutual Fund and the Specified Undertaking of
the Unit Trust of India effective from February 2003. The Assets under management of
the Specified Undertaking of the Unit Trust of India has therefore been excluded from the
total assets of the industry as a whole from February 2003 onwards.

Performance of Mutual Funds in India

Let us start the discussion of the performance of mutual funds in India from the day the
concept of mutual fund took birth in India. The year was 1963. Unit Trust of India invited
investors or rather to those who believed in savings, to park their money in UTI Mutual
Fund.

For 30 years it goaled without a single second player. Though the 1988 year saw some
new mutual fund companies, but UTI remained in a monopoly position.

The performance of mutual funds in India in the initial phase was not even closer to
satisfactory level. People rarely understood, and of course investing was out of question.
But yes, some 24 million shareholders was accustomed with guaranteed high returns by
the begining of liberalization of the industry in 1992. This good record of UTI became
marketing tool for new entrants. The expectations of investors touched the sky in
profitability factor. However, people were miles away from the praparedness of risks
factor after the liberalization.

The Assets Under Management of UTI was Rs. 67bn. by the end of 1987. Let me
concentrate about the performance of mutual funds in India through figures. From Rs.
67bn. the Assets Under Management rose to Rs. 470 bn. in March 1993 and the figure
had a three times higher performance by April 2004. It rose as high as Rs. 1,540bn.

The net asset value (NAV) of mutual funds in India declined when stock prices started
falling in the year 1992. Those days, the market regulations did not allow portfolio shifts
into alternative investments. There were rather no choice apart from holding the cash or
to further continue investing in shares. One more thing to be noted, since only closed-end
funds were floated in the market, the investors disinvested by selling at a loss in the
secondary market.

The performance of mutual funds in India suffered qualitatively. The 1992 stock market
scandal, the losses by disinvestments and of course the lack of transparent rules in the
whereabout rocked confidence among the investors. Partly owing to a relatively weak
stock market performance, mutual funds have not yet recovered, with funds trading at an
average discount of 1020 percent of their net asset value.

The supervisory authority adopted a set of measures to create a transparent and

competitve environment in mutual funds. Some of them were like relaxing investment
restrictions into the market, introduction of open-ended funds, and paving the gateway for
mutual funds to launch pension schemes.
The measure was taken to make mutual funds the key instrument for long-term saving.
The more the variety offered, the quantitative will be investors.

At last to mention, as long as mutual fund companies are performing with lower risks and
higher profitability within a short span of time, more and more people will be inclined to
invest until and unless they are fully educated with the dos and donts of mutual funds.

Mutual Fund Companies in India

The concept of mutual funds in India dates back to the year 1963. The era between 1963
and 1987 marked the existance of only one mutual fund company in India with Rs. 67bn
assets under management (AUM), by the end of its monopoly era, the Unit Trust of India
(UTI). By the end of the 80s decade, few other mutual fund companies in India took their
position in mutual fund market.

The new entries of mutual fund companies in India were SBI Mutual Fund, Canbank
Mutual Fund, Punjab National Bank Mutual Fund, Indian Bank Mutual Fund, Bank of
India Mutual Fund.

The succeeding decade showed a new horizon in indian mutual fund industry. By the end
of 1993, the total AUM of the industry was Rs. 470.04 bn. The private sector funds
started penetrating the fund families. In the same year the first Mutual Fund Regulations
came into existance with re-registering all mutual funds except UTI. The regulations
were further given a revised shape in 1996.

Kothari Pioneer was the first private sector mutual fund company in India which has now
merged with Franklin Templeton. Just after ten years with private sector players
penetration, the total assets rose up to Rs. 1218.05 bn. Today there are 33 mutual fund
companies in India.

Major Mutual Fund Companies in India

ABN AMRO Mutual Fund

ABN AMRO Mutual Fund was setup on April 15, 2004 with ABN AMRO Trustee
(India) Pvt. Ltd. as the Trustee Company. The AMC, ABN AMRO Asset Management
(India) Ltd. was incorporated on November 4, 2003. Deutsche Bank A G is the custodian
of ABN AMRO Mutual Fund.

Birla Sun Life Mutual Fund

Birla Sun Life Mutual Fund is the joint venture of Aditya Birla Group and Sun Life
Financial. Sun Life Financial is a golbal organisation evolved in 1871 and is being
represented in Canada, the US, the Philippines, Japan, Indonesia and Bermuda apart from
India. Birla Sun Life Mutual Fund follows a conservative long-term approach to
investment. Recently it crossed AUM of Rs. 10,000 crores.

