FINANCIAL MARKETS AND SERVICES

Objective: To enlighten the students with the Concepts and Practical dynamics of Financial Markets
and Financial Services
UNIT – I : Structure of Financial System – role of Financial System in Economic Development –
Financial Markets and Financial Instruments – Capital Markets – Money Markets – Primary Market
Operations – Role of SEBI – Secondary Market Operations – Regulation – Functions of Stock
Exchanges – Listing – Formalities – Financial Services Sector Problems and Reforms.
UNIT – II : Financial Services: Concept, Nature and Scope of Financial Services – Regulatory Frame
Work of Financial Services – Growth of Financial Services in India – Merchant Banking – Meaning-
Types – Responsibilities of Merchant Bankers – Role of Merchant Bankers in Issue Management –
Regulation of Merchant Banking in India. Leasing – types of Leases – Evaluation of Leasing Option
Vs. Borrowing.
UNIT – III : Venture Capital – Growth of Venture Capital in India – Financing Pattern under Venture
Capital – Legal Aspects and Guidelines for Venture Capital. Factoring, Forfeiting and Bill Discounting
– Types of Factoring Arrangements – Factoring in the Indian Context.
UNIT – IV : Credit Rating – Meaning, Functions – Debt Rating System of CRISIL, ICRA and CARE.
Mutual Funds – Concept and Objectives, Functions and Portfolio Classification, Organization and
Management, Guidelines for Mutual Funds. Working of Public and Private Mutual Funds in India.
Debt Securitization – Concept and Application – De-mat Services-need and Operations-role of NSDL
and CSDL.
UNIT – V : Microfinance: Over view of Microfinance, Indian Rural financial system, introduction to
Microfinance, Microfinance concepts, products, (savings, credit, insurance, pension, equity, leasing,
hire-purchase service, Microfinance in kind, Micro-remittances, Micro Securitization. Microfinance
models: Generic models viz. SHG, Grameen, and Cooperative, variants SHG NABARD model, SIDBI
model, SGSY model, Grameen Bangladesh model, credit unions. Poverty and Need of Microfinance.
Gender issues in Microfinance.
UNIT – I : Structure of Financial System –
The financial system is the main part of running the economy smoothly. financial system provides the
flow of finance in the economy. which leads to the development of the country financial system show
the strength of the country.
Indian Financial System is a combination of financial institutions, financial markets, financial
instruments and financial services to facilitate the transfer of funds. Financial system provides a
payment mechanism for the exchange of goods and services. It is a link between saver and investor.

Structure
of Indian Financial System
Structure of Indian Financial System
The following are the four major components that comprise the Indian Financial System:
 Financial Institutions
 Financial Markets
 Financial Instruments/Assets/Securities
 Financial Services.
Financial Institutions
Financial institutions are the intermediaries who facilitate the smooth functioning of the financial
system by making investors and borrowers meet. They mobilize savings of the surplus units and
allocate them in productive activities promising a better rate of return. Structure of Indian Financial
System also provides services to entities (individual, business, government) seeking advice on various
issues ranging from restructuring to diversification plans. They provide whole range Of services to the
entities who want to raise funds from the markets or elsewhere. The financial Institutions is very
important for the function of a financial system
Types of Financial Institutions
Financial institutions can be classified into two categories

 Banking Institutions
 Non-Banking Financial Institutions
Financial Markets
Financial markets may be broadly classified as negotiated loan markets and open The negotiated loan
market is a market in which the lender and the borrower personally negotiate the terms of the loan
agreement, e.g. a businessman borrowing from a bank or from a small loan company. On the other
hand, the open market is an impersonal market in which standardized securities are treated in large
volumes. The stock market is an example of an open market. The financial markets, in a nutshell, the
credit markets catering to the various credit needs Of the individuals, links and institutions. Credit is
supplied both on a short as well as a long
On the basis of the credit requirement for short-term and long term purposes, financial markets are
divided into two categories
Types of the financial market
 Money Market
 Capital Market
Financial Instruments/ Assets/ Securities
This is an important component of the financial system. Financial instruments are monetary contracts
between parties. The products which are traded in a financial market are financial assets, securities or
other types of financial instruments. There is a wide range of securities in the markets since the needs
of investors and credit seekers are different. Financial instruments can be real or virtual documents
representing a legal agreement involving any kind of monetary value. Equity-based financial
instruments represent ownership of an asset. Debt-based financial instruments represent a loan made
by an investor to the owner of the asset.
Types of Financial Instruments

 Cash Instruments
 Derivative Instrument
Financial Services
It consists of services provided by Asset Management and Liability Management Companies. They
help to get the required funds and also make sure that they are efficiently invested. They assist to
determine the financing combination and extend their professional services up to the stage of servicing
of lenders

Role of financial system in economic development

The following are the roles of financial system in the economic development of a country.
Savings-investment relationship
To attain economic development, a country needs more investment and production. This can happen
only when there is a facility for savings. As, such savings are channelized to productive resources in
the form of investment. Here, the role of financial institutions is important, since they induce the public
to save by offering attractive interest rates. These savings are channelized by lending to various
business concerns which are involved in production and distribution.

Financial systems help in growth of capital market

Any business requires two types of capital namely, fixed capital and working capital. Fixed capital is
used for investment in fixed assets, like plant and machinery. While working capital is used for the
day-to-day running of business. It is also used for purchase of raw materials and converting them into
finished products.

 Fixed capital is raised through capital market by the issue of debentures and shares.
Public and other financial institutions invest in them in order to get a good return with
minimized risks.
 For working capital, we have money market, where short-term loans could be raised by
the businessmen through the issue of various credit instruments such as bills, promissory
notes, etc.
Foreign exchange market enables exporters and importers to receive and raise funds for settling
transactions. It also enables banks to borrow from and lend to different types of customers in various
foreign currencies. The market also provides opportunities for the banks to invest their short term idle
funds to earn profits. Even governments are benefited as they can meet their foreign exchange
requirements through this market.
Government Securities market
Financial system enables the state and central governments to raise both short-term and long-term
funds through the issue of bills and bonds which carry attractive rates of interest along with tax
concessions. The budgetary gap is filled only with the help of government securities market. Thus, the
capital market, money market along with foreign exchange market and government securities market
enable businessmen, industrialists as well as governments to meet their credit requirements. In this
way, the development of the economy is ensured by the financial system.
Financial system helps in Infrastructure and Growth
Economic development of any country depends on the infrastructure facility available in the country.
In the absence of key industries like coal, power and oil, development of other industries will be
hampered. It is here that the financial services play a crucial role by providing funds for the growth of
infrastructure industries. Private sector will find it difficult to raise the huge capital needed for setting
up infrastructure industries. For a long time, infrastructure industries were started only by the
government in India. But now, with the policy of economic liberalization, more private sector
industries have come forward to start infrastructure industry. The Development Banks and the
Merchant banks help in raising capital for these industries.
Financial system helps in development of Trade
The financial system helps in the promotion of both domestic and foreign trade. The financial
institutions finance traders and the financial market helps in discounting financial instruments such as
bills. Foreign trade is promoted due to per-shipment and post-shipment finance by commercial banks.
They also issue Letter of Credit in favor of the importer. Thus, the precious foreign exchange is earned
by the country because of the presence of financial system. The best part of the financial system is that
the seller or the buyer do not meet each other and the documents are negotiated through the bank. In
this manner, the financial system not only helps the traders but also various financial institutions. Some
of the capital goods are sold through hire purchase and installment system, both in the domestic and
foreign trade. As a result of all these, the growth of the country is speeded up.
Employment Growth is boosted by financial system
The presence of financial system will generate more employment opportunities in the country. The
money market which is a part of financial system, provides working capital to the businessmen and
manufacturers due to which production increases, resulting in generating more employment
opportunities. With competition picking up in various sectors, the service sector such as sales,
marketing, advertisement, etc., also pick up, leading to more employment opportunities. Various
financial services such as leasing, factoring, merchant banking, etc., will also generate more
employment. The growth of trade in the country also induces employment opportunities. Financing by
Venture capital provides additional opportunities for techno-based industries and employment.
Venture Capital
There are various reasons for lack of growth of venture capital companies in India. The economic
development of a country will be rapid when more ventures are promoted which require modern
technology and venture capital. Venture capital cannot be provided by individual companies as it
involves more risks. It is only through financial system, more financial institutions will contribute a
part of their investable funds for the promotion of new ventures. Thus, financial system enables the
creation of venture capital.
Financial system ensures Balanced growth
Economic development requires a balanced growth which means growth in all the sectors
simultaneously. Primary sector, secondary sector and tertiary sector require adequate funds for their
growth. The financial system in the country will be geared up by the authorities in such a way that the
available funds will be distributed to all the sectors in such a manner, that there will be a balanced
growth in industries, agriculture and service sectors.
Financial system helps in fiscal discipline and control of economy
It is through the financial system, that the government can create a congenial business atmosphere so
that neither too much of inflation nor depression is experienced. The industries should be given
suitable protection through the financial system so that their credit requirements will be met even
during the difficult period. The government on its part, can raise adequate resources to meet its
financial commitments so that economic development is not hampered. The government can also
regulate the financial system through suitable legislation so that unwanted or speculative transactions
could be avoided. The growth of black money could also be minimized.

Financial system’s role in Balanced regional development

Through the financial system, backward areas could be developed by providing various concessions or
sops. This ensures a balanced development throughout the country and this will mitigate political or
any other kind of disturbances in the country. It will also check migration of rural population towards
towns and cities.

Role of financial system in attracting foreign capital

Financial system promotes capital market. A dynamic capital market is capable of attracting funds both
from domestic and abroad. With more capital, investment will expand and this will speed up the
economic development of a country.
Financial system’s role in Economic Integration
Financial systems of different countries are capable of promoting economic integration. This means
that in all those countries, there will be common economic policies, such as common investment, trade,
commerce, commercial law, employment legislation, old age pension, transport co-ordination, etc. We
have a standing example of European Common Market which has gone to the extent of creating a
common currency, representing several countries in Western Europe.

Role of financial system in Political stability

The political conditions in all the countries with a developed financial system will be stable. Unstable
political environment will not only affect their financial system but also their economic development.

Financial system helps in Uniform interest rates

The financial system is capable of bringing an uniform interest rate throughout the country by which
there will be balanced movement of funds between centres which will ensure availability of capital for
all kinds of industries.

Financial system role in Electronic development:

Due to the development of technology and the introduction of computers in the financial system, the
transactions have increased manifold bringing in changes for the all round development of the country.
The promotion of World Trade Organization (WTO) has further improved international trade and the
financial system in all its member countries.

Financial Markets

Definition: Financial Market refers to a marketplace, where creation and trading of financial assets,
such as shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a crucial role in
allocating limited resources, in the country’s economy. It acts as an intermediary between the savers
and investors by mobilising funds between them.
The financial market provides a platform to the buyers and sellers, to meet, for trading assets at a price
determined by the demand and supply forces.

Functions of Financial Market

The functions of the financial market are explained with the help of points below:

 It facilitates mobilisation of savings and puts it to the most productive uses.

 It helps in determining the price of the securities. The frequent interaction between
investors helps in fixing the price of securities, on the basis of their demand and supply in
the market.
 It provides liquidity to tradable assets, by facilitating the exchange, as the investors can
readily sell their securities and convert assets into cash.
 It saves the time, money and efforts of the parties, as they don’t have to waste resources
to find probable buyers or sellers of securities. Further, it reduces cost by providing valuable
information, regarding the securities traded in the financial market.
The financial market may or may not have a physical location, i.e. the exchange of asset between the
parties can also take place over the internet or phone also.

Classification of Financial Market

1. By Nature of Claim
o Debt Market: The market where fixed claims or debt instruments, such as
debentures or bonds are bought and sold between investors.
o Equity Market: Equity market is a market wherein the investors deal in equity
instruments. It is the market for residual claims.
2. By Maturity of Claim
 o Money Market: The market where monetary assets such as commercial paper,
certificate of deposits, treasury bills, etc. which mature within a year, are traded is
called money market. It is the market for short-term funds. No such market exist
physically; the transactions are performed over a virtual network, i.e. fax, internet or
phone.
o Capital Market: The market where medium and long term financial assets are
traded in the capital market. It is divided into two types:
 Primary Market: A financial market, wherein the company listed on an
exchange, for the first time, issues new security or already listed company
brings the fresh issue.
 Secondary Market: Alternately known as the Stock market, a secondary
market is an organised marketplace, wherein already issued securities are
traded between investors, such as individuals, merchant bankers,
stockbrokers and mutual funds.
3. By Timing of Delivery
o Cash Market: The market where the transaction between buyers and sellers are
settled in real-time.
o Futures Market: Futures market is one where the delivery or settlement of
commodities takes place at a future specified date.
4. By Organizational Structure
o Exchange-Traded Market: A financial market, which has a centralised organisation
with the standardised procedure.
o Over-the-Counter Market: An OTC is characterised by a decentralised
organisation, having customised procedures.

Importance of Financial Markets

There are many things that financial markets make possible, including the following:

 Financial markets provide a place where participants like investors and debtors, regardless of
their size, will receive fair and proper treatment.
 They provide individuals, companies, and government organizations with access to capital.
 Financial markets help lower the unemployment rate because of the many job opportunities it
offers

Financial Instruments
A financial instrument is a monetary contract between parties. We can create, trade, or modify them.
We can also settle them. A financial instrument may be evidence of ownership of part of something, as
in stocks and shares. Bonds, which are contractual rights to receive cash, are financial instruments.

Checks (UK: cheques), futures, options contracts, and bills of exchange are also financial instruments.

Securities, i.e., contracts that we give a value to and then trade, are financial instruments.

Put simply; a financial instrument is an asset or package of capital that we can trade.
The Association of Chartered Certified Accountants (ACCA) has the following definition or a financial
instrument:

“A financial instrument is any contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity.”

“The definition is wide and includes cash, deposits in other entities, trade receivables, loans to other
entities. investments in debt instruments, investments in shares and other equity instruments.”

A
financial instrument can represent ownership of something, a loan that an investor made to the asset’s
owner, or a foreign currency.
Financial instrument – cash or derivative

There are two main types of financial instruments, derivative or cash instruments.

Derivative instruments
Derivative instruments are instruments whose worth we derive from the value and characteristics of at
least one underlying entity. Assets, interest rates, or indexes, for example, are underlying entities.

We also call them ‘derivatives.’ They are contracts whose values come from the performance of an
underlying entity.

Derivative instruments are securities that we link to other securities such as stocks or bonds. ‘Stocks,’
in this context, means the same as ‘shares.’ Derivative instruments can also be linked
to Forex and Cryptocurrencies.
According to TradingOnlineGuide.com, the term FOREX stands for the Foreign Exchange Market.

Cash instruments
Cash instruments are instruments that the markets value directly. Securities, which are readily
transferable, for example, are cash instruments. Deposits and loans, where both lender and borrower
must agree on a transfer, are also cash instruments.

Financial instrument by asset class

We can also categorize financial instruments by asset class, depending on whether they are debt or
equity based.

Debt-based financial instruments reflect a loan the investor made to the issuing entity.

Equity-based financial instruments, on the other hand, reflect ownership of the issuing entity.

Regarding these types of financial instruments, Wikipedia writes:

“If the instrument is debt, it can be further categorized into short-term (less than one year) or long-
term.”

“Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their
own category.”

Capital Markets –

Definition: Capital Market, is used to mean the market for long term investments, that have explicit or
implicit claims to capital. Long term investments refers to those investments whose lock-in period is
greater than one year.

In the capital market, both equity and debt instruments, such as equity shares, preference shares,
debentures, zero-coupon bonds, secured premium notes and the like are bought and sold, as well as it
covers all forms of lending and borrowing.

Capital Market is composed of those institutions and mechanisms with the help of which medium and
long term funds are combined and made available to individuals, businesses and government. Both
private placement sources and organized market like securities exchange are included in it.

Functions of Capital Market

 Mobilization of savings to finance long term investments.
 Facilitates trading of securities.
 Minimization of transaction and information cost.
 Encourage wide range of ownership of productive assets.
 Quick valuation of financial instruments like shares and debentures.
 Facilitates transaction settlement, as per the definite time schedules.
  Offering insurance against market or price risk, through derivative trading.
 Improvement in the effectiveness of capital allocation, with the help of competitive price
mechanism.
Capital market is a measure of inherent strength of the economy. It is one of the best source of finance,
for the companies, and offers a spectrum of investment avenues to the investors, which in turn
encourages capital creation in the economy.

Types of Capital Market

The capital market is bifurcated in two segments, primary market and secondary market:

1. Primary Market: Otherwise called as New Issues Market, it is the market for the trading of
new securities, for the first time. It embraces both initial public offering and further public
offering. In the primary market, the mobilisation of funds takes place through prospectus, right
issue and private placement of securities.
2. Secondary Market: Secondary Market can be described as the market for old securities, in the
sense that securities which are previously issued in the primary market are traded here. The
trading takes place between investors, that follows the original issue in the primary market. It
covers both stock exchange and over-the-counter market.

Capital market improves the quality of information available to the investor regarding the investment.
Add to that, it plays a crucial role in encouraging the adoption of rules of corporate governance, which
backs the trading environment. It includes all the processes that help in the transfer of already existing
securities.

Money Markets –
Definition: Money Market can be understood as the market for short term funds, wherein lending and
borrowing of funds varies from overnight to a year. It is an important part of the financial system that
helps in fulfilling the short term and very short term requirements of the companies, banks, financial
institution, government agencies and so forth.

Salient Features of Money Market

  It is a wholesale market, as the transaction volume is large.
 Trading takes place over the telephone, after which written confirmation is done by way of
e-mails.
 Participants include banks, mutual funds, investment institutions and Central Banks.
 There is an impersonal relationship between the participants in the money market, and so,
pure competition exists.
 Money market operations focus on a particular area, which serves a region or an area. On
the basis of the market size and needs, the area may differ.
There are five major segments of money market which are Certificate of Deposits (CD), Commercial
Paper, Swaps, Repo and Government treasury securities.

Money Market Instruments

In this market, only those financial instruments are traded which are immediate substitutes for money,
which includes:

1. Call/Notice Money: When the money raised or borrowed on demand for a very short term
which ranges from one day to 14 days, then it may be called as notice money, and when it
exceeds 14 days it is termed as call money.
2. Treasury Bills: These are short term, negotiable financial assets issued by the central bank, on
behalf of the government, for overcoming liquidity shortfalls.
3. Commercial Bills: A commercial bill is a negotiable, self-liquidating instrument that is less
risky in nature. When goods are bought on credit, these bills improve the liability to make
payment at the specified date.
4. Commercial Paper: It alludes to an unsecured promissory note, issued by large and
creditworthy companies, at a discount on its face value and redeemable at its face value.
5. Certificate of Deposit: It is an unsecured, negotiable financial instrument which a bank and
financial institution issues to individuals, corporation, trust, funds etc. at a discount on its face
value and its maturity vary from 15 days to one year.

The financial assets dealt in the money market possess high liquidity, low transaction cost, less risky
and no loss in value. And so, it acts as a whole sale debt market for such instruments.

Functions of Money Market

The three basic functions of money market are:
  It provides a balancing tool for equating the demand for and supply of short term funds.
 It provides a centre for the intervention of central bank, for controlling liquidity and general
interest rate level.
 It provides a proper reach to the suppliers and users of the short term funds, to fulfil their
requirements, at a reasonable market clearing price.
Money market plays a vital role in equating the short term liquidity imbalances within the country.
Indeed, with the help of this market, the central bank controls liquidity and interest rates level in the
country.

Primary Market Operations

Primary Market

In a primary market, securities are created for the first time for investors to purchase. New

securities are issued in this market through a stock exchange, enabling the government as well as

companies to raise capital.

For a transaction taking place in this market, there are three entities involved. It would include a

company, investors, and an underwriter. A company issues security in a primary market as an initial

public offering (IPO), and the sale price of such new issue is determined by a concerned

underwriter, which may or may not be a financial institution. An underwriter also facilitates and

monitors the new issue offering. Investors purchase the newly issued securities in the primary

market. Such a market is regulated by the Securities and Exchange Board of India (SEBI).

The entity which issues securities may be looking to expand its operations, fund other business

targets or increase its physical presence among others. Primary market example of securities

issued includes notes, bills, government bonds or corporate bonds as well as stocks of companies.
Functions of Primary Market
The functions of such a market are manifold –

 New issue offer

The primary market organises offer of a new issue which had not been traded on any other

exchange earlier. Due to this reason, it is also called a New Issue Market. Organising new issue

offers involves a detailed assessment of project viability, among other factors. The financial

arrangements for the purpose include considerations of promoters’ equity, liquidity ratio, debt-

equity ratio and requirement of foreign exchange.

 Underwriting services
Underwriting is an essential aspect while offering a new issue. An underwriter’s role in a primary

marketplace includes purchasing unsold shares if it cannot manage to sell the required number of

shares to the public. A financial institution may act as an underwriter, earning a commission on

underwriting.

Investors rely on underwriters for determining whether undertaking the risk would be worth its

returns. It may so thus happen that an underwriter ends up buying all the IPO issue, and

subsequently selling it to investors.

 Distribution of new issue

A new issue is also distributed in a primary marketing sphere. Such distribution is initiated with a

new prospectus issue. It invites the public at large to buy a new issue and provides detailed

information on the company, issue, and involved underwriters.

Investing in stocks is now super simple

Types of Primary Market Issuance

After the issuance of securities, investors can purchase such securities in various ways. There are

5 types of primary market issues.

 Public issue
Public issue is the most common method of issuing securities of a company to the public at large. It

is mainly done via Initial Public Offering (IPO) resulting in companies raising funds from the

capital market. These securities are listed in the stock exchanges for trading.

A privately held company converts into a publicly-traded company when its shares are offered to

the public initially through IPO. Such public offer allows a company to raise funds for expansion of

business, improving infrastructure, and repay its debts, among others. Trading in an open market

also increases a company’s liquidity and provides a scope for issuance of more shares in raising

further capital for business.

The Securities and Exchange Board of India is the regulatory body that monitors IPO. As per its

guidelines, a requisite due enquiry is conducted for a company’s authenticity, and the company is

required to mention its necessary details in the prospectus for a public issue.

 Private placement
When a company offers its securities to a small group of investors, it is called private placement.

Such securities may be bonds, stocks or other securities, and the investors can be both individual

and institutional.

Private placements are easier to issue than initial public offerings as the regulatory stipulations are

significantly less. It also incurs reduced cost and time, and the company can remain private. Such

issuance is suitable for start-ups or companies which are in their early stages. The company may

place this issuance to an investment bank or a hedge fund or place before ultra-high net worth

individuals (HNIs) to raise capital.

 Preferential issue
A preferential issue is one of the quickest methods available to companies for raising capital. Both

listed and unlisted companies can issue shares or convertible securities to a select group of

investors. However, the preferential issue is neither a public issue nor a rights issue. The

shareholders in possession of preference shares stand to receive the dividend before the ordinary
shareholders are paid.

 Qualified institutional placement

Qualified institutional placement is another kind of private placement where a listed company

issues securities in the form of equity shares or partly or wholly convertible debentures apart from

such warrants convertible to equity shares and purchased by a Qualified Institutional Buyer (QIB).

QIBs are primarily such investors who have the requisite financial knowledge and expertise to

invest in the capital market. Some QIBs are –

  Foreign Institutional Investors registered with the Securities and Exchange Board of

India.

 Foreign Venture Capital Investors.

 Alternate Investment Funds.

 Mutual Funds.

 Public Financial Institutions.

 Insurers.

 Scheduled Commercial Banks.

 Pension Funds.

Issuance of qualified institutional placement is simpler than preferential allotment as the former

does not attract standard procedural regulations like submitting pre-issue filings to SEBI. The

process thus becomes much easier and less time-consuming.

 Rights and bonus issues

Another issuance in the primary market is rights and bonus issue, in which the company issues

securities to existing investors by offering them to purchase more securities at a predetermined

price (in case of rights issue) or avail allotment of additional free shares (in case of bonus issue).

For rights issues, investors retain the choice of buying stocks at discounted prices within a

stipulated period. Rights issue enhances control of existing shareholders of the company, and also

there are no costs involved in the issuance of these kinds of shares. For bonus issues, stocks are

issued by a company as a gift to its existing shareholders. However, the issuance of bonus shares

does not infuse fresh capital.

Examples of Primary Stock Market Selling

Company Details

One of the remarkable IPOs that were undertaken includes the Facebook initial
Facebook
public offering. The offer initiated in 2012 is to date the largest IPO in the
 technology sector. The company successfully raised $16 billion through its initial
public offering. As an effect, its turnover increased by close to 100%.

Also, there was a high demand for the stock in the primary market, which led to the

pricing of Facebook’s stock to be fixed at $38 for each share as determined by the

underwriters. The valuation of the stock eventually amounted to $104 billion,

highest for a newly formed public company.

The biggest IPO undertaken in India was by Coal India in 2010, which raised Rs.
Coal 15,200 Crore. The shares were listed at Rs. 287.75 and eventually increased to
India Rs.340. The company offered a 5% discount on the final IPO price to retail
investors, along with the subsidiaries and employees of the company.

Furthermore, the Union Budget 2020-2021 also proposed the sale of a part of the government’s

stake in Life Insurance Corporation. Even a 10% stake sale may fetch Rs. 80,000 crore to the

government. Listing of the insurer will thus make it the biggest initial public offer in India

surpassing Coal India IPO.