Bank of Baroda Mutual Fund (BOB Mutual Fund)

Bank of Baroda Mutual Fund or BOB Mutual Fund was setup on October 30, 1992 under
the sponsorship of Bank of Baroda. BOB Asset Management Company Limited is the
AMC of BOB Mutual Fund and was incorporated on November 5, 1992. Deutsche Bank
AG is the custodian.

HDFC Mutual Fund

HDFC Mutual Fund was setup on June 30, 2000 with two sponsorers nemely Housing
Development Finance Corporation Limited and Standard Life Investments Limited.

HSBC Mutual Fund

HSBC Mutual Fund was setup on May 27, 2002 with HSBC Securities and Capital
Markets (India) Private Limited as the sponsor. Board of Trustees, HSBC Mutual Fund
acts as the Trustee Company of HSBC Mutual Fund.

ING Vysya Mutual Fund

ING Vysya Mutual Fund was setup on February 11, 1999 with the same named Trustee
Company. It is a joint venture of Vysya and ING. The AMC, ING Investment
Management (India) Pvt. Ltd. was incorporated on April 6, 1998.

Prudential ICICI Mutual Fund

The mutual fund of ICICI is a joint venture with Prudential Plc. of America, one of the
largest life insurance companies in the US of A. Prudential ICICI Mutual Fund was setup
on 13th of October, 1993 with two sponsorers, Prudential Plc. and ICICI Ltd. The Trustee
Company formed is Prudential ICICI Trust Ltd. and the AMC is Prudential ICICI Asset
Management Company Limited incorporated on 22nd of June, 1993.

Sahara Mutual Fund

Sahara Mutual Fund was set up on July 18, 1996 with Sahara India Financial Corporation
Ltd. as the sponsor. Sahara Asset Management Company Private Limited incorporated on
August 31, 1995 works as the AMC of Sahara Mutual Fund. The paid-up capital of the
AMC stands at Rs 25.8 crore.

State Bank of India Mutual Fund

State Bank of India Mutual Fund is the first Bank sponsored Mutual Fund to launch
offshor fund, the India Magnum Fund with a corpus of Rs. 225 cr. approximately. Today
it is the largest Bank sponsored Mutual Fund in India. They have already launched 35
Schemes out of which 15 have already yielded handsome returns to investors. State Bank
of India Mutual Fund has more than Rs. 5,500 Crores as AUM. Now it has an investor
base of over 8 Lakhs spread over 18 schemes.

Tata Mutual Fund

Tata Mutual Fund (TMF) is a Trust under the Indian Trust Act, 1882. The sponsorers for
Tata Mutual Fund are Tata Sons Ltd., and Tata Investment Corporation Ltd. The
investment manager is Tata Asset Management Limited and its Tata Trustee Company
Pvt. Limited. Tata Asset Management Limited's is one of the fastest in the country with
more than Rs. 7,703 crores (as on April 30, 2005) of AUM.

Kotak Mahindra Mutual Fund

Kotak Mahindra Asset Management Company (KMAMC) is a subsidiary of KMBL. It is

presently having more than 1,99,818 investors in its various schemes. KMAMC started
its operations in December 1998. Kotak Mahindra Mutual Fund offers schemes catering
to investors with varying risk - return profiles. It was the first company to launch
dedicated gilt scheme investing only in government securities.

Unit Trust of India Mutual Fund

UTI Asset Management Company Private Limited, established in Jan 14, 2003, manages
the UTI Mutual Fund with the support of UTI Trustee Company Privete Limited. UTI
Asset Management Company presently manages a corpus of over Rs.20000 Crore. The
sponsorers of UTI Mutual Fund are Bank of Baroda (BOB), Punjab National Bank
(PNB), State Bank of India (SBI), and Life Insurance Corporation of India (LIC). The
schemes of UTI Mutual Fund are Liquid Funds, Income Funds, Asset Management
Funds, Index Funds, Equity Funds and Balance Funds.

Reliance Mutual Fund

Reliance Mutual Fund (RMF) was established as trust under Indian Trusts Act, 1882. The
sponsor of RMF is Reliance Capital Limited and Reliance Capital Trustee Co. Limited is
the Trustee. It was registered on June 30, 1995 as Reliance Capital Mutual Fund which
was changed on March 11, 2004. Reliance Mutual Fund was formed for launching of
various schemes under which units are issued to the Public with a view to contribute to
the capital market and to provide investors the opportunities to make investments in
diversified securities.

Standard Chartered Mutual Fund

Standard Chartered Mutual Fund was set up on March 13, 2000 sponsored by Standard
Chartered Bank. The Trustee is Standard Chartered Trustee Company Pvt. Ltd. Standard
Chartered Asset Management Company Pvt. Ltd. is the AMC which was incorporated
with SEBI on December 20,1999.

Franklin Templeton India Mutual Fund

The group, Frnaklin Templeton Investments is a California (USA) based company with a
global AUM of US$ 409.2 bn. (as of April 30, 2005). It is one of the largest financial
services groups in the world. Investors can buy or sell the Mutual Fund through their
financial advisor or through mail or through their website. They have Open end
Diversified Equity schemes, Open end Sector Equity schemes, Open end Hybrid
schemes, Open end Tax Saving schemes, Open end Income and Liquid schemes, Closed
end Income schemes and Open end Fund of Funds schemes to offer.

Morgan Stanley Mutual Fund India

Morgan Stanley is a worldwide financial services company and its leading in the market
in securities, investmenty management and credit services. Morgan Stanley Investment
Management (MISM) was established in the year 1975. It provides customized asset
management services and products to governments, corporations, pension funds and non-
profit organisations. Its services are also extended to high net worth individuals and retail
investors. In India it is known as Morgan Stanley Investment Management Private
Limited (MSIM India) and its AMC is Morgan Stanley Mutual Fund (MSMF). This is the
first close end diversified equity scheme serving the needs of Indian retail investors
focussing on a long-term capital appreciation.

Escorts Mutual Fund

Escorts Mutual Fund was setup on April 15, 1996 with Excorts Finance Limited as its
sponsor. The Trustee Company is Escorts Investment Trust Limited. Its AMC was
incorporated on December 1, 1995 with the name Escorts Asset Management Limited.

Alliance Capital Mutual Fund

Alliance Capital Mutual Fund was setup on December 30, 1994 with Alliance Capital
Management Corp. of Delaware (USA) as sponsorer. The Trustee is ACAM Trust
Company Pvt. Ltd. and AMC, the Alliance Capital Asset Management India (Pvt) Ltd.
with the corporate office in Mumbai.

Benchmark Mutual Fund

Benchmark Mutual Fund was setup on June 12, 2001 with Niche Financial Services Pvt.
Ltd. as the sponsorer and Benchmark Trustee Company Pvt. Ltd. as the Trustee
Company. Incorporated on October 16, 2000 and headquartered in Mumbai, Benchmark
Asset Management Company Pvt. Ltd. is the AMC.
Canbank Mutual Fund

Canbank Mutual Fund was setup on December 19, 1987 with Canara Bank acting as the
sponsor. Canbank Investment Management Services Ltd. incorporated on March 2, 1993
is the AMC. The Corporate Office of the AMC is in Mumbai.

Chola Mutual Fund

Chola Mutual Fund under the sponsorship of Cholamandalam Investment & Finance
Company Ltd. was setup on January 3, 1997. Cholamandalam Trustee Co. Ltd. is the
Trustee Company and AMC is Cholamandalam AMC Limited.

LIC Mutual Fund

Life Insurance Corporation of India set up LIC Mutual Fund on 19th June 1989. It
contributed Rs. 2 Crores towards the corpus of the Fund. LIC Mutual Fund was
constituted as a Trust in accordance with the provisions of the Indian Trust Act, 1882. .
The Company started its business on 29th April 1994. The Trustees of LIC Mutual Fund
have appointed Jeevan Bima Sahayog Asset Management Company Ltd as the
Investment Managers for LIC Mutual Fund.

GIC Mutual Fund

GIC Mutual Fund, sponsored by General Insurance Corporation of India (GIC), a

Government of India undertaking and the four Public Sector General Insurance
Companies, viz. National Insurance Co. Ltd (NIC), The New India Assurance Co. Ltd.
(NIA), The Oriental Insurance Co. Ltd (OIC) and United India Insurance Co. Ltd. (UII)
and is constituted as a Trust in accordance with the provisions of the Indian Trusts Act,
1882.

Future of Mutual Funds in India

By December 2004, Indian mutual fund industry reached Rs 1,50,537 crore. It is

estimated that by 2010 March-end, the total assets of all scheduled commercial banks
should be Rs 40,90,000 crore.

The annual composite rate of growth is expected 13.4% during the rest of the decade. In
the last 5 years we have seen annual growth rate of 9%. According to the current growth
rate, by year 2010, mutual fund assets will be double.

Let us discuss with the following table:

Aggregate deposits of Scheduled Com Banks in India (Rs.Crore)

 Mar-
Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Mar-03 Sep-04 4-Dec
04
113118 128085 156725
Deposits 605410 851593 989141 - 1622579
8 3 1
Change in %
  15 14 13 12 - 18 3
over last yr
Source - RBI

Mutual Fund AUM’s Growth

Mar- Mar- Mar- Mar- Mar-
Month/Year Mar-04 Sep-04 4-Dec
98 00 01 02 03
MF AUM's 68984 93717 83131 94017 75306 137626 151141 149300
Change in % over
  26 13 12 25 45 9 1
last yr
Source - AMFI

Some facts for the growth of mutual funds in India

 100% growth in the last 6 years.