Advantages of Primary Market

 Companies can raise capital at relatively low cost, and the securities so issued in the

primary market provide high liquidity as the same can be sold in the secondary market
almost immediately.

 The primary market is an important source for mobilisation of savings in an economy.

Funds are mobilised from commoners for investing in other channels. It leads to

monetary resources being put into investment options.

 Chances of price manipulation in the primary market are considerably less when

compared to the secondary market. Such manipulation usually occurs by deflating or

inflating a security price, thereby deliberately interfering with fair and free operations of

the market.
  The primary market acts as a potential avenue for diversification to cut down on risk. It

enables an investor to allocate his/her investment across different categories involving

multiple financial instruments and industries.

 It is not subject to any market fluctuations. The prices of stocks are determined before an

initial public offering, and investors know the actual amount they will have to invest.

Disadvantages of Primary Market

 There may be limited information for an investor to access before investment in an IPO

since unlisted companies do not fall under the purview of regulatory and disclosure

requirements of the Securities and Exchange Board of India.

 Each stock is exposed to varying degrees of risk, but there is no historical trading data in

a primary market for analysing IPO shares because the company is offering its shares to

the public for the first time through an initial public offering.

 In some cases, it may not be favourable for small investors. If a share is oversubscribed,

small investors may not receive share allocation.

With this information regarding the primary market, individuals can make a well-thought-out

decision regarding investment in the market. It also makes way for the creation of an investment

portfolio with diversified risk.

Role of SEBI
Securities and Exchange Board Of India [SEBI] is a regulator of securities market in India. Initially, it
was formed for the purpose of observing the activities afterward in May 1992, Government of India
granted legal status to SEBI. What is the function of Primary Market under SEBI? What is the role of
SEBI? What is the process of issuance of securities? Role of SEBI in eliminating insider trading?

Functions of Primary Market Under SEBI

 Primary Market facilitates capital growth by encouraging individuals to convert savings into
investments.
 Primary Market being the part of Capital market also issues new securities.
  Government or Public sector institutions and companies can obtain funds in exchange of a
new stock or bond issues via an investment Bank or financial Syndicate of securities
dealers.
 It encourages Initial Public Offerings [IPO]

Role of SEBI

Protecting the interest of investors

 SEBI ensures that the investors do not get befooled by misleading and false advertisements.
In return, SEBI issued guidelines so as to protect investors and also ensured that the
advertisement is fair and concise.
 Regulation of price rigging: Price rigging refers to manipulation of prices by way of
fluctuating the prices with the object of inflating and depressing the market price of
securities.
 SEBI make efforts to educate investors so that they are able to make choices between the
offerings of different companies and choose the most profitable securities.
 SEBI has issued guidelines to investigate cases of fraud and insider trading. Adding to this
the provisions for fine and Imprisonment.

To ensure Development activities in Stock Exchange

 E-Trading: Concept of E-trading have been introduced few years back by SEBI to eliminate
the discomfort. It simplifies the process of buying and selling of securities.
 The initial public offering of Primary Market (which is a part of Capital market) permits
through stock exchange.
 SEBI promotes training of intermediaries of securities market with the object of smooth
functioning.

Regulate the business of stock exchange and activities of stock exchange

SEBI introduced proper Code Of Conduct applicable to everyone who is a part of the process of
buying and selling of securities, stock exchange, etc. Following are the areas of concern:

 Rules and Regulations to regulate intermediaries such as Broker, underwriters, etc.

  Registers and Regulates the working of merchant Bankers, sub-brokers, stock-brokers, share
transfer agent, trustees, etc.
 Registers the working of mutual Funds.
 SEBI regulates turnover of the companies.
 It also conducts inquiry and audits.

To Regulate Insider Trading

Insider Trading have been a problem since the introduction of the Market dealing with buying and
selling of securities, stock exchange, etc. An Insider is a person or a group of people having first- hand
knowledge about the internal issues and Ups and downs of a company. The moment insider gets to
know about the loss which is going to occur, the shares under insider’s name are sold immediately.
Hence, company suffers a huge amount of loss.

Secondary Market Operations –

Secondary market is the platform where the existing securities are dealt with. Here, the new investors
can invest into the securities and the existing investors can disinvest or invest more, as they wish. It is
very helpful in economic growth and development as it channelizes the funds to the most productive
use through the activity of investment, reinvestment and disinvestment. Here the main role is played by
the stock exchanges or stock markets. With the advanced technology, it has become easier to buy and
sell the securities as per the comfort from anywhere at any time. National stock exchange, Bombay
stock exchange are some examples of the same.

Secondary market is thus the place where the existing securities are bought as well as sold. It has a
geographical location and thus a physical existence. In secondary markets there is not a fixed price for
the securities but it fluctuates based on the demand and supply of the securities in the market. It is
quick so that the investors can get the funds they invested quickly back in the form of cash

1. Economic Barometer:

A stock exchange is a reliable barometer to measure the economic condition of a country.

Every major change in country and economy is reflected in the prices of shares. The rise or fall in the

share prices indicates the boom or recession cycle of the economy. Stock exchange is also known as a

pulse of economy or economic mirror which reflects the economic conditions of a country.

2. Pricing of Securities:

The stock market helps to value the securities on the basis of demand and supply factors. The securities

of profitable and growth oriented companies are valued higher as there is more demand for such
securities. The valuation of securities is useful for investors, government and creditors. The investors

can know the value of their investment, the creditors can value the creditworthiness and government

can impose taxes on value of securities.

3. Safety of Transactions:

In stock market only the listed securities are traded and stock exchange authorities include the

companies names in the trade list only after verifying the soundness of company. The companies

which are listed they also have to operate within the strict rules and regulations. This ensures safety of

dealing through stock exchange.

4. Contributes to Economic Growth:

ADVERTISEMENTS:

In stock exchange securities of various companies are bought and sold. This process of disinvestment

and reinvestment helps to invest in most productive investment proposal and this leads to capital

formation and economic growth.

5. Spreading of Equity Cult:

Stock exchange encourages people to invest in ownership securities by regulating new issues, better

trading practices and by educating public about investment.

6. Providing Scope for Speculation:

To ensure liquidity and demand of supply of securities the stock exchange permits healthy speculation

of securities.

Regulation –

Secondary Market Regulations

Secondary market regulations protect investors by curbing insider trading and through regulations
governing the buyback of shares by the company.

Insider trading: An insider is any person, who is or deemed to be or was connected with the company
and who is reasonably expected to have access, by virtue of such a connection, to unpublished, price
sensitive information about the securities of the company. Unpublished, price-sensitive information
pertains to any information which is of direct or indirect concern to the company and is not generally
known or published, but which, if published or known, might materially affect the price of the
securities of that company in the market. The following information is deemed to be price sensitive:
a. Periodical financial results;
b. intended declaration of interim/final dividends;
c. Issue of securities/buy back;
d. Major expansion/new projects;
e. amalgamation/takeovers;
f. Disposal of whole/substantial part of the undertaking; and
g. Any significant change in policies, plans, or operations of the company.
The insiders of a company (directors/promoters/officers/designated employees, and others) are
prohibited from trading in shares/ securities of the company based on unpublished, price-sensitive
information.

SEBI has given a model code of internal procedure and conduct for implementation and compliance by
companies and others associated with the securities market. As per the code:
 The compliance officer of the company (a senior level employee) is made responsible for the
preservation of price-sensitive information and pre-clearing of trading in securities of
designated employees and their dependents. The compliance Officer maintains a record of
designated employees who will include officers of the top three tiers of the management and
all employees of the finance department. Specific employees may also be designated by the
company for this purpose.
 The unpublished, price-sensitive information should be disclosed by the company only to
those within the company who need the information for the discharge of their duties and in
whose possession the information will not give rise to a conflict of interest or misuse.
 The company has to specify a trading period (trading window) during which trading of
securities can be done by the directors/ officers/designated employees. They cannot trade in
the company’s securities during the period when the trading window is closed.
 The trading window will be closed, among others, at the time of declaration of financial
results/dividends (interim/final), decisions are taken using price sensitive information. The
trading window for the insider will be opened 24 hours after the above information is made
public. The trading window can be closed during other periods also, at the discretion of the
company.
 All directors/officers/designated employees should get a preclearance of the transactions in
securities that they intend to deal. The company is permitted to fix a minimum threshold
limit above which such pre-clearance would be required. An application has to be made by
such a person, giving prescribed particulars to the compliance officer. Once the compliance
officer gives his approval, the person concerned has to execute the order within a week.
Moreover, if securities are acquired, the same has to be held for a minimum period of 30
days.
 The compliance officer has to place before MD/CEO/a committee all the details of the
dealings in securities by employees/ directors/officers. This is to be done on a monthly basis.
 The company has to ensure that adequate and timely disclosure of price-sensitive information
is given on continuous and immediate basis to the stock exchanges. The compliance officer
has to approve and oversee the disclosures. The company has to lay down the procedure for
responding to any queries/ requests for verification of market rumours by stock exchanges.
 The compliance officer is also responsible for deciding whether a public announcement is
necessary for verifying/denying rumours and then make the disclosure. The disclosure has to
be done through various media/company web site. Information sent to stock exchanges may
be put on the website. While dealing with institutions, only public information has to be
provided. At least two company representatives should be present at meetings with
institutions and discussions should preferably be recorded.
Buyback of shares:
The Companies (Amendment) Ordinance promulgated on October 3 1, 1998 has empowered
companies to purchase their own shares or other specified securities (referred to as “buy-back”). As the
Companies (Amendment) Bill, 1998 introduced in the House of the People has not been passed, the
ordinance was repromulgated on January 7, 1999 .Thee permission for buy back is subject to the
conditions specified by the Ordinance, including the stipulation that it should be in accordance with
regulations framed by SEBI. The SEBI regulations on buy-back apply only to listed securities and as
such unlisted securities issued through private placement or otherwise fall

outsidethepurviewofSEBIregulations
A company, authorized by a resolution passed by the board of directors at its meeting to buy back its
securities, may buy back its securities subject to the following conditions:
 It should be authorized by the articles of association of the company.
 A special resolution has been passed at the general meeting of the company authorizing the
buy back.
 If the buy back is or less than 10 percent of the total paid up equity share capital, a resolution
at the general meeting is not needed to be passed rather a simple board resolution is enough.
 Provided that no offer of buy back shall be made within three sixty five days reckoned from
the date of proceeding offer of buy back.
 The buy back is or less than 25 percent of the total paid up equity share capital and free
reserves
 The ratio of debt owned by the company is not more than twice the capital and its free
reserves after such buy back.
 All the shares or other specified securities for buy back are fully paid up.
 The buyback of shares or other specified securities listed on any recognized stock exchange is
in accordance with the regulations made by the securities and exchange board of India in
this behalf:
 The buy back in respect of shares and other specified securities other than those specified in
the aforesaid clause is in accordance with the guidelines specified.
Buyback through tender offer/buyback of odd lot specified securities
A company may buy back its specified securities from its existing securities holders on a proportionate
basis. The offer for buyback remains open to the members for a period not less than 15 days and not
exceeding 30 days. The date of the opening of the offer cannot be earlier than seven days or later than
thirty days after the specified date. The letter of offer has to be sent to the securities holders so as to
reach them before the opening of the offer. In case the number of specified securities offered by the
securities holders is more than the total number of specified securities to be bought back by the
company, the acceptances per securities holder will be on a proportionate basis. The company has to
open an escrow account on or before the opening of the buyback offer. The escrow account consists of
cash deposited with a scheduled commercial bank, bank guarantee in favor of the merchant banker, or
deposit of acceptable securities with the merchant banker, or a combination of above. The escrow
account balance will be at the rate of 25 per cent of the consideration payable if the total consideration
payable does not exceed Rs. 100 crores. If the consideration payable exceeds Rs. 100 crores, then
beyond the base level of 25 per cent, for every additional Rs. 100 crores a 10 per cent additional
balance is required.

Buyback from open market

1. A company intending to buy-back its shares from the open market shall do so in accordance
with the provisions of this Chapter.
2. The buy-back of shares from the open market may be in any one of the following methods:
a. through stock exchange
b. Book Building process.
Buyback through stock exchange
company shall buy-back its shares through the stock exchange as provided here under:
a. The special resolution referred to in regulation 5 shall specify the maximum price at which
the buy-back shall be made;
b. The buy-back of the shares shall not be made from the promoters or persons in control of the
company;
c. The company shall appoint a merchant banker and make a public announcement as referred to
in regulation 8;
d. The public announcement shall be made at least seven days prior to the commencement of
buy-back;
e. A copy of the public announcement shall be filed with the Board within two days of such
announcement along with the fees as specified in schedule IV;
f. The public announcement shall also contain disclosures regarding details of the brokers and
stock exchanges through which the buy-back of shares would be made;
g. The buy-back shall be made only on stock exchanges with electronic trading facility;
h. The buy-back of shares shall be made only through the order matching mechanism except ‘all
or none’ order matching system;
i. The company and the merchant banker shall give the information to the stock exchange on a
daily basis regarding the shares purchased for buy-back and the same shall be published in a
national daily;
j. The identity of the company as a purchaser shall appear on the electronic screen when the
order is placed.

Functions of Stock Exchanges –

1. Continuous market for securities
The Investors are able to invest in good securities and in case of any risk, it enables people to switch
over from one security to another. So stock markets provides a ready and continuous opportunities for
securities.

2. Evaluation of securities
It the stock exchange, the prices of securities clearly indicate the performance of the companies. It
integrates the demand and supply of securities in an effective manner. It also clearly indicates the
stability of companies. Thus, investors are in a better position to take stock of the position and invest
according to their requirements.

3. Mobilizes savings
The savings of the public are mobilized through mutual funds, investments trusts and by various other
securities. Even those who cannot afford to invest in huge amount of securities are provided
opportunities by mutual funds and investment trusts.

4. Healthy speculation
The stock exchange encourages healthy speculation and provides opportunities to shrewd businessmen
to speculate and reap rich profits from fluctuations in security prices. The price of security is based
on supply and demand position. It creates a healthy trend in the market. Any artificial scarcity is
prevented due to the rules and regulations of the market.
5. Mobility of funds
The stock exchange enables both the investors and the companies to sell or buy securities and thereby
enable the availability of funds. By this, the money market also is strengthened as even short-term
funds are available. The banks also provide funds for dealing in the stock exchanges.
6. Stock exchange Protect investors
As only genuine companies are listed and the activities of the stock exchange are controlled, the funds
of the investors are very much protected.

7. Stock exchange helps Capital formation

Stock exchange plays an active role in the capital formation in the country. Companies are able to raise
funds either by issuing more shares through rights shares or bonus shares. But when a company wants
to go in for diversification, they can issue the shares and raise more funds. Thus, they are able to
generate more capital and this promotes economic growth in the country.
Stock exchanges also creates the habit of saving, investing and risk bearing amongst the investing
public.

8. Liquidity in Stock Exchange

Institutions like banks can invest their idle funds in the stock exchange and earn profit even within a
short period. When necessity arises , these securities can be immediately sold for raising funds. Thus, it
is the stock exchange which provides opportunities for converting securities into cash within a short
notice.

9. Economic barometer
The most important function of a stock exchange is that it acts as an economic indicator of conditions
prevailing in the country. A politically and economically strong government will have an upward trend
in the stock market. Whereas an unstable government with heavy borrowings from other countries will
have a downward trend in the stock market. So, every government will adopt policies in such a manner
that the stock exchange remains dynamic.

10. Control on companies

One of the major function of stock exchange is that it has control on companies. The companies listing
their securities in the stock exchange has to submit their annual report and audited balance sheet to the
stock exchange. Thus, only genuine companies can function and have the shares transacted. If not,
such companies will be black listed and they will find it difficult to raise their capital.
11. Attracts foreign capital
Due to its dynamism and higher return on capital, the stock exchange is capable of attracting more
foreign funds. Due to this, the exchange rate of the currency will improve when there is more trade
undertaken by the government.
12. Monetary and fiscal policies
The monetary policy and the fiscal policy of the government have to be favorable to businessmen and
producers. If they are not so, then through the stock exchange the government may indicate and
accordingly suitable steps can be taken.
13. Safety of Capital and Fair Dealing
The stock exchange transactions are made publicly under well defined rules and regulations and bye-
laws. This factor ensures a great measure of safety and fair dealings to the average investors.

14. Proper Canalization of Capital

Stock exchange directs the flow of savings into the most productive and profitable channels.

15. Regulation of Company management

The companies, which want to get their securities listed in the stock exchange, should have to follow
certain rules and fulfill certain conditions. Thus stock exchanges safeguards the interest of the
investing public and also regulates company management.

Listing –

Listing means the admission of securities of a company to trading on a stock exchange. Listing is not
compulsory under the Companies Act 2013/1956. It becomes necessary when a Public Limited
Company wants to issue shares or debentures to the public. When securities are listed on a stock
exchange, the company has to comply with the requirements of the exchange.

The listing provides an exclusive privilege to securities on the stock exchange. Only listed shares are
quoted on the stock exchange. Stock exchange provides transparency in transactions of listed securities
and equality and competitive conditions. Listing is beneficial for the company, to the investor, and to
the public at large.

Objectives of Listing

 To provide liquidity to securities

 To provide a mechanism for effective control and supervision of trading
 To mobilize savings for economic development
 To provide free negotiability to stocks.
 Ability to raise further capital

Eligibility Criteria
1. Applicant Company, desirous of getting listed should comply with the required Eligibility criteria as
prescribed by the stock exchange. Minimum Listing Requirements for New Companies-

 The minimum post-issue paid-up capital of the company shall be INR. 10 Crore for IPOs and
INR.3 crore for FPOs, and
 The minimum issue size shall be INR. 10 crore, and
 The minimum market capitalization of the Company shall be INR. 25 crore ;
 Default in compliance with the listing agreement shall not be done by applicant, promoters and
/or group companies
 In addition to the above eligibility criteria, certain conditions prescribed under SEBI ICDR
(Issue of Capital & Disclosure Requirements) Regulations, 2009.
 The issuer shall comply with all the applicable guidance, regulations interlaid from
 Securities Contracts (Regulations) Act 1956
 Securities Contracts (Regulation) Rules 1957
 Securities and Exchange Board of India Act 1992
 And any other circular, clarifications, guidelines issued by the appropriate authority.
 Companies Act 2013/1956

2. Permission to Use the Name of BSE Listing Process in Issuer Company’s Prospectus

Companies have to take prior approval from BSE to use the name of BSE in their prospectus or offer
for sale documents before filing the same with the concerned office of the Registrar of Companies

3. Submission of Letter of Application

A Letter of Application need to be submitted to all the stock exchanges where they want to get it listed
before filing to the Concerned ROC

4. Allotment of Securities

As per the Listing Agreement, a company is required to complete the allotment of securities within 30
days of the date of closure of the subscription list to the public

5. Trading Permission

After the completion of allotment, within 7 working days, the issuer Company has to complete the
formalities for trading at all the stock exchanges, where the securities are to be listed.

6. The requirement of 1% Security

Companies have to deposit 1% of the issue amount with the designated stock exchange before the issue
opens.

7. Listing Fees

All listed companies are required to pay to BSE, an Annual Listing Fees by 30th April of every
financial year

8. Compliance with the Listing Agreement

When companies get listed at stock exchanges, whether it is BSE/NSE Listing Process they are
required to enter into an agreement which is called the listing Agreement under which they are
required to file certain compliances and disclosures which are given by listing Agreement, failing
which the company may face some disciplinary action, including suspension/delisting of securities.
Under listing agreements, all the terms and conditions are written on the basis of which the company
has to perform like

 provide facilities for direct transfer, registration, sub-division, and consolidation of securities;
 send proper notices of the closure of transfer books and record dates, forward 6 copies of
Annual Reports, Balance Sheets and Profit and Loss Accounts to BSE
 to file shareholding patterns and financial results on a quarterly basis;
 to intimate Exchange the happenings which are likely to materially affect the financial
performance of the Company and its stock prices,
 to comply with the conditions of Corporate Governance, etc.

Financial Services Sector Problems and Reforms

In India, a decade old on-going financial reforms have transformed the operating environment of the
finance sector from an administrative regime to a competitive market base system. Since mid-1991, a
number of reforms have been introduced in the financial sector in India. Rangarajan once noted that
domestic financial liberalization has brought about the deregulation of interest rates, dismantling of
directed credit, reforming the banking system, improving the functioning of the capital market,
including the government securities market. The main emphasis on the financial sector reform has
been on the banking system so as to improve the performance of public sector banks. The Narasimhan
Committee constituted in 1991 laid the foundation for the revamping of the financial sector in
India. The Committee had submitted two reports– in 1992 and 1998 which gave immense importance
on enhancing the efficiency and viability of this sector.

Taking a cue from the developments in the finance sector taking place globally, India undertook
structural changes by way of these reforms and successfully relaxed the external constraints in its
operation i.e. reduction in Cash Reserve Ratio and Statutory Liquidity Ratio, capital adequacy reforms,
restructuring and recapitulation of banks and enhancement in the competitive element in the market
through the entry of new banks. Banks in India had to give a go-by to their traditional operational
methods of directed credit, fixed interest rates and directed investments, all of which, had the effect of
deteriorating the quality of loan portfolios and inadequacy of capital and erosion of profitability.
Another prominent consequence of the reforms was the sprouting up of a number of banks due to the
entry of new private and foreign banks, increased transparency in the banking system through the
introduction of prudential norms and increase in the role of the market forces due to the deregulated
interest rates. All these measures lead to major changes in the operational environment of the finance
sector.

Objectives of Financial Sector Reforms in India

The primary objective of financial sector reforms in the 1990s was to create an efficient, competitive
and stable that could contribute in greater measure to stimulate growth. Economic reform process took
place amidst two serious crises involving the financial sector:

1. The crisis involving the balance of payments that had threatened the international credibility of
the country and dragged it towards the brink of default.
2. The crisis involving the grave threat of insolvency threatening the banking system which had
concealed its problems for years with the aid of defective accounting policies.

Apart from the above two dilemmas, there were many deeply rooted problems of the Indian economy
in the early 1990s which were strongly related to the finance sector. Prevalent among these were:

 Till the early 1990s, the Indian financial sector could be described as an example of financial
repression. The sector was characterized by administered interest rates fixed at unrealistically
low levels, large pre-emption of resources by authorities and micro regulations which direct
the major flow of funds back and forth from the financial intermediaries.
 The act of the government involving large scale pre-emption of resources from the banking
system to finance its fiscal deficit.
 More than necessary structural and micro-regulation that inhibited financial innovation and
increased transaction costs.
 Relatively inadequate level of prudential regulation in the financial sector.
 Inadequately developed debt and money markets.
 Obsolete and out-dated technological and institutional structures that lead to the consequent
inefficiency of the capital markets and the rest of the financial system.
 Till the early 1990s, the Indian financial system was characterized by extensive regulations viz.
administered interest rates, weak banking structure, directed credit programmes, lack of proper
accounting, risk management systems and lack of transparency in operations of major financial
market participants. Furthermore, this period was characterized by the restrictive entry of
foreign banks since after the nationalization of banks in 1969 and 1980, almost 90 per cent of
the banking assets were under the control of government owned banks and financial
institutions. The financial reforms initiated in this era attempted to overcome these weaknesses
with the view of enhancing efficient allocation of resources in the Indian economy.

The Reserve Bank of India had been making efforts since 1986 to develop efficient and healthy
financial markets which were accelerated after 1991. RBI focused on the development of financial
markets especially the money market, government securities market and the forex markets. Financial
markets also benefited from close coordination between the Central Government and the RBI as also
between the other regulators.

Major Contours of the Financial Sector Reforms in India

On a general understanding, there are three groups of reform measures that are used to handle the
problems faced by the financial sector. These are that of removal of financial repression, rehabilitation
of the banking system and lastly, deepening and development of capital markets.

The focal issues addressed by financial sector reforms in India have primarily aimed to include the
following:

1. Removal of the problem of financial repression.

2. Creation of an efficient, profitable and healthy financial sector.
3. Enabling the process of price discovery by market determination of interest rates which leads to
an improvement in the efficiency in the allocation of resources.
4. Providing institutions with greater operational and functional autonomy.
5. Prepping up the financial system for international exposure and competition.
6. Introduction of private equity in public sector banks and their listing.
7. Opening up of the external sector in a regulated manner.
8. Promoting financial stability in the back-drop of domestic and external shocks.

The Two Phases of Financial Sector Reforms in India

To overcome the economic crisis that plagued the Indian economy in May 1991, the government
undertook extensive economic reform policies that brought along with them an era of privatization,
deregulation, globalization and most importantly, liberalization.

The financial reforms since the 1990s can be classified into two phases. The first phase, also known as
the first generation reforms, was aimed at the creation of an efficient, productive, profitable and
healthy financial sector which would function in an environment of functional autonomy and
operational flexibility. The first phase was initiated in 1992 based on the recommendations of the
Committee on Financial System. While the early phase of reforms was being implemented, the global
economy was also witnessing prominent changes coinciding with the movement towards global
integration of financial services. Narasimhan Committee I noted that the objective of Financial Sector
Reforms in India should not focus on correcting the present financial weaknesses but should strive to
eliminate the roots of the cause of the present challenges being faced by the Indian market economy.

The second generation reforms or the second phase commenced in the mid-1990s and laid greater
emphasis on strengthening the financial system and on the introduction of structural improvements.
Narasimhan Committee II was to look into the extent of the effectiveness of the implementation of
reforms suggested by Narasimhan Committee I and was entrusted with the responsibility to lay down a
course of future reforms for the growth and integration of the Indian banking sector with international
standards.