 Number of foreign AMC's are in the que to enter the Indian markets like Fidelity
Investments, US based, with over US$1trillion assets under management
worldwide.

 Our saving rate is over 23%, highest in the world. Only channelizing these
savings in mutual funds sector is required.

 We have approximately 29 mutual funds which is much less than US having more
than 800. There is a big scope for expansion.

 'B' and 'C' class cities are growing rapidly. Today most of the mutual funds are
concentrating on the 'A' class cities. Soon they will find scope in the growing
cities.

 Mutual fund can penetrate rurals like the Indian insurance industry with simple
and limited products.

 SEBI allowing the MF's to launch commodity mutual funds.

 Emphasis on better corporate governance.

 Trying to curb the late trading practices.

  Introduction of Financial Planners who can provide need based advice.

Types of Mutual Funds Scheme in India

Wide variety of Mutual Fund Schemes exist to cater to the needs such as financial
position, risk tolerance and return expectations etc. The table below gives an overview
into the existing types of schemes in the Industry. TYPES OF MUTUAL FUND
SCHEMES

 By Structure
o Open - Ended Schemes
o Close - Ended Schemes
o Interval Schemes

 By Investment Objective
o Growth Schemes
o Income Schemes
o Balanced Schemes
o Money Market Schemes

 Other Schemes
o Tax Saving Schemes
o Special Schemes
 Index Schemes
 Sector Specfic Schemes

Organisation of Mutual Funds in India

There are many entities involved and the diagram below illustrates the organisational set
up of a mutual fund:

Organisation of a Mutal Fund

Association of Mutual Funds in India (AMFI)

With the increase in mutual fund players in India, a need for mutual fund association in
India was generated to function as a non-profit organisation. Association of Mutual
Funds in India (AMFI) was incorporated on 22nd August, 1995.

AMFI is an apex body of all Asset Management Companies (AMC) which has been
registered with SEBI. Till date all the AMCs are that have launched mutual fund schemes
are its members. It functions under the supervision and guidelines of its Board of
Directors.

Association of Mutual Funds India has brought down the Indian Mutual Fund Industry to
a professional and healthy market with ethical lines enhancing and maintaining standards.
It follows the principle of both protecting and promoting the interests of mutual funds as
well as their unit holders.

The objectives of Association of Mutual Funds in India

The Association of Mutual Funds of India works with 30 registered AMCs of the
country. It has certain defined objectives which juxtaposes the guidelines of its Board of
Directors. The objectives are as follows:

 This mutual fund association of India maintains a high professional and ethical
standards in all areas of operation of the industry.

 It also recommends and promotes the top class business practices and code of
conduct which is followed by members and related people engaged in the
activities of mutual fund and asset management. The agencies who are by any
means connected or involved in the field of capital markets and financial services
also involved in this code of conduct of the association.

 AMFI interacts with SEBI and works according to SEBIs guidelines in the mutual
fund industry.

 Association of Mutual Fund of India do represent the Government of India, the

Reserve Bank of India and other related bodies on matters relating to the Mutual
Fund Industry.

 It develops a team of well qualified and trained Agent distributors. It implements

a programme of training and certification for all intermediaries and other engaged
in the mutual fund industry.

 AMFI undertakes all India awarness programme for investors inorder to promote
proper understanding of the concept and working of mutual funds.
  At last but not the least association of mutual fund of India also disseminate
informations on Mutual Fund Industry and undertakes studies and research either
directly or in association with other bodies.

The sponsorers of Association of Mutual Funds in India

Bank Sponsored

 SBI Fund Management Ltd.

 BOB Asset Management Co. Ltd.
 Canbank Investment Management Services Ltd.
 UTI Asset Management Company Pvt. Ltd.

Institutions

 GIC Asset Management Co. Ltd.

 Jeevan Bima Sahayog Asset Management Co. Ltd.

Private Sector

Indian:-

 BenchMark Asset Management Co. Pvt. Ltd.

 Cholamandalam Asset Management Co. Ltd.
 Credit Capital Asset Management Co. Ltd.
 Escorts Asset Management Ltd.
 JM Financial Mutual Fund
 Kotak Mahindra Asset Management Co. Ltd.
 Reliance Capital Asset Management Ltd.
 Sahara Asset Management Co. Pvt. Ltd
 Sundaram Asset Management Company Ltd.
 Tata Asset Management Private Ltd.

Predominantly India Joint Ventures:-

 Birla Sun Life Asset Management Co. Ltd.

 DSP Merrill Lynch Fund Managers Limited
 HDFC Asset Management Company Ltd.

Predominantly Foreign Joint Ventures:-

 ABN AMRO Asset Management (I) Ltd.

 Alliance Capital Asset Management (India) Pvt. Ltd.
 Deutsche Asset Management (India) Pvt. Ltd.
 Fidelity Fund Management Private Limited
  Franklin Templeton Asset Mgmt. (India) Pvt. Ltd.
 HSBC Asset Management (India) Private Ltd.
 ING Investment Management (India) Pvt. Ltd.
 Morgan Stanley Investment Management Pvt. Ltd.
 Principal Asset Management Co. Pvt. Ltd.
 Prudential ICICI Asset Management Co. Ltd.
 Standard Chartered Asset Mgmt Co. Pvt. Ltd.

Association of Mutual Funds in India Publications

AMFI publices mainly two types of bulletin. One is on the monthly basis and the other is
quarterly. These publications are of great support for the investors to get intimation of the
knowhow of their parked money.

Advantages of Mutual Funds

The advantages of investing in a Mutual Fund are:

 Diversification: The best mutual funds design their portfolios so individual

investments will react differently to the same economic conditions. For example,
economic conditions like a rise in interest rates may cause certain securities in a
diversified portfolio to decrease in value. Other securities in the portfolio will
respond to the same economic conditions by increasing in value. When a portfolio
is balanced in this way, the value of the overall portfolio should gradually
increase over time, even if some securities lose value.

 Professional Management:Most mutual funds pay topflight professionals to

manage their investments. These managers decide what securities the fund will
buy and sell.

 Regulatory oversight: Mutual funds are subject to many government regulations

that protect investors from fraud.

 Liquidity: It's easy to get your money out of a mutual fund. Write a check, make a
call, and you've got the cash.

 Convenience: You can usually buy mutual fund shares by mail, phone, or over the
Internet.

 Low cost: Mutual fund expenses are often no more than 1.5 percent of your
investment. Expenses for Index Funds are less than that, because index funds are
not actively managed. Instead, they automatically buy stock in companies that are
listed on a specific index

 Transparency
  Flexibility

 Choice of schemes

 Tax benefits

 Well regulated

Drawbacks of Mutual Funds

Mutual funds have their drawbacks and may not be for everyone:

 No Guarantees: No investment is risk free. If the entire stock market declines in

value, the value of mutual fund shares will go down as well, no matter how
balanced the portfolio. Investors encounter fewer risks when they invest in mutual
funds than when they buy and sell stocks on their own. However, anyone who
invests through a mutual fund runs the risk of losing money.

 Fees and commissions: All funds charge administrative fees to cover their day-to-
day expenses. Some funds also charge sales commissions or "loads" to
compensate brokers, financial consultants, or financial planners. Even if you don't
use a broker or other financial adviser, you will pay a sales commission if you buy
shares in a Load Fund.

 Taxes: During a typical year, most actively managed mutual funds sell anywhere
from 20 to 70 percent of the securities in their portfolios. If your fund makes a
profit on its sales, you will pay taxes on the income you receive, even if you
reinvest the money you made.

 Management risk: When you invest in a mutual fund, you depend on the fund's
manager to make the right decisions regarding the fund's portfolio. If the manager
does not perform as well as you had hoped, you might not make as much money
on your investment as you expected. Of course, if you invest in Index Funds, you
forego management risk, because these funds do not employ managers.

Frequently Used Terms

Net Asset Value (NAV)

Net Asset Value is the market value of the assets of the scheme minus its liabilities. The
per unit NAV is the net asset value of the scheme divided by the number of units
outstanding on the Valuation Date.
Sale Price

Is the price you pay when you invest in a scheme. Also called Offer Price. It may include
a sales load.

Repurchase Price

Is the price at which a close-ended scheme repurchases its units and it may include a
back-end load. This is also called Bid Price.

Redemption Price

Is the price at which open-ended schemes repurchase their units and close-ended schemes
redeem their units on maturity. Such prices are NAV related.

Sales Load

Is a charge collected by a scheme when it sells the units. Also called, ‘Front-end’ load.
Schemes that do not charge a load are called ‘No Load’ schemes.

Repurchase or ‘Back-end’ Load

Is a charge collected by a scheme when it buys back the units from the unitholders.