Principles of Financial Sector Reforms in India

Former RBI Governor, Dr. Y.V. Reddy has stated that the financial sector reforms in India are based
on Punch-sutra or five principles which are explained as follows:

1. Introduction of various measures by cautious and gradual phasing thus giving time to various
agents to carry out the necessary norms. For instance, the gradual introduction of prudential
norms.
2. Mutually reinforcing measures, that would serve as enabling reforms which would not in
anyway disrupt the confidence in the system. E.g. Improvement in the profitability of banks by
the combined reduction in refinance and Cash Reserve Ratio.
 3. Complementary nature of the reforms in the banking sector with other commensurate changes
in fiscal, external and monetary policies.
4. Development of the financial infrastructure in terms of technology, changing legal framework,
setting up of a supervisory body, and laying down of audit standards.
5. Introducing initiatives to nurture, integrate and develop money, Forex and debt market so as to
give an equal opportunity to all major banks to develop skills and to participate.

Policy Reforms in the Financial Sector

Indian financial reforms can be explained by way of a four-pronged approach viz. (a) banking reforms,
(b) debt market, (c) Forex market reforms, and (d) reforms in other segments of the financial sector.
These are explained in detail.

1. Banking Reforms

Despite the general approach of the financial sector reform process, many of the regulatory and
supervisory norms were started out first for commercial banks and thereafter were expanded to other
financial intermediaries. Banking reforms consisted of a two-fold process. Firstly, the process
involved recapitalization of banks from government resources to bring them at par with appropriate
capitalization standards. On a second level, an approach was adopted replacing privatization. Under
this, increase in capitalization has been brought about through diversification of ownership to private
investors up to a cap of 49 per cent and thus keeping majority ownership and control with the
government.

The main idea was to increase the competition in the banking system by a gradual process and unlike
other countries, banking reform in India, did not involve large-scale privatization. Due to such
widening of ownership, majority of these banks have been publicly listed which in turn has brought
about greater transparency through enhanced disclosure norms. The phased introduction of new banks
in the private sector and expansion in the number of foreign banks provided for a new level of
competition. Furthermore, increasingly tight capital adequacy norms, prudential and supervision
norms were to apply equally across all banks, regardless of their ownership.

2. Government Debt Market Reforms

A myriad of reforms have been introduced in the government securities debt market. Only in the
1990s a proper G-Sec debt market had been initiated which had progress from strategy of pre-emption
of resources from banks at administered rates of interest to a system that is more market oriented. The
main instrument of pre-emption of bank resources in the pre-reform period was through the
prescription of a Statutory Liquidity Ratio i.e. the ratio at which banks are required to invest in
approved securities. It was initially introduced as a prudential measure. The high SLR reserve
requirements lead to the creation of a captive market for government securities which were issued at
low administered interest rates. After the introduction of reforms, the SLR ratio has been brought
down to a statutory minimum level of 25 per cent. Numerous measure have been taken to broaden
the G-Sec market and to increase the transparency. Automatic monetization of the government’s deficit
has been given a go-by. At present, the market borrowings of the central government are undertaken
through a system of auctions at market-related rates.

3. Forex Market Reforms

The foreign exchange market in India had been characterized by heavy control since the 1950s
commensurate with increasing trade controls designed to foster import substitution. As a result of
these practices, the current and capital accounts were shut and Forex was made available through a
complex licensing system undertaken by the RBI. Thus, the major task before the government was to
move away from a system of total control to a market-based exchange rate system. This transformation
in 1993 and the subsequent adoption of current account convertibility were the highlights of the Forex
reforms introduced in the Indian market. Under these reforms, authorized dealers of foreign exchange
as well as banks have been given greater autonomy to carry out a wide range of activities and
operations. Furthermore, the entry of new players has been allowed in the market. The capital account
has become effectively convertible for non-residents but still has some reservations fore residents.

4. Reforms in Other Segments of the Finance Sector

Several measures have been introduced for non-banking financial intermediaries as well. Non-banking
financial companies (NBFCs) including those involved in public deposit taking activities, have been
brought under the supervision of the RBI. As for development finance institutions (DFIs), NBFCs,
urban cooperative banks, specialized term-lending institutions and primary dealers- all of these have
been brought under the regulation of the Board for Financial Supervision. Reforms were introduced in
phases for this segment as well.

Till the 1990s, insurance business was under the public ownership. After the passage of the Insurance
Regulation and Development Act in 1999, many changes have been introduced. The most prominent
amongst these was the setting up of the Insurance Regulatory and Development Agency as well as the
setting up of joint ventures to handle insurance business on a risk sharing or commission basis.

Another important step has been the setting of the Securities and Exchange Board of India as
a regulator for equity markets and to improve market efficiency and integration of national markets and
to prevent unfair practices regarding trading. The reform measures in the equity market since 1992
have laid emphasis mainly on regulatory effectiveness, enhancement of competitive conditions,
reduction of information asymmetries, development of modern technological infrastructure, mitigation
of transaction costs and lastly, controlling of speculation in the securities market. Furthermore, the
reform process had the effect of putting an end to the monopoly of the United Trust of India by
opening up of mutual funds to the private sector in 1992. Mutual funds have been permitted to open
offshore funds for the purpose of investing in equities in other jurisdictions. Another development
which took place in 1992 was the opening up of the Indian capital market for foreign institutional
investors. The Indian corporate sector has been granted permission to tap international capital
markets through American Depository Receipts, Foreign Currency Convertible Bonds, Global
Depository Receipts and External Commercial Borrowings. Moreover, now Overseas Corporate
Bodies and non-resident are allowed to invest in Indian companies.

UNIT – II :
Financial Services:
Meaning of financial services
Financial service is part of financial system that provides different types of finance through various
credit instruments, financial products and services.

In financial instruments, we come across cheques, bills, promissory notes, debt instruments, letter of
credit, etc.

In financial products, we come across different types of mutual funds. extending various types of
investment opportunities. In addition, there are also products such as credit cards, debit cards, etc.

In services we have leasing, factoring, hire purchase finance etc., through which various types of assets
can be acquired either for ownership or on lease. There are different types of leases as well as factoring
too.
Thus, financial services enable the user to obtain any asset on credit, according to his convenience and
at a reasonable interest rate.

Importance of Financial services

It is the presence of financial services that enables a country to improve its economic condition
whereby there is more production in all the sectors leading to economic growth.

The benefit of economic growth is reflected on the people in the form of economic prosperity wherein
the individual enjoys higher standard of living. It is here the financial services enable an individual to
acquire or obtain various consumer products through hire purchase. In the process, there are a number
of financial institutions which also earn profits. The presence of these financial institutions promote
investment, production, saving etc.

Hence, we can bring out the importance of financial services in the following points:

Importance of Financial Services

 Vibrant Capital Market.
 Expands activities of financial markets.
 Benefits of Government.
 Economic Development.
 Economic Growth.
 Ensures Greater Yield.
 Maximizes Returns.
 Minimizes Risks.
 Promotes Savings.
 Promotes Investments.
 Balanced Regional Development.
  Promotion of Domestic & Foreign Trade.
1. Promoting investment
The presence of financial services creates more demand for products and the producer, in order to meet
the demand from the consumer goes for more investment. At this stage, the financial services comes to
the rescue of the investor such as merchant banker through the new issue market, enabling the producer
to raise capital.
The stock market helps in mobilizing more funds by the investor. Investments from abroad is attracted.
Factoring and leasing companies, both domestic and foreign enable the producer not only to sell the
products but also to acquire modern machinery/technology for further production.

2. Promoting savings
Financial services such as mutual funds provide ample opportunity for different types of saving. In
fact, different types of investment options are made available for the convenience of pensioners as well
as aged people so that they can be assured of a reasonable return on investment without much risks.
For people interested in the growth of their savings, various reinvestment opportunities are provided.
The laws enacted by the government regulate the working of various financial services in such a way
that the interests of the public who save through these financial institutions are highly protected.

Financial Services offered by various financial institutions

 Factoring.
 Leasing.
 Forfaiting.
 Hire Purchase Finance.
 Credit card.
 Merchant Banking.
 Book Building.
 Asset Liability Management.
 Housing Finance.
 Portfolio Finance.
 Underwriting.
 Credit Rating.
 Interest & Credit Swap.
 Mutual Fund.
3. Minimizing the risks
The risks of both financial services as well as producers are minimized by the presence of insurance
companies. Various types of risks are covered which not only offer protection from the fluctuating
business conditions but also from risks caused by natural calamities.

Insurance is not only a source of finance but also a source of savings, besides minimizing the risks.
Taking this aspect into account, the government has not only privatized the life insurance but also set
up a regulatory authority for the insurance companies known as IRDA, 1999 (Insurance Regulatory
and Development Authority) .
4. Maximizing the Returns
The presence of financial services enables businessmen to maximize their returns. This is possible due
to the availability of credit at a reasonable rate. Producers can avail various types of credit facilities for
acquiring assets. In certain cases, they can even go for leasing of certain assets of very high value.

Factoring companies enable the seller as well as producer to increase their turnover which also
increases the profit. Even under stiff competition, the producers will be in a position to sell their
products at a low margin. With a higher turnover of stocks, they are able to maximize their return.
5. Ensures greater Yield
As seen already, there is a subtle difference between return and yield. It is the yield which attracts
more producers to enter the market and increase their production to meet the demands of the consumer.
The financial services enable the producer to not only earn more profits but also maximize their
wealth.

Financial services enhance their goodwill and induce them to go in for diversification. The stock
market and the different types of derivative market provide ample opportunities to get a higher yield
for the investor.
6. Economic growth
The development of all the sectors is essential for the development of the economy. The financial
services ensure equal distribution of funds to all the three sectors namely, primary, secondary and
tertiary so that activities are spread over in a balanced manner in all the three sectors. This brings in
a balanced growth of the economy as a result of which employment opportunities are improved.
The tertiary or service sector not only grows and this growth is an important sign of development of
any economy. In a well developed country, service sector plays a major role and it contributes more to
the economy than the other two sectors.

7. Economic development
Financial services enable the consumers to obtain different types of products and services by which
they can improve their standard of living. Purchase of car, house and other essential as well as
luxurious items is made possible through hire purchase, leasing and housing finance companies. Thus,
the consumer is compelled to save while he enjoys the benefits of the assets which he has acquired
with the help of financial services.

8. Benefit to Government
The presence of financial services enables the government to raise both short-term and long-term funds
to meet both revenue and capital expenditure. Through the money market, government raises short
term funds by the issue of Treasury Bills. These are purchased by commercial banks from out of their
depositors’ money.
In addition to this, the government is able to raise long-term funds by the sale of government securities
in the securities market which forms apart of financial market. Even foreign exchange requirements of
the government can be met in the foreign exchange market.

The most important benefit for any government is the raising of finance without offering any security.
In this way, the financial services are a big boon to the government.

9. Expands activities of Financial Institutions

The presence of financial services enables financial institutions to not only raise finance but also get an
opportunity to disburse their funds in the most profitable manner. Mutual funds, factoring, credit
cards, hire purchase finance are some of the services which get financed by financial institutions.
The financial institutions are in a position to expand their activities and thus diversify the use of their
funds for various activities. This ensures economic dynamism.

10. Capital Market

One of the barometers of any economy is the presence of a vibrant capital market. If there is hectic
activity in the capital market, then it is an indication of the presence of a positive economic condition.
The financial services ensure that all the companies are able to acquire adequate funds to boost
production and to reap more profits eventually.
In the absence of financial services, there will be paucity of funds which will adversely affect the
working of companies and will only result in a negative growth of the capital market. When the capital
market is more active, funds from foreign countries also flow in. Hence, the changes in capital
market is mainly due to the availability of financial services.
11. Promotion of Domestic and Foreign Trade
Financial services ensure promotion of domestic as well as foreign trade. The presence of factoring and
forfaiting companies ensures increasing sale of goods in the domestic market and export of goods in
the foreign market. Banking and insurance services further contribute to step up such promotional
activities.
12. Balanced Regional development
The government monitors the growth of economy and regions that remain backward economically are
given fiscal and monetary benefits through tax and cheaper credit by which more investment is
promoted. This generates more production, employment, income, demand and ultimately increase in
prices.
The producers will earn more profits and can expand their activities further. So, the presence of
financial services helps backward regions to develop and catch up with the rest of the country that has
developed already.

Nature and Scope of Financial Services

Financial services refer to economic services provided by various financial institutions that deal with
the management of money. It is an intangible product of financial markets like loans, insurance, stocks,
credit card, etc. Financial services are products of institutions such as banking firms, insurance
companies, investment funds, credit unions, brokerage firms, and consumer finance companies.
Nature of Financial Services
Nature of Financial Services
1. Customer Oriented: Financial services are customer-focused services that are offered
as per the requirements of customers. Financial institutions properly study customer
needs before designing and offering such services. They are meant to fulfill the specific
needs of a customer which differs from person to person.
2. Intangibility: These services are intangible which makes their marketing a challenging
task for financial institutions. Such institutions need to focus on building their brand
image by providing innovative and quality products to customers. Firms enjoying better
credibility in market are easily able to sell off their products.
3. Inseparable: Financial services are produced and delivered at the same time
simultaneously. These services are inseparable and can’t be stored in advance. Here
production and supply function both occurs at the same time.
4. Manages Fund: Financial services are specialized at managing funds of people. These
services enable peoples in allocating their idle lying funds into useful means for earning
revenues. Financial services provide various means to people for converting their
savings into investment.
5. Financial Intermediation: These services does the work of financial intermediation as
it brings together the lender and borrower. Financial services mobilize the funds of
people who are having enough of it and made it available to the one who are in need of
it.
6. Market Based: Financial services are market based which changes as per the changing
conditions. It is a dynamic activity which varies as per the variations in socio-economic
environment and varying needs of customers.
 7. Distributes Risk: Risk distribution is the key feature offered by financial services.
These services transfer the risk of an individual not willing to take among different
persons who all are willing to bear it. Financial institutions diversify the risk and secure
people against damages by providing them various insurance policies.
Scope of Financial Services
Financial services consist of wide range of activities which are broadly classified into 2: –
1. Traditional Activities.
2. Modern Activities.

Scope of
Financial Services

Traditional Activities
Financial intermediaries have been offering a large range of services traditionally

Related to capital and money market activities. These services are classified into 2 groups: – Fund
based activities and Non-fund based activities.
Fund Based Activities.
Fund based activities comprises of activities which are concerned with acquiring funds and assets for
clients. Different services covered under fund based activities are: Primary and secondary market
activities, dealing in money market instruments, foreign exchange market activities and involving in
hire purchase, venture capital, equipment leasing etc.

Non-fund based Activities.

These services are provided by financial intermediaries on non-fund basis and are called fees-
based services. Non-fund bases activities are specialized services offered by financial institutions to
customers in exchange for fees, commission, dividend and brokerage. This comprises of services such
as Portfolio management, issue management, stock broking, merchant banking, credit rating, debt and
capital reconstructing, bank guarantee etc.
Modern Activities
Financial intermediaries beside the traditional services offers a wide range of financial services at
present. These activities are mostly in the category of non-fund based activities.

Few of the modern activities are listed below: –

 Merger and acquisition planning and helping with their smooth carry out.
 Providing guidance in capital reconstructing to corporate customers.
 Assisting in rehabilitation and reconstruction of sick companies.
 Portfolio management of large public sector corporations.
 Providing recommendations in management style and structure for attaining better
results.
 Acting as trustees to the debentures-holders.
 Providing project advisory services ranging from project preparation to capital raising.
–
Regulatory Frame Work of Financial Services
The Financial and Corporate Service Providers Act 2000 provides for the licensing and regulation of
certain financial and corporate services in The Bahamas.

Regulated Activities

The act regulates the following activities:

 the conduct or the carrying on of financial services in or from The Bahamas, including online
financial services;

 the registration or management and administration of international business companies

incorporated or existing under the International Business Companies Act 2000;

 the provision of registered agent services and registered office services for Bahamian
international business companies (IBCs);

 the provision of directors or officers for Bahamian IBCs;

 the provision of nominee shareholders for Bahamian IBCs;

 the provision of partners for partnerships registered and existing under the Exempted Limited
Partnership Act 1995; and

 the provision of registered agent services and registered office services for partnerships
registered and existing under the Exempted Limited Partnership Act 1995.

Authorized Persons
The following persons only are authorized to provide the regulated services: (i) banks and trust
companies licensed under the Banks and Trust Companies Regulation Act 2000, and (ii) persons
licensed as financial and corporate service providers under the Financial and Corporate Service
Providers Act.

Individuals or organizations conducting the business of financial and corporate services, including
registered agent services, immediately prior to the commencement of the Financial and Corporate
Service Providers Act are required to submit an application for a licence to the inspector within three
months of the commencement date of the act (December 29 2000).

Criteria for Obtaining a Licence

In granting a licence, the inspector will consider the following:

 whether the applicant is a fit and proper person;

 whether the applicant is qualified to carry out the business of a financial and corporate service
provider;

 the professional reputation and experience of the applicant;

 whether each officer, director or manager of the applicant is a fit and proper person to act as
such;

 in the case of an application by a partnership, whether each partner is a fit and proper person to
act as such; and

 whether the applicant, if an individual, is resident in The Bahamas or, if a company, is

registered under the Companies Act.

In the event that the inspector refuses to grant a licence, the applicant may appeal to the court against
the decision.

A licence is valid for one year, until December 31 of each year, and renewable annually thereafter as of
January 1, subject to the payment of a renewal fee. The criteria for renewing a licence are identical to
those items considered upon submission of an application for a licence.

Register of Licensees
The inspector will maintain a register of licensees, which will be opened to the public. The name,
address and location of the registered office of each licensee, and the date on which the licence was
issued, will be stated therein.

Functions of the Inspector

The inspector's role is to maintain a general review of financial and corporate services in The Bahamas.
On an annual basis and when required by the minister of finance, the inspector also conducts on-site
and off-site examinations of the licensee's business, at the expense of the licensee, in order to ensure
that the licensee is in compliance with the provisions of the Financial and Corporate Service Providers
Act, the Financial Transaction Reporting Act 2000, the International Business Companies Act 2000
and any other laws. In such cases, where the inspector is unable to conduct such examination, he may
appoint an auditor, at the expense of the licensee, to conduct such examination and to report thereon.

Powers of the Inspector

With respect to the performance of his duties under the act, the inspector has the power to require a
licensee to (i) produce for examination its books, records and other documents that it is required to
maintain pursuant to the provisions of the Financial and Corporate Service Providers Act, and (ii)
supply such information or explanation as the inspector may reasonably require for the purpose of
enabling him to perform his functions under the act.

Duties of a Licensee

A licensee has the following duties under the act:

 to maintain a high standard of professional conduct in the performance of its duties and refrain
from engaging itself or any of its employees in any illegal or improper conduct. This includes
engaging in any activity, in or outside of The Bahamas, which may reflect negatively on other
service providers or on the reputation of the country as an international financial centre;

 to verify the identity of each client upon receipt of instructions; and

 to maintain a record of each client for a period of at least six years from the date of termination
of such relationship.

Suspension or Revocation of Licences

Where the inspector is of the opinion that a licensee is in contravention of any provision under the
Financial and Corporate Service Providers Act or any other law, he may require the licensee
immediately to take such steps as may be necessary to rectify the contravention, and suspend the
licensee's licence for a maximum period of 30 days. A suspension for a longer period requires a court
order and in such instance may only be for a maximum period of 60 days.

The inspector may revoke the licence of a licensee if:

 the inspector is of the opinion that the licensee is carrying on its business in a manner that is
detrimental to the public interest, the interest of the companies managed by him or the
reputation of The Bahamas;

 the licensee has ceased to carry on financial and corporate services; or

 the licensee becomes bankrupt or goes into liquidation, or is wound up or otherwise dissolved.

A licensee may appeal to the court a decision by the inspector to suspend or revoke its licence.

Offences under the Act

The offences under the act are as follows:

 Any person who engages in or carries on the business of financial corporate services in or from
within The Bahamas without a licence commits an offence and is liable upon summary
conviction to a fine of $75,000. Where the offence continues subsequent to conviction that
person is liable to a fine of $1,000 for each day that the offence continues.

 A person who, with intent to deceive, contravenes any provision or requirement of the act by
any action or omission commits an offence and is liable upon summary conviction to a fine of
$100,000.

 Any licensee who invites, either directly or indirectly by advertisement, other parties to commit
breaches of the law of the country in which such advertisement appears, or to which such
advertisement is directed, commits an offence and is liable upon summary conviction to a fine
of $50,000. Such liability is imputed to every director and officer concerned with the
management of a company convicted for this offence, unless such director or officer satisfies
the court that the offence was committed without his knowledge or consent, or that he took all
reasonable steps to prevent commission of the offence.

 Any person who, with intent to deceive, for any purposes of the act makes any representation
that he knows to be false or does not believe to be true commits an offence and is liable upon
 summary conviction to a fine of $100,000.

 Any person who assaults or obstructs the inspector or his appointee in the performance of his
functions, or contravenes any provision of the act for which no punishment is specially
provided, commits an offence and is liable upon summary conviction to a fine of $10,000.

 Any licensee who fails to comply with the record-keeping requirement of the act commits an
offence and is liable upon summary conviction to a fine of $50,000.

Growth of Financial Services in India

The present growth rate of financial sector in India is about 8.5% p.a. An increase in growth rate is
equivalent to growth of our economy.Over the past few years,there have been reforms in monetary
policies,economicpolicies,opening up of financial markets,development of other financial sectors
e.t.c.In present times,a wide variety of financial products and services are offerred to consumers to
keep them satisfied.The Reserve Bank of India has also played a major role to help in growth of
financial sector of India.

The diversified financial sector of India comprises of banks,mutualfunds,insurancecompanies,pension

funds e.t.c.Do you know that the banking sector in India holds more than 60% of the total financial
asstes of the country?At present ,India is without any doubts one of the world’s most vibrant capital
market.Let’s take a look at growth of some of the financial sectors of India one by one-

Growth of the banking sector

Being one of the most extensive,the entire Indian banking system has a total asset value of
approximately US$ 270 billion with total deposits being around US$ 220 billion.The banking system
in India is continuously advancing and tranformingitself.The current development of Core
banking,Internet banking e.t.c. has made banking operations easy and customer friendly.

Growth of the Capital Market in India

The capital markets in India have also witnessed changes.Some of them are-

 Stock exchanges facing privatisation.

 Removal of ill-used forward trading mechanism
 In order to serve different investors in different locations,the introduction of infotech systems in
National Stock Exchange.
 The increase in the ratio of transaction with deposit system and share ratio.

Growth in the Insurance sector in India

 The market potential in India is immense.But it is untapped.So now in order to utilise this
opportunity,both foreign and Indian private players are providing tailor made products with
opening of the market.
  Because of huge competiton and entry of new players,the insurance sector has also witnessed
innovations like innovative insurance based products,services and value ass-onse.t.c.
 Many foreign companies like New York Life,Aviva,Standard Life have also entered this sector.
 Now a days,the insurance companies are engaged in aggressive marketing,selling and
distribution techniques because of the extreme competition that they face from each other..
 The credit for the development of this sector also goes to the active part of the regulatory body
–Insurance Regulatory and Development Authority.

Growth of the Venture Capital market in India

 Inspite of the hindrances by the external setup,the venture capital sector in India is a very active
financial sector.
 In India,currently,there are around 2 international and 34 national venture capital funds
registered by SEBI.

Merchant Banking
Every corporation whether it is emerging or establish, require funds at some stage during its operation
and raise capital from the financial market is the most popular and convenient mode of arranging
finance. Hence, the business corporates raise from the market by issuing financial securities and on the
other hand individuals or institutional investors purchase these securities to invest their money to earn
a profit.

Thus the role of merchant banks emerges in such circumstances. In this topic, we will learn the concept
of Merchant Banking in brief.

Table of Contents
Merchant Banking:

“Merchant Banking refers to the financial intermediary services provided by specialised banks called
Merchant Bank (other than commercial banks) for business corporates and individual with high net
worth.”

Merchant banks act as an intermediary/ middleman between business corporates and investors. In other
words, merchant banking is financial intermediation between the business entities which require funds
and the investors who possess ready capital and seeking an opportunity for investment so that they can
make a return.

Thus, we can say that Merchant banking matches the gap between the issuer of capital (Corporates)
and purchaser of capital (Investors). Hence, it is the function that facilitates the flow of capital in
the financial system.

Role of Merchant Banking:

 Merchant Banking facilitates in channelising the financial surplus of the general public
into productive investment avenues.
 It coordinates the activities of various intermediaries to share issue.
 It ensures compliance with rules and regulations governing the securities market.
  Merchant banking is said to be the centre of capital market operations and their
activities are primarily non-fund based.
 Their basic requirement is a high professional with skills and worldwide contact.
Merchant Banking- Origin:

The concept of merchant banking is originated in the 13th century from Italy and the first-ever
merchant banks were Riccardi of Luca, Medici, Fugger etc. Initially, there was no distinction between
the functions of commercial banking and merchant banking until 1932.

The merchant banks are also known as “Accepting and Issuing Houses” in the United Kingdom and
they are known as Investment Banks in the United States as well.

Merchant Banking in India:

Merchant Banking Service in India was originated in 1969 when the merchant banking division of
Grindlays Bank was initiated for undertaking and management of the public issue and financial
consultancy. Further, State Bank of India stated merchant banking service in 1973 and ICICI Bank Ltd
became the first development financial institution to initiate merchant banking services in 1974.