Lecture 30

Unit Trust of India

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'Unit Trust of India was created by the UTI Act passed by the Parliament in 1963.For
more than two decades it remained the sole vehicle for investment in the capital market
by the Indian citizens. In mid- 1980s public sector banks were allowed to open mutual
funds. The real vibrancy and competition in the MF industry came with the setting up of
the Regulator SEBI and its laying down the MF Regulations in 1993.UTI maintained its
pre-eminent place till 2001, when a massive decline in the market indices and negative
investor sentiments after Ketan Parekh scam created doubts about the capacity of UTI to
meet its obligations to the investors. This was further compounded by two factors;
namely, its flagship and largest scheme US 64 was sold and re-purchased not at intrinsic
NAV but at artificial price and its Assured Return Schemes had promised returns as high
as 18% over a period going up to two decades..!!
Fearing a run on the institution and possible impact on the whole market Government
came out with a rescue package and change of management in 2001.Subsequently, the
UTI Act was repealed and the institution was bifurcated into two parts .UTI Mutual Fund
was created as a SEBI registered fund like any other mutual fund. The assets and
liabilities of schemes where Government had to come out with a bail-out package were
taken over directly by the Government in a new entity called Specified Undertaking of
UTI, SUUTI. SUUTI holds over 27% stake Axis Bank. In order to distance Government
from running a mutual fund the ownership was transferred to four institutions; namely
SBI, LIC, BOB and PNB, each owning 25%. Certain reforms like improving the salary
from PSU levels and effecting a VRS were carried out UTI lost its market dominance
rapidly and by end of 2005,when the new share-holders actually paid the consideration
money to Government its market share had come down to close to 10%!

A new board was constituted and a new management inducted. Systematic study of its
problems role and functions was carried out with the help of a reputed international
consultant. Fresh talent was recruited from the private market, organizational structure
was changed to focus on newly emerging investor and distributor groups and massive
changes in investor services and funds management carried out. Once again UTI has
emerged as a serious player in the industry. Some of the funds have won famous awards,
including the Best Infra Fund globally from Lipper. UTI has been able to benchmark its
employee compensation to the best in the market, has introduced Performance Related
Payouts and ESOPs.

The UTI Asset Management Company has its registered office at: UTI Tower, Gn Block,
Bandra - Kurla Complex, Bandra (East), Mumbai - 400 051.It has over 70 schemes in
domestic MF space and has the largest investor base of over 9 million in the whole
industry. It is present in over 450 districts of the country and has 100 branches called UTI
Financial Centres or UFCs. About 50% of the total IFAs in the industry work for UTI in
distributing its products! India Posts, PSU Banks and all the large Private and Foreign
Banks have started distributing UTI products. The total average Assets Under
Management (AUM) for the month of June 2008 was Rs. 530 billion and it ranked fourth.
In terms of equity AUM it ranked second and in terms of Equity and Balanced Schemes
AUM put together it ranked FIRST in the industry. This measure indicates its revenue-
earning capacity and its financial strength.

Besides running domestic MF Schemes UTI AMC is also a registered portfolio manager
under the SEBI (Portfolio Managers) Regulations. It runs different portfolios for is HNI
and Institutional clients. It is also running a Sharia Compliant portfolio for its Offshore
clients. UTI tied up with Shinsei Bank of Japan to run a large size India-centric portfolio
for Japanese investors.

For its international operations UTI has set up its 100% subsidiary, UTI International
Limited, registered in Guernsey, Channel Islands. It has branches in London, Dubai and
Bahrain. It has set up a Joint Venture with Shinsei Bank in Singapore. The JV has got its
license and has started its operations.
In the area of alternate assets, UTI has a 100% subsidiary called UTI Ventures at
Banglore This company runs two successful funds with large international investors
being active participants. UTI has also launched a Private Equity Infrastructure Fund
along with HSH Nord Bank of Germany and Shinsei Bank of Japan.

Lecture-31-34

Non-banking financial companies

Non-bank financial companies (NBFCs) are financial institutions that provide banking
services without meeting the legal definition of a bank, i.e. one that does not hold a
banking license. Operations are, regardless of this, still exercised under bank regulation.
However this depends on the jurisdiction, as in some jurisdictions, such as New Zealand,
any company can do the business of banking, and there are no banking licences issued.

Services Provided

Non-bank institutions frequently acts as

 suppliers of loans and credit facilities,

 supporting investments in property,
 Trading money market instruments
 funding private education,
 wealth management such as Managing portfolios of stocks and shares and
 Underwrite stock and shares, TFCs and other obligations
 retirement planning
 Advise companies in merger and acquisition
 Prepare feasibility, market or industry studies for companies
 Discounting services e.g, discounting of instruments

However they are typically not allowed to take deposits from the general public and
have to find other means of funding their operations such as issuing debt instruments.