During mid-seventies, India witnessed a boom in the growth of merchant banking organisations which
were sponsored by the banks, NBFCs, Brokers etc. This led to the diversification into the scope of the
following activities.

 Loan Syndication
 Portfolio Management
 Corporate Counselling
 Project Counselling
 Debenture Trusteeship
 Mergers and Acquisitions
However, the scope of such services was neither defined nor any rules and regulation were set up to
govern such activities. Then in 1992, the formation of SEBI (Securities of Exchange Board of
India) was taken place. This became a landmark in the evolution of merchant banking as a professional
service in the country.

Merchant Banker Functions:

Although merchant banks provide numerous services to their client these days, some of the most
significant functions of merchant banks are explained below.
1) Underwriting of Debt and Equity:

Underwriting/ management of debt securities such as debentures and share capital is one of the most
important functions of a merchant banker. The merchant banks act as middlemen between the issuer of
debt securities and individual or institutional investor and assists the companies in raising funds from
the market. Merchant banks evaluate the value of the business and the number of shares or debentures
is to be issued.

2) Placement and Distribution:

The merchant bankers facilitate in distributing various securities like equity shares, debt instruments,
mutual funds, fixed deposits, insurance policies, commercial papers and distribution network of the
merchant banker can be classified as institutional and retail.

3) Corporate Advisory Services:

Merchant bankers offer customised solutions to their clients’ financial problems and financial
structuring includes determining the right debt-equity ratio and gearing ratio for the client and
appropriate capital structure theory is framed as well.

Merchant banker explores the refinancing alternatives for the client and evaluates cheaper sources of
funds. It also provides Rehabilitation, Turnaround and Risk management services such as designing a
revival package in coordination with banks and financial institutions for sick industrial units,
appropriate hedging strategies to reduce the risk associated.

4) Project Advisory Services:

Merchant bankers help their clients in various stages of the project undertaken by the clients:
 1. They assist them in conceptualising the project idea in the initial stage
2. Once the idea is formed, they conduct feasibility studies to examine the viability of the
proposed project
3. They also assist the client in preparing different documents like a detailed project report
5) Loan/ Credit Syndication:

Merchant bankers arrange tie-up loans for their clients. This takes place in a series of steps. Firstly they
analyse the pattern of the client’s cash flows, based on which the terms of borrowings can be defined.
Then the merchant banker prepares a detailed loan memorandum, which is circulated to various banks
and financial institutions and they are invited to participate in the syndicate. The banks then negotiate
the terms of lending based on which the final allocation is done.

6) Provide Venture Capital and Mezzanine Financing:

Merchant bankers help companies in obtaining venture capital financing for financing their new and
innovative strategies. They also help small organisations and entrepreneurs to obtain initial funding,
other business ideas and opportunities, Government policies and incentives.

In addition, merchant bankers also provide various other services as well.

7) Portfolio Management Services:

Merchant banks offer portfolio management service to their clients. They guide their clients regarding
profitable, easy liquid and less risky investment avenue. They also update their clients with important
and crucial news and updates regarding investment opportunities and market fluctuations.

8) Interest/ Dividend Management:

Merchant bankers also facilitate their client on computing, declaration and allocation of interest on
debt securities such as debentures and dividend of shares/stocks.

9) Brokerage Services:

Merchant banks also act as a broker in the stock exchange. They purchase or sell the shares on behalf
of their clients and also provide guidance on which or when to buy or sell shares.

10) Manage Money Market Instruments:

Merchant bankers also manage money market instruments like Government bonds, Treasury bills,
commercial papers, certificate of deposits for the Government entities as well as large companies and
financial institutions.

Registration of Merchant Bankers:

To function as a merchant banker, a business firm or company needs to register with SEBI and comply
with the following terms and conditions:

 The applicant should be a body corporate and should have a minimum net worth of Rs.5
crores.
 The applicant should not carry on any business other than those connected with the
securities market
 The applicant should have the necessary infrastructure like office space, equipment,
manpower etc
 The applicant must have at least two employees with prior experience in merchant
banking
 Any associate company, group company, subsidiary or the interconnected company of
the applicant should not have been a registered merchant banker.
 The applicant should not have been involved in any securities scam or proved guilt for
any offer.

Types

Types of Merchant Banks in India

The Securities and Exchange Board of India (SEBI), which is a regulatory body, has
classified ‘Merchant Bankers’ under the following four categories –

Category I Merchant Bankers:

This category contains the Merchant Bankers who can act as Issue Managers, Consultants, Advisors,
Portfolio Managers and Underwriters.

Category II Merchant Bankers:

These Merchant Bankers can act as Advisors, Consultants, Portfolio Managers and Underwriters. But
they cannot act as issue managers on their own but as Co-Managers.

Category III Merchant Bankers:

This category of Bankers is allowed to act as Advisors, Consultants and Underwriters only. They can
neither act as Issue Managers on their own nor as Co-Managers. Also, they cannot undertake portfolio
management activities.

Category IV Merchant Bankers:

This category of Merchant Bankers can only act as Advisors or Consultants regarding an issue of
capital.

Responsibilities of Merchant Bankers

Merchant banker’s role in Public Issue

1. Furnishing Information:
 Number of issues for which the merchant banker is engaged as banker to issue.
 Number of applications received and details of application money received
 Dates on which applications from investors were forwarded to issuing company.
 Details of amount as refund to investors.
2. Books to be Maintained:
 Books of accounts for a minimum period of 3 years
 Records regarding the company
 Documents such as company applications, names of investors, etc.
3. Agreement with issuing company
Agreement with the issuing company by the merchant banker should contain

 Number of collection centres

 Application money received
 Daily statement by each branch which is a collecting centre.
4. Action by RBI: Any action by RBI on merchant banker should be informed to SEBI by the
merchant banker concerned.
5. Code of Conduct
 Having high integration in dealing with clients.
 Disclosure of all details to the authorities concerned. Avoiding making exaggerated
statements.
 Disclosing all the facts to its customers.
 Not disclosing any confidential matter of the clients to third parties.
A rights issue is the offer of shares of a company to the existing shareholders. A merchant banker has
the following responsibilities in Rights issue.
Responsibilities of merchant bankers in Rights Issue

1. The merchant banker will ensure that when Rights issues are taken up by a company, the
merchant banker who is responsible for the Rights issue, shall see that an advertisement regarding the
same is published in an English national daily, in an Hindi national daily and in a regional daily.
These newspapers should be in circulation in the city / town where the registered office of the company
is located.

2. It is the duty of the merchant banker to ensure that the application forms for Rights issue should
be made available to the shareholders and if they are not available, a duplicate composite application
form is made available to them within a reasonable time.
3. If the shareholders are not able to obtain neither the original nor the duplicate application for Rights
shares, they can apply on a plain paper through the merchant banker.

4. The details that should be furnished in the plain paper, while applying for Rights shares should be
provided by the merchant hanker.

5. The merchant banker should mention in the advertisement, the company official to whom the
shareholders should apply for Rights shares.

6. The merchant banker should also inform that no individual can apply twice, in standard form as well
as in plain paper.
Regulation of Merchant Banking in India
Regulations by SEBI on Merchant Banking
Reforms for the merchant bankers
SEBI has made the following reforms for the merchant banker

1. Multiple categories of merchant banker will be abolished and there will be only one equity merchant
banker.

2. The merchant banker is allowed to perform underwriting activity. For performing portfolio manager,
the merchant banker has to seek separate registration from SEBI.
3. A merchant banker cannot undertake the function of a non-banking financial company, such as
accepting deposits, financing others’ business, etc.

4. A merchant banker has to confine himself only to capital market activities.

Recognition by SEBI on merchant bankers

SEBI will grant recognition a merchant banker after taking into account the following aspects

1. Considering how much the merchant are professionally competent.

2. Whether they have adequate capital

3. Track record, experience and general reputation of merchant bankers.

4. Quality of staff employed by merchant bankers, their adequacy and available infrastructure are taken
into account. After considering the above aspects, SEBI will grant permission for the merchant banker
to start functioning.

Conditions by SEBI for merchant bankers

SEBI has laid the following conditions on the merchant bankers, for conducting their operations. They
are

1. SEBI will give authorization for a merchant banker to operate for 3 years only. Without SEBI’s
authorization, merchant bankers cannot operate.

2. The minimum net worth of merchant banker should be Rs. 1 crore.

3. Merchant banker has to pay authorization fee, annual fee and renewal fee.

4. All issue of shares must be managed by one authorized merchant banker. It should be the lead
manager.

5. The responsibility of the lead manager will be clearly indicated by SEBI.

6. Lead managers are responsible for allotment of securities, refunds, etc.

7. Merchant banker will submit to SEBI all returns and send reports regarding the issue of shares.
8. A code of conduct for merchant bankers will be given by SEBI, which has to be followed by them.

9. Any violation by the merchant banker will lead to the revocation of authorization by SEBI.

Leasing
WHAT IS A LEASE OR LEASING?
A famous quote by Donald B. Grant says, “Why own a cow when the milk is so cheap? All you really
need is milk and not the cow.” The concept of Lease is influenced by this quote. We can compare
‘milk’ with the ‘rights to use an asset’ and ‘cow’ with the ‘asset’ itself. Ultimately, a person who wants
to manufacture a product using machinery can get to use that machinery under a leasing arrangement
without owning it.
A lease can be defined as an arrangement between the lessor (owner of the asset) and the lessee (user
of the asset) whereby the lessor purchases an asset for the lessee and allows him to use it in exchange
for periodical payments called lease rentals or minimum lease payments (MLP). Leasing is beneficial
to both the parties for availing tax benefits or doing tax planning.
At the conclusion of the lease period, the asset goes back to the lessor (the owner) in an absence of any
other provision in the contract regarding compulsory buying of the asset by the lessee (the user). There
are four different things possible post-termination of the lease agreement.
 The lease is renewed by the lessee perpetually or for a definite period of time.
 The asset goes back to the lessor.
 The asset comes back to the lessor and he sells it off to a third party.
 Lessor sells to the lessee.
PURPOSE OF LEASING
The purpose of choosing a lease can be many. Generally, a lease is structured for the following
reasons.
BENEFITS OF TAXES
The tax benefit is availed to both the parties, i.e. Lessor and Lessee. Lessor, being the owner of the
asset, can claim depreciation as an expense in his books and therefore get the tax benefit. On the other
hand, the lessee can claim the MLPs i.e. lease rentals as an expense and achieve tax benefit in a similar
way.
AVOID OWNERSHIP AND THEREBY AVOIDING RISKS OF OWNERSHIP
Ownership is avoided to avoid the investment of money into the asset. It indirectly keeps the leverage
low and hence opportunities of borrowing money remain open for the business. A Lease is an off-
balance sheet item.
ADVANTAGES OF LEASING
BALANCED CASH OUTFLOW
The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over
several years, hence saving the burden of one-time significant cash payment. This helps a business to
maintain a steady cash-flow profile.
QUALITY ASSETS
While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays
the rental expense. Given this agreement, it becomes plausible for a business to invest in good quality
assets which might look unaffordable or expensive otherwise.

BETTER USAGE OF CAPITAL

Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for
the business to fund its other capital needs or to save money for a better capital investment decision.
TAX BENEFIT
Leasing expense or lease payments are considered as operating expenses, and hence, of interest, are tax
deductible.

OFF-BALANCE SHEET DEBT

Although lease expenses get the same treatment as that of interest expense, the lease itself is treated
differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on the
company’s balance sheet.

BETTER PLANNING
Lease expenses usually remain constant for over the asset’s life or lease tenor or grow in line
with inflation. This helps in planning expense or cash outflow when undertaking a budgeting exercise.
LOW CAPITAL EXPENDITURE
Leasing is an ideal option for a newly set-up business given that it means lower initial cost and lower
CapEx requirements.

NO RISK OF OBSOLESCENCE
For businesses operating in the sector, where there is a high risk of technology becoming obsolete,
leasing yields great returns and saves the business from the risk of investing in a technology that might
soon become out-dated. For example, it is ideal for the technology business.
TERMINATION RIGHTS
At the end of the leasing period, the lessee holds the right to buy the property and terminate the leasing
contract, thus providing flexibility to business.

DISADVANTAGES OF LEASING
LEASE EXPENSES
Lease payments are treated as expenses rather than as equity payments towards an asset.

LIMITED FINANCIAL BENEFITS

If paying lease payments towards a land, the business cannot benefit from any appreciation in the value
of the land. The long-term lease agreement also remains a burden on the business as the agreement is
locked and the expenses for several years are fixed. In a case when the use of asset does not serve the
requirement after some years, lease payments become a burden.
REDUCED RETURN FOR EQUITY HOLDERS
Given that lease expenses reduce the net income without any appreciation in value, it means limited
returns or reduced returns for an equity shareholder. In such a case, the objective of wealth
maximization for shareholders is not achieved.
DEBT
Although lease doesn’t appear on the balance sheet of a company, investors still consider long-term
lease as debt and adjust their valuation of a business to include leases.

LIMITED ACCESS TO OTHER LOANS

Given that investors treat long-term leases as debt, it might become difficult for a business to tap
capital markets and raise further loans or other forms of debt from the market.

PROCESSING AND DOCUMENTATION

Overall, to enter into a lease agreement is a complex process and requires thorough documentation and
proper examination of an asset being leased.

NO OWNERSHIP
At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though
quite a good sum of payment is being done over the years towards the asset.
MAINTENANCE OF THE ASSET
The lessee remains responsible for the maintenance and proper operation of the asset being leased.

LIMITED TAX BENEFIT

For a new start-up, the tax expense is likely to be minimal. In these circumstances, there is no added
tax advantage that can be derived from leasing expenses.

types of Leases
Types of leases:
Different types of Leasing
1. Financial Lease
Financial leasing is a contract involving payment over a longer period. It is a long-term lease and the
lessee will be paying much more than the cost of the property or equipment to the lessor in the form of
lease charges. It is irrevocable. In this type of leasing the lessee has to bear all costs and the lessor does
not render any service.

2. Operating Lease
In an operating lease, the lessee uses the asset for a specific period. The lessor bears the risk of
obsolescence and incidental risks. There is an option to either party to terminate the lease after giving
notice. In this type of leasing

 lessor bears all expenses

 lessor will not be able to realize the full cost of the asset
  specialized services are provided by the lessor.
This kind of lease is preferred where the equipment is likely to suffer obsolescence.

3. Leveraged and non-leveraged leases

In leveraged and non-leveraged leases, the value of the asset leased may be of a huge amount which
may not be possible for the lessor to finance. So, the lessor involves one more financier who will have
charge over the leased asset.

4. Conveyance type lease

In Conveyance type lease, the lease will be for a long-period with a clear intention of conveying the
ownership of title on the lessee.

5. Sale and leaseback

In a sale and leaseback, a company owning the asset sells it to the lessor. The lessor pays immediately
for the asset but leases the asset to the seller. Thus, the seller of the asset becomes the lessee. The asset
remains with the seller who is a lessee but the ownership is with the lessor who is the buyer. This
arrangement is done so that the selling company obtains finance for running the business along with
with the asset.

6. Full and non-pay-out lease

A full pay-out lease is one in which the lessor recovers the full value of the leased asset by way of
leasing. In case of a non pay-out lease, the lessor leases out the same asset over and over again.

7. Specialized service lease

The lessor or the owner of the asset is a specialist of the asset which he is leasing out. He not only
leases out but also gives specialized personal service to the lessee. Examples are electronic goods,
automobiles, air-conditioners, etc.

8. Net and non-net lease

In non-net lease, the lessor is in charge of maintenance insurance and other incidental expenses. In a
net lease, the lessor is not concerned with the above maintenance expenditure. The lessor confines only
to financial service.

9. Sales aid lease

In case, the lessor enters into any tie up arrangement with manufacturer for the marketing, it is called
sales aid lease.

10. Cross border lease

Lease across national frontiers are called cross border lease, Shipping, air service, etc., will come under
this category.

11. Tax oriented lease

Where the lease is not a loan on security but qualifies as a lease, it will be considered a tax-oriented
lease.

12. Import Lease

In an Import lease, the company providing equipment for lease may be located in a foreign country but
the lessor and the lessee may belong to the same country. The equipment is more or less imported.

13. International lease

Here, the parties to the lease transactions may belong to different countries which is almost similar to
cross border lease.

Evaluation of Leasing Option Vs. Borrowing

Evaluation of Lease Decision: 3 Methods (with formula)

The methods used in evaluation of lease decision are as follows: - 1. Present Value Method 2. Cost of
Capital Method 3. Bower-Herringer-Williamson Method.

1. Present Value Method:

Under this method the present value of lease rentals are compared with the present value of the cost of
an asset acquired on outright purchase by availing a loan. In leasing, the tax advantage in payment of
lease rentals will reduce the cash outflow.

In case an asset is purchased by borrowing a loan, the repayment of principal and interest charges on
loan is considered as cash outflow and it is reduced by tax advantage of depreciation claim and interest
charge. The present value of the net cash outflows over the period of lease is considered to ascertain
the present value over the lease/loan period. The alternative with low total present value of cash
outflow will be selected.

2. Cost of Capital Method:

Under this method, the rate of cost of capital is calculated for the payments of installments and then it
is compared with the cost of capital of the other available sources of finance such as fresh issue of
equity capital, retained earnings, debentures, term loans etc. The lease option is chosen if the rate is
lower than the cost of equity capital etc. This method does not require the prior selection of any
discounting rate.

3. Bower-Herringer-Williamson Method:
Under this method, the financial and tax aspects of lease financing are considered separately.

The following steps are involved in evaluation of lease decision:

Step 1:
Make a comparison of the present value of cost of debt with the discounted value of gross amount of
lease rentals. The rate of discount applicable is being the gross cost of debt capital. Then, obtain the
total present value of a financial advantage/disadvantage of leasing.

Step 2:
Again compute the comparative tax benefit during the lease period and discount it at an appropriate
cost of capital. The total present value is the operating advantage/ disadvantage of leasing. Step 3 –
When the present value of operating advantage of lease is more than its financial disadvantage, then
select the leasing. When the present value of financial advantage is more than operating disadvantages,
then select the leasing.

Illustration:
Vindhya Papers Ltd. planning to install a captive generator set at its plant. Its Finance Manager is
asked to evaluate the alternatives either to purchase or acquire generator on lease basis.

Depreciation @ 20% p.a. on written down value. Corporate tax rate 40%. After tax cost of debt is 14%.

The time gap between the claiming of the tax allowance and receiving the benefit is one year.

Evaluate the lease or buy decision based on the above information.

Solution:

Analysis:
From the above analysis, by applying the discounted cashflow technique, we can observe that the net
present value of cash outflow is higher in case of leasing decision i.e., Rs. 3,76,030 as compared to
buying decision it is only Rs. 3,30,557. The company may go for purchase of the generator instead of
acquiring on lease basis.

Financial Evaluation of Leasing: Way # 1.

Lessee’s Point of View:
(Lease or Buy/Lease or Borrow Decisions):
Once a firm has evaluated the economic viability of an asset as an investment and accepted/selected
the proposal, it has to consider alternate methods of financing the investment. However, in making an
investment, the firm need not own the asset. It is basically interested in acquiring the use of the asset.

Thus, the firm may consider leasing of the asset rather than buying it. In comparing leasing with
buying, the cost of leasing the asset should be compared with the cost of financing the asset through
normal sources of financing, i.e., debt and equity.

Since, payment of lease rentals is similar to payment of interest on borrowings and lease financing is
equivalent to debt financing, financial analysts argue that the only appropriate comparison is to
compare the cost of leasing with that of cost of borrowing. Hence, lease financing decisions relating to
leasing or buying options primarily involve comparison between the cost of debt-financing and lease
financing.

The evaluation of lease financing decisions from the point of view of the lessee involves the
following steps:
(i) Calculate the present value of net-cash flow of the buying option, called NPV (B).

(ii) Calculate the present value of net cash flow of the leasing option, called NPV (L)

(iii) Decide whether to buy or lease the asset or reject the proposal altogether by applying the following
criterion:

(a) If NPV (B) is positive and greater than the NPV (L), purchase the asset.

(b) If NPV (L) is positive and greater than the NPV (B), lease the asset.

(c) If NPV (B) as well as NPV (L) are both negative, reject the proposal altogether.

Since many financial analysts argue that the lease financing decisions arise only after the firm has
made an accept-reject decision about the investment; it is only the comparison of cost of leasing and
borrowing options.
The following steps are involved in such an analysis:
(i) Determine the present value of after-tax cash outflows under the leasing option.

(ii) Determine the present value of after-tax cash outflows under the buying or borrowing option.

(iii) Compare the present value of cash outflows from leasing option with that of buying/borrowing
option.

(iv) Select the option with lower presented value of after-tax cash outflows.

We have illustrated the above analysis in the following illustrations.

Illustration 1:
A limited company is interested in acquiring the use of an asset costing Rs. 5,00,000. It has two
options:
(i) To borrow the amount at 18% p.a. repayable in 5 equal installments or

(ii) To take on lease the asset for a period of 5 years at the year end rentals of Rs. 1,20,000.

The corporate tax is 50% and the depreciation is allowed on w.d.v. at 20%. The asset will have a
salvage of Rs. 1,80,000 at the end of the 5th year.

You are required to advise the company about lease or buy decision. Will decision change if the firm is
allowed to claim investment allowance at 25%?

Note:
(1) The present value of Re. 1 at 18% discount factor is:

1st year – .847

2nd year – .718

3rd year – .609

4th year – .516

5th year – .437

(2) The present value of an annuity of Re. 1 at 18% p.a. is Rs. 3.127.

Solution:
(v) Evaluation:
As the present value of after-tax cash outflows under the leasing option is lesser than the present value
of after-tax cash outflows of the buying option, it is advisable to take the asset on lease.

(vi) Decision if Investment Allowance is allowed:

In case Investment Allowance is allowed on purchase of asset the total of present value of net cash
outflows will decrease by the present value of tax savings on investment allowance as below:
In that case, the P.V. of cash outflows under buying option shall be lesser than the P.V. of cash
outflows under leasing option and the company should buy the asset.

Financial Evaluation of Leasing: Way # 2.

Lessor’s Point of View:
The financial viability of leasing out an asset from the point of view of lessor can be evaluated with the
help of the two time adjusted methods of capital budgeting:

(a) Present Value Method

(b) Internal Rate of Return Method.

(a) Present Value Method:

This method involves the following steps:
(i) Determine cash outflows by deducing tax advantage of owning an asset, such as investment
allowance, if any.

(ii) Determine cash inflows after-tax as below:

(ii) Determine the present value of cash outflows and after tax cash inflows by discounting at weighted
average cost of capital of the lessor.

(iv) Decide in favour of leasing out an asset if P.V. of cash inflows exceeds the P.V. of cash outflows,
i.e., if the NPV is +ve; otherwise in case N.P.V. is -ve, the lessor would lose on leasing out the asset.

The above technique has been explained with the help of the following example.

Illustration 2:
From the information given below, you are required to advise about leasing out of the asset:
Solution:

Since the present value of cash inflows is more than the present value of cash outflows or says N.P.V.
is positive, it is desirable to lease out the asset.

(b) Internal Rate of Return Method:

The internal rate of return can be defined as that rate of discount at which the present value of cash-
inflows is equal to the present value of cash outflows.

It can be determined with the help of the following mathematical formula:

C = A1/(1+r) + A2/(1+r)2 + A3/(1+r)3 + … … … … + An/(1+r)n
where, C = Initial Outlay at time Zero.

A1, A2, … … … An = Future net cash flows at different periods.

2,3 …….. , = Numbers of years

r = Rate of discount of internal rate of return.

The Internal rate of return can also be determined with the help of present value tables.

The following steps are required to practice the internal rate of return method:
(1) Determine the future net cash flows for the period of the lease. The net cash inflows are estimated
future net cash flows for the period of the lease. The net cash inflows are estimated future earnings,
from leasing out the asset, before depreciation but after taxes.
(2) Determine the rate of discount at which the present value of cash inflows is equal to the present
value of cash outflows. This may be determined as follows:

(a) When the annual net cash flows are equal over the life of the asset:

Firstly, find out Present Value Factor by dividing initial outlay (cost of the investment) by annual cash
flow, i.e., Present Value Factor = Initial Outlay/Annual Cash Flow. Then, consult present value annuity
tables with the number of year equal to the life of the asset and find out the rate at which the calculated
present value factor is equal to the present value given in the table.

Illustration 3:

Solution:

(b) When the annual cash flows are unequal over the life of the asset:
In case annual cash flows are unequal over the life of the asset, the internal rate of return cannot be
determined according to the technique suggested above. In such cases, the internal rate of return is
calculated by hit and trial and that is why this method is also known as hit and trial yield method.

We may start with any assumed discount rate and find out the total present value of all the cash flows
by consulting present value tables.

The so calculated total present value of cash inflows as compared with the present value of cash
outflows which is equal to the cost of the initial investment where total investment is to be made in the
beginning. The rate, at which the total present value of all cash inflows equals the initial outlay, is the
internal rate of return. Several discount rates may have to be tried until the appropriate rate is found.
The calculation process may be summed up as follows.

(i) Prepare the cash flow table using an arbitrary assumed discount rate to discount the net cash flow to
the present value.
(ii) Find out the Net Present Value by deducting from the present value of total cash flows calculated
in (i) above the initial cost of the investment.

(iii) If the Net Present Value (NPV) is positive, apply higher rate of discount.

(iv) If the higher discount rate still gives a positive net present value, increase the discount rate further
until the NPV becomes negative.