Classification

Depending upon their nature of activities, non- banking finance companies can be
classified into the following categories:

1. Development finance institutions

2. Leasing companies
3. Investment companies
4. Modaraba companies
5. House finance companies
6. Venture capital companies
7. Discount & guarantee houses
 NBFCs were required to necessarily hold their
investments in Government securities either in CSGL
with SCB/SHCIL or in a dematerialised account with
depositories (NSDL/CDSL) through a depository
participant registered with SEBI and dematerialise
Government securities held in physical form by
October 31, 2002. All further transactions of
•purchase and sale of Government securities have to
be compulsorily through CSGL /demat account. The
NBFCs need not seek prior approval of the Reserve
Bank for opening a demat/SGL account with any of
the organisations mentioned above, but must inform
the concerned Regional Office of the Reserve Bank
on the details of the account within one week of
1 doing so.

As a depositor protection measure, NBFCs were

advised to include in their advertisements or
•
statements in lieu of advertisement the fact that the
deposits collected by them are not insured.

All NBFCs holding public deposits of Rs.50 crore

and above and RNBCs having aggregate liabilities to
the depositors of Rs.50 crore and above as on March
31, 2002 or thereafter were advised to furnish the
•
information regarding their exposure to the capital
market to the Reserve Bank in a quarterly return
within one month of the close of the respective
quarter.

Non-Banking Financial Companies (NBFCs)

1.49 The Reserve Bank had put in place a comprehensive regulatory framework for NBFCs in January 1998
(detailed in the last year's Annual Report), to ensure that the NBFCs function on sound and healthy lines and that
only financially sound and well run NBFCs are allowed to access public deposits. Protection of depositors' interest
has been accorded prime importance and the Reserve Bank has initiated various measures in this regard. NBFCs
accepting/holding public deposits are subject to accounting standards, prudential norms of asset classification,
income recognition and capital adequacy which are in alignment with those applicable to banks in India. NBFCs not
accepting/holding public deposits are regulated only to a limited extent. The Reserve Bank has put in place a
supervisory framework for overseeing the implementation of regulatory framework, which comprises a system of
compulsory registration, on-site examination of their books, off-site surveillance, a comprehensive market
intelligence system and exception reports from statutory auditors of NBFCs.

Prudential Regulation and Capital Adequacy Norms

1.50 In the light of the increased incidence of financial problems faced by NBFCs, policy announcements were
made to strengthen the health of NBFCs and improve their operational transparency. Capital adequacy ratio was
raised in a phased manner to 10.0 per cent and thereafter to 12.0 per cent to be achieved by end-March 1998 and
end-March 1999, respectively. The credit concentration norms in respect of a single borrower and single group of
borrowers were kept unaltered at 15 per cent and 25 per cent of the owned funds, respectively. The investment
concentration norms stipulated that investments in a single company and in a group of companies be subject,
respectively, to a ceiling of 15 per cent and 25 per cent of the owned funds of NBFCs. Composite limits on credit
and investments by an NBFC in a single entity and a single group of entities were prescribed at 25 per cent and 40
per cent, respectively, of its owned funds. Certain restrictions have been placed on NBFCs' investment in real estate;
such investments, except for their own use, should not exceed 10 per cent of their owned funds. Further, a ceiling
has been prescribed for investment in unquoted shares of other than group/subsidiary companies, the amount of
which shall not exceed i) 10 per cent of the owned fund for equipment leasing and hire purchase finance companies;
and ii) 20 per cent of the owned fund for loan/investment companies. Three years' time period has been allowed to
the companies to bring down the excess assets held as also for disposal of such assets acquired by the company in
satisfaction of its debts in case the company surpasses the ceiling.

1.51 The statutory requirement of minimum NOF of Rs.25 lakh in terms of the RBI (Amendment) Act, 1997 for
obtaining a certificate of registration (COR) from the Reserve Bank and commencing/carrying on the business of an
NBFC has been raised to Rs.200 lakh for NBFCs whose applications are received on or after April 21, 1999. Of the
37,445 applications for registration received by the Reserve Bank before June 30, 1999, 10,399 satisfied the
statutory requirement of minimum NOF. The Reserve Bank has approved certificate of registration to 7,661
companies. Of these companies, 607 are permitted to hold/accept public deposits. The applications for COR of
1,104 companies have been rejected whereas the applications of 26,929 companies and 1,751 companies are
pending for not satisfying the minimum prescribed NOF and other reasons, respectively. Companies not satisfying
the minimum prescribed NOF were given three years' time for augmenting the owned fund which will expire on
January 8, 2000.