(v) If the NPV is negative at this higher rate, the internal rate of return must be between these two
rates:

(3) Accept the proposal if the internal rate of return is higher than or equal to the minimum required
rate of return, i.e. the cost of capital or cut off rate.

(4) In case of alternative proposals select the proposal with the highest rate of return as long as the
rates are higher than the cost of capital or cut-off rate.

Illustration 4:
Initial Investment – Rs. 60,000

Life of the Asset – 4 years

Estimated Net Annual Cash Flows:

Compute the internal rate of return and also advise the lessor about the leasing out decision if his
expected minimum rate of return is 15%.

Note:
Present Value Factor at various rates of discount.
(1) The present value of cash flows at 14% rate of discount is Rs. 60,595 and at 15% rate of discount it
is t 59,285. So the initial cost of investment which is Rs. 60,000 falls in between these two discount
rates. At 14% the NPV is+ 595 but at 15% the NPV is – 715, we may say that IRR = 14.5% (approx).

(2) As the IRR is less than the minimum required rate of return, the lessor should not lease out the
asset.

UNIT – III : Venture Capital

‘Venture Capital’ is an important source of finance for those small and medium- sized firms, which
have very few avenues for raising funds. Although such a business firm may possess a huge potential
for earning large profits in the future and establish itself into a larger enterprise. But the common
investors are generally unwilling to invest their funds in them due to risk involved in these types of
investments. In order to provide financial support to such entrepreneurial talent and business skills, the
concept of venture capital emerged. In a way, venture capital is a commitment of capital, or
shareholdings, for the formation and setting-up of small scale enterprises at the early stages of their
lifecycle.

The term venture capital comprises of two words, namely, ‘venture’ and ‘capital’. The term venture
literally means a course or proceeding, the outcome of which is uncertain but which is uncertain but
which is attended by the risk of danger of ‘loss’. On the other hand, the term capital refers to the
resources to start the enterprise. However, the term venture capital can be understood in two ways.

According to narrow sense, the capital which is available for financing the new business ventures is
called venture capital. Generally, it involves lending finance to the growing companies.

In the broad sense, venture capital is the investment of long-term equity finance where the venture
capitalist earns his returns primarily in the form of capital gain. It is under the assumption that the
entrepreneur and thee venture capital would act as partners. It is a commitment of capital for the
formation and setting up of small scale enterprises specializing in new ideas or new technologies.
Venture capital does not deal in financing the enterprise which is engaged intrading, broking,
investment or financial services and agency or liaison work. It is generally considered as a high risk
capital. Venture capital is not an injection of funds into new firm but also an input of the skills need to
set up thee firm, design its marketing strategy, organize and then manage it.

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 also associated with job creation, the knowledge economy and used as a proxy
measure of innovation within an economic sector or geography. The term Venture Capital fund is
usually used to denote Mutual funds or Institutional investors. They provide equity finance or risk
capital to little known, unregistered, highly risky, young and small private business, specially in
technology oriented and knowledge intensive business.

Venture Capital termed as long-term funds in equity or semi- equity from to finance hi-tech investment
in novel technology based projects with display potential for significant growth and financial return.”

According to JameKoloskiMorries, “ Venture capital is defined as providing seed, startup, and first
stage financing and also funding expansion of companies that have already demonstrated their business
potential but do not yet have access to the public securities market or to credit-oriented institutional
funding sources, Venture Capital also provides management in leveraged buy out financing”.

Features of Venture Capital

1) For New Entrant: Venture Capital investment is generally made in new enterprises that use new
technology to produce new products, in expectation of high gains or sometimes, spectacular returns.

2) Continuous Involvement: Venture capitalists continuously involve themselves with the client’s
investments, either by providing loans or managerial skills or any other support.

3) Mode of Investment: Venture capital is basically an equity financing method, the investment being
made in relatively new companies when it is too early to go to the capital market to raise funds. In
addition, financing also takes the form of loan finance/ convertible debt to ensure a running yield on
the portfolio of the venture capitalists.

4) Long-term Capital: The basic objective of a venture capitalist is to make a capital gain on equity
investment at the time of exit, and regular return on debt financing. It is a long-term investment in
growth- oriented small/medium firms. It is a long-term capital that is an injected to enable the business
to grow at a rapid pace, mostly from the start-up stage.

5) Hands-On Approach: Venture capital institution take active part in providing value – added
services such as providing business skills, etc., to investee firms. Thy do not interfere in the
management of the firms nor do they acquire a majority / controlling interest in the investee firms. The
rationale for the extension of hands- on management is that venture capital investments tend to be
highly non- liquid.

6) High risk- return Ventures: Venture capitalists finance high risk-return ventures. Some of the
ventures yield very high return in order to compensate for the heavy risks related to the ventures.
Venture capitalists usually make hug capital gains at the time of exit.

7) Source of Finance: Venture capitalists usually finance small and medium- sized firms during the
early stages of their development, until they are established and are able to raise finance from the
conventional industrial finance market. Many of these firms are new, high technology- oriented
companies.

8) Liquidity: Liquidity of venture capital investment depends on the success or otherwise of the new
venture or product. Accordingly, there will be higher liquidity where the new ventures are highly
successful.

Venture Capital Funding Process

Obtaining capital for a project through this rout is very difficult. It involves many steps, which a
prospective entrepreneur has to adopt when he approaches an investor. They are:

1) Making a Deal (Deal Origination): A continuous flow of deals is essential for the venture capital
business. Deals may originate in various ways. Referral system is an important source of deals. Deals
may be referred to the VCs through their parent organizations, trade partners, industry associations,
friends, etc. The venture capital industry in India has become quit proactive in its approach to
generating the dal flow by encouraging individuals to come up with their business plans.

VCFs carry out initial screening of all projects on the basis of some broad criteria. For example the
screening process may limit projects to areas in which the venture capitalist is familiar in terms of
technology, or Product, or market scope. The size of investment, geographical location and stage of
financing could also be used as the broad screening criteria.

2) Evaluation or Due Diligence: Once a proposal has passed through initial screening, it is subjected to
a detailed evaluation or due diligence process. Most ventures are new and the entrepreneurs may lack
operating experience. Hence a sophisticated, formal evaluation is neither possible nor desirable. The
Vcs thus rely on a subjective but comprehensive evaluation. VCFs evaluate the quality of the
entrepreneur before appraising the characteristics of the product, market or technology. Most venture
capitalists ask for a business plan to make an assessment of the possible risk and expected return on the
venture.

3) Investment Valuation: The investment valuation process is aimed at ascertaining an acceptable price
for the deal. The valuation process goes through the following steps.
i) Projections on future revenue and profitability.
ii) Expected market capitalization.
iii) Deciding on the ownership stake based on the return expected on the proposed investment.
iv) The pricing thus calculated is rationalized after taking into consideration various economic
scenarios, demand and supply of capital, founders/ management team’s track record, innovation/unique
Selling Propositions (USPs), the product/ Service size of the potential market, etc.

4) Deal Structuring: Once the venture has been evaluated as viable, the venture capitalist and the
investment company negotiate the terms of the deal, i.e., the amount, form and price of the investment.
This process is termed as dal structuring. The agreement also includes the protective covenants and
earn-out arrangements. Covenants include the venture capitalists’ right to control the invest company
and to change its management if needed, buy back arrangements, acquisition, making Initial Public
Offerings (IPOs), etc. Earn- out arrangements specify the entrepreneur’s equity share and the
objectives to be achieved. Venture capitalists generally negotiate deals to ensure protection of their
interests. They would like a deal to provide for a return commensurate with the risk, influence over the
firm through board membership, minimizing taxes, assuring investment liquidity and the right to
replace management in case of consistent poor managerial performance.

5) Post-Investment Activities and Exit: Once the deal has been structured and agreement finalized, the
venture capitalist generally assumes the role of a partner and collaborator. He also involves in shaping
of the direction of the venture. This may be done via a formal representation on the board of director,
or informal influence in improving the quality of marketing, finance and other managerial functions.
The degree of the venture capitalists involvement depends on his policy. It may not, however, be
desirable for a venture capitalist to get involved in the day-to-day operation of the venture. If a
financial or managerial crisis occurs, the venture capitalist may intervene and even install a new
management team. Venture capitalists typically aim at making medium- to long- term capital gains.
They generally want to cash-out their gains in five to ten years after the initial investment. They play a
positive role in directing the company towards particular exit routes. A venture capitalist can exit in
four ways.

i) Initial Public Offerings (IPOs): When the company is making good profits and the market condition
is conductive, the venture capitalists offer their shareholding to the public, the advantage of this exit
rout is that the shares can be priced at premium in time with the market trend and will bring them good
fortune. However, there are some disadvantages like high cost of issue, lower demand, etc.

ii) Acquisition by Another Company: Another strategy is to sell their holdings to another company
who are interested to expand their business in this line. The advantage of this strategy is that they can
negotiate the deal and results into transfer of controlling interest, the existing promoters may play
defensive strategies for fear of loss of control. Sometimes the negative reputation of the acquiring
company may bring down the business of the acquired company also.

iii) Repurchase of the Venture Capitalist’s Share by the Investee Company: If the promoters have
enough cash at their disposal, thy can buy- back the shares from the venture capitalists so that they can
retain their control over the company. However, if the company is enjoying good reputation in the
market, the venture capitalists may demand a hefty amount as compensation for their exit.

iv) Purchase of VCs Share by a Third Party: Venture capitalists can sell their holdings through private
placements to one or more third parties. Here also there is a chance of loss of control to the existing
promoters, who may play some defensive strategies. However, compared to the public offer, this will
be a cheaper route for exit.

Growth of Venture Capital in India

The venture capital in India is still an emerging concept and is still at an introductory state. For
Venture Capital firms to flourish in India, there should be a proper promotion of innovation, enterprise,
commercial execution of innovative ideas, entrepreneurial culture etc. India has already entered the era
of Information technology and this sector has seen tremendous growth over the years. The “Make in
India” campaign has attracted many individuals and companies from all over to invest and build in
India.

A development in the Venture Capital environment will fill the gap between the capital requirement of
tech-based and knowledge based startups and traditional financing systems. The traditional Indian
Venture Capital environment can be dated back to 150 years when agencies provided both finance and
skills to projects.

Phases of Venture Capital

The growth and development of venture capital in India has taken in different phases. The need for the
venture capital was first noticed by the Bhatt Committee in 1972 under the chairmanship of R.S.
Bhatt. This committee identified the problems of new entrepreneurs and technologists in setting up
industries.

 In 1975, venture capital financing was introduced in India by all-india financial institutions
with the establishment of Risk Capital Foundation (RCF) supported by Industrial Finance
Corporation (IFCI).
 In 1976, seed capital scheme was introduced by Industrial Development Bank of India (IDBI).
 In 1984, Industrial Credit and Investment Corporation of India (ICICI) decided to allocate
funds for providing assistance to venture capital firms.
  In 1985, the government announced the creation of a Venture Capital Fund and presented it in
parliament. The fund created equity capital for pilot projects with potential businesses.
The First Phase 1986-1995
 April 1, 1986, Venture Capital Fund established by the government was operational and
administered by IDBI Bank.
 In 1986, ICICI launched a venture capital scheme to encourage new technocrats in the private
sector in the emerging field of high-risk technology.
 In August, 1986, ICICI Bank undertook administration of Programme for Advancement of
Commercial Technology (PACT)
 In 1987, IDBI started a venture capital fund scheme
 In 1987-1988, Technology Development Fund (TDF) changed the course of Venture Capital in
India.Government of India and World Bank joined together for economic liberalisation in
India. November 25, 1988, government announced guidelines for the establishment and
functioning of venture capital activities.
 In 1993, Indian Venture Capital Association (IVCA) was established headquartered in
Bangalore.
 First phase of Venture Capital in india was a developing experience and policy making with
some regulatory framework
The Second Phase 1995-1999
Capital Under Management in India increased after 1995. Non-resident Indians (NRIs) invested in
Venture Capital Funds. Suggestion from Shri Vishnu Varshney in 1998, resulted in tax privileges ,
progressive liberalisation in IPO guidelines and institutions.

In 1999, 80% of total venture capital investment were derived overseas firms.Such overseas firms
were registered in Mauritius and operated in India to avoid the regulation by Indian government. IVCA
refined its terms and framework to facilitate the Venture Capital ecosystem

The Third Phase 2000 and above

 In 1999, various regulations were adjusted and the horizon of investment in venture capital for
other financial institutions was broadened. All the banks with permission were allowed to
invest 5% of their new fund in venture capital annually.
 Venture capital industry faced liquidity, legal, political, economical and operational problems
during the course of action. K.B. Chandrasekhar committee addressed all these issues and
submitted a report to SEBI.
 In 2012 A.D., $3.1 B capital was deployed in India and by the end of 2018, this capital
investment amounted to $6.4 billion. By the end of 2019, this amount will reach $ 10 billion.
 Similarly, In 2012, the number of Venture Capitalists investment was 458 and by the end of
2019, the number of investments was more than 750.

Legal Aspects and Guidelines for Venture Capital

Venture Capital in India governs by the SEBI[8] Act, 1992 and SEBI (Venture Capital Fund)
Regulations, 1996. According to which, any company or trust proposing to carry on activity of a
Venture Capital Fund[9] shall get a grant of certificate from SEBI[10]. However, registration of
Foreign Venture Capital Investors (FVCI) is not obligatory under the FVCI regulations[11]. Venture
Capital funds and Foreign Venture Capital Investors are also covered by Securities Contract
(Regulation) Act, 1956, SEBI (Substantial Acquisition of Shares & Takeover) Regulations, 1997,
SEBI (Disclosure of Investor Protection) Guidelines, 2000.

Constitution of Venture Capital Funds

There are three layers of structured or institutional venture capital funds i.e. venture capital funds set
up by high net worth individual investors, venture capital subsidiaries of corporations and private
venture capital firms/ funds. Venture funds in India can be divided on the basis of the type of
promoters.

1. Venture Capital Funds promoted by the Central government controlled development financial
institutions such as TDICI, by ICICI, Risk capital and Technology Finance Corporation Limited
(RCTFC) by the Industrial Finance Corporation of India (IFCI) and Risk Capital Fund by IDBI.

2. It is promoted by the state government-controlled development finance institutions such as Andhra

Pradesh Venture Capital Limited (APVCL) by Andhra Pradesh State Finance Corporation (APSFC)
and Gujarat Venture Finance Company Limited (GVCFL) by Gujarat Industrial Investment
Corporation (GIIC)

3. Also, promoted by Public Sector banks such as Canfina and SBI-Cap.

4. Venture Capital Funds promoted by the foreign banks or private sector companies and financial
institutions such as Indus Venture Fund and Grindlay's India Development Fund[12].

Eligibility and Investment Criteria for Venture Capital Funds

For Venture Capital Funds it is required that Memorandum of Association or Trust Deed must have
main objective to carry on action of Venture Capital Fund including prohibition by Memorandum of
Association & Article of Association for making an invitation to the public to subscribe to its
securities. Further, it is required that Director or Principal Officer or Employee or Trustee is not caught
up in any litigation connected with the securities market and has not at any time been convicted of any
offence involving moral turpitude or any economic offence. Also, in case of, body corporate, it must
have been set up under Central or State legislations and applicant has not been refused certificate by
SEBI[13].
A Venture Capital Funds may generate investment from any investor (Indian, Foreign or Non-resident
Indian) by means of issue of units and no Venture Capital Fund shall admit any investment from any
investor which is less than five Lakhs. Employees or principal officer or directors or trustee of the VCF
or the employees of the fund manager or Asset Management Company (AMC) are only exempted. It is
also mandatory that VCF shall have firm commitment of at least five Crores from the Investors before
the start of functions by the VCF. Disclosure of investment strategy to SEBI before registration, no
investment in associated companies and duration of the life cycle of the fund is compulsorily being
done. It shall not invest more than twenty five percent of the funds in one Venture Capital
Undertaking. Also, minimum 66.67% of the investible funds shall be utilized in unlisted equity shares
or equity linked instruments of Venture Capital Undertaking.

It is also mandatory that not more than 33.33% of the investible funds may be invested by way of
following as stated below:-
1. Subscription to IPO[14] of a Venture Capital Undertaking (VCU)
2. Debt or debt instrument of a VCU in which VCF has already made an investment by way of equity
3. Preferential allotment of equity shares of a listed company subject to lock in period of one year
4. The equity shares or equity linked instruments of a monetarily weak company or a sick industrial
company whose shares are listed.
5. SPV (special purpose vehicles) which are created by VCF for the purpose of making possible
investment.

RBI and Investment Criteria

A foreign venture capital investor proposing to carry on venture capital activity in India may register
with the Securities and Exchange Board of India (“SEBI”), subject to fulfilling the eligibility criteria
and other requirements contained in the SEBI Foreign Venture Capital Investor Regulations. The SEBI
Foreign Venture Capital Investor Regulations prescribe the following investment guidelines, which can
impact overall financing plans of foreign venture capital funds.

a) The foreign venture capital investor must disclose its investment strategy and life cycle to SEBI,
and it must achieve the investment conditions by the end of its life cycle.

b) At least 66.67 per cent of the investible funds must be invested in unlisted equity shares or equity
linked instruments.

c) Not more than 33.33 per cent of the investible funds may be invested by way of:
· Subscription to initial public offer of a venture capital undertaking, whose shares are proposed to be
listed.
· Debt or debt instrument of a venture capital undertaking in which the foreign venture capital investor
has already made an investment, by way of equity.
· Preferential allotment of equity shares of a listed company, subject to a lock-in period of one year.
· The equity shares or equity linked instruments of a financially weak or a sick industrial company (as
explained in the SEBI FVCI Regulations) whose shares are listed.

A foreign venture capital investor may invest its total corpus into one venture capital fund[15].

Tax Matters related to Venture Capital Funds

Indian Venture Capital Funds are allowed to tax payback under Section 10(23FB) of the Income Tax
Act, 1961. Any income earned by an SEBI registered Venture Capital Fund (established either in the
form of a trust or a company) set up to raise funds for investment in a Venture Capital Undertaking is
exempt from tax[16]. It will also be extensive to domestic VCFs and VCCs which draw overseas
venture capital investments provided these VCFs/VCCs be conventional to the guidelines pertinent for
domestic VCFs/VCCs. On the other hand, if the Venture Capital Fund is prepared to forego the tax
exemptions available under Section 10(23F) of the Income Tax Act, it would be within its rights to
invest in any sector[17].

Factoring, Forfeiting
Factoring also known as account receivables factoring or debtor financing , is a method in which a
company (client) sell its account receivables (debt) to a bank or financial institution (called
factor) at a certain discount.

There are three parties involved in factoring contract –

1. Debtor (Buyer of Goods) – One who has purchase goods or services on credit and has to
pay for same once the credit period gets over.
 2. Client (Seller of Goods) – who has supplied goods or services to the customer on credit
terms.
3. Factor (Financier) – who purchase the account receivables from client (seller of goods) and
collect the money from debtor of his clients.

In other words, Factoring is a mechanism in which an exporter (seller) transfer his rights to receive
payment against goods exported or services rendered to the importer, in exchange for instant cash
payment from a forfaiter.

Factoring is prevalent in business in various ways. For example, Credit Card. Factoring is often more
short term than forfaiting and is applicable where receivables are due within around 90 days.

Factoring Process

Factoring Process
1 – Client concludes a credit sale with the customer

2 – Client sells the account receivable to the factor (financier) and notify the same to customer

3 – Factor makes a part payment (advance) against the account receivable purchased after adjusting the
discount or commission and interest on advance.

4 – Factor maintains the customer’s account and follows up the payment

5 – Debtor makes the payment due to the factor

6 – Factor makes the final payment to the client when the account receivable is collected or on a
guaranteed payment date.

Factoring may be recourse or non recourse.

In recourse factoring, Factor buys the account receivable from client with an agreement that the client
will buy them back if they remain uncollected from debtor.

Whereas in Non Recourse factoring, Client sells the account receivables to Factor without any
obligation of buying them back if they remain unpaid by the debtor. As Factors have to bear any losses
arising on account of irrecoverable debts, factor charges higher commission in this type of factoring.

Forfaiting

In Forfaiting, Exporter sell their medium and long term account receivables at a discount and obtain
cash from the forfaiter on non recourse basis. In Forfaiting, there is no risk for exporter of importer
becoming insolvent as there is 100 percent finance of contract value. Forfaiting is generally evidenced
by a legally enforceable and transferable payment obligation such as bills of exchange, promissory
note, a letter of credit.

Forfaiting is a specialized form of factoring which is undertaken on export transactions on a non

recourse basis.

The major parties involved in a transaction of Forfaiting are : An exporter, an importer, a domestic
bank, a foreign bank and a primary forfaiter.

Forfaiting Process

Exporter sells the goods to importer on deffered payment basis. Importer issues series of promissory
notes undertaking to pay the exporter in installments with interest.

Importer approaches its banker (Avalling Bank) for adding the bank gurantee on the promissory note
that the payment will be made on each maturity date. The promissory notes are now avallised and sent
to exporter.
Forfaiting Process
Avalled notes are sold to forfaiter (usually exporter’s bank) as a discount at a non recourse basis and
exporter obtain finance from forfaiter.

Forfaiter hold till maturity date and obtain payment from importer’s bank / avalling bank or sell it in
the secondary market or sell it to a group of investors.

Key Differences between Factoring and Forfaiting

Basis for difference Factoring Forfaiting

Factoring is the process in which you

In Forfaiting, Exporter sell their
receive advance against account
medium and long term account
Definition / Meaning receivables / debt from the factor (bank
receivables and obtain cash from the
or financial institution) without waiting
forfaiter.
for payment in future.

Maturity of It involves account receivables of short It involves account receivables of

Receivables term maturities medium and long term maturities.

Usually 80-90 percent of the value of

Extent of Finance 100 percent of value of invoice.
invoice.

Recourse Factoring and Non Recourse

Type Non Recourse
Factoring
 Factor does the credit rating in case of no Forfaiting Bank relies on the
Credit Worthiness
recourse factoring transaction. creditability of the Avalling Bank.

Factoring Cost is borne by the Client Cost of forfaiting borne by the

Cost
(seller). overseas buyer

Day to Day administration of sales and

Services Provided No Services are provided
other allied services are provided

Forfaiting is evidenced by bills of

Negoatiable
No dealing with Negotiable Instruments exchange, promissory note, a letter
Instruments
of credit.

Bill Discounting –
What is Bill Discounting?

In bill discounting, the seller of goods draws up a bill of exchange on the buyer of the goods and then
discounts the said bill of exchange with a bank or financial company. The seller is able to get
immediate finance minus the fee charged by the finance firm. Bill discounting lets the seller recover
their receivables faster thereby improving cash flow. Before purchasing the bill, the bank or financial
institution has to consider a number of factors including the risk of non-payment associated with the
bill and the amount of time remaining for the bill to become due. A bill with lower risk and shorter
duration of becoming due is preferred. Once the buyer of the goods makes the payment to the bank the
transaction is settled.

What is the difference between Factoring and Bill Discounting?

Factoring and bill discounting are both sources of short term finance which offer traders and sellers an
avenue to obtain payment for receivables in a fast and convenient manner. Both forms of short term
financing help improve cash flow and working capital management. Despite their similarities, there are
a few differences between factoring and bill discounting. Bill discounting is always recourse, whereas
factoring may be recourse or non-recourse. Factoring also maintains sales ledgers and collect debt,
while bill discounting only involves the purchase of the bill and no sales ledger maintenance is carried
out by the finance company. It is possible for a bill to be discounted a number of times before maturity.
However, this is not the case for factoring. Factoring is a facility that can be extended over a number of
invoices, whereas in bill discounting each bill is assessed individually before being discounted.

Factoring vs Bill Discounting

• Factoring and bill discounting are both sources of short term finance which are offered by banks and
financial institutions.

• In factoring receivables, the trader sells their unpaid invoices to factoring companies such as banks
and financial institutions at a discounted rate.

• In the process of factoring receivables, factoring companies are also responsible for maintaining all
credit control activities including management of the sales ledger and collecting debts directly by
contacting customers.

• In bill discounting, the seller of goods draws up a bill of exchange on the buyer of the goods and then
discounts the said bill of exchange with a bank or financial company.

• Before purchasing the bill, the bank or financial institution has to consider a number of factors
including the risk of nonpayment associated with the bill and the amount of time remaining for the bill
to become due.

• Factoring is a facility that can be extended over a number of invoices, whereas in bill discounting
each bill is assessed individually before being discounted.

Types of Factoring Arrangements

Factoring – different types of factoring arrangements : Factoring has its recent origin in India after
RBI constituted a high powered committee to examine the score for offering factoring services in the
country in 1988. Committee submitted its recommendation to set up factoring subsidiaries in 1989.
Following the announcement of the guidelines, the State Bank of India and Canara Bank have set-up
their factoring subsidiaries – SBI Factors & Commercial Services Limited and Canbank Factors
Limited. We recommend you to read our previous article on what is Factoring and its process. After
reading this article you will be able to understand about different types of factoring arrangements
between the client and factor.

Different Types of Factoring Arrangements

1. Recourse Factoring
 2. Non Recourse Factoring
3. Maturity Factoring
4. Advance Factoring
5. Invoice Discounting
6. Full Factoring
7. Bank Participation Factoring
8. Domestic and Cross border Factoring

Recourse Factoring :

In this type of factoring, the factor has recourse to the client (seller of goods) if importer(buyer of
goods) become insolvent. In other words, risk of account receivables purchased from client becoming
bad is borne by client himself.

Non RecourseFactoring :

In this type of factoring, factor has no recourse to the client if the debt / account receivables purchased
turns out be bad or irrecoverable. Factor can not claim the amount from the client. As factor bear the
risk of non payment, commission charged for the services is higher than recourse type of factoring.

The additional commission charged by the factor for bearing the risk of insolvency / bad debts is
called del credere commission.

Maturity Factoring :

No advance payment is made by the factor to client. Factor pay the client only after collection of
account receivables/ debt or on a guaranteed payment date. The guaranteed payment date is usually
fixed taking into account the previous ledger experience of the client and a period for slow collection
after the due date of the invoice.

Advance Factoring :

Factor pay the advance varying between 75-85 percent of the value of receivables or invoice factored.
The balance is paid upon collection or on the guaranteed payment date.

Invoice Discounting :
Under Invoice Factoring arrangement, factor makes prepayment to the client against the purchase of
book debts and charges interest for the period spanning the date of pre payment to the date of
collection. The sales ledger administration and collection are carried out by the client. The client
provides the factor with periodical reports on the value of unpaid invoices and the ageing schedule of
debts. This facility is usually kept confidential i.e., the customers (whose debts have been purchased by
the factor) are not informed of the arrangement. Therefore, this arrangement is also referred
as ‘Confidential Factoring’ or undisclosed factoring.

Full Factoring :

Also known as Conventional Factoring, it combines the features of both non recourse and advance
factoring arrangement. Full factoring provides the entire spectrum of services – collection, credit
protection, sales-ledger administration and short-term finance.

Bank participation factoring :

Under this arrangement, a bank participate in factoring by providing an advance to the client against
the reserves maintained by the factor. For example, assume that a factor has advanced 80 percent of the
value of factored receivables and the commercial bank provides an advance limited to 50 percent of the
factor reserves. The client is required to fund only 10 percent of the investment in receivables, the
balance 90 percent being provided by the factor and the commercial bank.

Domestic and Cross Border Factoring :

The basic difference in domestic and cross border factoring is on account of number of parties
involved in factoring process.

In domestic factoring, three parties are involved – seller (client), Factor, Buyer

While in cross border or export factoring, four parties are involved in transaction – Exporter
(Seller/client), Importer (buyer), Export Factor, Import Factor.

It is also known as Two Factor system of Factoring as there are two factors involved in the
transaction.
UNIT – IV : Credit Rating
CREDIT RATING: CONCEPT, TYPES AND FUNCTIONS
Many a times, it has happened that investors in debentures or fixed deposits were shown rosy
pictures of companies and offered very high rates of interests by bogus companies and in the end
the investor neither got his money back nor the promised interest. Actually, it is very difficult for
an individual investor to gather details about creditworthiness of a company, neither he has the
time nor the skills to undertake risk evaluation.
Every investor wants to ensure safety of his investment. Credit rating agencies investigate the
financial position of the company issuing various kinds of instruments and assess risks involved
in investing money in them. In the system of credit rating, the credit rating agency rate the risks
involved in investment in instruments of a particular company, they may rank it from very safeto
very risky. At present credit rating is done only for debt-instruments and rarely for preference or
equityshares.
DEFINITION
Creditratingsystemcanbedefinedasanactofassigningvaluestocreditinstrumentsbyassessing the
solvency i.e., the ability of the borrower to repay debt, and expressing them through pre-
determinedsymbols.
Investopedia defines Credit Rating as “An assessment of the creditworthiness of a borrower in
general terms or with respect to a particular debt or financial obligation”. A credit rating can be
assigned to any entity that seeks to borrow money – an individual, corporation, state or
provincial authority, or sovereign government.

CHARACTERISTICS OF CREDIT RATING

1. Assessment of issuer's capacity to repay. It assesses issuer's capacity to meet its financial
obligations i.e., its capacity to pay interest and repay the principal amountborrowed.
2. Basedondata.Acredit ratingagencyassessesfinancialstrengthoftheborroweronthefinancial data.
3. Expressedinsymbols.Ratingsareexpressedinsymbolse.g.AAA,BBBwhichcanbeunderstood by a
laymantoo.
4. Done by expert. Credit rating is done by expert of reputed, accreditedinstitutions.
5. Guidance about investment-not recommendation. Credit rating is only a guidance to investors
and not recommendation to invest in any particularinstrument.
WHAT CREDIT RATING IS NOT
1. Notforcompanyasawhole.Creditratingisdoneforaparticularinstrumenti.e.,foraparticular class of
debentures and not for the company as a whole, it is quite possible that two instruments issued by
the same company may carry differentrating.
2. Does not create a fiduciary relationship. Credit rating does not create a fiduciary relationship
(relationship of trust) between the credit rating agency and theinvestor.
3. Not attestation of truthfulness of information provided by rated. company. Rating does not
imply that the credit rating agency attests the truthfulness of information provided by the rated
company.
4. Ratingnotforever.Creditratingisnotaone-timeevaluationofrisk.whichremainsvalidforthe entire
life of a security. It can change from time totime.
COMPULSORY CREDIT RATING
Obtaining credit rating is compulsory in the following cases
1. For debt securities. The Reserve Bank of India and SEBI have made credit rating compulsoryin
respect of all non-government debt securities where the maturities exceed 18months
2. Public deposits. Rating of deposits in companies has also been madecompulsory.
3. For commercial papers (CPs). Credit rating has also been made compulsory for commercial
papers. As per Reserve Bank of India guidelines rating of P2 by CRISIL or A2 by ICRA or PP2
by CARE is necessary for commercialpapers.
4. Forfixeddepositswithnon-bankingfinancialinstitutions(NBFCs).UndertheCompaniesAct,
credit rating has been made compulsory for fixed deposits withNBFs.

FACTORS CONSIDERED IN CREDIT RATING

1. Issuers ability to service its debt. For this credit rating agenciescalculate
a) Issuer company's past and future cashflows.
b) Assesshowmuchmoneythecompanywillhavetopayasinterestonborrowedfundsandhow much
will be itsearnings.
c) How much are the outstandingdebts?
d) Company's short term solvency through calculation of currentratio.
e) Value of assets pledged as collateral security by thecompany.
f) availability and quality of raw material used, favorable location, costadvantage.
g) Track record of promoters, directors and expertise of thestaff.
2. Market positon of the company. What is the market share of various products of the company,
whetheritwillbestable,doesthecompanypossesscompetitiveadvantageduetodistributionnet- work,
customer base research and development facilitiesetc.
3. Quality of management. Credit rating agency will also take into consideration track record,
strategies, competency and philosophy of seniormanagement.
4. Legal position of the instrument. It means whether the issued instrument is legally valid, what
are the terms and conditions of issue and redemption; how much the instrument is protected from
frauds, what are the terms of debenture trust deedetc.
5. Industry risks. Industry risks are studied in relation to position of demand and supply for the
productsofthatindustry(e.g.carsorelectronics)howmuchistheinternationalcompetition,what are the
future prospects of that industry, is it going to die orexpand?
6. Regulatory environment. Whether that industry is being regulated by government (like liquor
industry), Whether there is a price control on it, whether there is government support for it, can it
take advantage of tax concessionsetc.
7. Otherfactors.Inadditiontotheabove,theotherfactorstobenotedforcreditratingofacompany are its
cost structure, insurance cover undertaken, accounting quality, market reputation, working
capital management, human resource quality, funding policy, leverage, flexibility, exchange rate
risksetc.
CREDIT RATING PROCESS
In India credit rating is done mostly at the request of the borrowers or issuer companies. The
borrower or issuer company requests the credit rating agency for assigning a ranking to the
proposed instrument. The process followed by most of the credit rating agencies is as follows:
1. Agreement. An agreement is entered into between the rating agency and the issuer company.
It covers details about terms and conditions for doing therating.
2. Appointment of analytical team. The rating agency assigns the job to a team of experts.The
team usually comprises of two analysts who have expert knowledge in the relevant business
area and is responsible for carrying outrating.
3. Obtaining information. The analytical team obtains the required information from the client
companyandstudiescompany'sfinancialposition,cashflows,natureandbasisofcompetition,
marketshare,operatingefficiencyarrangements,managementstrackcoststructure,sellingand
distribution record, power (electricity) and labour situation etc.
4. Meeting the officials. To obtain clarifications and understanding the client's business the
analytical team visits and interacts with the executives of theclient.
5. Discussion about findings. After completion of study of facts and their analysis by the
analytical team the matter is placed before the internal committee (which comprises of senior
analysts) an opinion about the rating istaken.
6. Meeting of the rating committee. The findings of internal committee are referred to the
“rating committee" which generally comprises of a few directors and is the final authority for
assigningratings.
7. Communication of decision. The rating decided by the rating committee is communicatedto
the requestingcompany.
8. Information to the public. The rating company publishes the rating through reports and the
press.
9. Revision of the rating. Once the issuer company has accepted the rating, the rating agency is
under an obligation to monitor the assigned rating. The rating agency monitors all ratings
during the life of theinstrument.

TYPES OF CREDIT RATING

1. Rating of bonds and debentures. Rating is popular in certain cases for bonds and debentures.
Practically, all credit rating agencies are doing rating for debentures andbonds.
2. Ratingofequityshares.RatingofequitysharesisnotmandatoryinIndiabutcreditratingagency ICRA
has formulated a system for equity rating. Even SEBI has no immediate plans for compulsory
credit rating of initial public offerings(IPOs).
3. Rating of preference shares. In India preference shares are not being rated, however Moody's
Investor Service has been rating preference shares since 1973 and ICRA has provision forit.
4. Rating of medium term loans (Public deposits, CDs etc.). Fixed deposits taken by companies
are rated on regular scale inIndia.
5. Rating of short-term instruments [Commercial Papers (CPs). Credit rating of short term
instrumentslikecommercialpapershasbeenstartedfrom1990.CreditratingforCPsismandatory which
is being done by CRISIL, ICRA andCARE.
6. Rating of borrowers. Rating of borrowers, may be an individual or a company is known as
borrower’srating.
7. Rating of real estate builders and developers. A lot of private colonisers and flat builders are
operatinginbigcities.Ratingaboutthemisdonetoensurethattheywillproperlydevelopacolony or build
flats. CRISIL has started rating of builders anddevelopers.
8. Ratingofchitfunds.Chitfundscollectmonthlycontributionsfromsaversandgiveloanstothose
participants who offer highest rate of interest. Chit funds are rated on the basis of their ability to
make timely payment of prize money to subscribers. CRISIL does credit rating of chitfunds.
9. Ratings of insurance companies. With the entry of private sector insurance companies, credit
rating of insurance companies is also gaining ground. Insurance companies are rated on the basis
of their claim paying ability (whether it has high, adequate, moderate or weak claim-paying
capacity). ICRA is doing the work of rating insurancecompanies.
10. Rating of collective investment schemes. When funds of a large number of investors are
collectively invested in schemes, these are called collective investment schemes. Credit rating
about them means (assessing) whether the scheme will be successful or not. ICRA is doing credit
rating of suchschemes.
11. Ratingofbanks.PrivateandcooperativebankshavebeenfailingquiteregularlyinIndia.People like to
deposit money in banks which are financially sound and capable of repaying back the deposits.
CRISIL and ICRA are now doing rating ofbanks.
12. Rating of states. States in India are now being also rated whether they are fit for investment or
not. States with good credit ratings are able to attract investors from within the country and from
abroad.
13. Ratingofcountries.Foreigninvestorsandlendersareinterestedinknowingtherepayingcapacity and
willingness of the country to repay loans taken by it. They want to make sure that investment in
that country is profitable or not. While rating a country the factors considered are its industrial
and agricultural production, gross domestic product, government policies, rate of inflation, extent
of deficit financing etc. Moody’s, and Morgan Stanley are doing rating ofcountries.

FUNCTIONS/IMPORTANCE OF CREDIT RATING

1. It provides unbiased opinion to investors. Opinion of good credit rating agency is unbiased
because it has no vested interest in the ratedcompany.
2. Provide quality and dependable information. Credit rating agencies employ highly qualified,
trainedandexperiencedstafftoassessrisksandtheyhaveaccesstovitalandimportantinformation
andthereforecanprovideaccurateinformationaboutcreditworthinessoftheborrowingcompany.
3. Provideinformationineasytounderstandlanguage.Creditratingagenciesgatherinformation,
analyseandinterpretitandpresenttheirfindingsineasytounderstandlanguagethatisinsymbols like
AAA, BB, C and not in technical language or in the form of lengthyreports.
4. Provideinformationfreeofcostoratnominalcost. Creditratingsofinstrumentsarepublished in
financial newspapers and advertisements of the rated companies. The public has not to pay for
them. Even otherwise, anybody can get them from credit rating agency on payment of nominal
fee. It is beyond the capacity of individual investors to gather such information at their owncost.
5. Helps investors in taking investment decisions. Credit ratings help investors in assessing risks
and taking investmentdecision.
6. Disciplines corporate borrowers. When a borrower gets higher credit rating, it increases its
goodwillandothercompaniesalsodonotwanttolagbehindinratingsandinculcatefinancial
 discipline in their working and follow ethical practice to become eligible for good ratings, this
tendency promotes healthy discipline among companies.
7. Formationofpublicpolicyoninvestment.Whenthedebtinstrumentshavebeenratedbycredit rating
agencies, policies can be laid down by regulatory authorities (SEBI, RBI) about eligibility of
securities in which funds can be invested by various institutions like mutual funds, provident
fundstrustetc.Forexample,itcanbeprescribedthatamutualfund cannotinvestindebenturesof a
company unless it has got the rating ofAAA.

BENEFITS OF CREDIT RATING

Credit rating offers many advantages which can be classified into
A. Benefits toinvestors.
B. Benefits to the rated company.
C. Benefits tointermediaries.
D. Benefits to the businessworld.

BENEFITS TO INVESTORS
1. Assessment of risk. The investor through credit rating can assess risk involved in an investment.
A small individual investor does not have the skills, time and resources to undertake detailed risk
evaluation himself. Credit rating agencies who have expert knowledge, skills and manpower to
study these matters can do this job for him. Moreover, the ratings which are expressed insymbols
like AAA, BB etc. can be understood easily byinvestors.
2. Information at low cost. Credit ratings are published in financial newspapers and are available
fromratingagenciesatnominalfees.Thiswaytheinvestorsgetcreditinformationaboutborrowers at no
or littlecost.
3. Advantage of continuous monitoring. Credit rating agencies do not normally undertake rating
of securities only once. They continuously monitor them and upgrade and downgrade the ratings
depending upon changedcircumstances.
4. Provides the investors a choice of Investment. Credit ratings agencies helps the investors to
gather information about creditworthiness of different companies. So, investors have a choice to
invest in one company or theother.
5. Ratings by credit rating agencies is dependable. A rating agency has no vested interest in a
security to be rated and has no business links with the management of the issuer company. Hence
ratings by them are unbiased andcredible.
BENEFITS TO THE RATED COMPANY
1. Ease in borrowings. If a company gets high credit rating for its securities, it can raise funds with
more ease in the capitalmarket.
2. Borrowingatcheaperrates.Afavourablyratedcompanyenjoystheconfidenceofinvestorsand
therefore, could borrow at lower rate ofinterest.
3. Facilitates growth. Encouraged by favourable rating, promoters are motivated to go in for plans
of expansion, diversification and growth. Moreover, highly rated companies find it easy to raise
funds from public through issue of ownership or credit securities in future. They find it easy to
borrow frombanks.
4. Recognitionoflesserknowncompanies.Favourablecreditratingofinstrumentsoflesserknown or
unknown companies provides them credibility and recognition in the eyes of the investing
public.
5. Addstothegoodwilloftheratedcompany.Ifacompanyisratedhighbyratingagenciesitwill
automatically increase its goodwill in themarket.
6. Imposes financial discipline on borrowers. Borrowing companies know that they will get high
creditratingonlywhentheymanagetheirfinancesinadisciplinedmanneri.e.,theymaintaingood
operating efficiency, appropriate liquidity, good quality assets etc. This develops a sense of
financial discipline among companies who want toborrow.
7. Greaterinformationdisclosure.Togetcreditratingfromanaccreditedagency,companieshave to
disclose a lot of information about their operations to them. It encourages greater information
disclosures, better accounting standards and improved financial information which in turn help in
the protection of theinvestors.

BENEFITS TO INTERMEDIARIES

1. Merchant bankers' and brokers' job made easy. In the absence of credit rating, merchant
bankers or brokers have to convince the investors about financial position of the borrowing
company. If a borrowing company's credit rating is done by a reputed credit agency, the task of
merchant bankers and brokers becomes much easy.

BENEFITS TO THE BUSINESS WORLD

1. Increaseininvestorpopulation.Ifinvestorsgetgoodguidanceaboutinvestingthemoneyindebt
instrumentsthroughcreditratings,moreandmorepeopleareencouragedtoinvesttheirsavingsin
corporatedebts.
2. Guidance to foreign investors. Foreign collaborators or foreign financial institutions will invest
in those companies only whose credit rating is high. Credit rating will enable them to instantly
identify the position of thecompany.
CREDIT RATING AGENCIES IN INDIA
There are 6 credit rating agencies which are registered with SEBI. These are CRISIL, ICRA,
CARE, Fitch India, Brickwork Ratings, and SMERA.

1. Credit Rating and Information Services of India Limited(CRISIL)

 It is India’s first credit rating agency which was incorporated and promoted by the
erstwhile ICICI Ltd, along with UTI and other financial institutions in1987.
 After 1 year, i.e. in 1988 it commenced itsoperations
 It has its head office in Mumbai.
 ItisIndia’sforemostproviderofratings,dataandresearch,analyticsandsolutions, with
a strong track record of growth andinnovation.
 It delivers independent opinions and efficientsolutions.
 CRISIL’s businesses operate from 8 countries including USA, Argentina, Poland,
UK, India, China, Hong Kong andSingapore.
 CRISIL’s majority shareholder is Standard &Poor’s.
 It also works with governments and policy-makers in India and other emerging
markets in the infrastructuredomain.
2. Investment Information and Credit rating agency(ICRA)
 The second credit rating agency incorporated in India was ICRA in1991.
 It was set up by leading financial/investment institutions, commercial banks and
financial services companies as an independent and professional investment
Information and Credit RatingAgency.
 It is a public limitedcompany.
 It has its head office in NewDelhi.
 ICRA’s majority shareholder isMoody’s.
3. Credit Analysis & Research Ltd.(CARE)
 The next credit rating agency to be set up was CARE in1993.
 It is the second-largest credit rating agency inIndia.
 It has its head office in Mumbai.
 CARERatingsisoneofthe5partnersofaninternationalratingagencycalledARC
Ratings.
4. ONICRA
 It is a private sector agency set up by OnidaFinance.
 It has its head office inGurgaon.
 Itprovidesratings,riskassessmentandanalyticalsolutionstoIndividuals,MSMEs
andCorporates.
 It is one of only 7 agencies licensed by NSIC (National Small Industries
Corporation) to rateSMEs.
 They have Pan India Presence with offices over 125locations.
Mutual Funds –

Introduction
There are many investment avenues available in the financial market for an investor.
Investors can invest in bank deposits, corporate debentures and bonds, post office saving
schemes etc. where, there is low risk together with low return. They may invest in stock of
companies where the risk is high and sometimes the returns are also proportionately high. For
retail investors, who do not have the time and expertise to analyze and invest in stock, Mutual
Funds is a viable investment alternative. This is because Mutual Funds provide the benefit of
cheap access to expensive stocks. A Mutual Fund is a collective investment vehicle formed
with the specific objective of raising money from a large number of individuals and investing
it according to a pre-specified objective, with the benefits accrued to be shared among the
investors on a pro-rata basis in proportion to their investment. According to Encyclopedia
Americana, “Mutual funds are open end investment companies that invest shareholders’
money in portfolio or securities. They are open ended in that they normally offer new shares
to the public on a continuing basis and promise to redeem outstanding shares on any business
day.” According to Securities and Exchange Board of India Regulations, 1996 a mutual fund
means “a fund established in the form of trust to raise money through the sale of units to the
public or a section of the public under one or more schemes for investing in securities,
including money market instruments”.
Concept of Mutual Fund
A Mutual Fund is a trust registered with the Securities and Exchange Board of India (SEBI)
which pools up the money from individual/corporate investors and invests the same on behalf
of the investors/units holders, in equity shares, government securities, bonds, call money
market etc. The income earned through these investments and the capital appreciations
realized are shared by its unit holders in proportion to the number of units owned by them.
This pooled income is professionally managed on behalf the unit-holders, and each investor
holds a proportion of the portfolio.
Operational flow of Mutual Fund
The following diagram depicts the operational flow of Mutual Fund

Parties to Mutual fund

The following diagram illustrates various entities involve in organizational structure of
mutual fund:
 Objectives of Mutual Funds
Most people have neither the time nor interest to research and select individual stocks and
bonds for their investment portfolios, and that's where mutual funds come in. Mutual funds
can invest in a variety of stocks, bonds and other assets, giving you diversification, which
means a decline in value in any one stock or bond won't significantly hurt your overall
return. A handful of well-chosen mutual funds or index funds can offer a diversified
portfolio that allows the individual investor to spend his or her time on other pursuits.
Thousands of mutual funds are available that can satisfy the objectives of different types of
investors.

Tips
 A mutual fund acts as a diversified, relatively stable investment vehicle that allows casual
investors to profit from market action without requiring constant oversight and management
on their part.

Diversification of Assets

Investors are often advised that they shouldn't "put all their eggs in one basket." Investors
who have too high of a percentage of their assets in one or two stocks can be severely
affected if one of the companies goes belly-up. Most financial experts say investors should
have at least 15 stocks in their portfolios. It takes a lot of time and effort to keep up with
that many companies. Conversely, mutual funds hold a number of stocks, which gives
investors instant diversification and protects them from a sharp decline in any one holding.

Exploring Growth Funds

Some mutual fund investors are looking for rapid growth in the value of their funds. Stocks
have historically offered the best long-term returns of any asset class, though it can be an
up-and-down ride. Stock funds that are labeled "growth" typically invest in companies with
bright prospects, while "value" funds target stocks that seem inexpensive compared with
the company's earnings.
When discussing mutual fund investments, it is important to note the distinction between
closed-end and open-end funds. Whereas there is no limit to the number of open-end fund
shares that can be purchased or distributed, closed-end funds feature a limited number of
shares. Open-end funds are also not traded on the open market, whereas closed-end funds
are traded through standard markets.

Evaluating the Benefits of ETFs

Exchange-traded funds, or ETFs, have become attractive investment opportunities for many
individuals due to the numerous benefits they offer. Thanks to a highly diverse grouping of
assets, ETFs are considered a relatively stable form of investment, and are linked to every
major index today. Compared to mutual funds, ETFs typically feature a lower expense
ratio, making them more affordable for investors.

Identifying Steady Income Opportunities

Other fund investors care more about receiving income from their investments. Numerous
stock funds invest in companies with high dividend payouts. Bond funds also can provide
steady income, as can funds that invest in real estate investment trusts, or REITs. All these
income-focused funds pass the yields along to their investors, usually on a monthly or
quarterly basis. Yields of 3 percent to 7 percent are often available with income-oriented
mutual funds.

Gaining International Exposure

Some large international firms offer their shares on U.S. markets, but others don't. For
example, individual investors can have a hard time getting access to shares in the fast-
growing Chinese market. But international-focused mutual funds have an easier time
investing in these shares. Exposure to overseas stocks and mutual funds may add much-
needed diversification and open the door to additional lucrative opportunities.

Benefitting From Low Fees

Stock picking can be expensive thanks to broker commissions, but many "no-load" mutual
funds are available that don't charge investors anything. Many other funds charge investors
less than 1 percent a year for operational fees.
Investors looking for especially inexpensive funds might consider index funds, which
charge fees as low as 0.1 percent per year. In 2018, Fidelity even introduced zero-fee index
funds. These funds usually hold every stock or bond in a given asset class, which offers
tremendous diversification at a low cost.

Mutual Fund Functions

The personalized sales approach of the modern investment industry has helped fuel recent
growth in mutual funds, but investors mainly flock to them because of their versatility.
Mutual funds pool assets and let you invest in different industries and different types of
stocks and bonds with the help of investment professionals. These funds have multiple
functions, such as saving you time and money, as well precisely tailoring your portfolio to
reach your financial objectives. Pooling your funds with other investors can also grant you
access to blue-chip stocks and expensive investments you couldn't afford on your own.

Exploring Fund Management

When you invest in a mutual fund, you benefit from professional money managers and
their research team. Spectacular returns aren't guaranteed just because professionals run
the fund, but you do know your funds lie in the hands of an experienced crew who
understand the financial markets. This means you don't have to spend a lot of time
researching stocks yourself, as you would if you were investing in individual stocks.
Instead, mutual fund managers track the financial markets and the day-to-day fluctuation of
different industries for you and then act accordingly.
Understanding Fund Diversification

When you buy into a mutual fund you have the opportunity to buy multiple stocks, bonds or
other assets, depending on the type of fund it is. This diversified approach minimizes the
effect of price fluctuations in a single asset. The more assets you own, the less overall
effect each individual asset has on your portfolio.
Invest in a single mutual fund and you are already more diversified than if you purchased a
single stock. Buying multiple funds, including bond, stock and money-market funds,
provides a diversification level nearly impossible to achieve by purchasing stocks and
bonds one at a time.