Residuary Non-Banking Companies (RNBCs)

1.52 The quantum of deposits that can be accepted by Residuary Non-Banking Companies (RNBCs) is not linked to
their NOF. For the purpose of safeguarding depositors' interest, they are enjoined upon to invest at least 80 per cent
of the deposit liabilities in securities as per the pattern prescribed by the Reserve Bank. These securities are required
to be entrusted to a public sector bank and can be withdrawn only for the purpose of repayment to the depositors.
RNBCs are required to pay interest on their deposits which shall not be less than 6 per cent per annum (to be
compounded annually) on daily deposit schemes and 8 per cent (to be compounded annually) on other deposit
schemes of higher duration or term deposits. Other provisions of the directions relate to minimum and maximum
period of deposits, prohibition from forfeiture of any part of the deposit or interest payable thereon, disclosure
requirements in the application forms and the advertisements soliciting deposits, furnishing of periodical returns and
information to the Reserve Bank.

Mutual Benefit Financial Companies (Nidhis)

1.53 While the deposit acceptance activities of Nidhis are regulated by the Reserve Bank, the directions for
deployment of their funds are issued by the Department of Company Affairs (DCA) of the Government of India. To
ameliorate the difficulties faced by non-notified companies working like Nidhis which were treated as loan
companies for the purpose of acceptance of public deposits, a new set of guidelines was announced by the Reserve
Bank in April 1999 in consultation with the Central Government. As an interim measure, these companies will be
classified as Mutual Benefit Companies (MBCs) subject to their satisfying certain eligibility conditions prescribed
by the Reserve Bank in this regard and the privileges enjoyed by Nidhi companies shall be extended to these
companies on their compliance.

Task Force on NBFCs

1.54 In August 1998, a Task Force on NBFCs was constituted under the Chairmanship of Shri C.M. Vasudev. The
terms of reference of the Task Force were to (i) examine the adequacy of the present legislative framework, (ii)
devise improvements in the procedure relating to customer complaints, (iii) consider the need, if any, for a separate
regulatory agency and (iv) examine whether state Governments could be involved in the regulation of NBFCs. The
Task Force submitted its recommendations to the Government on October 28, 1998. The major recommendations of
the Task Force which have been acted upon include i) doing away with the requirement of minimum investment
credit rating for Equipment Leasing and Hire Purchase (EL & HP) Finance Companies for acceptance of public
deposits up to Rs.10 crore or 1.5 times their NOF, whichever is less, provided they have minimum CAR of 15 per
cent, and ii) prescribing a minimum investment grade credit rating and CAR of 15 per cent for loan/investment
companies to be eligible for acceptance of public deposits up to 1.5 times their NOF. The details of implementation
of major recommendations of the Task Force are given in Box VIII.1 of the Report.

Financial Institutions: Policy Changes

1.55 Select (eight) all-India financial institutions (AIFIs) were permitted to raise resources by way of term money
borrowings, certificates of deposit, term deposits and Inter-Corporate Deposits (ICDs). While three institutions, viz.
IDBI, ICICI and IFCI had umbrella limits equivalent to 100 per cent of their respective NOF as on March 31, 1997,
EXIM Bank and SIDBI had umbrella limits equivalent to 75 per cent and 50 per cent of their respective NOF for
raising of resources through these instruments; the remaining three had instrument-wise limits. In December 1998,
two more institutions, viz. IIBI and TFCI were given umbrella limits in place of instrument-wise limits. Moreover,
with a view to providing flexibility in raising resources, the uniform umbrella limits were fixed equivalent to the 100
per cent of NOF of institutions as per their latest available audited balance sheets. Consequently, the aggregate
limits of AIFIs for raising of resources through these instruments increased to Rs.19,572 crore as on March 31, 1999
from Rs.15,923 crore as on March 31, 1998.

Non-Banking Financial Institutions

Non-banking Financial Institutions carry out financing activities but their

resources are not directly obtained from the savers as debt. Instead, these
Institutions mobilise the public savings for rendering other financial
services including investment. All such Institutions are financial
intermediaries and when they lend, they are known as Non-Banking
Financial Intermediaries (NBFIs) or Investment Institutions.
  UNIT TRUST OF INDIA

 LIFE INSURANCE CORPORATION (LIC)

 GENERAL INSURANCE CORPORATION (GIC)

Apart from these NBFIs, another part of Indian financial system consists of
a large number of privately owned, decentralised, and relatively small-sized
financial intermediaries. Most work in different, miniscule niches and make
the market more broad-based and competitive. While some of them restrict
themselves to fund-based business, many others provide financial services
of various types. The entities of the former type are termed as "non-bank
financial companies (NBFCs)". The latter type are called "non-bank
financial services companies (NBFCs)".

Post 1996, Reserve Bank of India has set in place additional regulatory and
supervisory measure that demand more financial discipline and
transparency of decision making on the part of NBFCs. NBFCs regulations
are being reviewed by the RBI from time to time keeping in view the
emerging situations. Further, one can expect that some areas of co-
operation between the Banks and NBFCs may emerge in the coming era
of E-commerce and Internet banking.