Evaluating Cost-Effectiveness

When you buy a fund, you will have to pay a commission as well as a yearly management
fee. Ranging from 1 percent of your total investment to several percentage points, this
fee compensates the fund controllers for managing your money. Don't let these fees deter
you from investing. Remember that mutual funds hold multiple assets. Purchasing all those
assets individually to attain a similar diversification level on your own could result in
an even more expensive commission bill and higher brokerage fees.

Assessing Your Precise Investment Goals

Mutual funds let you tailor your portfolio to meet investment objectives by purchasing
different fund types. Mutual funds range from conservative and low-risk to exotic and high-
risk. Bonds and money-market funds are typically low-risk, providing stable but relatively
small returns. Funds invested in domestic and foreign stock are riskier than bond funds, but
over the long haul usually provide a higher return.

Organization and Management

Organisation Structure of Mutual Funds in India

Introduction

What we often phrase as “Mutual Fund” is actually a type of business. Within this line of
business, there are approximately 35-40 nos fund houses.

These fund house are actually the companies, whom SEBI has allowed to operate mutual
fund schemes. It is these schemes which we common people buy and sell as investment
products.

I am sure you already know this, but allow me to present this information in a more graphical
form for clearer understanding.
India’s Top 5 Fund Houses in term of the size of the Asset Under Management (AUM) – as
on Dec’18, are listed below:

SL Mutual Fund Houses AUM (Rs.Crore)

1 HDFC Mutual Fund 3,34,964
2 ICICI Prudential Mutual Fund 3,07,735
3 SBI Mutual Fund 2,64,353
4 Aditya Birla Sun Life Mutual Fund 2,42,344
5 Reliance Mutual Fund 2,36,256

The most visible person of a mutual fund is the “Fund Manager”. But do you know, there is a
Chairman, CEO, CFO of a fund house?

Example: Aditya Birla Sun Life Mutual Fund.

 Chairman: Kumar Mangalam Birla.

 CEO: A. Balasubramanian.

To have more clarity about how a mutual fund operates, we will have to know the
organisation structure of a typical mutual fund house in India.

THREE TIER STRUCTURE OF FUND HOUSE

The three tier structure of a mutual fund house consist of the following heads:
 1. Sponsor.
2. Trustee.
3. AMC.

It is SEBI who has prepared the framework of the above 3-tier structure of mutual funds. All
mutual funds operates in India under SEBI guidelines.

It is the SPONSORS (also called promoters) who first conceptualise the idea of starting a
mutual fund business. Before they can act further, they must approach SEBI
for registration of the business.

If the sponsors has the necessary credentials, SEBI will issue the “Certificate of Registration”
to the sponsors. Which are the credentials required?

 The sponsor must have experience of 5 years in financial services.

 They must be a profit making company (3 out of 5 years).
 Last 5 years net worth of the company must be positive.

Once the certification is received, further steps can be taken to start a mutual fund activity.
Which are the next steps?

1. Formation of Trust.
2. Appointment of AMC.
3. Appointment of Depository (Custodian), Registrar, Transfer Agent, and Auditor.

#1. Trustee – Father Figure

The sponsors of mutual fund forms a Trust. This Trust must have a “Board of Trustees” (like
board of directors).
Who shall be in the Board of Trustee (BOT)? There is a stipulation of SEBI which must be
followed in the BOT.

The minimum strength of the board must be four (4) members.

Out of the whole board members, two-third members must be “Independent Directors”. Who
are independent directors? Those people who have no relation with the sponsors in any way.

The idea of the formation of a Trust is to have a management in place. The priority of this
management will be like this:

“Protect the interest of the unit-holders and their invested money”

It is also the responsibility of the Trustee to ensure that, mutual fund operates as per the
regulations of SEBI.

As per SEBI guidelines, at all times, out of the total net worth of the AMC, a minimum
amount must be contributed by the sponsors.

There is another reason why SEBI has stipulated such strict norms related to the Board of
Trustees. What is the reason? Generally corporate houses are the sponsors of mutual fund
schemes. Example: Tata Group, ICICI bank, Mahindra and Mahindra Group, HDFC bank
etc.

SEBI has stipulated such rules to ensure that the investors pooled money is not used by the
sponsors in their group companies.

BOT members may not engaged in the day to day operations of the mutual fund.

Daily operations of the mutual fund is managed by the appointed “Managers (AMC)” and
other team members.

#2. AMC – Manager of Mutual Fund

After Trustees, the most important entity in the mutual fund is its AMC (The Asset
Management Company).

AMC of a mutual fund is formed as per the “Companies Act 1956”. The AMC must also be
registered with the Government of India accordingly.

After an AMC is registered, it will start functioning as a full fledged company. This is one
reason why we see the following three types of AMC’s in India:

1. Private Limited Company.

2. Wholly Owned Subsidiary of an already Public Limited Co.
3. Joint Venture (Indian or Overseas Companies).

When the trustees are forming the AMC, it is also their job to appoint the following managers
who will in turn run the AMC:
  CEO
 Chief Investment Officer.
 Fund Manager
Chief Marketing Officer (CMO)Chief Operations Officer (COO)Compliance
Officer.Etc.
 Chief Marketing Officer (CMO)Chief Operations Officer (COO)Compliance
Officer.Etc.

Example of Three Tier Structure:

#3. What is the role of the Custodian (Depository)?

A mutual fund scheme purchases various types of financial assets. Some of these assets can
be like this:

1. Stocks of companies.
2. Government bonds.
3. Company deposits.
4. Cash etc.

It is the responsibility of the depository (custodian) to hold all financial assets safely in its
custody.

A good analogy of a ‘depository’ is our bank’s locker. In the locker we can keep important
documents, jewellery etc.

Example: HDFC Bank provides custodian service to ICICI Pru Mutual Fund.
#4. What a Transfer Agent does?

AMC appoints a transfer agent. The transfer agent handles the following:

 Communication with investors.

 Maintains investors data.
 Process all transactions of units (purchased or redeemed).

Example: For ICICI Pru Mutual Fund, the transfer agent is ICICI Infotech along with CAMS
Ltd. For Tata AMC, the transfer agent if CAMS.
#5. What is the role of a Registrar?

Again, it is the AMC who appoints the Registrar for its mutual funds.

These days generally the role of Transfer Agent and Registrar is performed by the same
company.

In India the most common registrar utilised by mutual fund companies are CAMS and Karvy.

The main functions of Registrar are the following:

 Data Entry.
 Send Account Statements to Investors.
 Etc.
#6. Role of an Auditor…

As per companies act, all companies must get their book of accounts audited by an external
financial auditor. These auditors are basically certified chartered accountants.

All financial transactions done by a mutual fund company must be presented to the auditors
for scrutiny. At the end of the financial year, the auditors also checks and certifies the
financial reports prepared by the mutual fund companies.

Guidelines for Mutual Funds

The regulator for markets in India, SEBI (Securities and Exchange Board of India), works for
the protection of investors’ interest in securities while regulating and promoting the
securities’ market. The organisation has created guidelines for investors to gain awareness
regarding the manner in which mutual funds function by offering the required information.
The regulator aims to simplify the wide variety of schemes that tend to confuse investors due
to their complexity. The guidelines regarding the consolidation and merger of MF schemes
are created in an effort to make it easier for investors to compare different schemes made
available by mutual fund companies.
Guidelines Regarding Structure
 The guidelines regarding the structure of schemes define a Guarantor as someone who
introduces a mutual fund. The guarantor’s role is to generate revenue through the launch of a
mutual fund. The fund is then handed to a fund manager.
A sponsor, according to the guidelines, is defined as someone who sets up schemes in
keeping with the regulations of the Indian Trust Act, 1882. Sponsors primarily have the role
of listing the schemes with the Securities and Exchange Board of India.
The Securities and Exchange Board of India is responsible for making policies related to
mutual funds. It also has the responsibility of regulating the industry and laying down the law
so that investors’ interest is safeguarded. So far as ‘asset allocation’ and ‘investment strategy’
are concerned, mutual funds can be very different from one another. The new guidelines have
focused on uniformity so far as the functioning of schemes is concerned. Investors will,
therefore, find it easier to make investment decisions. To make things standard and to
introduce uniformity in schemes that are similar to one another, the following is the manner
in which mutual funds are categorised:
 Equity funds
 Debt funds
 Balanced or hybrid funds
 Solution-oriented funds
 Other funds

Major Highlights of SEBI Regulations for Investment in Mutual Funds

The following are the major highlights of the regulator’s guidelines regarding mutual funds:
 Mutual funds have been categorised into 5 groups – equity, debt, balanced, solution-
oriented, and others.
 Definitions of small, mid, and large cap have been made clearer to facilitate uniformity.
 Solution-oriented funds come with a lock-in period.
 Only one scheme is permitted in each category, apart from ETFs or index funds, thematic
or sectoral funds, and fund of funds.
Apart from laying down the law, the Securities and Exchange Board of India has also created
guidelines for investors.
SEBI Guidelines for Investors
 Assessing personal finances: Mutual funds are highly diverse investment options. As a
result, they carry some risk with them. Investors are urged to be clear when they assess
their financial standing. They are also asked to be careful when assessing their ability to
bear risk in case a scheme does not perform as expected. The risk appetite of investors
must be considered individually in keeping with each scheme.
 Research information regarding schemes: Before making investments in mutual funds, it is
essential for investors to attain detailed information regarding the scheme in which they
wish to invest. Equipping yourself with all the details regarding your investment options
will make it easy to make the right decision.
 Diversification of portfolios: Investors can spread their investments carefully by
diversifying their portfolios. As a result, the potential to mitigate risks or maximise profits
of potentially major losses increases. Diversification of portfolios is instrumental in gaining
sustainable long-term financial results.
 Refrain from cluttering portfolios: Select the right funds to create a portfolio needs
professional management of the schemes in addition to careful monitoring. Investors
should ensure that their portfolio is not cluttered while choosing the number of schemes to
add to their portfolio in order to ensure that the schemes can be well-managed individually
as well as collectively.
 Assign time frames: Investors are advised to ensure that a time frame is assigned to each
scheme in order to ensure that the plan grows. If there is stability in the maintenance of the
schemes, market fluctuations and volatility can be curbed significantly.
Effects of New Categorisation on Investors
Investors will be affected by the new categorisation in the following ways:
 The number of schemes available may be lower, thus making it relatively easier for
investors to make a selection.
 Some schemes may be merged with others.
 The expense ratio of investors could decline because of the higher Assets Under
Management per scheme.
Experts suggest that the latest guidelines regarding the merger and consolidation of schemes
will essentially simplify things for investors when it comes to comparing and investing in the
numerous schemes made available by fund houses. The guidelines are also expected to
reduce clutter while introducing uniformity, thereby making it easy for individuals across the
country to invest in mutual funds.

Debt Securitization

Securitization is the method of converting the receivables of the financial institutions, i.e.,
loans and advances, into bonds which are then sold to the investors. In simple terms, it is the
means of turning the illiquid assets into liquid assets to free up the blocked capital.

The receivables on debts against collateral assets like property, land, building and other real
estate, become exchangeable financial instruments in this process of securitization.

Securitization Process

Securitization is a complex and lengthy process since it is the conversion of the receivables
into bonds; it involves multiple parties.

The steps involved in the process of securitization are as follows:

Origination Function: The borrower approaches a bank or other financial institution

(originator) for a loan. The respective financial institution allows a certain sum as debts in
exchange for any collateral.

Pooling Function: The originator then sells off its receivables through pledge receipts to the
special purpose vehicle.

Securitization: The SPV transforms these receivables into marketable securities, i.e., either
Pay Through Certificate or PTC (Pass-Through Certificate). These instruments are then
forwarded to the merchant banks for selling it to the investors. The investors buy these
instruments to benefit in the long run.
Since the investors extend the loan, they are liable to receive a return on investment. The
borrowers are unaware of this securitization and pay timely instalments.

The originator receives a lump sum amount, though at a discounted value from the SPV. The
merchant bank charges fees for its services.

Types of Securitization

Asset-Backed Securities (ABS)

The bonds which are supported by underlying financial assets. The receivables which are
converted into ABS include credit card debts, student loans, home-equity loans, auto loans,
etc.

Residential Mortgage-Backed Securities (MBS)

These bonds comprise of various mortgages like of property, land, house, jewellery and other
valuables.

Commercial Mortgage-Backed Securities (CMBS)

The bonds that are formed by bundling different commercial assets mortgage such as office
building, industrial land, plant, factory, etc.

Collateralized Debt Obligations (CDO)

The CDOs are the bonds designed by re-bundling the personal debts, to be marketed in the
secondary market for prospective investors.

Future Flow Securitization

The company issues these instruments over its debts receivable in a future period. The
company meets the principal and interest through its routine business operations, though such
obligations are secured against its future receivables.

Advantages of Securitization

In the securitization process, the multiple parties involved are borrowers, originator, special
purpose vehicle, merchant bank and investors.

To the Originator

The originator derives maximum benefit from securitization since the purpose is to get the
blocked funds released to take up other alluring opportunities. Let us discuss each one of
these:

Unblocks Capital: Through securitization, the originator can recover the amount lent, much
earlier than the prescribed period.
Provides Liquidity: The illiquid assets, such as the receivables on loans sanctioned by the
bank, are converted into liquid assets.

Lowers Funding Cost: With the help of securitization, even the BB grade companies can
benefit by availing AAA rates if it has an AAA-rated cash flow.

Risk Management: The financial institution lending the funds can transfer the risk of bad
debts by securitizing its receivables.

Overcoming Profit Uncertainty: When the recovery of debts is uncertain, its profitability, in
the long run, is equally doubtful. Thus, securitization of such obligations is a suitable option
to avoid loss.

Reduces Need for Financial Leverage: Securitization releases the blocked capital to maintain
liquidity; therefore, the originator need not seek to financial leverage in case of any
immediate requirement.

To the Investor

The investor’s aim is to accelerate the return on investment. Following are the different ways
in which securitization is worth investing:

Quality Investment: The purchase of MBS and ABS are considered to be a wise investment
option due to their feasibility and reliability.

Less Credit Risk: The securitized assets have higher creditworthiness since these are treated
separately from their parent entity.

Better Returns: Securitization is a means of making a superior return on their investment;

however, it depends more on the investor’s risk-taking ability.

Diversified Portfolio: The investor can attain a well-diversified portfolio on including the
securitized bonds; since these are very different from other instruments.

Benefit Small Investors: The investors having minimal capital for investment can also make
a profit out of securitized bonds.

Disadvantages of Securitization

Securitization requires proper analysis and expertise; otherwise, it may prove to be quite
unsound to the investors. Let us now discuss its various drawbacks:

 Lack of Transparency: The SPV may not disclose the complete information about the
assets included in a securitized bond to the investors.
 Complex to Handle: The whole process of securitization is quite complicated
involving multiple parties; also, the assets need to be blended wisely.
 Quite Expensive: When compared to share flotation, the cost of a securitized bond is
usually high, including underwriting, legal, administration and rating charges.
  Investor Bears Risk: The non-repayment of debts by the borrower would ultimately
end up as a loss to the investors. Therefore, the investor is the sole risk-bearer in the
process.
 Inaccurate Risk Assessment: Sometimes, even the originator fails to identify the
value of underlying assets or the associated credit risk.
 Loss from Prepayment: If the borrower pays off the sum earlier than the defined
period, the investors will not make superior gains on their investment value.

De-mat Services-need and Operations

Before getting to know what is Demat account, let us first understand why holding
documents in digital form is more beneficial than having them in physical form.
Today, we are more into digital wallets like Google Pay, Paytm, and all such. Because they
are more secured and easily accessible.
Isn’t it?
The same way, having a Demat account helps you keep all your financial assets in a single
electronic form.
The main purpose of the Demat ac is to hold all the shares that you have bought or
dematerialized (converted to electronic format physical shares) and to make trading easier for
you.
What is the Meaning of a Demat Account?
Demat account is also known as a Dematerialized account. The primary use of Demat
account is to hold shares and securities in an electronic format. It helps you in online trading
like buying or selling shares, or converting physical shares into electronic form. All the
shares, mutual funds, bonds, government securities, and other investments are saved in a
dematerialized account. Also, through demat account investors can perform intraday trades.
What is Dematerialization?
Dematerialization is the term used to define the process of transferring physical certificates
into electronic ones. Overall, it makes the documents available round the clock and accessible
at your fingertip. The main motto of dematerialization is to avoid holding physical shares and
help you with seamless tracking and monitoring. A demat account helps convert physical
shares to electronic form.
What is the Use of Demat Account?
Below are the four major features of Demat account that make you understand the need of
Demat account:

1. Lower Costs: Usually, investors need to spend on different unexpected expenses when
transacting with physical share certificates such as handling cost, stamp duty and so on. You
can eliminate the costs of holding shares in the form of physical share certificates by
choosing a Demat account. You can also get to know the exact amount of the transaction
beforehand.
2. Less Paperwork: Earlier, shares transactions used to happen through certificates or physical
receipts which used to incur a lot of paperwork and used to slow down the trading activities.
Nobody used to be able to do any transaction without presenting their certificates. A Demat
account holds shares and securities in electronic form. Hence making it easy to transact.
3. No-Risk: Trading through physical securities was always risky with the threat of physical
damage, loss, misplacement, or forgery. Demat accounts in india eliminate all these risks and
give you peace of mind.
4. Instant Transactions: Delivering physical certificates used to take days even weeks
sometimes due to the administrative system that needed to be fulfilled. With the help of
Demat account, you are avoiding the waiting period as it offers instant transactions.

Benefits of Demat Account

Following are some of the benefits that a Demat account offers,

 Easy to use, convenient, and secured.

 Automatic credit of share in the event of a company merger, bonus, consolidation, and so on.
 All the Demat account information is accessible online just using a secure login.
 You do not need to keep visiting the stock market for transactions.
 Low transaction costs
 No stamp duty
 Unlike physical shares, here you can make transactions with odd numbers too.
 If you have a common Demat account, you do not need to update details from time to time.
The companies will automatically receive your information from the Demat account.
 It offers a common banking solution.

How to use a Demat Account?

There is something important to note here before getting to know how to operate the online
Demat account. A Demat account comes with a trading account linked to it, with unique
login credentials. So, you will need to use the trading account for transacting and investing in
stocks. Demant account holds all the purchased shares while trading account helps you sell
and purchase the securities. Hence both demat and trading accounts are necessary for trading
online.
So, whenever you are planning to buy or sell a share, you should log in to the trading
account, which is also connected with your bank account. When you try to buy or sell a share,
the request is sent to a trading account of a particular stock, with all other details. Then, your
DP (Depository Participant) will forward all this to the stock exchanges immediately.
In case, if the request is to buy. The stock exchanges will find a seller who is selling a
specific number of shares. And then forwards the order to clearinghouses to debit that
quantity of shares the seller’s demat account. The same is credited into your demat account.
If the request is to sell, it works the other way around. Finally, the buyer and the seller can
hold the Demat account with Depository Participants of different depositories. You can buy
any shares or securities through the Demat account. For instance, many have been struggling
to understand how to buy mutual funds online, as mutual fund investments have been one of
the best investment options lately. The good news is, you can do all this through an online
demat account. Don’t go anywhere else!
What is the Procedure for Opening a Demat Account?
Here is the account opening process for a Demat account

1. Firstly, decide where you want to open the demat account. Then choose a DP you want to
open the Demat account with. You can find many financial institutions and brokerages
offering this service.
2. Fill up the account opening form and submit it along with the copies of all the necessary
documents and a passport size photo.
3. Have original documents handy for verification.
4. You will receive a copy of the terms and conditions agreement. Go through it.
5. A member of DP will get in touch with you and verify the details you have submitted.
6. If the application is processed, you will get a Demat account number along with a client ID
which you can use for the account online.
7. You need to pay some account opening charges such as annual maintenance charge and the
transaction fee (monthly basis). The fee differs from one to another Depository Participant.
Some DPs charge a fat fee for each transaction while some charge a percentage to the total
transaction value. DPs also charge for converting shares from physical forms to electronic
ones, or vice-versa.
8. There is no limit on the minimum number of securities to keep your account active.

Documents required for opening a Demat account

While opening a Demat account online, you need to submit your ID proof, address proof and
a passport size photo along with an opening form. You will need to submit the photocopies of
the documents required. Also, you have to keep originals handy for verification. Here is the
detailed list of documents required that are accepted as proofs for opening a Demat
account online.
Proof of Identity

 Voter ID
 Pan Card
 Passport
 IT returns
 Bank Attestation
 Telephone Bill
 Electricity Bill
 Any other ID card which has your photo, issued by state or central government and other
departments, regulatory or statutory authorities, scheduled commercial banks, PSUs (public
sector undertakings), public financial institutions, or professional bodies like ICSI, ICAI, bar
council, etc.

Proof of Address

 Passport
 Ration Card
 Driving License
 Voter ID
 Bank Statement
 Bank Passbook
 Electricity Bill
 Telephone Bill
 Agreement for Sale
 Self-Declaration by Supreme Court or High Court Judges
 Document or ID card issued by State or Central Government and its departments, regulatory
or statutory authorities, scheduled commercial banks, PSUs (public sector undertakings),
public financial institutions, or professional bodies like ICSI, ICAI, bar council, etc.

Demat Account Glossary

Following are some of the jargons associated with Demat ac that you need to know about:
Electronic Certificate
You need a bank account, Demat AC, and a trading account to deal with investments.
Whenever you purchase equity shares, your ownership for those shares is marked through a
certificate, which is available in electronic form. It is called an electronic certificate.
Central Depository
Central Depository or CD is a central agency that maintains all the information associated
with Demat accounts opened with DPs around the country. India’s CDs include NSDL
(National Securities Depository Limited) and CDSL (Central Depository Services Limited).
NSDL (National Securities Depository Limited) is the largest and oldest depository in India.
It is the first depository in India to offer trading and settlement of securities in dematerialized
account format. CDSL (Central Depository Services Limited) is the second-largest depository
in India. it facilitates account transfer.
Depository Participants DP
The depository participants DP are the fundamental intermediaries standing between the CDs
and the Demat account holders. Several banks, financial institutes, and brokerage firms that
offer Demat accounts in india to investors are all DPs.
Transaction Identification: To be able to buy or sell electronic security, you need to have a
trading account as already discussed. It is as important as opening a Demat account. Every
trading account comes with a unique ID that is used for all the investment transaction. It is
called Transaction Identification.
Portfolio Holding
A Demat account keeps all your investment holdings such as exchange-traded funds, equity
holdings, government securities, bonds, and mutual fund investments. All these together are
referred to as portfolio holding. Also, you can access them all through your Demat account.
Consolidation
If you own different portfolios of any particular company and wish to consolidate them into a
single portfolio, you can get it done by forwarding the physical certificates to the RSTA of
that company along with a letter with your signature.
Account Freezing
You have the option of freezing your account or specific security for a given period.

Role of NSDL and CSDL

National Securities Depository Limited (NSDL) is a financial organization created to hold

securities such as bonds, shares etc. in the form of physical or non-physical certificates i.e. in
dematerialized format. These securities are held in depository accounts such as funds held in
bank accounts. It facilitates prompt transfer of securities as ownership is transferred simply
through book entries. This is usually done electronically thus eliminating the extra time that
was taken in following the traditional practice where physical certificates had to be
exchanged after a trade was completed.

The capital market of India, that is more than a century old, has always been very active.
However, it had certain shortcomings like bad delivery, delayed execution of transfer, etc.
due to paper based settlements. To curb these issues, The Depositories Act, 1996, was passed
and it came into force on September 20, 1995. This act provided for creation of Security
Depositories in India for managing securities.

Securities are financial assets that can be traded, i.e., they can be bought or sold in the
financial market. They are financial instruments and include equity, fixed income
instruments, equity warrants, common stocks, etc. They can be of 2 types – debt and equity.
Debt instruments such as bank notes, bonds, debentures, etc. are like borrowed money and
hence have to be repaid. Stocks and shares provide the buyers with partial ownership of the
company.

Business Partners of NSDL

NSDL carries out its activities through various functionaries called “Business Partners” such
as:

 Depository Participants (DPs),

 Issuing companies
 Registrars and Share Transfer Agents,
 Clearing corporations/Houses of the Stock Exchanges
 Investor
 Broker

These entities should get integrated into NSDL’s depository system to provide key services to
the clearing members and investors. The investor can obtain depository services through a
depository participant of NSDL. It is similar to opening an account in bank. As a person
opens a bank account to avail the services of a bank, an investor opens a depository account
with a depository participant in order to avail depository facilities. Some salient features of
NSDL’s business partners are:

 A clearing member is allowed to open a special account with the depository system
for settling trades carried through stock exchanges.
 The clearing account helps the clearing member in receiving securities from clients
for the purpose of delivery to the Clearing House/Corporation as pay-in
 This account allows the clearing member to distribute the pay-out to clients received
from the Clearing House/Clearing Corporation.
 The clearing corporations/houses of stock exchanges also have to be electronically
linked to the depository
 Once linked, these corporations can electronically receive securities delivered by
clearing members towards pay-in
 Clearing corporations can give out securities to clearing members towards pay-out.
  An issuer can allow its shareholders to dematerialize by signing an agreement with
NSDL.
 After the issuer signs the agreement, an electronic link is established between NSDL,
issuer or its R & T Agent.
 NSDL is electronically linked to each of these business partners.
 Specific processes are defined to make an application to NSDL for becoming a
business partner.

The business partners of NSDL are as follows:

Depository Participants (DP)

NSDL provides services to the investors through Depository Participants. Bank, financial
institution, custodian, broker or any entity eligible as per SEBI regulations can be appointed
as a DP. Using the existing distribution channel helps NSDL reach large number of investors
spread across wide geographical area. Investors are required to open a depository account
with a DP to avail depository facilities. Appointment of DPs is a 2 step process:

 Evaluation and confirmation by SEBI

 Evaluation and approval by NSDL

Issuers

To become an issuer in NSDL, the entity must be able to offer dematerialization facilities to
the shareholders. Security issuers, who have entered into an agreement with NSDL can
dematerialize the security issued in NSDL depository. Issuers have to verify the certificates
and maintain electronic connectivity. Following is the process for appointment of the issuer:

 An issuer needs to submit the prescribed documents including the letter of intent,
audited financials for last 2 years, etc. to NSDL
 NSDL forwards blank Tripartite Agreement to R & T agent.
 The R&T Agent and the issuer signs the agreement
 This agreement is sent back to the NSDL

Registrar and Transfer (R&T) Agent

In NSDL depository system, the issuer can create and extinguish securities held in the demat
form. Securities in demat can be created and extinguished in 2 ways. The ways in which
securities can be created are:

 By converting the physical securities into demat form, i.e. dematerialization

 The issuer releases instructions to NSDL to credit eligible beneficial owners with
securities as per their entitlements
The two ways in which securities can be extinguished are:

 Rematerialisation, i.e. converting demat form securities into physical certificate form
 The issuer releases instructions to NSDL to debit eligible beneficial owners with
securities as per their entitlements

To effect these actions, the issuer may utilize the computer facility (named DPM-SHR) that is
built in-house or borrowed from the said R&T Agent. Thus, the R&T Agent lends the
required computer facility to confirm and execute these activities. Following is the process
for appointment of R&T agent:

 Submit an introduction letter to NSDL

 Procurement and installation of required hardware and software
 Submission of the fee to procure DPM-SHR software
 Provision of training to the personnel who shall be managing the operations and
equipment
 Pilot testing has to be done to check the working and response of the software system
configured
 When NSDL activates the respective business partner as a share registrar, R&T Agent
status is confirmed

Clearing Corporation/House

Any stock exchange that desires to facilitate settlement in demat shares should have a
clearing corporation/house with a fully operational settlement guarantee mechanism. The
settlement guarantee mechanism should be approved by SEBI. A clearing house is a mediator
between the buyers and the sellers of financial instruments. It is responsible for settling
trading accounts, clearing trades, collecting and maintaining margin money, regulating
delivery, and reporting trading data.

 The corporation needs to have an operational structure that guarantees settlement

 The corporation also ensures that the payment against delivery is done flawlessly and
in a timely manner
 NSDL has to be satisfied that the Clearing Corporation/House possesses the
operational expertise to provide services related to the settlement of transactions with
respect to securities that are in demat form
 The Clearing Corporation/House must have possession of necessary hardware and
software systems that are crucial for interaction with the Depository without
lags/timeouts.
 A clearing house has to ensure the redressal of grievances of clients and participants
with respect to its operations in relation to the depository
  The procedure for joining NSDL, systems specification and investments and expenses
to be incurred by a clearing corporation/house is same as that of Depository
Participant.

Investor

An investor is a person or entity that invests in the financial instruments. An investor has to
just open a beneficiary account with the DP along with the required documents.

Broker

Brokers are an important link between investors and the associated Clearing
Corporation/House. They must have a clearing account with any DP. Such an account can be
utilized only for the purpose of receiving and transferring the shares from and to the
concerned Clearing Corporation/House. The broker does not have any ownership rights on
the shares that move to and fro his account.

Clearing Member Accounts

The clearing member account has three parts:

 Pool Account: Shares are received from selling clients in the pool account. Transfer
to buying clients is also done from the pool account.
 Delivery Account: Shares received from selling clients are moved from the pool
account to the clearing corporation/house through the delivery account.
 Receipt Account: Shares are received in the pool account from the clearing
corporation/house through the receipt account.

entral Depository Services Limited (CDSL) is a depository service that works for the
Bombay Stock Exchange (BSE) and is promoted by the State Bank of India (SBI), Bank of
India, Bank of Baroda, HDFC Bank, Standard Chartered Bank, Axis Bank and the Union
Bank of India.

The primary function of this depository is to hold securities either in certificated or un-
certificated (dematerialized) form, and it helps enable the book-entry transfer of securities
up to 500 shares in physical form. However, most traders have now adapted to the
electronic format for trading in securities. CDSL's primary focus is to provide safe, useful,
reliable and secure depository services. CDSL began its operations from February 1999
onwards after obtaining prior clearance from market watchdog Securities and Exchange
Board of India (SEBI).

A Depository Participant (DP) offers depository services to investors. According to SEBI-

issued regulations, financial institutions, banks, custodians, and stockbrokers are eligible
to act as DPs. The DP is a CDSL-authorized agent who serves as a link between the
account holder or Beneficial Owner (BO), the issuing company, CDSL, the BO's broker
and the Stock Exchange
Investors using depository services of the depository is known as the Beneficial Owner
(BO), and they have to maintain a demat account to access the functions of the CDSL,
including the facilities of dematerialization and transferring of securities. When the
investor’s purchases securities, they are automatically credited to the depository account,
and when those securities are sold, they are automatically debited from the investor’s
depository account.

Benefits of holding demat securities in CDSL:

 As the share certificates are in an electronic format, the investor is safe from the risk
of theft, loss or damage to the physical share certificates.
 The investor need not be skeptical about the genuineness of the securities purchased
as the securities in the depository cannot be returned under objection for any reason,
and it also eliminates the risk of bad delivery.
 The securities are immediately transferred to the investor’s account as soon as the
payment is transferred to the company’s account. There is no need for the investor to
wait for the registration process from the company or its Registrar.
 The stock exchanges follow the method of T+2 rolling settlement cycle, i.e. settlement
of trades is done on the 2nd working day from the trade. This action is possible
because dematerialized securities have paved the way for liquidity and swift transfer
of securities.
 No stamp duty is applicable for investors when transferring securities in
dematerialized format.
 Companies can directly credit their investors account in case of bonus issue or rights
issue of shares.
 Any update or changes in the personal information or transmission of the BO can be
directly updated with the CDSL. A single standing instruction to the CDSL would
help the investor update their details with all companies in which they have a vested
interest.
 The CDSL also sends the investor a statement that consolidates the position of all
their holdings. This would enable investors to make informed decisions about their
financial strategy.

UNIT – V : Microfinance:
Over view of Microfinance,

Microfinance is a basis of financial services for entrepreneurs and small businesses deficient
in contact with banking and associated services. The two key systems for the release of
financial services to such customers include ‘relationship-based banking’ for individual
entrepreneurs and small businesses along with ‘group-based models’ where several
entrepreneurs come together to apply for loans and other services as a group. Similar to
banking operation traditions, microfinance entities are supposed to charge their lender’s
interests on loans. In most cases the so-called interest rates are lower than those charged by
normal banks, certain rivals of this concept accuse microfinance entities of creating gain by
manipulating the poor people’s money.
As per the World Bank estimates, more than 500 million people have improved their
economic conditions via microfinance-related entities. Microfinance is an important topic for
the IAS Exam and is included under the GS-II section of the UPSC Syllabus. Candidates can
also download the notes PDF at the end of this article.

History of Microfinance
The history of microfinance can be traced back to the middle of the 1800s. During the 1800s,
the benefits of small credits to entrepreneurs and farmers was written by Lysander Spooner,
the theorist, as a way to get people out of poverty. Later, the first cooperative lending bank
was founded independently by Friedrich Wilhelm Raiffeisen to support the farmers in rural
Germany.
The term “microfinancing” was first used in the 1970s during the development of Grameen
Bank of Bangladesh, which was founded by the microfinance pioneer, Muhammad Yunus. In
1976, Yunus institutionalized the approaches of microfinance, along with the foundation of
Grameen Bank in Bangladesh. Since, in the developing countries, a large number of people
still depends largely on subsistence farming or basic food trade for their livelihood, therefore,
smallholder agriculture in these developing countries has been supported by the significant
resources.

Microfinance in India
Lack of security and high operating costs are some of the major limitations faced by the
banks while providing loans to poor people. These limitations led to the development of
microfinance in India as an alternative to provide loans to the poor with an aim to create
financial inclusion and equality.
SEWA Cooperative Bank was initiated in 1974 in Ahmedabad, Gujarat, by Ela Bhatt which
is now one of the first modern-day microfinance institutions of the country. The National
Bank for Agriculture and Rural Development (NABARD) offered financial services to the
unbanked people, especially women and later decided to experiment with a very different
model, which is now popularly known as Self-help Groups (SHGs). The SHG-Bank linkage
programme in India has savings accounts with 7.9 million SHGs and involves the
participation of regional rural banks (RRBs), commercial banks and cooperative banks in its
operations. The origin of SHGs in India can be traced back to the establishment of the Self-
Employed Women’s Association (SEWA) in 1972.
To know more on Self-help Groups (SHGs), refer to the linked page.
In 2013, a loan of $144 million was provided by Grameen Capital India to the microfinance
groups. Apart from the Grameen Bank, another microfinance organization named Equitas
was developed in Tamil Nadu. The Southern and Western states of India are the ones
attracting the greatest number of microfinance loans.
What is MUDRA?
The central government had introduced the Micro Units Development Refinance Agency
(MUDRA) where the scheme aims to refinance collateral-free loans of up to Rs 10 lakh
granted by lending entities to non-corporate small borrowers, for revenue growth actions in
the non-farm sector. Currently, loans granted under this system have falls under three
categories namely, Shishu loans for up to Rs 50,000, Kishor loans in a range between Rs
50,001 to Rs 5 lakhs and Tarun loans ranging from Rs 5 lakhs to 10 lakhs. As a way to make
the MUDRA scheme popular, the government aims to set up a Rs 3000-crore Credit
Guarantee Fund to back these loans.

Benefits of Microfinance
As per the World Bank estimates, more than 500 million people have improved their
economic conditions via microfinance-related entities. Also, the International Finance
Corporation (IFC) estimated that, as of 2014, over 130 million people were directly benefited
from the microfinance-related operations. But, approximately only 20% of the three billion
people who fall under the category of the world’s poor can avail these microfinance
operations. IFC also helped in establishing or improving the credit reporting bureaus in 30
developing nations.
Microfinance is also a source of capital for the people. It also empowers women in particular,
which may lead to more stability and prosperity for families.
Microfinance is an important topic in the General Studies Paper-II of the UPSC exam.
Questions can be asked from this topic in both the IAS prelims as well as the IAS mains
exams. Candidates preparing for the UPSC 2021 should keep a track of the latest current
affairs topics related to any economic development in the country.

Microfinance products

Offering financial services to poor people in developing countries is expensive business. The
cost is one of the biggest reasons why traditional banks don´t make small loans, the resources
requierd for a 50$ loan is the same as for a 1000$ loan.

MFIs also have big personnel and administration costs. Field staff managers must perform
village surveys before entering a village, conduct interviews with potential borrowers,
educate the borrowers in credit discipline, travel to the villages every week to collect interest
and distribute loans and control that the loans are being used for the given purpose.

The microcredit loan cycles are usually shorter than traditional commercial loans with terms
from typically six months to a year with payments plus interest, payed weekly. Shorter loan
cycles and weekly payments help the borrowers stay current and not become surprised by
large payments. Clearly the transaction-intense nature of weekly payment collections, often
in rural areas, is more expensive than running a bank branch that provides large loans to
economically secure borrowers in a metropolitan area. As a result, MFIs must charge interest
rates that might sound high.

In order to be able to lend out money, the microfinance institutions must in addition borrow
from the traditional finance sector with commercial perspective. There´s always about 1-2%
loss on loans due to people not paying back. To be able to expand business the MFIs must
also make some profit, at least 1-2%. All in all it´s easier to understand why the MFIs charge
their customer interest rates which in first sight might appear high. With a growing market,
better economics of scale and increasing efficiency the cost will reduce and lower interest
rates are able.

For a financial institution to scale and remain sustainable, at a bare minimum it has to cover
its costs. A large bank can charge lower rates in order to recoup its costs. Because of smaller
loan size and more transactions, the MFI has to charge higher minimum rates.

Data from the MicroBanking Bulletin reports that 63 of the world’s top MFIs had an average
rate of return, after adjusting for inflation and after taking out subsidies programs, of about
2.5% of total assets. This lends to the hope that microfinance can be sufficiently attractive for
investors, as well as the mainstream in the retail banking sector.

Typical microcredit products look like this (the numbers are only hypethetical):

Product Purpose Terms Inte

Income Generation Loan Income generation, asset development 50 weeks loan paid weekly 12.5
(IGL) (eff

Mid-Term Loan (MTL) Same as IGL, available at middle (week 50 weeks loan paid weekly 12.5
25) of IGL (eff

Emergency Loan (EL) All emergencies such as health, funerals, 20 weeks loan 0%
hospitalization

Individual Loan (IL) Income generation, asset development 1-2 years loan repaid 11%
monthly
The Income Generating Loan is used for a variety of activities that generate income for their
families. Clients submit a loan application and based on approval receive the loan after one
week. Loans are paid in 50 equal, weekly installments. After completion of a loan cycle, the
client can submit a loan application for a future loan. The approach with smaller short-term
loan is to avoid long-term economic problems with bigger loans.

The Mid Term Loan is available to clients after 25 weeks of repaying their IGL loan. A client
is eligible for a MTL if the client has not taken the maximum amount of the IGL. The
 residual amount can be taken as a MTL. The terms and conditions of the MTL are otherwise
exactly the same as IGL.

The Emergency Loan is available to all clients over the course of a fiscal year. The loan is
interest free and the amount and repayment terms are agreed upon by the MFI and the client
on a case by case basis. The amount is small compared to the income generating products and
is only given in times of dire need to meet expenses such as funerals, hospital admissions,
prenatal care and other crisis situations.

The Individual Loan is designed for clients and non clients that have specific needs beyond
the group lending model. Loans are given to an individual outside of the group lending
process. Amounts are typically higher than that of the income generating loan and
repayments are less frequent. Applicants must complete a strict business appraisal process
and have both collateral and a guarantor.

Microfinance is not panacea from all troubles, this also means that not any poor person can
obtain the loan. In particular, representatives of very poor population, lacking stable income,
living by means of chance earnings, and particularly having debts (in relation to community
facilities, relatives, friends, etc…) cannot be clients of microfinance, since in case of
microcredit non-repayment they will have more debts, becoming poorer. For such people
special programs of social assistance are needed, which are able to support main needs of
people living in the poorest dwellings, lacking garments and food.

There is some restrictions regarding what the money is used for. Usually micro credits can´t
be used for the purposes like:

 Payments of other loans or other debts;

 Production of tobacco and liquor;
 Forming turnover capital of trade and intermediary business;
 Organization or purchasing products for gambling or entertainment services for the
population;
 Establishing trading points;
 Purchase of property that´s not used for business.

In the microfinance sector there´s other services expanding as well. The poor need, like all of
us, a secure place to save their money and access to insurance for their homes, businesses and
health. Microfinance institutions are now innovating new products to help meet these needs,
empowering the world’s poor to improve their own lives. Products common used in the
microfinance sector today is:

 Micro savings – A possibility to save money without no minimum balance. Allows people to
retain money for future use or for unexepected costs. In SHGs the members save small
amounts of money, as little as a few rupees a month in a group fund. Members may borrow
from the group fund for a variety of purposes ranging from household emergencies to school
fees. As SHGs prove capable of managing their funds well, they may borrow from a local
bank to invest in small business or farm activities. Banks typically lend up to four rupees for
every rupee in the group fund;
 Micro insurance – Gives the entrepreneurs the chance to focus more on their corebusiness
which drastically reduces the risk affecting their property, health or workingpossibilities. The
is different types of insurance services like life insurance, property insurance, healt insurance
and disability insurance. The spectrum of services in this sphere is constantly expanded, as
schemes and terms of providing insurance services are determined by each company
individually;
 Micro leasing – For entrepreneurs or small businesses who can´t afford buy at full cost they
can instead lease equipment, agricultural machinery or vehicles. Often no limitations of
minimum cost of the leased object;
 Money transfer – A service for transferring money, mainly overseas to family or friends.
Money transfers without opening current accounts are performed by a number of commercial
banks through international money transfer systems such as Western Union , Money Gram,
and Anelik. On the surface they may seem like small money transfers, but when one
considers that such transactions take place millions of times around the world each week, the
numbers start to become impressive. According to the World Bank, the annual global market
for remittances – money transferred home from migrant workers – is around 167 billion US
dollars. The estimated total is closer to 230 billion dollars if one counts unregulated
transactions. Remittances are also an important source of income for many developing
countries including India, China and Mexico, all of which receive over 20 billion dollars each
year in remittances from abroad.

Micro-remittances,
Micro Securitization.
Microfinance models:

"Microfinance:Credit Lending Models" is an attempt to document the various models currently

being used by microfinance institutions throughout the world.

A total of 14 models are described below. They include, associations, bank guarantees,
community banking, cooperatives, credit unions, grameen, group, individual, intermediaries,
NGOs, peer pressure, ROSCAs, small business, and village banking models.

In reality, the models are loosely related with each other, and most good and sustainable
microfinance institutions have features of two or more models in their activities.

Many of these models are in deed "formalized" versions of informal financial systems. Informal
systems have historical precedents that predate modern banking systems. They are still in
existence today used mostly by low-incoe households who do not have access to formal
banks. GDRC has developed a continuum of informal credit suppliers that clearly illustrates the
link between such informal systems and the models illustrated below.

The models were developed through extensive field work/observations and interviews carried
out in India, Thailand, Philippines, Indonesia and Sri Lanka, and includes information from
literature as well.

Associations Model
 This is where the target community forms an 'association' through which various microfinance
(and other) activities are initiated. Such activities may include savings. Associations or groups
can be composed of youth, women; can form around political/religious/cultural issues; can
create support structures for microenterprises and other work-based issues.

In some countries, an 'association' can be a legal body that has certain advantages such as
collection of fees, insurance, tax breaks and other protective measures. Distinction is made
between associations, community groups, peoples organizations, etc. on one hand (which are
mass, community based) and NGOs, etc. which are essentially external organizations.

Closely related to the group model and similar models.

Bank Guarantees Model

As the name suggests, a bank guarantee is used to obtain a loan from a commercial bank. This
guarantee may be arranged externally (through a donor/donation, government agency etc.) or
internally (using member savings). Loans obtained may be given directly to an individual, or
they may be given to a self-formed group.

Bank Guarantee is a form of capital guarantee scheme. Guaranteed funds may be used for
various purposes, including loan recovery and insurance claims. Several international and UN
organizations have been creating international guarantee funds that banks and NGOs can
subscribe to, to onlend or start microcredit programmes.

Community Banking Model

Community Banking model essentially treats the whole community as one unit, and establishes
semi-formal or formal institutions through which microfinance is dispensed. Such institutions
are usually formed by extensive help from NGOs and other organizations, who also train the
community members in various financial activities of the community bank.

These institutions may have savings components and other income-generating projects included
in their structure. In many cases, community banks are also part of larger community
development programmes which use finance as an inducement for action.

Closely related to the village banking model.

Cooperatives Model
A co-operative is an autonomous association of persons united voluntarily to meet their
common economic, social, and cultural needs and aspirations through a jointly-owned and
democratically-controlled enterprise. Some cooperatives include member-financing and savings
 activities in their mandate.

See the International Cooperative Alliance website for more details.

Credit Unions Model

A credit union is a unique member-driven, self-help financial institution. It is organized by and
comprised of members of a particular group or organization, who agree to save their money
together and to make loans to each other at reasonable rates of interest.

The members are people of some common bond: working for the same employer; belonging to
the same church, labor union, social fraternity, etc.; or living/working in the same community.
A credit union's membership is open to all who belong to the group, regardless of race, religion,
color or creed.

A credit union is a democratic, not-for-profit financial cooperative. Each is owned and

governed by its members, with members having a vote in the election of directors and
committee representatives.

Grameen Model
The Grameen model emerged from the poor-focussed grassroots institution, Grameen Bank,
started by Prof. Mohammed Yunus in Bangladesh. It essentially adopts the following
methodology:

A bank unit is set up with a Field Manager and a number of bank workers, covering an area of
about 15 to 22 villages. The manager and workers start by visiting villages to familiarize
themselves with the local milieu in which they will be operating and identify prospective
clientele, as well as explain the purpose, functions, and mode of operation of the bank to the
local population.

Groups of five prospective borrowers are formed; in the first stage, only two of them are
eligible for, and receive, a loan. The group is observed for a month to see if the members are
conforming to rules of the bank.

Only if the first two borrowers repay the principal plus interest over a period of fifty weeks do
other members of the group become eligible themselves for a loan.

Because of these restrictions, there is substantial group pressure to keep individual records
clear. In this sense , collective responsibility of the group serves as collateral on the loan.

More information on Grameen Bank can be found in the Case Studies section.
Group Model
The Group Model's basic philosophy lies in the fact that shortcomings and weaknesses at the
individual level are overcome by the collective responsibility and security afforded by the
formation of a group of such individuals.

The collective coming together of individual members is used for a number of purposes:
educating and awareness building, collective bargaining power, peer pressure etc.

The Group model is closely related to, and has inspired, many other lending models. These
include Grameen, community banking, village banking, self-help, solidarity, peer pressure etc.

One example of the Group Model is "Joint Liability". When a group takes out a loan, they are
jointly liable to repay the loan when one of the group's members defaults on the repayments.

Several resources for the group model can be found in the Capacity Building for
Microfinance section.

Individual Model
This is a straight forward credit lending model where micro loans are given directly to the
borrower. It does not include the formation of groups, or generating peer pressures to ensure
repayment.

The individual model is, in many cases, a part of a larger 'credit plus' programme, where other
socio-economic services such as skill development, education, and other outreach services are
provided.

Intermediaries Model
Intermediary model of credit lending positions a 'go-between' organization between the lenders
and borrowers. The intermediary plays a critical role of generating credit awareness and
education among the borrowers (including, in some cases, starting savings programmes. These
activities are geared towards raising the 'credit worthiness' of the borrowers to a level sufficient
enough to make them attractive to the lenders.

The links developed by the intermediaries could cover funding, programme links, training and
education, and research. Such activities can take place at various levels from international and
national to regional, local and individual levels.

Intermediaries could be individual lenders, NGOs, microenterprise/microcredit programmes,

and commercial banks (for government financed programmes). Lenders could be government
agencies, commercial banks, international donors, etc.

Most models mentioned here invariably have some form of organizational or operational
intermediary - dealing directly with microcredit, or non-financial services. Also called the
 'partnership' model. Specifically see NGOs.

NGO Model
NGOs have emerged as a key player in the field of microcredit. They have played the role of
intermediary in various dimensions. NGOs have been active in starting and participating in
microcredit programmes. This includes creating awareness of the importance of microcredit
within the community, as well as various national and international donor agencies.

They have developed resources and tools for communities and microcredit organizations to
monitor progress and identify good practices. They have also created opportunities to learn
about the principles and practice of microcredit. This includes publications, workshops and
seminars, and training programmes.

See Internet Resources and Networking sections of the Virtual Library.

Peer Pressure Model

Peer pressure uses moral and other linkages between borrowers and project participants to
ensure participation and repayment in microcredit programmes. Peers could be other members
in a borrowers group (where, unless the initial borrowers in a group repay, the other members
do not receive loans. Hence pressure is put on the initial members to repay); community leaders
(usually identified, nurtured and trained by external NGOs); NGOs themselves and their field
officers; banks etc.

The 'pressure' applied can be in the form of frequent visits to the defaulter, community meetings
where they are identified and requested to comply etc.

The Grameen model extensively uses peer pressure to ensure repayment among its borrower
groups.

ROSCA Model
Rotating Savings and Credit Associations or ROSCAs, are essentially a group of individuals
who come together and make regular cyclical contributions to a common fund, which is then
given as a lump sum to one member in each cycle.

For example, a group of 12 persons may contribute Rs. 100 (US$33) per month for 12 months.
The Rs. 1,200 collected each month is given to one member. Thus, a member will 'lend' money
to other members through his regular monthly contributions.

After having received the lump sum amount when it is his turn (i.e. 'borrow' from the group), he
then pays back the amount in regular/further monthly contributions. Deciding who receives the
 lump sum is done by consensus, by lottery, by bidding or other agreed methods.

See "A Typology of Informal Credit Suppliers"

Small Business Model

The prevailing vision of the 'informal sector' is one of survival, low productivity and very little
value added. But this has been changing, as more and more importance is placed on small and
medium enterprises (SMEs) - for generating employment, for increasing income and providing
services which are lacking.

Policies have generally focussed on direct interventions in the form of supporting systems such
as training, technical advice, management principles etc.; and indirect interventions in the form
of an enabling policy and market environment.

A key component that is always incorporated as a sort of common denominator has been
finance, specifically microcredit - in different forms and for different uses. Microcredit has
been provided to SMEs directly, or as a part of a larger enterprise development programme,
along with other inputs.

Village Banking Model

Village banks are community-based credit and savings associations. They typically consist of
25 to 50 low-income individuals who are seeking to improve their lives through self-
employment activities.

Initial loan capital for the village bank may come from an external source, but the members
themselves run the bank: they choose their members, elect their own officers, establish their
own by-laws, distribute loans to individuals, collect payments and savings. Their loans are
backed, not by goods or property, but by moral collateral: the promise that the group stands
behind each individual loan.

The Village Banking model is closely related to the Community Banking and Group models.
This model is widely adopted and implemented by FINCA. See their Village Banking
Homepage.